Reinsurance is often described as insurance for insurance companies. It’s a way for insurance companies to transfer some of the financial risk they assume when issuing insurance policies. They do this by ceding (passing) some of their risk on to another insurance company, the reinsurer. What are the main types of reinsurance?

There are two basic types of reinsurance arrangement: facultative reinsurance and treaty reinsurance. Facultative reinsurance is designed to cover single (or defined packages of) risks, whereas treaty reinsurance covers a ceding company’s entire book of business.

Facultative reinsurance

With facultative reinsurance, the ceding company offers a defined package of risks to a reinsurer. The reinsurer retains the right to accept or reject the risk, just like the primary insurer has the right to decide whether to insure a policyholder. In deciding, the reinsurer will perform its own underwriting for some or all of the policies to be reinsured, and each policy is considered a single transaction.

Such reinsurance is often used for high-value/hazardous risks because the policies can be tailored to specific circumstances, and the reinsurer may insist the ceding company retains some of the liability on the riskiest policies. In those scenarios, the ceding company may have to approach multiple reinsurers to transfer ant remaining liability.

Treaty reinsurance

In contrast, in treaty reinsurance the ceding company transfers all risks within a book of business to the reinsurer. For example, a primary insurer might transfer its entire book of commercial auto or all of its homeowners’ risk. The two parties enter into an agreement, known as the treaty, in which the reinsurer is obliged to accept all covered business issued by the primary insurance company.

Treaty reinsurance arrangements are typically long-term, and will include accepting policies the ceding company has not yet written, as long as they fit in with the treaty’s pre-agreed definitions of risk class. The reinsurer typically expects to make a profit, but these expectations are measured and adjusted over time.

In contrast to facultative arrangements, treaty reinsurers do not carry out individual underwriting on the risks assumed. That responsibility is left to the ceding company, which is why reinsurers will do lots of due diligence to ensure the ceding company is practicing adequate underwriting processes before entering a treaty.

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