Reinsurance Explained: Treaty vs Facultative

Insurance companies don't carry every risk they underwrite entirely on their own books. When an insurer writes a policy covering a major property, a large liability exposure, or an entire book of similar risks, it often passes some of that risk on to another insurer in exchange for a share of the premium. This is reinsurance, and the two main ways it's structured, treaty and facultative, determine how much of an insurer's book is covered and how much discretion remains over individual risks.

What Reinsurance Does

Reinsurance is insurance for insurance companies. A primary insurer, sometimes called the "cedant" or "ceding company", transfers part of the risk it has underwritten to a reinsurer, paying a premium in exchange. If a claim arises, the reinsurer pays its agreed share, reducing how much the primary insurer has to cover from its own capital. Reinsurance serves several purposes for an insurer: it limits exposure to catastrophic losses that could otherwise threaten solvency, it frees up capital that would otherwise be held in reserve against large or concentrated risks, and it allows an insurer to write larger or riskier policies than its own balance sheet could support alone.

Treaty Reinsurance

Treaty reinsurance is an agreement covering an entire category or book of business automatically, rather than being negotiated risk by risk. Under a treaty, the primary insurer agrees to cede, and the reinsurer agrees to accept, a defined share of every policy that falls within the treaty's scope, for example all commercial property policies the insurer writes in a given year up to a certain size. Because acceptance is automatic within the agreed terms, treaty reinsurance is efficient to administer and gives the primary insurer certainty of cover across its whole book without needing to negotiate each individual risk. The trade-off is that the reinsurer has less visibility into each specific risk it's taking on, and instead prices the treaty based on the overall quality and historical loss experience of the insurer's book as a whole.

Facultative Reinsurance

Facultative reinsurance works the opposite way. Each individual risk is offered to the reinsurer separately, and the reinsurer has the "faculty", or choice, to accept or decline it and to price it on its own specific merits. This is typically used for unusually large, complex or unusual risks that fall outside the scope of an insurer's standard treaties, such as a single very high-value commercial property or a bespoke liability exposure. Facultative reinsurance gives both parties more control and underwriting precision on that one risk, but it takes more time and administrative effort to arrange than treaty cover, since every risk has to be separately underwritten and agreed.

Proportional and Non-Proportional Structures

Within both treaty and facultative reinsurance, cover can be structured as proportional or non-proportional. In proportional reinsurance, the reinsurer takes an agreed percentage of every premium and every claim on the covered business, sharing losses and premium income in that fixed ratio. In non-proportional reinsurance, often called excess-of-loss cover, the reinsurer only pays once losses exceed an agreed threshold, acting more like an insurance policy on the insurer's aggregate losses rather than a straightforward sharing arrangement. Excess-of-loss treaties are particularly common for catastrophe risk, where an insurer wants protection against a single severe event rather than routine, predictable claims.

Reinsurance Alongside Other Risk Transfer Tools

Reinsurance sits alongside other structures insurers and corporates use to manage concentrated risk. A company that self-insures through a captive insurer will typically still buy reinsurance to cap the captive's own exposure to a severe loss, effectively layering risk transfer on top of self-insurance. At the largest end of the market, insurers and reinsurers also increasingly use capital markets structures such as catastrophe bonds and insurance-linked securities to pass peak catastrophe risk directly to investors, supplementing traditional reinsurance capacity when it is scarce or expensive.

Reinsurance in Finance and Accounting Careers

Reinsurance arrangements have a direct effect on an insurer's financial statements, from how premium income and claims are recognised net of ceded reinsurance, to how reinsurance recoverables are assessed for credit risk under current accounting standards. Actuaries, auditors and finance professionals working with insurers need a solid grasp of how treaty and facultative structures affect reported results, and this is an area covered within the broader insurance and risk finance topics in Learnsignal's CPD courses.

FAQ

Who buys reinsurance?
Primary insurance companies buy reinsurance to manage their own risk; it's a business-to-business market between insurers and reinsurers rather than something available directly to individual policyholders.

Is treaty reinsurance cheaper than facultative reinsurance?
Generally treaty reinsurance is more cost-efficient per unit of risk because of its automatic, portfolio-wide structure, while facultative reinsurance carries higher relative costs due to the individual underwriting effort each risk requires.

Can an insurer use both treaty and facultative reinsurance at the same time?
Yes. Most large insurers run a core treaty programme covering their standard book of business, and supplement it with facultative reinsurance for specific large or unusual risks that fall outside the treaty's scope.