What it means
Insurers spread risk by passing some of it to reinsurers, and they do so in two broad ways. Treaty reinsurance covers a whole class of business automatically under a standing contract, while facultative reinsurance is arranged individually, which is why it is described as optional for both parties.
It exists because standing treaties have limits and exclusions. When an insurer is offered a risk that is unusually large, unusually hazardous or simply outside what the treaty will absorb, facultative cover lets it write the business anyway by finding a reinsurer willing to take a share of that specific exposure.
The trade-off is cost and effort. Each facultative placement involves underwriting, negotiation, documentation and often a broker, so the administrative cost per risk is far higher than under a treaty.
Insurers therefore reserve it for the small number of risks where the value of the extra capacity justifies the work. Money moves in both directions in a facultative deal.
The ceding insurer passes a share of the premium to the reinsurer, and the reinsurer typically pays back a ceding commission that recognises the acquisition and administration costs the insurer already incurred in writing the policy. The critical nuance for anyone reading an insurer's accounts is that ceding risk does not remove the obligation to the policyholder.
The original insurer still owes the claim in full, so if the reinsurer fails to pay, the insurer absorbs the loss, which is why reinsurer credit quality is monitored so closely.
In practice
Real-world examples.
Example
A regional insurer is offered cover for a landmark stadium worth far more than its treaty limit. It places 85% facultatively across three reinsurers, keeps a modest share and earns the client relationship it would otherwise have had to decline.
Example
A marine insurer writes hull cover for a vessel scheduled to transit a region its treaty excludes. Facultative cover for that single voyage lets the insurer support a long-standing client without breaching treaty terms.
Example
A liability insurer takes on a pharmaceutical manufacturer launching a new product with an uncertain claims profile. It cedes 60% facultatively for the first two years while it gathers its own loss experience, then brings more of the risk back in-house.
Think of it
“Facultative is one-off reinsurance-negotiated separately for specific risks.
Formula
Calculation
Ceded Share = Amount Ceded / Total Sum Insured
Net Cost of Reinsurance = Ceded Premium - Ceding Commission
An insurer is asked to cover a single chemical processing plant with a total sum insured of $50,000,000. Its treaty capacity and its own appetite together allow it to retain $10,000,000, so it seeks facultative cover for the remaining $40,000,000.
Ceded share = $40,000,000 / $50,000,000 = 80%. The full annual premium for the risk is $500,000, so the ceded premium is $500,000 x 80% = $400,000.
The reinsurer allows a ceding commission of 25% on the ceded premium: $400,000 x 25% = $100,000.
Net cost of reinsurance = $400,000 - $100,000 = $300,000. The insurer keeps $100,000 of premium plus the $100,000 commission, a total of $200,000, in exchange for carrying $10,000,000 of exposure.Case study
Seen in the real world.
This is an illustrative and fictional case. Pentland Regional Insurance, an invented commercial insurer, was invited to quote for a $120,000,000 food processing complex owned by its largest broker's biggest client. Its treaty capacity topped out at $25,000,000 per risk, and declining the invitation risked the broker relationship.
The underwriting team placed $95,000,000 facultatively with two reinsurers at a ceded premium of $760,000 and a ceding commission of 22%, worth $167,200. Pentland retained $25,000,000 of exposure and $200,000 of premium, plus the commission, giving it $367,200 of income against a manageable retained risk.
A fire two years later caused a $30,000,000 loss in this fictional scenario. Pentland paid its retained share and recovered the balance from its reinsurers, and because it had checked both reinsurers' financial strength before placing the risk, the recovery arrived without dispute.
Watch out
Common mistakes.
- Confusing facultative with treaty reinsurance. Treaty cover is automatic across a class of business, while facultative cover is negotiated risk by risk and can be declined.
- Assuming ceding the risk ends the insurer's liability, when the policyholder still has a claim against the original insurer regardless of what the reinsurer does.
- Ignoring the administrative cost of facultative placements, which can quietly consume the margin on smaller risks.
Questions
People also ask.
Why would an insurer use facultative cover instead of just declining the risk?
Because declining can cost a broker relationship and a whole account, while facultative cover lets the insurer say yes within its risk appetite.
Who pays the ceding commission?
The reinsurer pays it to the ceding insurer, reimbursing part of the acquisition and administration costs already incurred.
Is facultative reinsurance more expensive than treaty cover?
Per unit of exposure it usually is, because each placement is individually underwritten and administered.
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