What Is Facultative Reinsurance?
Facultative reinsurance is coverage acquired by a primary insurer for individual risks or clusters of risks within its portfolio. Unlike treaty reinsurance, which spans a broader, long-term arrangement, facultative reinsurance is tailored for potential one-off transactions.
Key Takeaways
- Facultative reinsurance is designed for specific or a group of risks within the primary insurer’s business portfolio.
- This type of reinsurance enables thorough risk evaluation by the reinsurer, allowing them to selectively accept or reject risks, providing a more focused approach compared to treaty reinsurance.
- By covering individual risks, it provides greater security and stability to insurers, especially in atypical or major events.
How Facultative Reinsurance Works
When an insurance company decides to transfer some of its risk to a reinsurer, known as the ceding company, a detailed reinsurance contract is established. This contract varies by the reinsurance type—either specific or a chunk of risks—and dictates the reinsurer’s right to assess individual risks before acceptance.
For an arrangement to enter effect, a facultative certificate is issued, indicating that the reinsurer has agreed to cover a defined risk. While facultative reinsurance setups can be costlier, especially compared to treaty reinsurance that covers broad balances of risks, they provide a customized solution for high-risk circumstances that primary insurers alone might hesitate to underwrite.
Treaty Reinsurance vs. Facultative Reinsurance
Both treaty and facultative reinsurance types can operate on proportional or excess-of-loss frameworks. Treaty reinsurance encompasses a broader scope, like an insurer’s workers’ compensation that includes all categorized risks under its terms, barring exclusions.
Facultative reinsurance, conversely, concentrates on explicit risks within insurance policies, creating contract-specific terms for each engagement, thus often appropriate for extraordinary and substantial risk exposures. This narrow focus necessitates considerable expertise and technical underwriting efforts.
Benefits of Facultative Reinsurance
- Ensures the insurer’s equity security and solvency stability amidst significant events or unique risk conditions.
- Enables underwriting without high cost spikes related to coverage of solvency margins, fostering broader market penetration with optional liquidity arrangements for unpredictable loss scenarios.
Real-World Example of Facultative Reinsurance
Consider an insurance company providing coverage for a high-valued commercial property worth $35 million. However, the company has a liability threshold of $25 million. To cover the remaining $10 million potential liability, the insurer leverages facultative reinsurance. It might distribute that $10 million across multiple reinsurers until reaching full insured value capacity.
Such a sophisticated arrangement assures the insurance entity of total coverage, thereby allowing policy issuance despite breakable risks, maintaining financial stability and full-fledged risk indemnification.
Related Terms: Reinsurance, Ceding Company, Solvency, Proportional Reinsurance, Excess-of-Loss Reinsurance.
