Day 9: Types of Reinsurance

Contracts – Facultative

ReinsuranceTARIQ AL-BASHA

TARIQALBASHA@OUTLOOK.COM – 00962 7 9767 7418

Index

Concept & nature of facultative reinsurance

Use & utility of facultative reinsurance

Advantages & Disadvantages of facultative reinsurance

About Tariq Al-Basha

Concept & Nature

Facultative reinsurance is the name given to the type of reinsurance wherebyboth the insurer (or cedant) and the reinsurer have the “faculty” or option tocede and accept, respectively, the business in question.

Facultative reinsurance usually applies to risks in isolation, named and detailedindividually.

The term “facultative” is used to define something that is optional and,according to the dictionary, applicable to an act that is not necessary but thatcan be freely carried out or not.

These terms, therefore, describe the very essence of facultative reinsurance:the insurer’s freedom to decide whether or not to cede a transaction and tochoose which reinsurer is to be offered the risk. By the same philosophy, thereinsurer has the power to accept or refuse the transaction offered.

Concept & Nature (Cont.)

First of all, the direct insurer has to submit a precisely defined offer to the reinsurer,containing all information on the risk offered. Then, after examining the offer, the reinsurerdecides whether to accept (a share) the risk or reject it.

Facultative reinsurance is the oldest form of reinsurance.

Some people maintain that facultative reinsurance is actually the only type that conformsto the classic principles of reinsurance insofar as the conditions of each risk are analyzedfrom an extraordinarily technical perspective. This is the second feature of facultativereinsurance: its individuality. The cessions refer to individual risks with specific featureswhich make them particularly suitable for facultative handling since, for one reason oranother, they fall outside the rules governing policies that fall into the contractualframework of obligatory treaties.

Similarly, the relationship between the insurer and the reinsurer, and the latter’sknowledge of the cedant’s underwriting philosophy, constitute a key factor for assessingthe professionalism, prestige and technical expertise used by the direct insurer’sunderwriters.

Use & utility

The development of facultative business in recent years is linked to the

increasing size of risks in technical and also financial terms, together with

the enormous concentration of values in small areas.

It is precisely these features, together with a few other less important ones,

that determine the use of facultative reinsurance: everything that cannot

be ceded to treaties, mainly due to size, but also due to its nature.

Those cases in which certain risks are placed facultatively are listed below:

1. The non-availability of specific protection under a treaty as a special type of

cover is required or because the small number of policies issued by the cedant

does not warrant the arrangement of a reinsurance treaty.

Use & utility (Cont.)

2. Policies which, due to their high sum insured, exceed the capacity of a treaty.

3. Risks that are among those excluded from automatic obligatory treaties.

As will be seen below, obligatory reinsurance treaties usually have a list of exclusionswhich may relate to:

- Geographical area covered

- Nature of the insured business

- Type of policy

- Perils not covered

- Atypical covers

The insurer will need to look for reinsurance individually and therefore on a facultativebasis.

Use & utility (Cont.)

4. Transactions which, although not excluded from the treaty, represent an

increase in risk which, in the cedant’s opinion, could prejudice the treaty’s results,

as it incorporates an exposure factor that could distort a more uniform portfolio.

5. Tailor-made policies for preferential clients that fall outside the standard

conditions owning to their size and complexity.

6. New types of insurance being introduced into the market.

7. Specific cooperation agreements whereby an undertaking has been given to

supply a reinsurer with facultative cessions in return for certain concessions.

Advantages & Disadvantages of

facultative reinsurance

Any consideration of advantages and disadvantages always involves an

element of subjectivity depending on the position taken, since what may

constitute a facility for the reinsurer may end up being an obstacle for the

insurer.

Advantages & Disadvantages of

facultative reinsurance - Advantages

1. It increases underwriting capacity as it enables risks to be written over and

above the capacity of automatic treaties.

2. It makes the insurer’s underwriting policy more flexible.

For example, it allows the underwriting of risks excluded from automatic obligatory

treaties.

3. It provides access to reinsurers’ experience on specific types of risks or covers.

4. It enables automatic treaties to be protected, reducing their exposure to

hazardous risks.

5. It makes it possible to ascertain the reinsurers’ level of response and service.

Advantages & Disadvantages of

facultative reinsurance - Disadvantages

1. Administrative complexity: it increases management expenses substantially. Asspecial risks are involved, i.e. with a high hazard level, the ceding insurer has to

seek and obtain sufficient reliable protection through international reinsurance. This

increases its expenses to a great extent since, in general, it has to contact specific

reinsurers located in different countries, requesting their reinsurance cover and

providing full information on the risk in question. It also takes longer to undertake

this work.

2. Lack of agility: since these are individual transactions, many of which are

extraordinarily complex, it is not always possible to access acceptances with the

desired speed. In fact, to the extent that delays arise, the cedant is able to

compare the levels of service offered competing reinsurers in terms of speed of

response.

Advantages & Disadvantages of

facultative reinsurance – Disadvantages

(Cont.)

3. Lower levels of commission: the increase in the insurer’s administrative costs isaccentuated because the commission that the reinsurer normally pays for

facultative cessions is normally lower than the available under obligatory treaties.

This is due to the technical instability they represent and to the shorter term

reinsurer/reinsured relationship with facultative reinsurance.

4. Dependence: give the reinsurers’ “faculty” to accept the risk or not, it is

necessary to have full confirmation of their support before issuing the cover

document (policy).

About Tariq Al-

Basha• Promoting entrepreneurship and innovative SMEs

in MENA Market.

• Business & Financial Modelling Consultant atseveral consulting firms in the Middle East.

• Independent business planning & feasibilitystudies specialist.

• Business management graduate from theUniversity of Greenwich, London – UK.