Sorting Out the Reinsurance Contract Morass

March 2002

Reinsurance terminology, like technical terms in other industries, seems unintelligible at first glance. In this article, Larry Schiffer defines the terms and their usage for the uninitiated.

by Larry P. Schiffer
LeBoeuf, Lamb, Greene & MacRae, L.L.P.

To the uninitiated, the terms used to describe reinsurance contracts are strange indeed. Reinsurance contracts go by a variety of names: treaty, facultative certificate, obligatory fac, semi-automatic fac, stop-loss, surplus share, excess-of-loss, proportional, quota share, and many others. While each simply indicates a different type of reinsurance contract, as terms of industry art, these terms have important differences—sometimes.

Basic Reinsurance Contracts

Most commentators and courts describe reinsurance contracts as being either treaties or facultative certificates. This, of course, is a simplistic view. Reinsurance agreements are difficult to categorize because reinsurance contracts become more complex depending on their use. The focus of this commentary is on more standard risk transfer reinsurance mechanisms and the terms used for these contracts.

Treaty

A reinsurance contract called a "treaty" has nothing to do with international agreements or commerce between nations. A treaty is merely a reinsurance contract that reinsures more than a specific risk. For example, if your insurer is writing a national book of truckers workers compensation insurance, the insurer may purchase a reinsurance contract to share a portion of the risk of the entire book of business—as opposed to a specific insured risk. If the risk reinsured is a program or book of business covering a variety of insureds in various locations, the reinsurance agreement most likely is a treaty.

Treaties tend to be long contracts containing detailed clauses. The nature of the risk, the responsibilities of the ceding company and the reinsurer, the reporting requirements, and various other clauses are provided with some precision. Generally, if the reinsurance contract is more than a few pages, it likely is a treaty. Treaties generally are drafted by the ceding company's reinsurance broker or, in the direct market, by the ceding company's contract wording department.

While there are regulatory requirements for when the parties must sign a treaty, generally the treaty is not signed until sometime after its effective date. This is because the parties often commence the relationship under a short-form document called a "slip." The slip is essentially an outline of the essential terms of the reinsurance agreement signed by the reinsurer and accepted by the cedent. Until the treaty wording is signed, the slip governs the reinsurance relationship. Many a reinsurance dispute as arisen over reinsurance arrangements documented only by a slip.

An insurance company can purchase reinsurance to share the risk of its book of business on a proportional or nonproportional basis. A quota share reinsurance treaty is a reinsurance contract that provides protection on a proportional basis. For example, an insurance company may wish to reinsure the first $100,000 of loss by allowing reinsurers to share in 80 percent of the risk on a quota share basis. If a $100,000 loss is paid, the ceding company retains 20 percent and the reinsurers pay 80 percent. Premiums, less a retained fee called a "ceding commission," are shared in the same proportion.

Let's say the insurance company wants to keep the first $100,000 of loss, but would like to reinsure losses above $100,000. The insurance company may purchase an excess-of-loss reinsurance treaty where the reinsurers cover 100 percent of all losses in excess of $100,000 up to $500,000. Here, the reinsurance is not on a proportional basis as the reinsurers only pay losses when a certain attachment point is breached.

Facultative Certificate

The other commonly known form of reinsurance is the "facultative certificate." A "fac cert" is a short-form reinsurance contract issued by a reinsurance company generally covering a specific risk. For example, an insurance company writes the property insurance for a large manufacturing plant for a chemical company. To spread its risk of loss, the insurance company may wish to purchase facultative reinsurance to share the risk of loss on this specific chemical plant. The reinsurance underwriter of a facultative risk evaluates the risk like a direct insurance underwriter because the reinsurance is only of the specific risk.

Fac certs generally have a declarations section showing the reinsurance participation in the underlying contract and a short form wording on the back of the reinsurer's pre-printed form. More recently, fac certs have expanded to include more detailed clauses appended to the certificate, but they generally do not cover all the provisions of a treaty. It's not the size of the contract that determines whether it is facultative. If the reinsurance is of a specific risk and a specific policy, it is a facultative risk whether the certificate is the traditional short form or whether it is as long as a treaty.

An important issue that arises with facultative reinsurance is the scope of the coverage. Certificates often have boxes that, when checked, indicate whether the coverage is concurrent or nonconcurrent with the underlying policy. Concurrency means that the same terms and conditions, and the same scope of coverage, passes through to the reinsurer. The reinsurer's risk is limited only by the risk and limit of liability assumed. Where the reinsurance is nonconcurrent, the possibility of a loss not being covered by the reinsurer exists.

Other Reinsurance Terms

Most reinsurance falls into the categories of treaty or facultative. A stop-loss reinsurance contract, surplus share contract, or catastrophe contract may be treaty or facultative, depending on the risk reinsured.

Sometimes reinsurance contracts are termed obligatory, automatic, or semiautomatic. These terms describe the responsibility of the insurance company to cede the risk to the reinsurer and the obligation of the reinsurer to accept the risk. Facultative, for example, implies that the reinsurer does not have to reinsure the risk unless the underwriter agrees to assume the risk. Treaty implies that the insurance company has to cede all risks written within the scope of the reinsurance and the reinsurer has to accept them.

But there are semiautomatic or automatic so-called facultative contracts that require the reinsurer to accept each risk presented by the ceding company. These hybrid contracts blur the distinction between treaty and facultative. Whether that matters usually depends on whether a dispute develops, and then the distinction becomes important.

Conclusion

Reinsurance terminology, like technical terms in other industries, seems unintelligible at first glance. Instead of reinsurance contract or agreement, we see the terms treaty and facultative certificate. The mystery vanishes quickly when we learn that a treaty is a reinsurance contract for a book of business covering multiple insureds and a facultative certificate is a reinsurance contract for a specific, individual risk. But the cloud of confusion reappears when we are faced with things like semiautomatic facultative certificates and contracts called facultative treaties. Welcome to the world of reinsurance!

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author’s employer or IRMI. This article does not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.