Thursday, May 7, 2020

The Advantages and Disadvantages of Facultative Reinsurance

Facultative reinsurance is the oldest form of proportional reinsurance and was the forerunner of surplus treaty reinsurance as we know it today.

The very essence of proportional reinsurance is “sharing.” This means that in return for accepting an identified proportion of risk, the reinsurer accepts a proportionate share of the premium, pays a proportionate share of the insurer's acquisition costs (in the form of “commission”), and if a claim occurs on that risk, pays a proportionate share of that claim, irrespective of the original claim amount.

Facultative proportional reinsurance could be used:
  • where the insurer requires capacity beyond its so-called “automatic” facilities;
  • to reinsure risks where no treaty protection is available;
  • to reinsure risks where the company does not wish to cede to its treaties;
  • to reinsure hazardous or complicated risks, including so-called “target” (or “market”) risks;
  • for unique commercial, financial or strategic reasons.

Since the placement of facultative reinsurance is a direct function of original insurance policies, it follows that any reinsurance underwriter should be aware of original policy terms, conditions, rating and markets involved, together with any changes or developments.

The Advantages and Disadvantages of Facultative Reinsurance

In brief, certain advantages of facultative reinsurance are:
  • risks are considered individually;
  • it increases the insurer's competitive edge within its chosen market;
  • the freedom to offer any risk (insurer) which may be accepted or declined (reinsurer);
  • a general account (or proportional treaty) might be protected by the use of facultative reinsurance;
  • the insurer might benefit from specific knowledge on the part of the facultative reinsurer;
  • there is an opportunity for both parties to develop a successful and professional relationship.

Certain disadvantages are:
  • the insurer cannot rely on successful placement of a risk;
  • the administration involved is complicated and expensive;
  • detailed risk and loss information have to be disclosed;
  • 'error factor' exists in hasty facultative placements;
  • there is low commission reimbursement to the insurer – if the insurer arranges surveys, reinsurers might be obtaining business at improved or advantageous terms;
  • cover cannot be confirmed until reinsurance placement is effected or completed.

Facultative proportional reinsurance is a complicated process. Not only is the initial placement complicated, but any subsequent amendment to the sum insured, period, retention and/or facultative cession itself would require additional technical and accounting documentation. The natural development of individual facultative cessions was to combine these into an automatic facility called treaty reinsurance.

John Pyall. 1999. Reinsurance. The Chartered Insurance Institute.

Facultative Reinsurance
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