Based on its business needs, an insurer negotiates with a reinsurer,
directly or through a broker, to determine the terms, conditions
and costs of a reinsurance contract. Under a reinsurance contract,
an insurer is indemnified for losses occurring on its insurance
policies and covered by the reinsurance contract. There are no standard
reinsurance contracts although two basic types, treaty and
facultative, are used and adapted to meet individual insurers'
requirements.
Underwriting treaty reinsurance differs greatly from that of facultative
reinsurance. Reinsurance treaties automatically cover all risks
written by the insured that fall within their terms unless they
specifically exclude exposures. While treaty reinsurance does not
require review of individual risks by the reinsurer, it demands
a careful review of the underwriting philosophy, practice and historical
experience of the ceding insurer, as well as a thoughtful evaluation
of the company's attitude toward claims management and engineering
control and management's general background, expertise and planned
objectives.
Facultative reinsurance contracts cover individual underlying policies
and are written on an individual basis. Stated simply, facultative
reinsurance covers a specific risk. Both facultative and treaty
contracts may be written on a proportional or an excess of loss
basis, or a combination of both.
A facultative agreement covers a specific risk of the ceding insurer.
A reinsurer and ceding insurer agree on facultative terms and conditions
in each individual contract. In contrast, a reinsurance treaty is
a broad agreement covering some portion of a particular class or
classes of business (e.g., an insurer's entire workers' compensation
or property book of business). Historically, treaties remain in
force for long periods of time and are renewed on a fairly automatic
basis unless either party wishes to negotiate a change in terms.
Facultative reinsurance agreements often cover catastrophic or
unusual risk exposures. Prior to the 1950's, U.S. insurers made
relatively little use of facultative reinsurance and Lloyd's of
London was virtually the sole source of facultative coverages. U.S.
reinsurers began to compete with Lloyd's for facultative business
ins the 1950's and today facultative reinsurance plays a major role
in the U.S. reinsurance market.
Facultative reinsurance requires substantial personnel and technical
resources for underwriting individual risks. Often, facultative
business presents significant potential for loss, thus a reinsurer
must have the necessary staff knowledge to underwrite each exposure
accurately.
Facultative reinsurance contracts are also used to supplement treaty
arrangements when treaties contain specific exclusions, such as
exposures involving long haul trucking or munitions manufacturing.
Insurers may fill coverage voids created by reinsurance treaty exclusions
by negotiating a separate facultative reinsurance contract for a
particular policy or group of policies.
Certain classes of risks anticipated to develop significant losses
may adversely affect an insurer's treaty experience. Although not
excluded from a treaty, these risks may be placed facultatively.
For example, a primary insurer that may not ordinarily provide commercial
automobile coverage might agree, as a service to its insured, to
write such a policy as an accommodation. The company may then seek
facultative reinsurance to protect its loss experience under treaty
agreements. The reinsurer providing an insurer's treaty coverage
may not necessarily provide its facultative reinsurance.
Reinsurers also purchase their own reinsurance protection, called
retrocessions, in the same forms and for the same reasons
as ceding insurers. By protecting reinsurers from catastrophic losses,
as well as an accumulation of smaller losses, retrocessions stabilize
reinsurer results, thus serving the same risk-spreading objectives
as the initial reinsurance transaction.
Reinsurance relationships range from the simple to the complex.
An insurer may enter into a single reinsurance treaty to cover certain
loss exposures or may purchase numerous treaties until the desired
level of reinsurance protection is achieved. This process, known
as layering, uses two or more reinsurance agreements to obtain
desired level of coverage. At the time a claim comes due, the reinsurers
respond in a predetermined sequence, as necessary, to cover the
loss. Layering of reinsurance coverage is no different in principle
than the layering of excess and umbrella coverage by a policyholder,
or the purchase of specific risk coverage through a rider on an
insurance policy. It is simply a means of securing the type and
amount of insurance or reinsurance protection desired by a purchaser.
Certain fundamental principles underlie all reinsurance contracts,
regardless of how simple or complex the reinsurance transaction.
First, the only parties to a reinsurance contract are a reinsured
company and its reinsurer. All contractual rights and obligations
run only between these two companies. Second, the proceeds collectible
under the reinsurance contract are an asset of the ceding company.
Finally, as a contract of indemnification, the reinsurance is payable
only after the reinsured company has paid losses due under its own
insurance or reinsurance agreements, unless there is an insolvency
clause, which allows the receiver of an insolvent insurer to collect
on reinsurance contracts.
