Based on its business needs, an insurer negotiates with a reinsurer 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. While there are no standard reinsurance contracts, treaty and facultative contracts are the two basic types used and adapted to meet individual insurers' requirements. Both facultative and treaty contracts may be written on a proportional or an excess of loss basis, or a combination of both.
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 a change in terms is desired. 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, including a thoughtful evaluation of the company's attitude toward claims management, engineering control, as well as the management's general background, expertise and planned objectives.
In contrast, facultative reinsurance contracts cover individual underlying policies and are written on a policy-specific basis. A facultative agreement covers a specific risk of the ceding insurer. A reinsurer and ceding insurer agree on terms and conditions in each individual contract. Facultative reinsurance agreements often cover catastrophic or unusual risk exposures.
Because it is so specific, facultative reinsurance requires the use of substantial personnel and technical resources for underwriting individual risks. Furthermore, facultative business often presents significant potential for loss. Therefore, a reinsurer must have the necessary staff knowledge to underwrite each exposure accurately.
Facultative reinsurance contracts may also supplement treaty arrangements when the treaties contain specific exclusions, such as exposures involving long haul trucking or munitions manufacturing. Insurers may fill voids in coverage created by reinsurance treaty exclusions by negotiating a separate facultative reinsurance contract for a particular policy or group of policies.
In addition, certain classes of risks that may develop significant losses could adversely affect an insurer's treaty experience. Although not excluded from a treaty, these risks may be placed facultatively. For example, to accommodate a policyholder, an insurance company that would not ordinarily provide commercial automobile coverage might agree to provide the coverage. The insurer may then seek facultative reinsurance to protect its losses under applicable 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, thereby spreading the risk.
Reinsurance relationships range from simple to 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 a 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 similar in principle to the purchase of specific risk coverage through a rider on an insurance policy. Layering allows an insurer to secure the type and amount of insurance or reinsurance protection desired.
There are certain fundamental principles underlying all reinsurance contracts regardless of how simple or complex the 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 payments that may be collected under the reinsurance contract are an asset of the ceding company. Finally, as a contract of indemnification, the reinsurance is payable only after the ceding insurer has paid losses due under its own insurance or reinsurance agreements. The exception to this final principle falls under an insolvency clause, which allows the receiver of an insolvent insurer to collect on reinsurance contracts.
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