When insurance companies face capital limitations or seek to reduce risks on specific policies or books of business, reinsurance can be a useful strategic tool.
Reinsurance, simply put, involves transferring portions of risk portfolios to other parties through agreements.
However, not all reinsurance policies are the same.
Understanding the differences between facultative and treaty reinsurance is crucial for making informed decisions about risk management strategies.
First, what is reinsurance and why do insurers need it?
Reinsurance is the practice where an insurance company (the “ceding company”) transfers portions of its risk portfolio to other parties (the “reinsurers”) to reduce the likelihood of paying a large obligation resulting from an insurance claim.
Essentially, it is insurance for insurance companies.
There are two types of reinsurance – facultative and treaty.
Facultative reinsurance – what is it?
Facultative reinsurance is tailored and considers each policy individually. It is designed primarily for shorter-term relationships between ceding companies and the reinsurer.
For instance, if an insurer lacks capital to cover a $10 million policy, they may seek facultative reinsurance for the remaining amount.
This type of reinsurance is ideal for high-value or high-risk policies but can be challenging to obtain due to its specificity and risk nature.
Treaty reinsurance – how does it differ?
Treaty reinsurance covers portions of an insurer’s overall book of policies and is better for long-term relationships.
While easier to access, it requires careful consideration of terms and restrictions.
For example, an insurer issuing $75 million in policies but aiming for $100 million would need treaty reinsurance for the $25 million deficit.
Agreements also known as “treaties” will outline treaty reinsurance arrangements entered into between the insurers. It will outline risk classes, capital provisions and operational details, leading to structured and enduring partnerships.
Types of facultative and treaty reinsurance
Facultative and treaty reinsurance can be structured either on a pro rata or excess of loss basis. Pro rata policies are generally simpler to manage, whereas excess of loss policies can be more cost-effective in terms of both premiums and administrative expenses.
Pro rata reinsurance
In a pro rata reinsurance agreement, the ceding company and the reinsurer share premiums and losses in proportion to the agreed terms. This method ensures that both parties take on a consistent share of the financial responsibilities and benefits.
Excess of loss reinsurance
Excess of loss reinsurance involves the ceding insurer covering losses up to a certain limit, after which the reinsurer steps in to cover any additional losses. This type of policy might also involve a fee paid to the reinsurer for assuming the risk beyond the specified threshold.
Which reinsurance is right for your business?
Choosing between facultative and treaty reinsurance (as well as pro rata vs excess of loss reinsurance) depends on factors such as business volume and risk preferences.
Pro rata and excess of loss underwriting further refine options, offering flexibility in risk-sharing and cost management.
Axxima offers consultation services to guide companies through decision-making processes and can assist with either facultative or treaty reinsurance strategy and placement.
Whether retaining solvency or expanding working capital, Axxima provides tailored solutions for effective risk management strategies.
Get in touch with the team at Axxima if you’re looking for more information.
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