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3

Features and Operation of Facultative Reinsurance

A- Requirements of facultative cover Follow the terms, conditions and exclusions of the original insurance policy. As original The term as original remains a contentious and problematic area.

B- Facultative proportional reinsurance


B1. Premium and claims calculations Reinsurer R accepts 10% of a facultative proportional reinsurance with a sum insured of 50 million at an original gross rate of 2%o.
What is the GP due to R?

C- Facultative non-proportional reinsurance

A fixed premium is paid by the reinsured to the reinsurer, usually at inception or by installments.

Example
This type of business is described as non-proportional because the reinsurer does not receive a fixed proportion of the premium in relation to the risk nor does it take a proportion of the claim. Once the claim exceeds a set limit, e.g. a retention of 250,000, the reinsurance contract is obliged to respond to the entire loss.

Illustration
Non-proportional reinsurance has been arranged for 500,000 excess of 250,000 Loss 500,000 less reinsureds retention 250,000 = 250,000 paid by reinsurers Reinsureds share of loss = 50% Reinsurers share of loss = 50% However if the loss were 625,000 less retention 250,000 = 375,000 paid by reinsurer Reinsureds share of loss = 40% Reinsurers share of loss = 60%

C1.

Features of facultative non-proportional reinsurance

Common Account
Besides buying facultative excess of loss reinsurance for its own protection, the reinsured may decide it also wants to protect the cession made to its proportional treaty reinsurers. This is referred to as protecting the common account and so benefits both the reinsured and its reinsurers to the full sum insured potential of the original risk. An example of low this works can be seen in figure 3.1

(i) TSI (total sum insured)


Fac. Excess protecting cedants retention
Pro-rata Treaty Cedants absolute net retention

(ii) TSI
Fac. Excess for common account

Cedants absolute net retention

Pro-rata Treaty

Retained by cedant 20% (say)

Ceded to Pro-rata treaties

100%

20%

100%

Captive insurance company Facultative excess of loss reinsurance is appropriate when:


Additional capacity is required to handle risks exceeding its existing limits; or No automatic cover is currently in existence for the particular class of business concerned; or The insurer does not want to expose its treaties to a certain risk.

C2.

Application of facultative non-proportional reinsurance


More beneficial administratively than on a proportional bases.

Example
Original risk: 60 million which is shared equality between insurer A and insurer B with 30 million each. Insurer A has a surplus reinsurance treaty of nine lines with a retention of 3million, so its gross automatic capacity is its retention of 3million plus 9 lines of 3million, in other words (3million plus 27 million) 30million. Insurer B has facultative excess of loss reinsurance of 27million excess of 3 million. This means that the facultative reinsurance would pay any loss incurred by insurer B that exceeds 3 million up to a total of 27 million (i.e. giving B cover for any original loss it sustains up to 30 million.
When any loss to this original risk occurs, whether partial or total, insurer A can expect to recover 90%o, or 27/30 from its surplus reinsurer. Conversely, insurer Bs facultative excess of loss reinsurance will only allow a recovery of any claim where Bs 50% share exceeds 3million.

Illustration:
Consider the following three losses: Loss 1. 2 million Insurer A can recover 90% of its 1 million share, so 900,000. Insurer B recovers nothing because its 3 million retention (or deductible) isnt exceeded. Loss 2. 5,500,000 Insurer A can recover 90% of its 2,750,000 million share, so 2,475,000. Insure B again recovers nothing because its 3 million retention (or deductible) isnt exceeded.

Loss 3. 8 million Insurer A can recover 90% of its 4 million share, so 3,600,000.
Insurer B can recover 1 million its 3 million retention (or deductible) has been exceeded.

Retention
The factors which influence the retention in a facultative arrangement are:
EML The class of risk in terms of its vulnerability (the insurer will retain more of the good risks than the bad) Any other commitments on the risks; Exposures from other nearby risks; Particular features of the risk in question which make it more or less attractive.

C3. Premium and claims calculations


Example
A food processing is valued at 50 million. The insurer seeks facultative excess of loss reinsurance broken down into three layers; 1st layer 2nd layer 9.5 million excess of 500,000. 20 million excess of 10 million.

3rd layer

20 million excess of 30 million.

Reinsurers participating on the third layer are liable for an amount equivalent to 40% of the total value (20 million part of 50 million). However, they cannot be exposed to a loss unless it exceeds 30 million. Experience tells us that there is a considerable difference in relationship between the total number of claims (the frequency of loss) and the size of claims that occur (the severity of loss).

100%

% of premium income

(B) 20%

0% 0%

50% (A)

100%

Deductible as a % of the value of risk If the amount of the deductible = A then the % of the premium for reinsurers = B

100%

% of premium income B

0% 0% A X 100%

Total value of risk or reinsurance if the amount of reinsurance required = the differenct between A and X Then the % of the premium for that exposure = the differenct between B and Y.

In the case of our food processing plant, the ceding company could meet its objective of a maximum retained amount per claim of 500,000 by combining proportional and excess of loss protection. For example, the cedant could retain 10% of the original risk and reinsurance 90% on a pro-rata basis. It could then seek to purchase excess of loss protection for, say, 10 % of 5 million excess of 5 million and 10% of 40 million excess of 10milion which would provide protection up to a total loss. The overall effect would be to reduce the companys maximum net exposure to 500,000, being 10% of the first layer deductible. Following figure shows how this would look in diagrammatic form.

retained
50m Excess reinsurance 2nd layer 10m 90% pro-rata reinsurance Excess reinsurance 1st layer 5m 0m 0% 10% 100%

Should a loss occur with a value of 8 million with the above reinsurances in place, the loss would be allocated as follows:

Proportional facultative reinsurance Cedant retains (gross) 1st layer reinsures pay 2nd layer reinsurance pay Cedant retains (net)

7.2 million (90% of 8 million) 800,000 (10% of 8 million) 300,000 (10% of 3 million) Nil 500,000 (the difference between its gross retention and its excess of loss recovery.

D-

Transacting with brokers, other intermediaries and counterparties.


D1. Open covers
D2. Line slips and binders D3. Delegated authority schemes.

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