The purpose of reinsurance is to spread risk. This post provides a simple overview for those new to the industry.
FACULTATIVE REINSURANCE
1. Facultative reinsurance is transacted on an individual risk basis. The ceding company has the option to offer an individual risk to the reinsurer and the reinsurer retains the right to accept or reject the risk.
(i) Individual risk review
(ii) Right to accept or reject each risk on its own merit
(iii) A profit is expected by the reinsurer in the short and long term, and depends primarily on the reinsurer’s risk selection process
(iv) Adapts to short-term ceding philosophy of the insurer
(v) A facultative certificate is written to confirm each transaction
(vi) Can reinsure a risk that is otherwise excluded from a treaty
(vii) Can protect a treaty from adverse underwriting results.
TREATY REINSURANCE
1. Treaty reinsurance A transaction encompassing a block of the ceding company’s book of business. The reinsurer must accept all business included within the terms of the reinsurance contract.
(i) No individual risk acceptance by the reinsurer
(ii) Obligatory acceptance by the reinsurer of covered business
(iii) A long-term relationship in which the reinsurer’s profitability is expected, but measured and adjusted over an extended period of time
(iv) Less costly than “per risk” reinsurance
(v) One treaty contract encompasses all subject risks
2. Facultative and treaty reinsurance can be written on either a pro rata or excess of loss basis.
FACULTATIVE PRO RATA
1. Its a term describing all forms of quota share and surplus share reinsurance in which the reinsurer shares the same proportion of the premium and losses of the ceding company. Pro rata reinsurance is also known as “proportional reinsurance”.
2. Along with sharing proportionally in premium and losses, the reinsurer typically pays a ceding commission to the ceding company to reimburse for expenses associated with issuing the underlying policy.
FACULTATIVE XOL
1. Its a term describing a reinsurance transaction that, subject to a specified limit, indemnifies a ceding company against the amount of loss in excess of a specified retention. Excess of loss reinsurance is also called “non-proportional reinsurance”
2. In excess of loss reinsurance, premiums are typically negotiated as a percentage of the primary insurer’s premium charge.
XOL OR PRO RATA
1. Advantages of XOL includes good protection against frequency or severity potential, depending upon the retention level. Allows a greater net premium retention. More economical in terms of reinsurance premium and cost of administration.
2. Advantages of pro rata includes easy to administer. Good protection against frequency/severity potential. Protection of net retention on first-dollar basis. Permits recovery on smaller losses.
FACULTATIVE REINSURANCE PROGRAMS
1. A program may be written to cover a line of business, such as low to moderate hazard commercial umbrellas, or a book of fairly homogeneous classes of property business. Programs terms and conditions are typically documented in more sophisticated binding agreements written up as formal contracts. These contracts often provide the right of rejection on the part of the reinsurer. However, they can also be written on an obligatory basis as well.
2. Advantages of facultative programs are instantaneous binding by the ceding company. Reinsurance terms, including pricing formulas, are predetermined by both a written contract and established underwriting guidelines. Bordereau reporting of premiums. Lower administrative cost.
FACULTATIVE CASUALTY REINSURANCE
1. Reinsurance Lines Of Businessies include Personal/Commercial Automobile, Workers’ Compensation and/or Employer’s Liability, and general liabilities
2. Most liabilities are reinsured as excess transactions. However, reinsurers may provide pro rata reinsurance of excess layers. Umbrella/Excess Liability can be reinsured on a pro rata or XOL basis.
FACULATATIVE PROPERTY REINSURANCE
1. Reinsurance Lines Of Business includes Standard Lines, Technical Risks, Excess and Surplus Lines.
2.Property reinsurance is offered on both a pro rata and excess basis. The amount of reinsurance written by a reinsurer depends heavily on individual risk characteristics, including the result of a PML and Maximum Foreseeable Loss (MFL) analysis.
PRO RATA CALCULATION EXAMPLES
1. Medium Risks commercial building (Restaurant) (100% PML). Buldings (10,000,000) + Contents (2,000,000) = Total Insured (12,000,000)
2. Assume Annual Premium at $20,000
3. Because of potential high severity of loss from a burn-out situation (100% PML), pro rata protection is appropriate. If the ceding company’s net retention is 80% and a reinsurer participates at 20%, a 20% pro rata protection on each and every loss will result.
4. The reinsurer receives 20% of the premium ($4,000) less a ceding commission. Assuming a loss of $9,000,000, the ceding company would pay 80%, or $7,200,000, and the reinsurer would pay 20%, or $1,800,000.
5. If PML is at 50% due to good safety measures installed, excess protection may be the most cost- efficient solution. The ceding company retains the PML net and facultatively reinsures the remaining limit on an excess basis.
6. The calculation would look like this. Ceding Company (6,000,000 PML Net with $15,000 premium). Faculative Reinsurer ( $ 6,000,000 excess $6,000,000 with $5,000 Net Premium)
7. Assuming a loss of $9,000,000, the facultative reinsurer pays $3,000,000 excess of the ceding company’s $6,000,000 first dollar retention.
XOL ALCULATION EXAMPLE 2
1. Commercial Umbrella Policy Limit ($1,000,000) with annual premium ($10,000).
2. The ceding company retains 25% net and places 75% facultative reinsurance on a pro rata basis. Reinsurance participation is expressed as $750,000 (75%).
3. The premium due the reinsurer is $7,500 (75% of $10,000) less the ceding commission it pays to the ceding company to defray expenses and acquisition costs. If a covered loss of $400,000 occurs, the ceding company would pay $100,000 (25% of $400,000), and the reinsurer would pay $300,000 (75% of $400,000).
4. For XOL, Assume the ceding company also writes a $1,000,000 underlying policy.
5. The ceding company's net and treaty retention may be limited to $1,250,000 per risk. Since the total combined limit of the two policies is $2,000,000, the reinsurance cover is excess of the net and treaty retention, expressed as $750,000 excess with $250,000 excess underlying (due to $1,000,000 umbrella limit)
6. Excess layer pricing is based on various formula guidelines, the underwriter’s evaluation of risk, primary rates, increased limits rates, and market conditions. Excess pricing may be net of commission or gross (before commission), depending on the arrangements between the ceding company and reinsurer.
(Source: MunichRe)
