Reinsurance contracts-or agreements between insurance firms and reinsurance businesses-serve as a safety net for insurance companies, as they allow the sharing or transfer of risks for a fee. This fee typically comes from the premium an insurer fetches from an insurance policy.
Two major types of reinsurance contracts exist: facultative reinsurance and treaty reinsurance. These reinsurance contracts can either cover specific risks or a pool of risks, with their categorization depending on if the reinsurer can choose to accept or reject an individual risk or if it must embrace all outlined risks.
In a facultative reinsurance contract, the reinsurer gets to meticulously analyze individual risks before deciding to accept or reject them. Profit margins in the reinsurance sector heavily rely on how wisely a reinsurance company chooses its clientele. As the name implies, facultative reinsurance is largely transactional, featuring non-binding agreements that detail the reinsurer’s acceptance of a specific risk.
However, these types of contracts tend to cost more than treaty reinsurance contracts because the latter covers a whole portfolio of risks, indicating a potential long-term relationship between the primary insurer and the reinsurer. Despite the added expense, a facultative reinsurance contract provides the primary insurer the freedom to reinsure risks that it otherwise would not be able to handle.
Meanwhile, treaty reinsurance contracts are more comprehensive, covering some elements of a specific insurance category-like workers' compensation or property business-provided by the insurer, encompassing all risks fall within the agreed terms, unless certain exclusions are expressly stated.
Although treaty reinsurance does not require the reinsurance company to review each risk individually, it necessitates a thorough evaluation of the insurance provider's underwriting practices and historical experience.
Facultative reinsurance contracts are generally the simplest form of reinsurance protection. They categorically cover each underlying policy on a case-to-case basis, often extending to catastrophic or irregular risk exposures. As a result, these contracts demand significant human and technical resources for underwriting activities.
Securing a reinsurance contract, either a singular or multiple risk, provides the insurance company more equity security and solvency, offering greater stability during abnormal or significant events. It enables an insurance company to underwrite numerous policies without drastically increasing its solvency margin costs, creating a pool of liquid asset reserves for insurers potentially encountering exceptional losses.
Consider a typical insurance provider issuing a policy on a major commercial asset, like a large corporate office building, that values at $35 million. The insurer foresees a liability of $35 million in case of a devastating event, but feels it can only afford a payout of $25 million. Subsequently, it seeks facultative reinsurance, acquiring pieces of the remaining $10 million liability from multiple reinsurers - this process permits the insurer to issue the policy with confidence, knowing it can, if needed, cover the full amount.