Written by Facultative reinsurance is a form of reinsurance transacted on an individual basis.
It is a method of reinsurance where the reinsurer and the insurer have the capability or option to accept and cede individual risk respectively.
In facultative reinsurance, the ceding company is free to choose whether or not to offer an individual risk to the reinsurer and the reinsurer is free to accept or reject the risk.
In other words, the reinsurer has the freedom to accept or reject any risk offered, and the ceding firm has the option to select a specific risk.
Therefore, facultative reinsurance means that reinsurance of risk is done on an individual basis.
Facultative reinsurance is considered the oldest form of reinsurance.
It usually applies to risks that are named and detailed individually.
Each facultative reinsurance acts as a full-fledged reinsurance contract on its own.
Features of Facultative Insurance
1. It is facultative: In facultative reinsurance, the primary insurer is not required to offer the risk and the reinsurer is not required to accept the risk.
That is, both parties (the insurer and the reinsurer) can decide whether or not to enter into a contract on individual risk.
2. Risk is reinsured on an individual basis: Each risk in facultative reinsurance is reinsured individually.
This means that each risk is evaluated separately and independently, with both the original insurer and the reinsurer determining whether they wish to place it as reinsurance based on their own risk tolerance and capacity.
3. Each risk is a separate contract: Each risk in facultative insurance forms a separate reinsurance contract.
This means that for every risk that the original insurer wishes to transfer to a reinsurer, a separate agreement is made between the two parties.
When is Facultative Reinsurance Used?
Generally, facultative insurance is used in situations where specific risks require coverage that isn’t provided by standard policies.
However, facultative insurance may also be used in the following situations:
1. Where the insurer requires capacity beyond its automatic underwriting capacity: Facultative insurance may be used when the insurer has reached the limit of its own retention and treaty limits for a particular risk, but still wants to accept the risk because it is a good opportunity.
In this situation, the insurer will seek out facultative reinsurance to cover the excess capacity needed for the risk, allowing them to accept the risk without exceeding their own risk exposure limits.
2. Where the risk is excluded from the treaty reinsurance of the insurer: Facultative insurance is also used when the insurer wants to reinsure a specific risk that is excluded from their treaty reinsurance coverage.
Let’s take the case of an insurer who specializes in property insurance and has a treaty insurance policy to indemnify him against losses resulting from hurricanes and earthquakes.
However, he also wants to insure a building that is situated in a flood-prone area.
In this situation, the insurer may use facultative insurance to transfer the flood risk to a different reinsurer, who can then provide a separate policy that exclusively covers the risk.
3. Where the insurer does not cede the risk to treaty reinsurance: Facultative reinsurance is used when an insurer wants to retain control over a specific risk, rather than ceding it to a reinsurance treaty.
This may be because the potential losses from that risk could negatively impact the premium rate for the insurer’s entire portfolio of risks
In this case, the insurer will typically enter into a separate, individual reinsurance contract with a reinsurer for that specific risk, rather than ceding it to the treaty insurance.
Advantages Of Facultative Reinsurance
1. Suitable premiums are charged: In facultative reinsurance, risks are considered individually.
As a result, reinsurers can negotiate an appropriate premium for that specific risk, rather than having to consider it as part of a larger portfolio of risks.
2. Flexibility: Facultative reinsurance is very flexible reinsurance in that it gives the insurer and the reinsurer the ability to choose the risk they want to cede and reinsured.
To the insurer, facultative reinsurance allows the reinsurance company to select the risk it wants to reinsure and the risk it does not want to reinsure.
In relation to the reinsurer, it allows the reinsurer to evaluate and apply underwriting judgement case by case before deciding whether or not to accept the risk.
3. Control to reinsurer: Facultative reinsurer gives some form of control to the reinsurer because it allows him to select the risk he is willing to take on.
By selecting the risk that he is willing to assume, facultative reinsurance can better manage its own risk portfolio.
Disadvantages Of Facultative Reinsurance
1. Uncertainty: As risks are considered on an individual basis, the primary insurer cannot be certain of the placement of the facultative reinsurance.
This is because the primary insurer may not know if the facultative reinsurance will be placed and if so, where it will be placed.
This lack of certainty can make it difficult for the primary to accurately assess the level of risk they are taking on and to price their policies accordingly.
2. Expensive and labour-intensive administration: The administration involved in facultative reinsurance is labour-intensive and expensive.
Each risk is considered individually in facultative insurance, which means a significant amount of time and resources will be dedicated to the underwriting process.
Indeed, the process of underwriting and placing facultative insurance can take longer than treaty reinsurance, making it very expensive.
3. Lack of consistency: Facultative reinsurance is not standardized, which means that policies and coverage may vary from one insurer to another.
This can lead to a lack of consistency in the reinsurance market.
Conclusion
To summarize, facultative reinsurance is a form of reinsurance that is transacted on an individual basis, where the reinsurer and the insurer have the option to accept or reject individual risks.
This type of reinsurance is considered the oldest form of reinsurance and is typically used for specific risks that are not covered by standard policies.
The reinsurer has the freedom to accept or reject any risk offered, and the ceding firm has the option to select a specific risk.
Facultative reinsurance is used when the insurer reaches the limit of its own retention and treaty limits for a particular risk, when a specific risk is excluded from the treaty reinsurance of the insurer or when the insurer wants to retain control over a specific risk.
The advantages of facultative reinsurance include suitable premiums being charged, flexibility in risk selection, and control over risk retention.
The disadvantages of facultative reinsurance are uncertainty in placement, expensive and labour-intensive administration, and lack of consistency in policies and coverage.
