Facultative vs. Treaty Reinsurance Demystified
There may come a time when an insurance company does not have enough working capital to back all the policies they want to underwrite. Or, an insurance company may wish to purchase reinsurance to help minimize their risk on a certain policy or book of business.
In these situations, the company should consider purchasing reinsurance. Reinsurance is where an insurance company will transfer portions of their risk portfolios to other parties through some form of agreement. But not all reinsurance policies are the same.
There are two types of reinsurance – facultative and treaty. While they are both forms of reinsurance, facultative considers each policy individually and generally indicates a shorter term relationship. Treaty, on the other hand, considers multiple policies of a specific class of insurance issued by an insurance company and indicates the companies will work together longer term.
Not sure which to choose? Read on to learn all about reinsurance and when it is appropriate to purchase each type.
Why Do Insurance Companies Need Reinsurance?
As mandated by insurance regulations, an insurance company can only write policies that they have sufficient capital to cover. If an insurance company wishes to expand their book of business, at some point they may not have enough capital to be able to continue writing policies. Reinsurance can be purchased to make up for the deficit in capital.
This would come into play if a company had $50 million of working capital but wanted to issue $75 million of policies. The company would then shop for reinsurance to make this possible. The reality is, most insurance companies need to employ some sort of reinsurance in order to balance their risk management plan with the amount of insurance policies they wish to issue.
Reinsurance can help an insurer manage their risk by transferring portions of their policies to another insurance company, insulating itself against the risk of a major claims event. There are two different types of reinsurance structures available to transfer this risk – a facultative reinsurance policy or treaty reinsurance policy.
What is Facultative Reinsurance?
Facultative reinsurance can be thought of as a more specific type of reinsurance in that the company purchasing the reinsurance (the ceding company) purchases reinsurance only on certain specified assets. For example, the ceding company may be approached to insure a business centre for $10 million, but they may not have $10 million in capital available to write the policy. The company will then approach reinsurance companies, asking them to cover the portion of the business centre insurance that they cannot cover. If they have enough capital to cover $7 million, they would look for reinsurance for $3 million.
Because the insurance policy written typically only covers a single asset (or a small set of assets) a facultative reinsurance policy is typically considered to be a shorter term engagement between the ceding company and the reinsurance company and considers a specific risk.
Continuing with the above example, if the company purchases a facultative reinsurance policy for the $3 million, then later raises enough capital to underwrite additional policies for a different asset, the original reinsurance policy has no say over these new policies. This is because a facultative insurance policy is only issued a single time.
Facultative reinsurance is typically used for high value or high-risk policies. Especially high risk or high-value assets may ultimately require the ceding company to shop around a bit before they find a company willing to issue reinsurance.
During the underwriting process of a facultative policy, the reinsurance company may also specify under which conditions they will pay, leaving most of the risk with insuring the asset in the hands of the ceding company. Of course, this is not always the case and facultative insurance varies largely based on the company that issues it and the asset(s) which are covered.
What is Treaty Reinsurance?
Unlike Facultative reinsurance, treaty reinsurance is issued to cover a portion of a ceding company’s book of policies, rather than just a single asset.
For example, a company that issues homeowners insurance may find that they don’t have enough capital to issue all the policies they desire to. Thus, they could shop for treaty reinsurance to cover a portion of their book of business.
For example, if they have capital to support writing $75 million in policies, but wish to write $100 million in policies, they will need to secure treaty reinsurance for the $25 million deficit. The reinsurer will accept risk for the $25 million that is reinsured, even if the policies haven’t been written yet.
Unlike facultative reinsurance, in treaty reinsurance, the reinsurance company is not involved in the underwriting of individual policies. Rather the ceding company does all of this under the agreement made with the reinsurance company. The name of this agreement is a ‘treaty’ which is where this type of reinsurance gets its name. The reinsurance company will typically have a close relationship to the ceding company because they will trust the company to issue policies and write business based on the terms of their agreement.
This agreement for future policies will be outlined between the two companies and will include what risk classes the ceding company can accept, as well as the capital the reinsurance company has agreed to provide/cover.
Because treaty reinsurance covers policies which aren’t yet underwritten by the ceding company and are more involved in defining the agreement terms between the parties, these relationships tend to be longer term and may include reviewing operations and auditing records.
The Benefits of Facultative Reinsurance
There are many benefits to a company that decides to reinsure on a facultative basis. The most important of which is that a company can limit their exposure to specific risks. Unlike treaty insurance which has to take on all policies written by the company, a facultative reinsurance policy allows the reinsurance company to only be exposed to the risks associated with a single asset.
In addition, both companies underwrite the policy together, meaning the reinsurance company has lots of say in what is included, or not included, in a specific policy. And if there is something insured by the company that they don’t wish to cover, this can be excluded from the policy.
If your company is seeking facultative reinsurance, you benefit by retaining solvency over the policy you are issuing while also getting the capital you need to issue larger policies to insureds.
The Challenges of Facultative Reinsurance
Although there are many benefits of facultative reinsurance, one of the downsides is that it can be difficult to find a company to provide this type of reinsurance because of the high-risk assets it covers. Even if a company is found, it may take a significant amount of time and effort to underwrite a policy and negotiate terms both parties agree on because of all the small details which must be worked out.
Just as risk is limited with facultative reinsurance, so too are the benefits. Because facultative reinsurance is typically a single policy for a single asset, if the ceding company flourishes in other areas the reinsurance company offering the policy will not receive those benefits. Therefore it is much more common in the insurance world for companies to seek treaty insurance rather than facultative insurance.
Droits d'auteur is experienced with facultative reinsurance and can help you to ensure that you remain at a desired level of solvency or transferring risk for a challenging placement.
The Benefits of Treaty Reinsurance
Treaty reinsurance has unique benefits. When entering a treaty reinsurance policy, a ceding company is typically engaging in a long-term relationship with a reinsurance company. Reinsurance companies tend to prefer this type of reinsurance as it typically involves a higher volume of business.
The ceding company retains more control of their underwriting process with treaty reinsurance because the reinsurance company isn’t involved in the process of underwriting each individual policy.
Business is written for a particular class of insureds and subject to the terms of the agreement with the reinsurer, as opposed to each risk being negotiated separately.
The Challenges of Treaty Reinsurance
Treaty reinsurance is often more readily available than facultative, but due to the long-term nature of the relationship between the two companies, entering into the treaty it can take longer to set up initially. A reinsurance company won’t jump in without thoroughly vetting the ceding company and ensuring their risk appetites are aligned.
Though this risk is mitigated through an established treaty, the ceding company retains the freedom to underwrite future policies but they must follow the terms of the treaty agreement.
For example, under a treaty, a ceding company may be allowed to issue automobile insurance policies. But if that company thinks they may want to insure higher-risk vehicles, such as propane transport, this may not be allowed under treaty reinsurance—hindering the growth of the ceding company.
Droits d'auteur provides consultation services to guide you through the process of setting up treaty reinsurance. Working with Axxima can help simplify the process of obtaining treaty reinsurance and guide you through a challenging negotiating process.
How to Choose Between Treaty and Facultative Reinsurance?
Choosing between treaty and facultative reinsurance is generally simple, as a company will know the volume and type of business it wishes to reinsure and this is often what dictates the type of reinsurance they will purchase.
When a company has a single, or a select few, high-value assets, this naturally leads to the seeking out of facultative reinsurance rather than treaty reinsurance. Similarly, if a company wants to expand their working capital to underwrite more policies this naturally lends itself to a treaty reinsurance policy as they don’t have a specific risk they wish to reinsure.
Types of Facultative and Treaty Reinsurance
Both facultative and treaty insurance can be written based on pro rata or an excess of loss underwriting.
Pro rata means that a reinsurance policy is written on the basis that the ceding company and the reinsurance company share the premiums and losses proportionately.
Pro rata is different from what is known as excess of loss policies. With this type of policy, the ceding insurer will be required to cover a certain amount of losses accrued from the underwritten asset. They may even have to pay a fee to the reinsurance company for coverage above a certain specified limit.
While pro-rata policies are easier to administer, excess of loss policies are typically more economical both in the cost of the reinsurance premium and the administration cost. Not sure whether your company would benefit from a pro rata or excess loss reinsurance policy? The professionals at Droits d'auteur can help you make your decision.
Ready to Buy Reinsurance?
Overall, facultative and treaty reinsurance are both beneficial to insurers and should be used to help manage an insurance company’s risk, while also helping maintain the capital needed to issue policies.
Whether you have decided to purchase a facultative reinsurance policy, or a treaty reinsurance policy, Axxima can help with the process.
Contact Droits d'auteur today to review your reinsurance needs.