Reinsurance companies work by providing insurance protection to insurance companies. Insurance companies transfer risk on their shoulders to the reinsurance company. This, in turn, reduces their liability on catastrophic losses. In other words, it is insurance for insurers. It enables the companies to remain solvent. Even though they have to pay for major claim events. It’s important to know that both facultative and treaty reinsurance could be proportional or non-proportional. Here, in this article, we will discuss the difference between facultative and treaty reinsurance.
Difference Between Facultative And Treaty Reinsurance: An Introduction
Treaty reinsurance and facultative reinsurance are two types of contracts of reinsurance. Facultative reinsurance is the one where insurer demands coverage for a single or block of risks. These risks are from their own books. Treaty reinsurance on the other side is insurance that the insurer buys from another company. In the case of facultative, the reinsurer reserves the right to review the risks mentioned in the policy. The reinsurance company has the right to either accept or reject the risks. Generally, a reinsurance company in a treaty reinsurance policy accepts every risk that comes with it.
The ceding company transfers all risks to the reinsurance company in treaty reinsurance. These risks belong to a specific class of insurance policies. In return, the reinsurance company signs a contract to indemnify the insurance company of all risks. Here, the reinsurance company doesn’t perform individual underwriting for every policy. In most cases, reinsurance even applies to those policies that are not written yet. The condition is that the new policies must belong to the same pre-agreed class. Certainly, this is a huge difference between facultative and treaty reinsurance.
One important characteristic of a treaty agreement is the lack of underwriting individually by the insurer. The structure moves underwriting risk from the ceding company to the assuming company. So there is a possibility that some of the risks are left unevaluated during the initial stage. The assuming company is responsible for the negligence during the underwriting process. There are different types of treaty agreements. One of these is proportional treaties. Here, a percentage of the insurance company’s original policies is reinsured up to a certain limit.
Let’s take an example to understand it. Suppose a reinsurance company agrees. Also, it pays for 75% of the original insurer’s policies. The policy limit is $1000 million. This clearly states that the insurance company will handle the first $250 million. Also, everything comes under the agreement. Here, $250 million is the retention limit of the ceding company. So suppose the insurance company writes a policy worth $2000 million. Now, it has to retain $250 million from the first $1000 million. And the remaining $1000 million too. It has to arrange a surplus treaty for the same. If the retention limit is high, the reinsurance policy premium amount is low.
Certainly, facultative reinsurance is one of the simplest ways of getting reinsurance protection. In fact, you will feel these policies are easy to tailor to specific circumstances. Here, the insurer demands coverage for single or block of risks. With a one-off transaction, the reinsurance company demands to perform underwriting on its own. Under this agreement, the underwritten policy is a single transaction. They do not group them into a single class. Since these reinsurance contracts are less interesting for their ceding companies. Thus, the ceding companies believe in retaining the riskiest policies. This clearly gives the difference between facultative and treaty reinsurance.
Let us take an example to understand the facultative reinsurance process. Suppose there is an insurance provider who issues a policy to corporate buildings. The company writes an insurance policy for $45 million. So the company has to pay the whole amount if the corporate building is damaged badly. The insurance company realizes it cannot afford to pay such a huge amount. It needs help in paying out $45 million. So it turns to a reinsurance company for a policy.
Before signing the final contract, the insurance company calculates its potential for paying out. It can pay $35 million. The company turns to facultative reinsurance in the market. So, the insurance company needs to keep trying until it gets reinsurance of $10 million. Also, it could be from a single company or a bunch of companies. Once the search is over, the insurance company can proceed for signing a contract.
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Reinsurance companies have come as a saviour for insurance companies. Even the insurance companies feel more secure after this. There are certain situations where even insurance companies do not have enough liable amount. They have to pay out all the claims as everything is written in the insurance policy. Reinsurance companies act as a bridge between the reinsurer and the ceding company. After the contract comes into the picture, there is a shift of risk to a reinsurance company.
Proportional and non-proportional reinsurance are types of reinsurance. In proportional one, the primary insurer and the reinsurer need to maintain a post-transfer relationship. It also requires assessing all the risks and uses it to calculate premiums. Non-proportional reinsurance, on the other hand, has its basis on loss retention. The ceding insurer agrees to handle all losses up to a certain set level. The reinsurer agrees to pay for the losses that the ceding insurer faces. Both types of reinsurance consider the collection of payments as assets. The assets belong to the ceding companies.
In a traditional insurance policy, the risk of loss is spread among multiple different insurance holders. All these policyholders pay a premium to the insurer in exchange for getting insurance protection. This is a different type of business model. It works when the sum of premiums received by the company exceeds the claim amount. However, there are times when the reverse happens. It means the claim amount exceeds the premium amounts received. In such a situation, the insurer faces the highest risk. Here, we went through the difference between facultative and treaty reinsurance in detail. We hope this article gives you a lot of information on this topic. In case of doubt, feel free to send us your queries through comments.