3 Ways To Combat Compression When Buying Non-Proportional Facultative
I received a call last week from an underwriter who wanted to use non-proportional facultative on a risk where he had a need for extra capacity. He knew that it was an ideal risk for non-proportional Fac - the values were high and the PML/EML was less than 100%.
He didn’t want to buy proportional facultative because a total loss was highly unlikely and even frequency losses were not expected as the hazards were well-protected and the deductible appropriate. Non-proportional Fac seemed like a good solution since he could cede the volatility at a cost that was a small percentage of the overall premium.
He was concerned, though, that his treaty reinsurer might object to the possibility that if there were a partial loss they would pay a higher percentage of the loss. The exposure to the treaty and net might be considered “compressed.” He asked me how other companies treat compression. I shared with him that we usually see one of the following courses of action in cases like his:
- The cedant uses a second retention or an increased retention as shown in the diagrams below.
These solutions allow for non-proportional Fac but don’t change the premium distribution or loss participation of the treaty. It does still change the position of the ceding company, but the premium distribution they receive reflects their higher share of a partial loss.
The cedant discusses the risk with his treaty reinsurer.
In our experience, many times the real issue behind compression is information. A treaty reinsurer who is taken by surprise by a compressed loss will not be happy. The way to solve this is to be transparent about the risks when non-proportional facultative is placed and disclose them to the treaty reinsurers. If there is a need, this can be contractually agreed with the treaty reinsurers.
The cedant and treaty reinsurer agree in advance to a premium distribution for situations where non-proportional Fac is used.
Since one of the concerns with compression is an unfair premium distribution between the treaty, the net and the non-proportional facultative placement, one solution is an up-front agreed upon premium distribution scale. Every risk where non-proportional facultative is then used will be subject to the same fair, premium distribution. But note, this is most likely to work on a homogeneous book of business where the risk of partial and total losses remains relatively constant.
If you would like to learn more about how to treat compression when buying Fac, get in touch with your local Gen Re underwriter or, for further reading, visit our article in Fac Matters.