By James A. Johnson
Reinsurance is a contract of indemnity between insurance companies defined by a historical relationship. One company, the reinsurer agrees with another, the cedent, to indemnify it against a loss, which the cedent has assumed under a separate and distinct contract of insurance. There are two basic types of reinsurance, facultative and treaty. Facultative involves ceding part or all of an individual policy to a reinsurer as distinguished from treaty, which covers all, or specified classes of a reinsured’s policies, at a specified percentage. A facultative reinsurance policy offers individual risks to the reinsurer, who has the right (faculty) to accept or reject it. A treaty reinsurance policy is automatic and binds the reinsurer to accept all risks ceded to it of a certain type or category.
The purpose of this article is to provide guidance to general practitioners, corporate counsel, risk managers, and insurance professionals on reinsurance. A fundamental purpose of reinsurance is to permit an insurer to reduce its reserve requirement. By utilizing reinsurance, an insurer can spread the risk it undertakes over a larger number of policies, reducing the amount of reserves required to maintain its business and increase its profitability. The reinsurance relationship is characterized by the mutual duty of “utmost good faith” and “follow the fortunes” which obligate the reinsurer to indemnify the ceding insurer for all losses paid by the ceding insurer on the reinsured policy. Utmost good faith is the guiding principal of reinsurance. In short, it is a commercial transaction between sophisticated companies governed by equity and utmost good faith.