Overview
This lecture explains facultative reinsurance, a flexible risk-transfer method in insurance, contrasting it with treaty reinsurance and outlining its structure, benefits, and drawbacks.
What is Facultative Reinsurance?
- Facultative reinsurance is when a primary insurer (ceding company) transfers a single risk or block of risks to a reinsurer using a separate agreement for each risk.
- Each risk is individually assessed and accepted or rejected by the reinsurer.
- This approach provides flexibility but requires negotiations and documentation for each risk.
Facultative vs. Treaty Reinsurance
- Facultative reinsurance evaluates and transfers risks one by one, unlike treaty reinsurance, which covers an entire portfolio without individual risk assessments.
- Treaty reinsurance offers broader, long-term coverage; facultative is case-by-case and more tailored.
- Facultative reinsurance is more expensive and administratively intensive compared to treaty reinsurance.
Structure and Examples
- Facultative reinsurance can be arranged on a proportional (pro-rata) or excess-of-loss basis.
- Pro-rata: premiums and losses are shared in proportion to the risk transferred.
- Excess-of-loss: the ceding company keeps some liability up to a limit, with coverage above that limit provided by the reinsurer.
- Example: A primary insurer covering a $50 million warehouse seeks facultative reinsurance; multiple reinsurers independently assess and decide on the risk.
Advantages and Disadvantages
- Benefits: enhances solvency, increases liquidity, and gives primary insurers more control over risk selection.
- Disadvantages: higher costs, administrative workload, risk of documentation errors, and no guaranteed risk placement.
- Requires full disclosure to reinsurers and careful handling of contracts.
Key Terms & Definitions
- Facultative reinsurance — reinsurance where each risk is considered and negotiated separately.
- Ceding company — the primary insurer transferring the risk.
- Treaty reinsurance — reinsurance covering a pre-defined portfolio of risks, not assessed individually.
- Pro-rata basis — sharing premiums and losses proportionally between insurer and reinsurer.
- Excess-of-loss basis — reinsurer covers losses above a set threshold, primary insurer retains losses up to that point.
Action Items / Next Steps
- Review differences between facultative and treaty reinsurance.
- Understand how pro-rata and excess-of-loss arrangements work.
- Prepare for examples involving risk assessment and reinsurance structures.