Facultative reinsurance is a form of reinsurance in which a contract is negotiated for a specific insurance policy. This type is purchased when a policy is unusual or large and the original insurer is concerned about the liability risks. The policyholder is not informed that reinsurance has been taken out, in contrast with coinsurance, in which multiple insurers take on the risk of a policy together. The other type is treaty reinsurance, in which a group of policies or risk categories are covered together.
Reinsurance is essentially an insurance policy on an insurance policy. When an insurance company takes on risks in the form of policies, it may be concerned that it will have difficulty covering those risks, or that the company could experience financial hardship if a large group of claims happened at the same time, as might occur in a natural disaster. The company mitigates its risks by taking out a reinsurance policy with another insurance company. This policy is used to cover the original policy.
In facultative reinsurance, the terms of the contract are negotiated for a specific policy. The reinsurer has the right to evaluate the risks involved, unlike in treaty reinsurance, when it cannot evaluate individual risks. The company proposes a price that it believes to be reasonable, and if the insurance company agrees, then the policy is written. Periodically, the terms are reviewed, giving both parties a chance to walk away from the contract if they feel that it is no longer necessary, that the policy is too risky for the reinsurer, or that the terms need to be renegotiated.
This type of reinsurance is generally used for tricky policies that may require some special coverage, with large policies as the obvious candidates. For the reinsurer, the advantage of such a policy is that it allows the company to develop a customized policy that will meet the needs of the specific situation, and the situation is less risky for them, because they have a chance to assess the individual risks and determine a rate for the reinsurance which they deem reasonable.
Facultative reinsurance is highly specialized and offered only by a small number of insurance companies. Along with treaty reinsurance, it is designed to ensure that insurance companies have the ability to cover their policies.