Facultative vs. Treaty Reinsurance: Key Differences & Benefits

Updated • Apr 2nd '25

What Is Facultative Reinsurance?

Facultative reinsurance is a form of risk transfer where an insurance company, known as the ceding insurer, seeks coverage for a specific risk from a reinsurer. Unlike treaty reinsurance, which provides automatic coverage for a portfolio of policies, facultative reinsurance is more customized. It involves the ceding insurer submitting individual risks to reinsurers, who assess each one on a case-by-case basis before agreeing to take on part of the risk.

This method is particularly beneficial for high-value or complex risks that are outside the normal scope of the insurer's underwriting capacity. For example, a reinsurance company might use facultative reinsurance to cover large industrial projects, expensive commercial properties, or specialized risks in aviation and marine insurance. By using facultative reinsurance, insurers can provide coverage for high-risk policies while limiting their exposure to catastrophic losses.

Why Facultative Reinsurance Matters

Facultative reinsurance is crucial for several reasons. It helps insurers in managing significant risks that would be too large to handle on their own. Without facultative reinsurance, insurers could face financial instability in the event of large claims, particularly when they offer coverage for high-value properties, complex industrial risks, or specialized liability policies.

Some examples of scenarios where facultative reinsurance is used include:

High-value commercial real estate: Insuring multi-million-dollar properties where the risks are significantly above the insurer's limits.
Energy and infrastructure projects: Large-scale projects, such as oil rigs or power plants, which involve substantial financial risks.
Aviation and marine insurance: These industries often face high-risk scenarios, including accidents or catastrophic events that can result in huge losses.
Liability coverage for corporations or high-net-worth individuals: Covering significant liabilities that could otherwise cripple the insurer in the event of a lawsuit or large claims.

Facultative reinsurance is a crucial tool that allows insurers to expand their underwriting capacity while maintaining financial stability. By transferring a portion of the risk to reinsurers, they can provide more comprehensive coverage for large, complex, or unique risks.

How Facultative Reinsurance Works

Facultative reinsurance involves several steps, each aimed at evaluating, negotiating, and managing the risks involved. Here's how the process typically works:

Risk Identification: The process begins when the primary insurer identifies a policy that exceeds its financial capacity or has a higher-than-average risk. This could be a commercial property with high-value assets or a liability policy with the potential for substantial claims. The insurer then recognizes the need to transfer part of the risk to a reinsurer to limit exposure.
Proposal Submission: Once the risk is identified, the insurer submits a detailed proposal to potential reinsurers. The proposal contains the following key information:
- Policyholder details: Information about the insured entity or individual.
- Nature of the risk: A thorough description of the risk being transferred, including property value, type of coverage (e.g., liability or property), and exposure to loss.
- Loss history: Any previous claims or losses associated with the risk, including the frequency and severity of past incidents.
- Underwriting assessment: The primary insurer’s evaluation of the risk, outlining the steps taken to assess and mitigate potential losses.
This information helps the reinsurer determine whether the risk is acceptable and what terms they are willing to offer.
Risk Evaluation by Reinsurer: Once the reinsurer receives the proposal, they assess the risk based on the provided information. This evaluation includes analyzing the loss history, the financial stability of the primary insurer, and the severity of the risk. In some cases, reinsurers may request additional documentation or even conduct independent risk assessments to better understand the exposure.

Reinsurers may also consider industry benchmarks and their existing portfolio of risks to assess the potential impact of adding this new risk. If the reinsurer feels the risk is manageable, they will proceed with the next step.
Agreement & Terms Negotiation: If the reinsurer is willing to accept the risk, both parties proceed to negotiate the terms of the reinsurance agreement. This negotiation process includes the following key elements:
- Premium rates: The cost of reinsurance is negotiated based on the level of risk and exposure. Higher-risk policies typically incur higher premiums.
- Coverage limits: The maximum amount the reinsurer will pay in the event of a claim is agreed upon. These limits vary depending on the size of the policy and the severity of the risks involved.
- Exclusions and conditions: Both parties agree on any exclusions (situations that are not covered) and conditions (requirements for claims to be paid).
Once both parties agree to the terms, the reinsurer issues a facultative certificate, which serves as a formal agreement between the two parties.
Facultative Certificate Issuance: The facultative certificate is an official document issued by the reinsurer to confirm that the risk has been accepted. It outlines the agreed-upon terms, including the coverage limits, premium rates, and exclusions. The certificate serves as proof that the reinsurer is now responsible for the agreed portion of the risk.
Claims Settlement: If a claim occurs on the covered policy, the reinsurer reimburses the ceding insurer for its agreed share of the loss. This helps the insurer maintain liquidity and financial stability, even after paying out a large claim. The reinsurer’s involvement ensures that the insurer can fulfill its obligations to policyholders without jeopardizing its financial health.

Advantages of Facultative Reinsurance

Facultative reinsurance offers several significant advantages for insurers:

1. Enhanced Risk Management

By transferring high-risk policies to a reinsurer, insurers reduce their exposure to large claims, helping to maintain financial stability. This is particularly important in industries with high volatility, such as aviation, energy, and construction.

2. Increased Underwriting Capacity

Facultative reinsurance allows insurers to underwrite policies that exceed their internal financial limits. This enables them to serve high-value clients and offer coverage for specialized or high-risk industries.

3. Customization and Flexibility

Facultative reinsurance agreements can be tailored to meet the specific needs of individual risks. Unlike treaty reinsurance, which offers blanket coverage for a portfolio of policies, facultative reinsurance provides insurers with more flexibility in choosing the risks they want to cover.

4. Improved Solvency Protection

By transferring a portion of the risk to reinsurers, insurers reduce their exposure to catastrophic losses, which helps improve their solvency and financial reserves. This ensures that the insurer remains solvent even after large claims.

5. Selective Risk Acceptance

Reinsurers can assess individual risks before accepting them, giving them the opportunity to build a portfolio that aligns with their risk tolerance and profitability goals.

Challenges of Facultative Reinsurance

While facultative reinsurance offers many advantages, it also presents several challenges:

1. Time-Consuming Process

Each risk requires individual assessment and negotiation, which can be time-consuming and resource-intensive. This makes facultative reinsurance less efficient for insurers handling a large number of policies.

2. Higher Costs

Due to the detailed underwriting and negotiation involved, facultative reinsurance tends to have higher administrative costs compared to treaty reinsurance. These additional costs may reduce its appeal for insurers with high volumes of policies.

3. Potential Coverage Gaps

If an insurer is unable to secure facultative reinsurance for a particular risk, it may need to retain more exposure or decline the policy altogether. This can lead to coverage gaps or missed opportunities to insure high-risk properties.

Real-World Example of Facultative Reinsurance

Consider an insurance company that issues a policy for a $50 million commercial skyscraper. However, the insurer’s retention limit is $30 million. To cover the remaining $20 million, the insurer seeks facultative reinsurance from multiple reinsurers. Each reinsurer agrees to cover a portion of the excess risk, ensuring the insurer remains financially protected in case of a claim.

Without facultative reinsurance, the insurer would either have to decline the policy or take on excessive risk, which could jeopardize its financial stability. This example demonstrates how facultative reinsurance allows insurers to expand their underwriting capacity while managing large-scale risks.

When Should Insurers Use Facultative Reinsurance?

Facultative reinsurance is particularly useful in the following situations:

High-value properties: Insuring large or expensive assets that exceed the insurer’s financial capacity.
Specialized risks: Covering risks that are not typically included in standard treaty reinsurance agreements.
Catastrophic events: Seeking additional coverage for rare but highly impactful events.
New market entry: Expanding into new markets with unfamiliar risks.
Unique policies: Offering customized coverage for complex or high-risk situations.

Frequently Asked Questions (FAQ)

What is the main advantage of facultative reinsurance?

Facultative reinsurance allows insurers to take on high-risk policies without overexposing themselves to large losses, providing increased underwriting capacity and financial security.

How does facultative reinsurance differ from treaty reinsurance?

Facultative reinsurance is negotiated on a case-by-case basis for individual risks, while treaty reinsurance provides automatic coverage for an entire portfolio of policies under pre-agreed terms.

Why is facultative reinsurance more expensive?

Facultative reinsurance requires detailed, individualized risk assessment and negotiation, which increases administrative costs compared to treaty reinsurance.

Final Thoughts

Facultative reinsurance plays a critical role in helping insurers manage large and complex risks. While it can be more costly and time-consuming than treaty reinsurance, it offers flexibility and customization that are invaluable when covering high-value or specialized policies. For insurers seeking to expand their underwriting capacity and protect their solvency, facultative reinsurance is a powerful tool in modern risk management.