Facultative reinsurance is a coverage that is taken out on a specific risk, such as a large property exposure or an event cancellation. It is purchased on an individual basis, rather than as part of a treaty. This type of reinsurance is often used to cover risks that are too large or too specialized to be covered by a treaty, or to provide additional coverage for risks that are already covered by a treaty. Facultative reinsurance can be placed with any insurer that is willing to write the coverage, and the terms and conditions of the coverage are negotiated between the insurer and the reinsured.
Proportional vs. Non-proportional Reinsurance
Reinsurance is a risk management tool used by insurance companies to spread their risk exposure. There are two main types of reinsurance: proportional and non-proportional.
**Proportional reinsurance** is a type of reinsurance in which the reinsurer shares a percentage of the risk and premium with the cedent (the insurance company that purchases the reinsurance). With proportional reinsurance, the reinsurer pays a share of the claims and receives a share of the premiums in the same proportion as their share of the risk.
**Non-proportional reinsurance** is a type of reinsurance in which the reinsurer only pays claims if the loss exceeds a certain threshold (known as the “retention”). With non-proportional reinsurance, the reinsurer does not receive any of the premiums until the retention is exceeded.
The following table summarizes the key differences between proportional and non-proportional reinsurance:
| Characteristic | Proportional Reinsurance | Non-proportional Reinsurance |
|---|---|---|
| Reinsurer’s share of risk | Based on a percentage | Based on a threshold (retention) |
| Reinsurer’s share of premiums | Based on a percentage | None until retention is exceeded |
| Reinsurer’s share of claims | Based on a percentage | Only if loss exceeds retention |
Facultative Reinsurance
Facultative reinsurance is a specific type of reinsurance that is arranged on a case-by-case basis. This means that the reinsurer and the ceding insurer agree to the terms of the reinsurance contract for each individual risk that is reinsured. Facultative reinsurance is often used for large or unusual risks that are difficult to place on a treaty basis.
Facultative vs. Treaty Reinsurance
- Facultative reinsurance is arranged on a case-by-case basis, while treaty reinsurance is arranged for a specific period of time and covers a defined portfolio of risks.
- Facultative reinsurance is more flexible than treaty reinsurance, as the reinsurer can assess the risk of each individual risk before agreeing to the terms of the contract.
- Treaty reinsurance is more efficient than facultative reinsurance, as the reinsurer does not have to assess the risk of each individual risk.
- Facultative reinsurance is more expensive than treaty reinsurance, as the reinsurer has to charge a higher premium to cover the risk of assessing each individual risk.
| Characteristic | Facultative Reinsurance | Treaty Reinsurance |
|---|---|---|
| Arrangement | Case-by-case basis | Specific period of time |
| Flexibility | More flexible | Less flexible |
| Efficiency | Less efficient | More efficient |
| Cost | More expensive | Less expensive |
Coverage and Limits of Facultative Reinsurance
Facultative reinsurance provides coverage for specific risks or perils, and the reinsurer’s liability is limited to the amount of the underlying insurance policy.
Coverage
- Specific risks or perils, such as property damage, business interruption, or marine cargo
- Can be tailored to the specific needs of the ceding insurer
Limits
The limits of facultative reinsurance are typically determined by:
- The amount of the underlying insurance policy
- The reinsurer’s underwriting capacity
- The type of risk being reinsured
| Risk | Limit |
|---|---|
| Property damage | $1 million |
| Business interruption | $500,000 |
| Marine cargo | $2 million |
## What is Facultative Reinsurance?
Facultative reinsurance is a form of reinsurance where insurance coverage is arranged on an individual risk basis, often used to provide specialized protection for large or unique risks. This form of reinsurance offers flexibility and customization to address specific underwriting needs.
Benefits of Facultative Reinsurance
* **Risk Capacity:** Enhances an insurer’s ability to write more business by providing a safety net against catastrophic losses.
* **Loss Control:** Allows insurers to diversify their portfolio and manage their risk exposure by transferring specific risks to the reinsurer.
* **Special Expertise:** Facilitates access to specialized underwriting and risk assessment expertise from the reinsurer.
* **Capital Management:** Frees up capital for insurers by assuming the risks beyond their retention level.
* **Regulatory Compliance:** Helps insurers meet solvency requirements and maintain adequate capital levels.
## Types of Facultative Reinsurance
* **Quota Share:** Reinsurer shares a fixed percentage of all losses and premiums for a specific segment of the insurer’s business.
* **Excess of Loss:** Reinsurer is liable for losses above a certain deductible limit.
* **Surplus Line:** Provides coverage for risks that fall outside the scope of standard insurance policies.
* **Stop Loss:** Protects insurers from catastrophic losses that exceed a specified amount.
## Process of Facultative Reinsurance
1. **Brokerage:** Insurers work with reinsurance brokers to secure coverage from potential reinsurers.
2. **Proposal:** Insurers submit a proposal outlining the risk and terms of the reinsurance.
3. **Assessment:** Reinsurers evaluate the proposal, conduct due diligence, and determine their willingness to provide coverage.
4. **Negotiation:** Insurers and reinsurers negotiate the terms of the reinsurance contract, including coverage, premium, and deductibles.
5. **Binding:** Once the terms are agreed upon, the reinsurance contract is bound and becomes effective.
## Example of Facultative Reinsurance
Consider an insurer that has underwritten a large construction project. To protect itself against a potential catastrophic loss, the insurer purchases a facultative excess of loss reinsurance policy with a limit of $50 million and a deductible of $25 million. If the project experiences a loss of $75 million, the insurer would pay the first $25 million and the reinsurer would cover the remaining $50 million.
## Conclusion
Facultative reinsurance offers a flexible and tailored approach to risk management for insurance companies. By transferring specific risks to reinsurers, insurers can expand their risk capacity, diversify their portfolio, and manage their capital more effectively.