The Value Of Non-Proportional Facultative Reinsurance

Part III—Treaty Compression and the Effects of Non-Proportional Facultative Reinsurance… What are the Real Issues?
Angelika Trotta and Dr. Arno Junke – General Re, Cologne

The advantages of non-proportional facultative reinsurance were depicted in Parts I and II of this three-part series on the value of non-proportional facultative reinsurance. In the examples of different structures, we essentially outlined situations where treaty reinsurance remains unaffected by the method of reinsuring individual risks. Regarding the interdependency between non-proportional facultative and treaty reinsurance, it is important for primary insurers and reinsurers to follow some guidelines. In this final article, additional structural examples using facultative and treaty are discussed. We look at how non-proportional facultative can be integrated with both pro-rata and non-proportional treaty reinsurance, and dissolve the concerns often directed at this innovative reinsurance concept.

Effects of Non-Proportional Facultative on Pro-Rata Treaties: Exposure to Loss

Non-proportional facultative reinsurance affects the performance of treaty reinsurance in a manner different from pro-rata facultative protection. The risk situation of the treaty reinsurer changes in a distinct way. Terms such as “compression,” “fac. XL on gross” or “capping the treaties” are commonly used to describe this phenomenon. These terms are intended to illustrate the increased exposure of the primary insurer’s net retention and the reinsurer’s treaty capacity resulting in a first-loss position (compression). There has been some controversy over the presence and extent of compression. We put compression into perspective without losing sight of the reasons for purchasing non-proportional facultative: so the primary insurer may see the overall picture and make the best reinsurance decisions.

With pro-rata reinsurance, it is common knowledge that the primary insurer and the reinsurer follow the fortunes of a risk with regard to exposure, premium and losses, in accordance with the cession. An example of this structure is a treaty construction involving proportional capacity of $75 million, with a $5 million net retention and a 14-line surplus. Given an insured risk of $100 million sum insured, a facultative requirement of $25 million arises. Traditionally, the primary insurer would cede 25% of the risk facultatively on a pro-rata basis. Then 70% of the original risk premium is apportionable to the surplus treaty, and also 70% of each original loss. As a result, the surplus treaty is not hit for its full capacity of $70 million until a total loss occurs. (See Figure 1.)


Alternatively, the primary insurer can cover its facultative requirement of $25 million for this risk on a non-proportional basis attaching above the surplus treaty and the net retention. Here, facultative reinsurance is not affected until an original loss in excess of $75 million occurs. (See Figure 2.) All partial losses up to $75 million are divided between the net retention and the surplus treaty at the ratio of the deployed capacities (in this case: 5:75 and 70:75, respectively). What partial loss fully exhausts the surplus treaty is therefore contingent upon the attachment point of the facultative layer. In the example chosen, the surplus treaty and net retention would be fully exhausted given an original loss of $75 million.


The effect of “compression” is that the treaty and the net retention will pay a higher percentage of every partial loss than they would pay if the facultative had been placed on a proportional basis. With a facultative cession on a pro-rata basis, the surplus treaty would have a 70% share of every loss. With a non-proportional facultative cession ($25 million xs $75 million), the treaty share increases to 93.3% (70:75) of all losses up to $75 million. However, the absolute liability of the surplus treaty remains unchanged: with both options the limit remains at $70 million.

Effects of Non-Proportional Facultative on Pro-Rata Treaties: Premium Distribution

The effects of premium distribution of non-proportional facultative on a pro-rata treaty
also draw some controversy. In many discussions, the financial advantages of non-proportional facultative for the primary insurer are often overlooked, and the focus remains on compression of the treaty. Non-proportional facultative enables the primary insurer to systematically reinsure only those volatile risk elements as defined by the insurer. The strategic advantages of purchasing non-proportional facultative only when and where it is needed on a risk is a concept detailed in our previous articles in this series (The Value of Non-Proportional Facultative, Parts I and II), and the advantages are only possible with a non-proportional structure. Non-proportional facultative is flexible in what it will cover; that is, the premium charged reflects the exposure ceded. The bulk of the risk premium is apportionable to the net retention and the treaty reinsurer. Thus, there is an increase in premium commensurate with the increase in exposure. Therefore, a premium comparison is necessary for the purpose of correctly evaluating the effects of compression.

Given the earlier pro-rata facultative reinsurance structure (Figure 1), the surplus treaty receives 70% of the original premium. Using the same non-proportional facultative structure (Figure 2), a premium is calculated for the non-proportional $25 million xs $75 million layer. This price for facultative reinsurance is then deducted from the original premium. The difference is subsequently apportioned between the net retention and the surplus treaty at a ratio of 5:75 and 70:75, respectively. It is significant to note that the premium deducted for the non-proportional facultative capacity reflects the exposure for that excess layer only. Experience and statistics demonstrate that the largest share of original premium remains for the net retention and the treaty. The facultative layer in the example chosen is not affected until an original loss of $75 million occurs. The high layer excess facultative capacity requires a commensurately smaller share of the original premium, which is usually calculated on the basis of loss curves.

A common argument lined up with compression is associated with the terms “original principle” and “following-the-fortunes.” According to traditional understanding of pro-rata treaties, the insurer cedes the risk at original terms and conditions; original premium and original losses are divided in accordance with the treaty share or surplus structure. In the case of a non-proportional facultative cession (Figure 2) the “original principle” is breached; the principle of “following-the-fortunes” must therefore be looked at differently. Given that the insurer's net retention is likewise compressed by non-proportional facultative, the retention and the pro-rata treaty continue to follow the fortunes of the premium and the losses at the same ratio to each other. The difference lies in the understanding of “following-the-fortunes” with respect to the original premium reduced by the cost of non-proportional facultative only.

Many discussions also center around the adequacy of the premium allotted to the treaty being drawn into a first-loss position by non-proportional facultative. Because it is generally independent of original premium and conditions, pricing for non-proporational facultative gives rise to a common misunderstanding that an unsuitably high portion of premium will be channelled to the non-proportional layer with too little left for covering the treaty exposure. This concern is countered by the fact that the primary insurer also has an interest in appropriate pricing for the facultative capacity, as the exposure to its net retention is also changed by non-proportional facultative. In the case of a pro-rata treaty, the reinsurer participates in the overall portfolio at original terms and conditions, irrespective of the adequacy of these terms and conditions or the original premium. The treaty reinsurer’s influence is more or less restricted to arranging the general terms and conditions of reinsurance and paying the losses. Therefore, if the primary insurer agrees to the premium allocation, the treaty reinsurer should feel comfortable as well.

Although the pro-rata treaty experiences higher exposure due to compression, the treaty reinsurer will be compensated by a correspondingly higher allocation of original premium. The compression of treaty reinsurance and the primary insurer’s net retention only turns problematic if the original premium is insufficient or pricing of the facultative layer is based on gross errors or inadequacies.

The Issues of Compression—Summarized

The continuity and consistency of treaty reinsurance is predicated upon an understanding of risk sharing between partners and a mutual element of trust. Trust must exist in the insurer’s underwriting policy, the portfolio balance and the long-term nature of the business relationship involving pay-back over time.

When compression is discussed, the context is facultative capacity for comparatively few risks. The effect on the net retention and treaty reinsurance is usually minute since both primary insurer and pro-rata treaty reinsurer are compensated for the increased exposure by an increased allotment of original premium and the increased premium allocation. There is seldom a reason for the treaty reinsurer to intervene in the underwriting of individual risks when it has confidence in the insurer's overall underwriting policy.

As we have seen, compression has to be considered when pricing for pro-rata capacities. The increased exposure to the treaty in individual cases can also be accompanied by greater fluctuation in the first-loss area. Conversely, the markedly increased premium basis for the treaty capacity helps manage that fluctuation over time. When pricing the pro-rata capacity, the treaty reinsurer will consider all of these factors. Obviously, the prerequisite is that the treaty reinsurer is furnished with relevant underwriting information allowing an evaluation of the overall structure and any compression effects resulting therein.

As only a relatively small number of policies are placed facultatively in relation to the overall portfolio, there is usually not much impact on a pro-rata treaty. Given a
well-balanced treaty portfolio and isolated facultative non-proportional covers, the fluctuations in the first loss area are not particularly marked. However, if a large number of risks are placed facultatively above the obligatory cover, or if the structure of the pro-rata capacity is not well balanced, treaty fluctuations may increase, and closer attention is warranted. Consideration is then afforded to the compression effect in the pro-rata pricing.

In certain situations, the treaty reinsurer actually benefits from a compression of its capacity by non-proportional facultative, certainly as opposed to pro-rata facultative. In cases of major policies involving several locations, this premium growth can reach considerable dimensions. At the same time, the treaty’s susceptibility to fluctuation is reduced if the primary insurer reinsures the more highly exposed risk components or perils via excess facultative reinsurance. In these cases, the treaty reinsurer capacity profits in exactly the same way as the insurer's net retention. All the advantages of non-proportional solutions described in Parts I and II of this series also apply analogously to treaty reinsurance.

Treaty Wording and Information Sharing

The treaty wording should also be addressed when compression comes into play. Some treaty wordings expressly permit compression of the treaty, while others may outright exclude the possibility. However, the wordings should at least address the issue, and the parties need to interpret the treaty language and intent. If an insurer wants to use non-proportional facultative reinsurance rarely or occasionally, special acceptances under the treaty remain a reasonable alternative. Even if these special acceptances require approval from the leading reinsurer, all the reinsurance partners should be informed of the number, terms and conditions of the compressed risks at regular intervals. Without such reporting, the reinsurer proceeds on the assumption that the original risk is apportioned on a pro-rata basis only. A surprise in the event of a loss should be avoided at all costs.

Insurers wishing to utilize non-proportional facultative capacity for all the advantages discussed in these articles should discuss the matter openly with their treaty reinsurers. Transparency and a policy of full disclosure on
all risks ceded on a non-proportional basis will help the treaty reinsurer evaluate its obligations and any future strategy. The key prerequisites are:

The treaty capacity must be structured so that any effects of compression are neutralized when long-term balance of the treaty is considered.

A regular flow of information is needed for the participating treaty reinsurers, including the number of risks, sum insured, PML, and original and non-proportional premium, in respect to the facultatively reinsured risks.

What About the Non-Proportional Treaty?

Instead of a pro-rata treaty, the insurer might have non-proportional or excess treaty protection as its core cover. A facultative layer placed above non-proportional treaty capacity exposes the first-loss position in a manner similar to the pro-rata treaty. However, a non-proportional treaty structure contemplates the fact that the reinsurer does not share risk or premium in accordance with the “original principle.” The price of non-proportional treaty capacity is calculated on the basis of a risk or loss profile. None of the considerations mentioned with regard to the “original principle” and “following-the-fortunes” are relevant. However, sharing information on the number and nature of non-proportional facultative covers is still an important part of the risk profile provided at renewal and may affect treaty pricing going forward.

Summary

Non-proportional facultative reinsurance offers the insurer a considerable degree of added value. The placement of non-proportional facultative in excess of treaty capacity is not only possible but constitutes a thoroughly innovative approach to structuring reinsurance. In particular, the insurer gains better control of its portfolio exposures and premium by directing the additional protection at selected risks. By interacting with the insurer, the reinsurer can analyse and address effects of compression to the treaty and the net retention. Clear communication between the insurer and its treaty reinsurers regarding the pricing and exposure of risks protected by non-proportional facultative reinsurance will avoid any misunderstandings, thereby allowing the insurer to focus on its portfolio needs. The insurer can then take full advantage of this flexible product to better control its underwriting results, thus achieving a major goal of reinsurance and non-proportional facultative reinsurance in particular.


Please contact your local General Re representative with any questions on this publication series or to request a presentation on this subject.