Facultative Reinsurance

Facultative reinsurance is reinsurance arranged for a single risk or a single policy, negotiated separately each time between the primary insurer (the ceding company, or cedent) and a reinsurer. The reinsurer reviews the particular risk, such as a large factory, a petrochemical plant or a very high-value life policy, and is free to accept it, decline it or accept it on its own terms. The word "facultative" reflects that freedom: neither side is obliged to deal.

Facultative cover is the counterpart of treaty reinsurance, under which a reinsurer agrees in advance to take part of a whole class of business without seeing each policy. Insurers turn to facultative placements for risks that are too large, too unusual or expressly excluded from their treaties. Placements are made directly or through reinsurance brokers, and the London market around Lloyd's of London is one of the main venues for them.

Picture a removals firm with a standing deal: a partner company automatically shares every ordinary house move. One day a customer asks the firm to move a grand piano up a narrow spiral staircase, a job the standing deal does not cover. The firm phones a specialist, describes this one job, and the specialist decides whether to help and what to charge.

That single phone call is facultative reinsurance. The insurer can say yes to a big or awkward customer it could not carry alone, because it has found someone to share that one job. The cost is effort: every request has to be described, checked and priced from scratch, so it is slower and more expensive to arrange than the standing deal.

A typical placement follows a sequence that mirrors ordinary underwriting:

1. The cedent prepares a submission describing the risk: location, values, construction, loss history, the original policy wording and the share or layer it wants to reinsure.
2. One or more reinsurers assess the submission, often asking for engineering surveys or medical evidence, and quote a price and conditions.
3. The cedent accepts a quote, and the reinsurer issues a facultative certificate, a short contract that refers to the underlying policy and records the reinsurer's share, premium and any special terms.
4. If a claim arises, the cedent handles it with the policyholder and collects the reinsurer's share, usually under a clause that the reinsurer follows the cedent's settlement in good faith.

Because the reinsurer sees each risk, the cedent owes it a duty of full and honest disclosure. Non-disclosure of a material fact can allow the reinsurer to avoid the contract, which is why submissions tend to be detailed.

Facultative cover comes in two broad shapes. In pro rata facultative, the reinsurer takes a fixed share of the risk, for example 40%, receives 40% of the premium and pays 40% of every loss, usually allowing the cedent a commission for its acquisition costs. This is the single-risk version of quota share reinsurance.

In excess facultative, the cedent keeps losses up to a set amount and the reinsurer pays above it, up to a limit. A cedent insuring a $60 million warehouse might keep the first $10 million and buy facultative cover for $50 million in excess of $10 million. This is the single-risk version of excess of loss reinsurance, and the reinsurer sets its own price rather than taking a share of the original premium.

A hybrid known as facultative obligatory ("fac-oblig") lets the cedent choose which risks to cede while the reinsurer must accept those that meet agreed criteria. It sits between pure facultative and treaty cover and needs careful monitoring, since the cedent controls the selection.

• Capacity above treaty limits. A risk larger than the insurer's retention plus its treaty capacity can only be written if the excess is placed facultatively.
• Excluded or unusual risks. Treaties often exclude hazards such as certain energy, aviation or nuclear exposures, and these need a separate placement.
• Protecting the treaty. Placing a volatile risk outside the treaty keeps it from distorting treaty results and helps the insurer avoid concentration risk in one location or client.
• Fronting. Where a risk must be insured by a locally licensed company, a local insurer may issue the policy and cede most or all of it facultatively to a foreign insurer or reinsurer that actually carries the risk.

Specialist classes, including marine liabilities beyond what P&I insurance clubs retain, have long relied on facultative and subscription placements.

Facultative reinsurance is the most expensive form of reinsurance to administer, because each placement needs its own submission, pricing and documentation. Reinsurers also guard against adverse selection: a cedent may be tempted to reinsure only its worst risks, so reinsurers price each case on its merits.

For the cedent, the main risk is counterparty risk, the chance that the reinsurer cannot pay. Insurers review reinsurers' financial strength and credit ratings, and regulators decide how much credit a cedent may take for reinsurance in its regulatory capital and on its balance sheet. In the United States, the NAIC Credit for Reinsurance Model Law and Regulation set the conditions, which may include collateral such as a trust fund or a letter of credit from reinsurers not licensed in the state. Reinsurance recoverables on unpaid claims also reduce the cedent's net claims reserve, so the quality of the reinsurer directly affects reported solvency.

• National Association of Insurance Commissioners (NAIC)
• International Association of Insurance Supervisors (IAIS)
• Lloyd's