Reinsurance contracts include both facultative reinsurance and reinsurance treaties. In facultative reinsurance, the leading insurer covers one risk or several risks it already has on its books. On the other hand, treaty reinsurance is when an insurance company buys insurance from another company. With facultative reinsurance, the reinsurer can look at the risks in an insurance policy and decide whether to accept them. In a treaty reinsurance policy, on the other hand, the reinsurer usually takes on all the risks that come with the policy.
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Facultative Reinsurance
Most of the time, facultative reinsurance is the easiest way for an insurer to get reinsurance coverage. These policies are also easy to change to fit different situations.
Facultative reinsurance is when an insurer buys reinsurance for a single risk or a set of risks that are known ahead of time. It happens when the reinsurance company insists on doing its underwriting for some or all of the policies to be reinsured. This is usually a one-time deal. Under these agreements, each policy written on a case-by-case basis is treated as a separate transaction and not grouped by class. The ceding company is usually less interested in reinsurance contracts and may be forced to keep only the riskiest policies.
Let’s say a standard insurance company gives a policy on a large piece of commercial property, like a big office building for a company. The policy is for $35 million, which means that if the building is badly damaged, the original insurer could be on the hook for $35 million. But the insurance company thinks it can’t pay more than $25 million. So, before the insurance company even agrees to give out the policy, it must look for facultative reinsurance and test the market until it finds buyers for the remaining $10 million. The insurer might get parts of the $10 million from 10 different reinsurers. But it can’t agree to put out the policy without that. Once the companies agree to pay the $10 million and the insurance company is sure it can pay the total amount if a claim is made, it can issue the policy.
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Reinsurance by Treaty
Treaty reinsurance is when the ceding company agrees to give the reinsurance company all of the risks in a particular class of insurance policies. In return, the reinsurance company agrees to cover all risks for the ceding company, even though it hasn’t done individual underwriting for each policy. The reinsurance often covers policies that haven’t been written yet, as long as they belong to a class that has already been agreed upon.
The most important thing about a treaty agreement is that the assuming insurer doesn’t have to do its underwriting. This structure moves the underwriting risks from the ceding company to the assuming company. This leaves the assuming company open to the risk that the risks to be insured were not correctly evaluated during the initial underwriting process.
There are many different types of treaties. The most common is called a “proportional treaty,” which involves reinsuring up to a certain amount of the ceding insurer’s original policies. The reinsurance treaty will not cover any policies written above the limit.
For example, one reinsurance company may agree to pay up to $100 million for 75% of the original insurer’s auto insurance policies. This means that the ceding company is not covered for the first $100 million in auto insurance policies written under the agreement, which are worth $25 million. This amount is called the ceding company’s retention limit. If the ceding company sells auto insurance for $200 million, it keeps $25 million of the first $100 million and all of the next $100 million unless it makes a surplus treaty. When retention limits are higher, reinsurance policy premiums are lower.
Things to think about
Reinsurance companies offer insurance to other insurers, protecting them in case the traditional insurer doesn’t have enough money to pay out all of the claims on its written policies. Reinsurance contracts are made between a reinsurer, also called an assuming company, and a reinsured, also called a ceding company. A standard insurance company can spread its own risk of loss even more by getting into a reinsurance contract.
Many policyholders share the risk of loss in a traditional insurance plan. Each policyholder pays a premium to the insurer in exchange for the insurer’s protection against some uncertain possible event. It is a way to run a business that works when the total amount of premiums paid by all members is more than the amount paid out in insurance claims. There are times, though, when the amount the insurance company pays out in claims is more than what it gets in premiums. In these situations, the insurance company is most likely to lose money.
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