The 3 Main Methods of Reinsurance: Treaty, Facultative, and Hybrid

Reinsurance is a critical risk management tool for insurance companies. It allows them to transfer a portion of policy risks to a reinsurer. There are three primary methods of reinsurance used – treaty, facultative, and hybrid. Each has advantages and disadvantages to consider.

Overview of Reinsurance Methods

• Treaty reinsurance covers a predefined group or book of business through an ongoing agreement. The reinsurer automatically accepts all risks within the treaty scope.

• Facultative reinsurance covers individual policy risks on a one-off negotiated basis. The reinsurer assess and accepts or declines each risk separately.

• Hybrid reinsurance combines elements of treaty and facultative approaches. The insurer cedes certain risks meeting set criteria, which the reinsurer can review and accept or reject individually.

• Most reinsurance arrangements use treaty or hybrid methods for efficiency. Facultative is used selectively for unique, complex or high-value risks.

• The approach used depends on factors like portfolio size, risk diversity, ceding company preferences and capital resources.

What is Treaty Reinsurance?

Treaty reinsurance is the most common arrangement. It involves a standing agreement covering a specified book of business:

• Reinsurer accepts all risks within scope without individual risk assessment.

• Scope defined by line of business, geography, policy limits or other criteria.

• Typically 12-month contracts renewed annually.

• Premiums and claims shared on an ongoing proportional basis.

• Administration is simple with little risk evaluation required.

• Allows insurers to easily grow business volume and diversify risks.

• Very common for high-volume, small-to-medium sized risk portfolios.

Advantages: Broad coverage, simple administration, portfolio diversification

Disadvantages: Reinsurer has limited underwriting control, high ceding commissions

What is Facultative Reinsurance?

With facultative reinsurance, risks are assessed and reinsured individually:

• No pre-defined covered risk group. Applies to specific policies.

• Ceding insurer offers risks, reinsurer evaluates and accepts/declines each one.

• Typically used for large, unusual or complex risk exposures.

• Reinsurer has full underwriting control to limit adverse selection.

• Each policy reinsured is separately negotiated.

• Higher administration costs but reinsurer retains selectivity.

• Vital where treaty reinsurance capacity is unavailable.

Advantages: Flexibility, risk selectivity, covers unique exposures

Disadvantages: High administrative costs, less diversification

What is Hybrid Reinsurance?

Hybrid reinsurance combines elements of treaty and facultative:

• Reinsurer automatically accepts risks meeting set underwriting criteria.

• For risks exceeding criteria, reinsurer can individually assess and accept or decline.

• Provides efficiencies of treaty approach with selectivity of facultative.

• Simplified administration for risks meeting guidelines.

• Individual risk evaluation when ceding insurer’s limits exceeded.

• Balances ceding insurer’s portfolio needs with reinsurer’s risk management.

• Also called facultative-obligatory or treaty-facultative reinsurance.

Advantages: Blends risk selectivity with administrative efficiency

Disadvantages: Complex to administer, still cedes some marginal risks

Detailed Overview and Comparison of Reinsurance Methods