This is the original form of reinsurance. Participation by the reinsurer in risk is not pre-arranged through a standing treaty contract.
Reinsurance has to be arranged by the insurer after getting a proposal of insurance from the would-be insured and preferably before giving any cover to the proposer.
Normally, after getting a proposal for insurance, the insurer decides how much he can retain on that particular risk.
If there remains a balance of retention, he goes to the facultative market with the request to make reinsurers interested in the risk. This request is usually made through a slip detailing the particulars of the risk.
If a reinsurer is interested in the risk, then he initials the slip clearly indicating the percentage or amount of risk he is willing to subscribe.
In this way, the insurer goes from the reinsurer to the reinsurer unless 100% of the risk is absorbed.
It is only then that the insurer is theoretically safe in issuing a cover to the insured for the full amount. It should be known by the students that reinsurers are not bound to accept risk when approached.
Facultative reinsurance explained with examples
Example:
Insurance company XYZ has received a proposal for $10,000,000 from a jute mill. For a jute mill, the company’s retention is $1,000,000. The company has no standing treaty arrangement.
This means that if company XYZ has to accept the full risk, it must go for facultative reinsurance and try the market until the full $10 million is absorbed.
After trying ten companies, say by the names A, B, C, D, E, F, G, H, I and J, the final closure of the business may look as follows;
| Company: | Percentage of acceptance | Amount of acceptance |
| A | 20% | $2,000,000 |
| B | 15% | $1,500,000 |
| C | 15% | $1,500,000 |
| E | 10% | $1,000,000 |
| G | 10% | $1,000,000 |
| H | 10% | $1,000,000 |
| J | 10% | $1,000,000 |
| XYZ (Retention) | 10% | $1,000,000 |
| 100% | $10,000,000 |
In this way, the whole amount has been absorbed and there is no difficulty of the XYZ Insurance Company in assuming the whole risk of $10,000,000 from the jute mill.
The student should realize from the above example that companies D. F and I were also tried, but they refused to participate in the risk as reinsurers.
The student should also appreciate that if the ceding company (XYZ), after trying all possible sources, could only manage up to 90% (including its retention), then.
In theory, it would not have been possible on its part to assume the risk from the jute mill for the full amount since such an attempt would create undesirable additional pressure on its fund to the extent of $10,000,000, for which there is no provision there.
It should be borne in mind by the students that in the case of a loss, it will also be paid by the reinsurers in the same proportion.
Merits of Facultative Reinsurance
- This type of reinsurance is advantageous to the ceding company since it can pick and choose which risks are to be reinsured and which risks are not.
- It is advantageous to reinsurers because they can apply underwriting judgment case by case and may accept or reject it. This is not so in treaty arrangements.
Demerits of Facultative Reinsurance
- The formalities involved in obtaining cover are much more expensive in comparison to the treaty.
- A lot of inconveniences are envisaged in the procedure involved.
- The insured is left insecure during the time required for the arrangement of facultative cover. Any mishap may take place during this period.
- Such a situation arising out of (iii) above may cause the business to be lost to a competitor who might have automatic treaty cover.
You must note that even though the demerits outweigh the merits, nevertheless, such a practice is still there for necessity and shall remain, howsoever advantageous the treaty arrangements might be.