Singled out: the hard property market and improvements in technology have led to dramatic increases in the facultative reinsurance market for catastrophe-exposed commercial business.

Hurricane Katrina's destructive winds and rains may have faded away a year ago, but they continue to send ripples through the reinsurance market.

One side effect is the blooming of the facultative reinsurance market for catastrophe-exposed commercial buildings.

The growth stems from a number of factors. As the industry scrambled to pay losses and come to terms with the damage wrought by hurricanes Katrina, Rita and Wilma in 2005--and by hurricanes Charley, Frances, Ivan and Jeanne in 2004--industry foundations have shifted. Property catastrophe prices went up and demands for improved data and modeling increased. At the same time, rating agencies, including A.M. Best Co., raised risk-based capital requirements. Insurers looking to limit their aggregate exposures have become more savvy about buying reinsurance and are increasingly employing facultative reinsurance.

In addition, reinsurers have harnessed new technologies to improve the underwriting process--a once laborious manual process has been turned into a quicker response that allows facultative reinsurers to consider more business, and in turn, to write more of it.

"In terms of volume, our markets in the U.S. are seeing a 30% to 40% increase," said John Threlfall, head of the facultative unit for broker John B. Collins Associates Inc.

Elliott Richardson, global team leader of broker Benfield's facultative office in London said his team's revenue doubled in 2005.

Swiss Re estimates a 25% increase in demand from the facultative market, said Gerry Anaszewicz, senior vice president and head of U.S. facultative reinsurance for Swiss Re. "It's cat-exposed properties driving that increase," he said.

"Companies are definitely looking at using the market as effectively as they can. With the tightening in the treaty market, the facultative market is one of the solutions they are exploring," said Dan Bilot, head of Collins' analytical service area. "There's a larger interest in exploring the facultative market, but they are not willing to buy at any price."

Fine Tuning 

As the treaty market hardened and primary writers were forced to carry higher retentions, some companies began to look more closely at removing some business from the treaty to be covered by the facultative market. The business isn't necessarily riskier, but doesn't mesh with other risks in the portfolio.

In general, reinsurance treaties cover a group or block of the primary insurers' policies or business, whereas facultative reinsurance covers a specific risk or policy. Facultative coverage is issued as a certificate to the original insured's policy. It can be written for a single building, or a single risk, such as a commercial interest which has dozens of locations around the United States.

Brokers such as Collins look at primary insurers' portfolios and identify which policies are driving a larger percentage of risk versus gross premiums, and then remove those risks from a treaty and seek to cover it with facultative reinsurance instead, Bilot said.

"[Primary insurers] have been stepping down in aggregate per risk that they are willing to write. Instead of offering $50 million on a policy, they might only want a gross position of $15 million or a net position with facultative insurance of $15 million," Bilot said. "It's a subset of risks that the facultative market has an appetite for that improves [the primary writers'] results."

Commercial property risk, especially in hurricane-prone areas, has become a prime candidate for the facultative market.

Companies have become more conservative and are increasing their loss expectations. "The larger expected loss scenarios mean more demand for capacity," Anaszewicz of Swiss Re said.

If a company used to be comfortable with a bucket of risk that was three-quarters full, now, due to changes in models and risk-based capital requirements, that bucket is overflowing with risk, said Threlfall of Collins. "It's not necessarily good business or bad business [moving to the facultative market]. It's companies looking to get coverage for this business because they haven't got enough premium income to offset potential claims," Threlfall said.

Treaty cover for property business has tightened the limits for risks on a per-occurence and aggregate basis.

"There's a lack of capacity in the treaty marketplace and as a result, facultative reinsurance has become a vehicle for some companies to place some of their exposures and off-load some of their risk," said Tom Stone, who specializes in catastrophe risk management for Ernst & Young's Insurance and Actuarial Services.

Typically, the facultative market comes into play before primary writers place their treaty coverage.

"Now, post-Katrina, because the market has shifted so much in the last 60 to 90 days, companies are going back out and looking at policies that they already have on the books. They've optimized the use of the treaty market, and now are going in and improving their net positions by looking at the facultative market retroactively to see if we can shave some of the aggregate risk off" Bilot said in late June.

Treaties also are becoming more aggressive in terms of placing aggregate limits, higher retentions, more sub-limits and carve-outs within treaties, Stone said. "It's a trend of a hard market where prices are going up" Stone said. "Reinsurance companies are a little less willing to accept risks, so they are restricting some of the coverage."

Threlfall said the commercial property market for facultative reinsurance used to be primarily driven by fire risk. Now wind risk, and earthquake exposure, are driving growth.

"Definitely hurricane exposure is the hot peril of the moment, because of the unexpected increase in severity and frequency," Stone said.

But the business isn't limited to U.S. locations.

Other areas also are seeing an increased need for cover, said Richardson of Benfield. "People are looking for catastrophe cover in just about every area of the world. Japan, Mexico and the Caribbean ... European winter wind storms are a concern. It's very much a global market," Richardson said.

Most reinsurers write facultative business in addition to treaty business.

Tom Davies, FM Global's corporate reinsurance manager, said FM Global still has the same capacity available today as it did prior to hurricanes Katrina, Rita and Wilma. "However, the market has changed and the cost of capacity has increased. As a result, the cost of catastrophe-exposed facultative reinsurance has increased tremendously, if it's even available," Davies said.

Improved Tools

Richardson disagreed that Katrina or the resulting hard market is driving the growth in facultative reinsurance.

"Facultative reinsurance isn't linked to a soft or hard market," Richardson said. "That's sort of a misconception."

He credited the growth in the market to improved technology that allowed facultative reinsurers to consider more business, and write more business.

"It's become much more efficient in its process" Richardson said. "I wouldn't put it down to Katrina or Rita. We've had a cultural shift in the market globally in the last three to five years. We wouldn't have been able to give this quality of advice three or four years ago."

The quality of data has improved dramatically, Richardson said. Also, technology has improved data quality and transparency. "Modeling, if anything, has given insurers and reinsurers a means of communicating exposures," said Bilot.

It's also speeded up the process.

Stone, of Ernst & Young, said, "Technology has increased so reinsurers can evaluate deals more quickly. It's led to an increase of business. The more business you can evaluate, the more deals you can strike."

In addition to helping insurers mad reinsurers communicate, improvements in models and technology have given reinsurers a means to crosscheck information.

"It's no longer the case that [reinsurance] companies will take the evaluations given to them [by primary insurers] and run with them. They are evaluating this data, sometimes using external sources," Stone said.

Also, while companies still use catastrophe models, they're more thoughtful about the process, he said.

"Companies are looking at several models and what's inside those models, what's under the hood," Stone said. "There's much more of an emphasis on quality of data and transparency."

Bilot said modeling is a practice, not an exact science. "There's much more of an awareness of what has been included in the modeling and what has not been. Probably, there were some reinsurers that were using a single cat model as their only tool. Now they are using it as one of their tools," Bilot said.

Stone of Ernst & Young said while facultative is a small part of the market, compared to the premium that treaties protect, it will continue to grow.

"As long as there's a hard market and insurance companies look for ways to off-load risk, facultative reinsurance will be a tool that insurers continue to use," Stone said.

Key Points

* The facultative reinsurance market, especially for such risks as U.S. wind, is growing quickly.

* Some credit the hard market for the growth in the facultative market, while others say it's a result of improved technology that allows underwriters to evaluate more business and write more business.

* Technology has improved the quality of data and made communication between insurers and reinsurers more effective.

Learn More

Swiss Re Group

A.M. Best Company # 85010

Distribution: Reinsurance brokers

FM Global

A.M. Best Company # 18502

Distribution: Direct and brokers

For ratings and other financial strength information about these companies, visit www.ambest.com.

TOP TARGET: The facultative reinsurance market is growing for catastrophe-exposed commercial buildings, such as this one destroyed by Hurricane Rita in Galveston, Texas, in 2005.

What's the Difference?

* Facultative Reinsurance--Reinsurance of individual risks by offer and acceptance wherein the reinsurer retains the "faculty" to accept or reject each risk offered by the ceding company.

* Treaty--A reinsurance contract under which the reinsured company agrees to cede and the reinsurer agrees to assume risks of a particular class or classes of business.

Source: Reinsurance Association of America