What is facultative reinsurance?

Facultative reinsurance is a type of reinsurance. Reinsurance is insurance for insurance companies. With facultative reinsurance, an insurance company buys reinsurance for individual insurance policies one at a time. This is different from treaty reinsurance, where an insurance company has an agreement with a reinsurance company to reinsure many insurance policies automatically.

How facultative reinsurance works

Let’s say there is an insurance company called ABC Insurance. ABC Insurance sells property insurance to businesses and homeowners. ABC Insurance wants to limit how much money it could lose if it has to pay many insurance claims. One way it can do this is by buying facultative reinsurance on some of the insurance policies it sells.

ABC Insurance has a customer named Joe’s Bakery. Joe’s Bakery bought a property insurance policy from ABC Insurance for $2 million. The insurance policy will pay Joe’s Bakery up to $2 million if the bakery is damaged or destroyed.

ABC Insurance worries that if it has to pay Joe’s Bakery the full $2 million, it will be a significant financial loss. So ABC Insurance contacts a reinsurance company called XYZ Reinsurance. ABC Insurance asks XYZ Reinsurance if it will reinsure part of Joe’s Bakery’s insurance policy.

XYZ Reinsurance looks at the details about Joe’s Bakery and decides it will reinsure half of the policy. XYZ Reinsurance and ABC Insurance sign a facultative reinsurance contract. In the agreement, XYZ Reinsurance agrees that if Joe’s Bakery makes an insurance claim, XYZ Reinsurance will pay ABC Insurance half of the claim amount, up to a maximum of $1 million. In exchange, ABC Insurance pays XYZ Reinsurance, part of the premium collected from Joe’s Bakery.

Now, ABC Insurance would have to pay Joe’s Bakery $1 million, even if the bakery is totally destroyed. XYZ Reinsurance would pay the other $1 million. ABC Insurance has limited its potential losses on Joe’s Bakery’s policy by buying facultative reinsurance. ABC Insurance has transferred some of the financial risk to XYZ Reinsurance.

When insurance companies use facultative reinsurance

Insurance companies often buy facultative reinsurance for significant insurance policies. The bigger the policy, the more the insurance company could lose if it has to pay a claim. Facultative reinsurance is a way to share that risk with a reinsurance company.

Insurance companies might also use facultative reinsurance if they are insuring something unusual with risks that are hard to predict. For example, consider ensuring a rocket launch or a famous actress’s legs. The insurance company might want a reinsurance company to share the risk.

Facultative reinsurance also helps when an insurance company grows fast and wants to sell more policies in a new area. The reinsurance lets the insurance company take on new customers while limiting its risk.

Advantages of facultative reinsurance

One advantage of facultative reinsurance for an insurance company is that it can choose which policies to reinsure. The insurance company isn’t locked into reinsuring a considerable number of policies as it would be with treaty reinsurance. The insurance company can pick just the policies where it wants help to manage the risk.

Another advantage is that the reinsurance company carefully reviews each policy before agreeing to reinsure it. The insurance and reinsurance companies both clearly understand the risk they are taking with each policy.

Disadvantages of facultative reinsurance

The main problem with facultative reinsurance is that it takes a lot of time and work. The insurance company has to negotiate with the reinsurance company for each policy it wants to reinsure. That means a lot of back-and-forth discussions and paperwork. It’s much less efficient than having an automatic treaty reinsurance agreement.

It can also be hard for an insurance company to facultatively reinsure policies if it’s a bad risk or the reinsurance company is worried there might be a lot of claims. The reinsurance company can refuse to reinsure a policy if it doesn’t like it. The insurance company doesn’t have that problem with treaty reinsurance.

The facultative reinsurance market

Many companies around the world provide facultative reinsurance. Some of the largest ones are Munich Re, Swiss Re, Hannover Re, SCOR, and Berkshire Hathaway. These reinsurance companies have bottomless pockets to take on significant risks from insurance companies.

The facultative reinsurance market also includes smaller, more specialized reinsurance companies. These often focus on particular types of risk, like aviation or marine policies.

Brokers also play a key role in the facultative reinsurance market. Reinsurance brokers help connect insurance companies with reinsurance companies. They shop an insurance policy around to different reinsurance companies to see which one will offer the best deal to reinsure it. Brokers save insurance companies a lot of time and know which reinsurers are most likely to be interested in a particular policy.

In the facultative reinsurance market, the insurance company buying the reinsurance is called the cedent or ceding company. That’s because they are ceding or transferring some of their risk to the reinsurance company. The reinsurance company is sometimes called the assuming company because it assumes the risk.

Facultative reinsurance contracts and pricing

The specific terms of a facultative reinsurance contract can vary a lot depending on the type of insurance policy and the needs of the cedent and reinsurer.

Here are some common types of facultative reinsurance contracts:

• Quota share: The reinsurer takes on a set percentage of both the premiums and losses for a policy. So if it’s a 50% quota share, the reinsurer gets half the premiums and pays half the losses.
• Surplus share: The reinsurer takes on a share of the risk that’s above the insurance company’s retention limit. So if the retention is $1M and the policy is for $5M, the reinsurer is taking 80% of the risk.
• Excess of loss: The reinsurer pays losses above a set amount. So if the cedent has a $1M excess of loss contract, the cedent pays the first $1M of a claim and the reinsurer pays the rest.

The pricing of facultative reinsurance depends on things like the type of risk being insured, the likelihood and potential size of losses, the location of the risk, and the financial strength of the cedent. Reinsurance companies use complex models to determine what premium to charge for taking on a particular slice of risk.

The reinsurance premium also has to give the reinsurer a good chance of making an underwriting profit. That means the premiums it collects should be more than the claims it pays out over time, even if it occasionally has to make a big payout.

The facultative reinsurance contract lists out exactly what risk is being reinsured, the reinsurance premium, how claims will be handled, and how the cedent and reinsurer will share information. The contract is a reinsurance policy, but it’s called a facultative certificate or a certificate of facultative reinsurance.

Recent trends in facultative reinsurance

Technology is starting to change how facultative reinsurance is transacted. In the past, facultative reinsurance involved a lot of emails, spreadsheets, and phone calls between cedents, brokers, and reinsurers. Some of that is now being streamlined with online platforms and application programming interfaces (APIs).

For example, a cedent might enter information about a policy to reinsure into an online platform. Based on their risk appetites, the platform then notifies reinsurers who might be interested. If a reinsurer intends to take a share of the policy, they just click a button to accept it. The technology makes the whole facultative reinsurance placement process faster and more efficient.

Insuretechs are also looking at ways to automate facultative reinsurance transactions using artificial intelligence and blockchain. The goal is straight-through processing, where an insurance policy is automatically reinsured based on preset rules without needing multiple rounds of human interaction.

As the risks that insurance companies cover get larger and more complex, the demand for facultative reinsurance is expected to grow. Insurance companies see it as an important tool to help manage their risk and protect their balance sheets. And reinsurance companies see it as an opportunity to deploy more of their capital at attractive returns.

Final Thoughts

Facultative reinsurance is a way for insurance companies to reduce their risk on individual insurance policies. The insurance company facultatively reinsures specific policies with a reinsurance company. In exchange for a reinsurance premium, the company agrees to pay a share of any claims on that policy.

Facultative reinsurance is especially useful for large, complex, or unusual risks an insurance company wants to offload. But it does take a lot of work to reinsure each policy facultatively, so many insurance companies only do it selectively. Treaty reinsurance is a more efficient choice for reinsuring many similar policies simultaneously.

The facultative reinsurance market is a big global business. It includes significant reinsurance companies that can take on massive risks, smaller specialty reinsurers, and brokers who help match cedents with reinsurers. As insurance companies look for more ways to manage their capital and risk, facultative reinsurance will continue to play an important role.