The Value of Non-Proportional Facultative Reinsurance

Obtaining Large Capacity Through the Use of Non-Proportional Facultative Reinsurance





Summary
Non-proportional facultative solutions are characterized by flexibility for easy integration with reinsurance treaties, and thus facilitate an effective and efficient division of responsibilities between the insurer and the reinsurer. The insurer is free to structure its product and premium for the insured in conjunction with a broker, and the reinsurer bears the risk from volatility and the exposure to major loss that this element entails – precisely one of the purposes of reinsurance.


While coinsurance is still used to structure programs in many markets, insurers increasingly accept leading participations in risks. Indeed, they frequently endeavour to accept and retain risks entirely on their own. The high capacities this approach requires are traditionally purchased on a proportional facultative basis. However, insurers are now also using non-proportional facultative reinsurance as an efficient method of generating high capacities. Non-proportional facultative allows the insurer to fix the scope of cover and the price of the original policy directly, and independently of the facultative market.
A number of possibilities are available for structuring non-proportional facultative capacity, working with current treaty structures. The general principle is that, in the case of non-proportional facultative reinsurance, the insurer carries more exposure in the frequency claims area. By way of compensation, it receives a larger share of the premium for the purpose of financing the correspondingly higher frequency loss burden. Therefore, non-proportional facultative reinsurance offers efficient risk transfer, high capacities offered at low premiums, and protection against volatility arising from unpredictable large losses or severe risk elements. Frequency claims, which can be predicted across a book, are left to the insurer to manage.
Without doubt, non-proportional facultative reinsurance easily complements non-proportional treaties. However, non-proportional facultative reinsurance, in conjunction with proportional treaties, is also possible and frequently occurs, generally by means of appropriate agreements with the treaty reinsurer(s). The treaty fares adequately, since the higher risk share is offset by a corresponding premium. The agreement usually states that the cession of individual risks to the treaty, using non-proportional facultative capacity, is allowed if the reinsurer is notified of such cessions. This information enables the treaty reinsurer to consider and account for the so-called compression of the obligatory treaty, e.g. its exposure by being in a first-loss position. The decisive factor is that the treaty reinsurer must be aware of the purchase of this type of facultative cover in order to avoid any claim surprises. Compression is simply an issue of allotting the correct premium to the increased exposure to frequency claims. In the case of carve-out covers (facultative reinsurance for single/severe risk elements only) for reducing volatility or increasing the retention share on proportional risks or risk segments, the reinsurance treaty enjoys the same benefits as the retention. Transparency and disclosure to the obligatory treaty reinsurers are also necessary in these cases.
As many terms are used to describe the same concepts, we use "retention" to mean the portion of a risk remaining with an insurer, and "layer" to mean non-proportional facultative reinsurance.
The Structural Flexibility of Non-Proportional Facultative:
Using Non-Proportional Facultative with Existing Obligatory Treaties
Several options are available to insurers for structuring non-proportional facultative capacity, and the selection will depend on the insurer's objectives. We provide four examples to illustrate the flexibility of non-proportional facultative products.
The first and simplest structure allows the layer to be placed in excess of the retention and the treaty (see figure 1). The layer is not a factor until the retention and the treaty capacity for the agreed exposure have been exhausted. However, in this structure it should be noted that both the treaty and the retention are compressed, as noted above, and thereby exposed on a first-loss basis. With regard to risk-adequate premium distribution between retention, treaty and layer, this so-called compression is not problematic. However, whether or not the reinsurance treaty wording permits such compression must be examined. In general, treaty reinsurers should be aware of and approve non-proportional facultative cessions in order to preclude those claim surprises. In many markets, and for many insurers, reinsurers approve the compression of treaties, due to the fact that it is only an issue of adequate pricing for the first-loss position on a select number of risks in the portfolio. 

 


Using Non-Proportional Facultative without the Existing Obligatory Treaty Strucutre
In the event of no agreement with treaty reinsurers, it is possible to structure non-proportional facultative reinsurance solely on the basis of an insurer's retention, or to agree to a second retention for the insurer. By this second method, risks are ceded to the proportional treaty in the traditional manner, i.e. the obligatory treaty is not affected by the facultative reinsurance. In order to avoid the obligatory treaties being compressed, a layer may relate exclusively to the relative share of the retention or, put another way, be placed above the retention (see figure 2). Once the retention has been fully exhausted, the layer bears the risk. Depending on the attachment point of the layer, the insurer is entitled to the majority or large share of the premium. 







If the insurer has already protected its retention by an excess of loss (XL) treaty, such an arrangement does not directly achieve the capacity objective without compression of the XL treaty. Here, the facultative requirement above a second retention could be covered in order to leave the XL treaty untouched (see figure 3). However, in this structure, the insurer absorbs an increased retention, which is not always in its interest. In this case, if for reasons of corporate policy the insurer is not willing to bear a higher net loss from a total loss event, it is possible to purchase additional accumulation protection for the two retentions. The absolute net exposure of the insurer would be restricted to the size of the first retention.







As an alternative and fourth method of leaving the obligatory treaties unaffected given an existing XL cover for the retention, it is also possible to place a layer based on an increased gross retention (see figure 4). In this structure, the proportional treaty is used for capacity generation purposes as usual. The insurer's original gross retention is increased by a unique non-proportional facultative structure. The layer is placed above the original net retention and is included in the cover provided by the XL treaty. This arrangement represents a different form of capacity generation on a non-proportional basis taking into account the existing XL treaty. The facultative reinsurer pays for losses above the insurer's net retention. In the event of a loss this reinsurer will check whether or not a claim against the XL treaty is justified. In relative terms, this solution leaves the insurer more highly exposed to basic losses. However, the insurer retains a fairly large proportion of the premium for financing the correspondingly higher loss burden, since it bears a higher relative proportion of the original risk.







While there are many other capacity-generating structures using non-proportional facultative reinsurance, these four most basic methods use treaty capacity or net retentions of the insurer. We welcome having more in-depth discussions with you about other possible solutions.
Non-Proportional Facultative Reinsurance Programmes
At times, it makes sense for an insurance company to package its individual risk non-proportional facultative placements into a facultative programme. Such programmes improve efficiencies and streamline cession procedures, while offering the comfort and benefits of automatic protection. Facultative programmes are supported by a contract between the insurer and the reinsurer, defining the obligations of each party, the automatic capacities, the reinsurance rating mechanism and the risk reporting procedures.
Facultative programmes are an appropriate means of reinsuring a variety of facultative portfolios. Homogeneous books of business are perfect candidates for such programmes. Similarly, a large number of small facultative capacities exceeding treaty limits can also be packaged into a facultative programme. Non-proportional facultative programmes are also an excellent alternative to treaties if a balanced portfolio has not been achieved. An imbalance between liability and premium volume is often created when there are too few risks in the portfolio, or in the case of new insurance products and multi-line policies. Since facultative programmes, like in any facultative reinsurance, accept a higher level of volatility than treaties, they can be appropriate solutions for such unbalanced portfolios.
Unlike treaties, programme capacities and premiums are based on the individual risk cessions within the scope of the agreed coverage and premium calculation mechanism. The contract will set forth the scope very clearly and establish a simple administrative procedure for each risk cession. Depending on the type of ceded portfolio, premium calculation can take a prerated automatic or individual quoting approach as risks are ceded. Reporting of cessions and premium can also be done on a case-by-case basis or summed up in monthly or quarterly bordereaus for greater efficiency, the latter being particularly desirable where the facultative cessions are small but numerous. Even though a programme grants guaranteed capacity, it still offers the advantages of facultative reinsurance through individual reinsurance treatment of each cession, thereby allowing individual risk discussions between insurer and reinsurer as appropriate.


By:

Willfried Schnabel & Gabi Blomberg -