Facultative vs. Treaty Reinsurance: Key Differences Explained

Facultative vs. Treaty Reinsurance: An Overview

Facultative and treaty reinsurance are the two main types of reinsurance contracts. Facultative reinsurance covers individual risks, allowing the reinsurer to assess and accept or reject each policy, making it ideal for large or unusual exposures requiring tailored coverage.

Treaty reinsurance, on the other hand, automatically covers a broad portfolio of policies without evaluating each risk separately, offering efficiency and stability for insurers managing large volumes of similar policies.

Insurers often choose facultative reinsurance for specialized protection and treaty reinsurance for consistent, wide-ranging risk transfer.

Understanding Facultative Reinsurance in Detail

Facultative reinsurance is usually the simplest way for an insurer to obtain reinsurance protection. These policies are also the easiest to tailor to specific circumstances.

Facultative reinsurance is reinsurance purchased by an insurer for a single risk or a defined package of risks. Usually a one-off transaction, it occurs whenever the reinsurance company insists on performing its own underwriting for some or all the policies to be reinsured. Under these agreements, each facultatively underwritten policy is considered a single transaction, not lumped together by class. Such reinsurance contracts are usually less attractive to the ceding company, which may be forced to retain only the riskiest policies.

Suppose a standard insurance provider issues a policy on major commercial real estate, such as a large corporate office building. The policy is written for $35 million, meaning the original insurer faces a potential $35 million in liability if the building is badly damaged. But the insurer believes it cannot afford to pay out more than $25 million. So before even agreeing to issue the policy, the insurer must look for facultative reinsurance and try the market until it gets takers for the remaining $10 million. The insurer might get pieces of the $10 million from 10 different reinsurers. But without that, it cannot agree to issue the policy. Once it has the agreement from the companies to cover the $10 million and is confident it can potentially cover the full amount should a claim come in, it can issue the policy.

Detailed Insights Into Treaty Reinsurance

Treaty reinsurance occurs whenever the ceding company agrees to cede all risks within a specific class of insurance policies to the reinsurance company. In turn, the reinsurance company agrees to indemnify the ceding company of all risks therein, even though the reinsurance company has not performed individual underwriting for each policy. The reinsurance often applies even to those policies that have not yet been written, so long as they pertain to the pre-agreed class.

The most important characteristic of a treaty agreement is the lack of individual underwriting on behalf of the assuming insurer. This structure transfers underwriting risks from the ceding company to the assuming company, leaving the assuming company exposed to the possibility that the initial underwriting process did not adequately evaluate the risks to be insured.

There are different kinds of treaty agreements. The most common is called proportional treaties, in which a percentage of the ceding insurer's original policies is reinsured, up to a limit. Any policies written in excess of the limit are not to be covered by the reinsurance treaty.

For example, one reinsurance company may agree to indemnify 75% of the original insurer's automobile policies—up to a $100 million limit. This means the ceding company is not indemnified for $25 million of the first $100 million in auto policies written under the agreement. That $25 million is known as the ceding company's retention limit. If the ceding company writes $200 million worth of automobile insurance, it retains $25 million from the first $100 million and all of the subsequent $100 million, unless it arranges a surplus treaty. Generally speaking, reinsurance policy premiums are lower when retention limits are higher.

Important Considerations in Reinsurance Agreements

Reinsurance companies offer insurance to other insurers, safeguarding against circumstances when the traditional insurer does not have enough money to pay out all of the claims against its written policies. Reinsurance contracts take place between a reinsurer or assuming company, and the reinsured or ceding company. In effect, a standard insurance provider can spread its own risk of loss even further by entering into a reinsurance contract.

In a traditional insurance arrangement, the risk of loss is spread among many different policyholders, each of whom pays a premium to the insurer in exchange for the insurer's protection against some uncertain potential event. It is a business model that works whenever the sum of received premiums from all members exceeds the amount paid out on insurance claims against the policies. There are times, however, when the amount paid out in claims by the insurer exceeds the sum of money received from policyholder premiums. In such instances, it is the insurer who faces the greatest risk of loss.

The Bottom Line

Facultative reinsurance provides flexibility by allowing insurers to negotiate coverage for specific risks, though it requires individual underwriting and more administrative effort.

Treaty reinsurance, in contrast, offers a streamlined approach by covering entire classes of policies under a single agreement, sacrificing customization for efficiency. Both types play a critical role in helping insurers manage risk exposure and maintain financial stability, protecting them from potential losses when claims exceed premium income.