4.3 Reinsurance Methods: Facultative vs Treaty, Proportional vs Non-Proportional

Primary Placement Methods: Facultative vs Treaty Reinsurance

Reinsurance arrangements are structured using two fundamental placement mechanisms: facultative reinsurance and treaty reinsurance. The core distinction lies in whether the risk is negotiated on an individual, discretionary basis or ceded automatically under an overarching contractual framework.

Facultative Reinsurance: Characteristics, Advantages, and Limitations

The term facultative is derived from the Latin facultas, meaning "liberty" or "power." In facultative reinsurance, the transaction is negotiated entirely on an individual, risk-by-risk basis.

• Dual Discretion: Complete freedom of contract exists on both sides. The cedant has total liberty to decide whether to offer the specific risk to the reinsurer, and the reinsurer has complete freedom to accept, reject, or modify the terms and pricing of the offer.
• Exhaustive Disclosure: Because the reinsurer evaluates the specific risk independently, the cedant must submit a full technical presentation—including engineering surveys, site plans, loss histories, and operational profiles—via a dedicated facultative slip.
• Primary Commercial Applications:
  • Exceptional, highly hazardous, or unusual risks that are specifically excluded from the cedant's standard reinsurance treaties (e.g., fireworks manufacturing or high-risk offshore drilling).
  • High-value commercial assets where the total sum insured exceeds the monetary capacity limits of the cedant's existing treaties (e.g., an international airport terminal or flagship bridge).
  • Protecting the cedant's treaty loss record by "carving out" a volatile risk that could otherwise trigger severe treaty losses and inflate future treaty renewal premiums.
• Operational Limitations: Facultative placement involves substantial administrative overhead, broker fees, and time delays. The cedant must obtain the reinsurer's acceptance and confirm when cover attaches under the agreed terms; an unaccepted submission provides no facultative protection.

Treaty Reinsurance: Portfolio Protection and Obligatory Cession

Treaty reinsurance is an overarching contractual agreement under which the reinsurer agrees in advance to accept, and the cedant agrees to cede, all risks that fall within defined underwriting parameters over a specified term (usually 12 months).

• Automatic and Obligatory: The treaty is mutually binding. The cedant is contractually obligated to cede every policy written that matches the treaty class and criteria; it cannot pick and choose ("anti-selection"). Conversely, the reinsurer is contractually obligated to accept every qualifying risk ceded without individual inspection.
• Underwriting on "Blind Trust" (Uberrima Fides & Utmost Good Faith): The treaty reinsurer does not examine individual policies or risk surveys. Instead, the treaty reinsurer places faith in the cedant's underwriting competence, governance, and integrity. The reinsurer evaluates the cedant's past claims records, rating guidelines, and management quality before executing the annual treaty.
• Primary Commercial Applications: Standardized commercial portfolios—such as commercial motor fleets, marine cargo, domestic property, or standard employers' liability.
• Operational Advantages: Low transaction cost per policy, administrative efficiency, and instant capacity. The primary underwriter can bind multi-million-pound commercial risks at the direct broker's desk, knowing treaty reinsurance attaches automatically.

Facultative-Obligatory (Fac/Oblig) Agreements

A hybrid placement form is the Facultative-Obligatory (Fac/Oblig) agreement. Under a Fac/Oblig contract, the cedant has complete discretion (facultative) whether or not to cede a particular risk, but if the cedant elects to cede the risk within the pre-agreed contractual boundaries, the reinsurer is legally obligated to accept it. Reinsurers price Fac/Oblig contracts cautiously due to the inherent potential for adverse selection against the reinsurer.

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Comparison of Facultative and Treaty Methods

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Proportional Reinsurance Mechanics: Quota Share and Surplus Treaties

Reinsurance contracts are categorized technically into two operational structures: Proportional and Non-Proportional.

In proportional (pro rata) reinsurance, premiums and claims are shared between the cedant and reinsurer in direct, predetermined mathematical proportions. If a reinsurer accepts 40% of the sum insured, it receives 40% of the gross premium (less commission) and pays exactly 40% of every covered loss.

Ceding Commission and Profit Override

Because the primary insurer incurs the operational expenses of marketing, broker commissions, risk surveys, policy drafting, and regulatory compliance, the proportional reinsurer reimburses the cedant by paying an agreed ceding commission (e.g., 25% to 30% of ceded premium). In highly profitable treaties, the reinsurer may also grant a profit commission (or profit override), returning a further percentage of net treaty underwriting profits back to the cedant.

1. Quota Share Treaties: Fixed Proportion Cession

A Quota Share treaty is the purest proportional mechanism. A fixed, uniform percentage of every single policy written within the specified portfolio is ceded to the reinsurer, subject to an agreed maximum monetary limit per risk.

• Mechanics: If a cedant maintains a 30% Quota Share treaty with a maximum limit of £3,000,000:
  • For every qualifying policy issued, the cedant retains 70% of the sum insured, keeps 70% of the premium, and pays 70% of all losses.
  • The reinsurer receives 30% of the premium (less ceding commission) and pays 30% of all losses.
• Commercial Purpose: Quota share treaties provide immediate capital relief for fast-growing insurers or newly established Lloyd's syndicates that lack large capital reserves. Sharing every covered loss reduces the cedant's retained loss exposure and can ease solvency strain; the retained percentage still bears a share of claims volatility.

2. Surplus Treaties: Monetary Lines and Variable Proportions

A Surplus treaty introduces flexibility by allowing the insurer to retain smaller risks entirely for its own account, ceding only the "surplus" exposure exceeding its defined capacity.

• The Line Concept: The cedant establishes a fixed monetary retention limit termed one line (e.g., £200,000). Any risk with a sum insured equal to or less than £200,000 is 100% retained by the cedant (0% ceded).
• Treaty Capacity in Lines: The capacity of the surplus treaty is expressed as a multiple of the retention (e.g., a "4-line surplus treaty"). If one line is £200,000, a 4-line treaty provides £800,000 of surplus capacity.
• Maximum Underwriting Capacity: Total underwriting capacity equals the cedant's retention (1 line) plus the treaty lines: $\text{Total Capacity} = \text{Retention (1 Line)} + \text{Treaty Lines} = £200,000 + £800,000 = £1,000,000$
• Variable Proportional Apportionment: Unlike Quota Share, the proportion of premium and losses ceded in a Surplus treaty is variable, calculated individually for each risk based on the ratio of ceded surplus to the total sum insured: $\text{Ceded Amount} = \min(\max(\text{Sum Insured} - \text{Retention},0),\text{Treaty Capacity})$ $\text{Ceded Proportion} = \frac{\text{Ceded Amount}}{\text{Sum Insured}}$ Risks within the retention are wholly retained. Any amount above total insurer-plus-treaty capacity needs separate protection or remains outside the assumed capacity of this example.

Surplus Treaty Calculation Scenarios

Consider a commercial property insurer with a £200,000 retention (1 line) protected by a 4-line Surplus treaty (maximum surplus capacity £800,000; total capacity £1,000,000):

Notice that in Risk B, the sum insured is £500,000. The cedant keeps £200,000 (40%) and cedes £300,000 (60%). When a £100,000 loss occurs, the claim is apportioned in identical percentages: £40,000 paid by the cedant, £60,000 paid by the reinsurer.

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Non-Proportional Reinsurance (Excess of Loss)

In non-proportional reinsurance, there is no proportional sharing of sums insured or premiums. Instead, the reinsurer agrees to indemnify the cedant for the amount of any loss exceeding a predetermined financial threshold, known as the retention, deductible, priority, or attachment point, up to an agreed monetary ceiling termed the layer limit.

Excess of Loss contracts are universally expressed as: $\text{Limit} \text{ excess of } \text{Retention} \quad (\text{e.g., } £5,000,000 \text{ xs } £5,000,000)$ In this structure, the cedant bears the first £5,000,000 of any covered loss. The reinsurer indemnifies claims exceeding £5,000,000 up to a total loss of £10,000,000. If a loss reaches £8,000,000, the cedant pays £5,000,000 and the reinsurer pays £3,000,000.

Premium Mechanics

Non-proportional reinsurers do not receive a proportional slice of the original policy premium, nor do they pay ceding commissions. Instead, they charge an independently negotiated premium. Rate on Line (ROL) is the reinsurance premium divided by the layer limit, expressed as a percentage. A treaty may separately calculate or adjust its premium by applying an agreed rate to defined subject premium income, such as GNPI; that rate has a different denominator.

The Three Primary Excess of Loss Types

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1. Per Risk Excess of Loss (Working Layer)

• Operational Scope: Applies separately to each individual loss event affecting a single insured risk (e.g., an explosion at a chemical refinery or a major fire in an office block).
• Function: Absorbs large individual shock losses, insulating the cedant's net account from volatility. Highly active low-deductible layers are called working layers because they expect regular claim activity.

2. Per Event / Catastrophe Excess of Loss (Cat XOL)

• Operational Scope: Aggregates all individual claims arising across an entire portfolio from a single catastrophic occurrence (e.g., a hurricane, earthquake, tsunami, or riot).
• Function: Protects the insurer against balance-sheet insolvency caused by accumulation risk.
• The Hours Clause: Natural catastrophes operate over extended geographic areas and multiple days. To determine what constitutes a "single event" for deductible and limit purposes, Cat XOL contracts commonly use an Hours Clause as part of their loss-occurrence definition:
  • The wording specifies consecutive time periods for the relevant perils, for example 72 hours for windstorm or 168 hours for earthquake. Periods for flood and other perils depend on the contract.
  • Covered individual losses must satisfy the treaty's catastrophe, timing and other aggregation requirements to form one loss occurrence. Unrelated losses are not combined merely because they occur within the same window.
  • The contract may allow the cedant to select the starting time, subject to its stated conditions and restrictions on overlapping periods.

3. Stop Loss / Aggregate Excess of Loss

• Operational Scope: Protects the cedant's overall annual loss ratio or aggregate monetary results across an entire class of business over a full calendar year.
• Function: A Stop Loss treaty might cover losses when the cedant's aggregate loss ratio exceeds 75% up to a maximum ceiling of 115%. Unlike Per Risk or Cat XOL, which protect against individual high-severity losses, Stop Loss protects the insurer against a destructive frequency of medium-sized attritional losses that never breach individual per-risk deductibles.

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Reinstatement Provisions and Reinstatement Premiums

Treaty limits and their availability are defined by the contract. In excess-of-loss cover with a limited annual recovery, a covered loss uses part or all of the available layer. Reinstatement provisions can restore that amount for subsequent losses, subject to the agreed number of reinstatements and overall annual capacity.

To restore protection for subsequent losses, Excess of Loss contracts incorporate a Reinstatement Clause:

• Reinstatement Terms: The treaty specifies the number of reinstatements permitted (e.g., "1 full reinstatement" or "2 reinstatements at 100% additional premium").
• Reinstatement Premium: While some treaties provide "free reinstatements," paid reinstatements require an additional reinstatement premium. The clause determines when reinstatement takes effect and how the premium is settled.
• Calculation Terms: Reinstatement premiums use the agreed percentage of the layer premium. A common basis is pro rata as to amount, with no reduction for time. If the contract specifies100% premium pro rata as to both amount and time, use: $\text{Reinstatement Premium} = \text{Original Layer Premium} \times \left( \frac{\text{Loss Paid}}{\text{Layer Limit}} \right) \times \left( \frac{\text{Days Unexpired in Policy Year}}{365} \right)$

Worked Reinstatement Example

An insurer maintains a £10,000,000 Cat XOL layer with an annual premium of £400,000. Exactly halfway through the policy year (182.5 days remaining), a hurricane causes an agreed claim of £5,000,000 (eroding 50% of the layer limit). The treaty provides one reinstatement at 100% additional premium pro rata as to amount and time:

$\text{Reinstatement Premium} = £400,000 \times \left( \frac{£5,000,000}{£10,000,000} \right) \times \left( \frac{182.5}{365} \right) = £400,000 \times 0.50 \times 0.50 = £100,000$

Under these specified terms, restoring the £5,000,000 used costs £100,000 and makes the full £10,000,000 available for a later event, subject to the remaining annual capacity. The reinstatement clause governs when cover is restored and payment is due. With amount-only terms, the same loss would instead generate £200,000 of reinstatement premium.