Facultative Reinsurance Clauses

legal contract

If you are part of an insurance company that either purchases or sells reinsurance policies, then you may eventually find yourself in a position where you need to understand facultative reinsurance clauses.

What is Facultative Reinsurance?

Before you can really understand the clauses embedded into reinsurance policies, it's important to first understand what facultative reinsurance is and the situations where it is an appropriate choice for an insurance company.

Definition of Facultative Reinsurance

In general, reinsurance is a fairly simple concept. An insurance company enters into an insurance contract with a policyholder. If the size of the policy or the risk associated with the policy is especially high, the insurance company may purchase a "reinsurance" policy with a second insurance company. This policy usually transfers a certain percentage of the overall risk to the second company. There are two types of reinsurance policies:

  • Treaty reinsurance covers an entire class of policies, such as a whole group of employee life insurance policies.
  • Facultative reinsurance covers individual policies depending on whether or not the reinsurer is willing to absorb the particular risks that are present. These policies are decided on a case by case basis.

Facultative reinsurance is more popular because the reinsured most often uses the policy as a way to reduce overall risk and manage liability, while the reinsurer is afforded the slightly less risky position of reviewing all of the risks present before making a decision.

Why Facultative Reinsurance Clauses are Necessary

A clause is an element of an insurance contract that defines a condition of that contract. Clauses are intended to protect each party in the contract and it does so by defining certain stipulations that must be met for the contract to remain valid. If conditions aren't met, the reinsurer could potentially back out of a contract and avoid legal liability for any losses. Any clause in a well-written reinsurance policy usually defines actions that could increase the risk after the contract policy is already defined. Typically, a reinsurer will want to re-evaluate a policy if risk ever changes.

Types of Facultative Reinsurance Clauses

There are many legal clauses that insurance company lawyers can insert into a reinsurance policy; however, the following list are a few of the most common ones used throughout the reinsurance industry.

  • Arbitration Clause - Insurance companies don't like to go to court to resolve disagreements. Instead, two insurance companies will agree on an independent third party that will act as a final decision maker. As part of the reinsurance contract, the two insurance companies agree to abide by the final majority decision of the third party if arbitration proceedings are ever necessary.
  • Commutation Clause - This clause allows for the reinsurer to pay the reinsured an estimated lump-sum payment to discharge obligations of the reinsurer to pay future benefits. This is a clause often used for policies that involve long term payment situations such as long term or lifetime benefits. Usually the estimated payment results from a formula that includes the medical needs and age of the policyholder.
  • Errors and Omissions Clause - In the event that either the reinsurer or the reinsured makes an error in calculating or estimating risk or the level of benefits for the policyholder, this clause will not hold the reinsurer liable for any other level of benefits or risk than as defined in the original contract.
  • Following the Fortunes - This clause is usually implied and not always written into an agreement. The Follow-the-Fortunes clause refers to the fact that the reinsurer must respect and honor (follow) the underwriting policies (fortunes) of the reinsured company. So long as there is no fraud or collusion with the insured party, the reinsurer must abide by the claims decision of the reinsured. This is one reason why reinsurance is typically "invisible" to policyholders, because the claims process and benefits distribution remains unchanged.
  • Intermediary Clause - If an intermediary is being used in the reinsurance negotiations, the agreement will include a provision that identifies the intermediary and details how payments will be transferred back and forth between the two other parties.
  • Offset Clause - This clause provides the reinsurer with the right to "offset" any claims payments by the amount that the reinsured owes on their reinsurance premium. This is a way to give reinsurers some protection against companies that don't always make policy payments on time or that become insolvent and stop making them altogether.
  • Reinstatement Clause - Whenever a catastrophic event occurs, the overall amount of reinsurance coverage is reduced by the total payments for that loss. The reinsurance will be automatically reinstated following such a catastrophe, but only after the reinsured pays a premium.

More Information

Insurance policies between a company and a policyholder can be complicated enough, but when you introduce agreements between two insurance companies, typically only lawyers are qualified to write such an agreement. If you are in the middle of reinsurance negotiations, make sure to consult a lawyer about facultative reinsurance clauses to ensure that your insurance company is properly protected and appropriately managing risk.

For more information about related insurance issues, make sure to check out the following LoveToKnow Insurance articles.

Facultative Reinsurance Clauses