Reinsurance is a critical facility for insurance companies as it enables them to underwrite large policies and transfer some of the risk to reinsurers. It also gives insurers the ability to manage large or even catastrophic losses. This is invaluable for stabilizing their financial position and increasing their capacity to underwrite more policies, without fear of insolvency.
This article focuses on a particularly interesting type of reinsurance – retrocession. So, how does retrocession in reinsurance work? What does it mean for insurers? We’ll discuss these and more.
Retrocession is a reinsurance transaction where a reinsurer transfers risks of an insurance company it has reinsured to another reinsurer. The reinsurance company that takes on another reinsurer’s risk is called the retrocessionaire.
A reinsurer can transfer or assign some of its risks to another reinsurance company in exchange for retrocession fees. Retrocession is a strategy used by reinsurers to mitigate their overall risk exposure.
In insurance, insurance brokers primarily serve as intermediaries between clients and insurance companies. But when it comes to reinsurance, brokers also work as intermediaries for insurance companies, reinsurers, and retrocessionaires.
For retrocession reinsurance, insurance brokers work to find suitable reinsurance or retrocession coverage, negotiate the terms, then facilitate the transaction. Here’s what an insurance broker typically does in retrocession agreements:
Insurance brokers would begin the retrocession process by analyzing the portfolio or exposure that needs to be retroceded.
Once a broker has analyzed the portfolio and its corresponding risk to be retroceded, they find potential retrocessionaires with the appropriate appetite and capacity for the insurer’s risk.
After the broker matches the reinsurance company with the right retrocessionaire, they proceed with the crafting of the retrocession contract. This includes fleshing out the important details like pricing, coverage limits, exclusions, and other contract terms.
After managing the placement process, brokers then handle the documentation and communication between all the involved parties.
The role of insurance brokers doesn’t always terminate once retrocession agreements are complete. Brokers can also help manage insurance claims and resolve disputes if losses occur.
When handling retrocession contacts, brokers typically earn a commission or receive retrocession fees from either the reinsurer or retrocessionaire.
There can be rare cases where both parties pay the insurance broker fees or commissions. This involves obtaining consent from both parties and ensuring compliance with legal and regulatory requirements.
Retrocession is one of the eight common types of reinsurance. Retrocession also comes in several types, including:
In this type of retrocession, the retrocessionaire receives a fixed percentage of the premiums and pays the same percentage of claims. Proportional retrocession can be further subdivided into these categories:
Quota share retrocession where the retrocessionaire takes a fixed share of all risks
Surplus share retrocession where the retrocessionaire takes on risks above a certain retention level, up to a limit
In this setup, the retrocessionaire only pays out if losses exceed a specified threshold.
Excess-of-loss retrocession – the retrocessionaire covers losses above a set amount (the retention), up to a maximum limit
Stop-loss retrocession – the retrocessionaire covers aggregate losses that exceed a certain percentage of the reinsurer’s premiums or a set amount
The retrocessionaire covers a specific, individual risk or policy, instead of a portfolio or class of business.
Facultative retrocession is used for unique or very large risks that require special handling.
This is the most common form of retrocession agreement, where the retrocessionaire covers a portfolio or class of risks, under a standing agreement (treaty), rather than on a case-by-case basis.
|
Type |
Description |
Sample use |
|---|---|---|
|
Proportional |
Shares premiums and losses in a fixed ratio |
Quota share of catastrophe risks |
|
Non-proportional |
Covers losses above a threshold |
Excess of loss for large disasters |
|
Facultative |
Covers specific, individual risks |
Single high-value property risk |
|
Treaty |
Covers a portfolio of risks under a contract |
Ongoing coverage for property lines |
Here are a couple of real-world examples of retrocession agreements in reinsurance and how they work:
Major reinsurance companies in the US, like Swiss Re or Munich Re, have significant exposure to hurricane risks after providing reinsurance to primary insurers. To manage their own risk, these reinsurers enter into a catastrophe excess-of-loss retrocession agreement with a panel of global retrocessionaires (other reinsurers or specialized retro firms). Under this agreement:
the retrocessionaires agree to cover losses exceeding a certain threshold (e.g., $1 billion) up to a specified limit (e.g., $2 billion) for hurricane events in the US
the reinsurer pays a premium to the retrocessionaires for this protection
should a major hurricane causes losses exceeding $1 billion, the retrocessionaires pay their share of losses up to the agreed limit
In this scheme, the reinsurer writing global property catastrophe business wants to protect itself against extreme industry-wide losses. To do so, it purchases an industry loss warranty (ILW) retrocession contract from a Bermuda-based retrocessionaire, for example. Under this ILW:
the retrocessionaire agrees to pay the reinsurer a fixed amount if total industry losses from a specific peril (e.g., US earthquake) exceed a pre-defined trigger (e.g., $20 billion)
the contract is triggered by industry loss estimates, not the reinsurer’s own losses
this type of retrocession is common in the global reinsurance market and provides efficient, event-driven protection
As you navigate the nuances of retrocession and reinsurance, you may come across retrocession in a slightly different but related industry – finance. Retrocession in finance has a different context, so it can be important to know its difference from retrocession in reinsurance. Understanding these differences can also be critical for insurance companies, fund managers, financial advisors, and investors.
In the insurance and reinsurance context, retrocession is where a reinsurer cedes part of the risks it has taken from an insurance company to another reinsurer or retrocessionaire. This risk transfer involves multiple parties and is designed to spread large or catastrophic risks across the market.
The primary goal is to enhance risk management and capital efficiency for insurers and reinsurers. In this case, retrocession is not related to investment products or fees, but rather to the sharing and management of insurance risk.
Retrocession takes on a different meaning in finance, particularly in the realm of investment products and investment funds, such as mutual funds. In this industry, retrocession refers to a form of commission or kickback. When a fund manager sells a financial product through a financial advisor or intermediary, the advisor may receive a retrocession fee, which is sometimes called a finder’s fee or trailing commission.
This fee is typically embedded in the total expense ratio or expense ratio of the investment fund, meaning investors indirectly pay for it through higher fund charges.
For instance, when an investor buys a mutual fund, the fund manager may pay a portion of the management fee to the financial advisor who facilitated the sale. This practice means the advisor receives retrocession fees as compensation for distributing the financial product.
While this can incentivize advisors to recommend certain investment funds, it also raises concerns about conflicts of interest. This is because advisors may only become motivated by earning commissions rather than acting in the best interests of their clients.
One of the important considerations about retrocession insurance is, how does this benefit insurance brokers? Here are some benefits:
Retrocession reinsurance allows brokers to access a broader network of reinsurers and retrocessionaires. This enables them to find optimal solutions for complex or large risks that may exceed the capacity of a single reinsurer.
By facilitating retrocession, brokers can offer insurance companies and reinsurers more comprehensive and tailored risk transfer options. This improves their value proposition to clients.
Brokers can help clients diversify risk across multiple parties. This can reduce the likelihood that a single catastrophic event will result in overwhelming losses for any one entity.
Retrocession arrangements create additional placement opportunities for insurance brokers. They can structure multi-layered reinsurance programs and participate in more transactions.
Brokers earn commissions or fees for arranging retrocession agreements. This provides an additional revenue stream beyond primary insurance and direct reinsurance placements.
Facilitating retrocession allows insurance brokers to demonstrate specialized expertise in structuring complex risk transfer solutions. This reinforces their role as trusted advisors to insurers and reinsurers.
Retrocession can be a valuable tool for reinsurers, but it is not without risks or imperfections. When considering retrocession in reinsurance, here’s what insurance companies and brokers should keep in mind:
Retrocession arrangements can create long chains of risk transfer, making it difficult to trace where the original or ultimate risk resides. This lack of transparency can obscure the true exposure of insurers, reinsurers, and retrocessionaires.
By spreading risk across multiple parties, retrocession can increase interconnectedness in the market.
The main caveat of this is that if one retrocessionaire fails, it can trigger losses throughout the chain, potentially threatening the stability of the broader insurance and reinsurance sector.
There is always a risk that a retrocessionaire may not be able to fulfill its obligations in the event of large losses. This counterparty risk is heightened when retrocessionaires are less financially stable or poorly regulated.
The global and multi-layered nature of retrocession makes oversight difficult. Inconsistent regulations across jurisdictions can create gaps in supervision and increase the risk of regulatory arbitrage.
Without careful monitoring, the same underlying risks can be unknowingly assumed by multiple parties. This can lead to dangerous concentrations of exposure within the market.
The ability to repeatedly transfer risk may encourage some reinsurers to take on more risk than they otherwise would, knowing they can pass it along. This can undermine prudent risk management.
All these risks in retrocession reinsurance indicate that the reinsurance industry can be heading into what’s termed a “polycrisis”.
If you need a list of the top reinsurers, our list of the biggest reinsurance companies in the US can prove useful.
Retrocession in reinsurance can empower insurance brokers to access broader markets, tailor risk solutions, and diversify exposures for clients. However, it’s important for brokers to stay vigilant and manage the added complexity and potential risks that can result from multi-layered risk transfers.
With the increasing number of catastrophic events like the recent Hawaiian tsunami and the notable deficiency of current catastrophe models, retrocession reinsurance may see increased use in the near future.
If managed well, offering retrocession reinsurance as part of your portfolio of services can spell a big difference in providing expanded expertise and greater advisory value to your clients.
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