Retrocession is the transfer by a reinsurer of part of the risk it has taken on from insurers to another party. It is, in effect, reinsurance of reinsurance. The reinsurer that passes the risk on is called the retrocedent, and the party that accepts it is the retrocessionaire, which may be another reinsurer, a specialist fund or a vehicle financed by capital market investors. Reinsurers buy it for the same reasons that insurers buy reinsurance: to limit their exposure to very large losses, to steady their results and to free capital for new business.
Retrocession forms the last link in the chain of risk transfer that begins with the policyholder. An insurer makes a reinsurance cession to a reinsurer, and the reinsurer retrocedes part of that to others. Each contract is separate: the retrocessionaire has no relationship with the original insurer or its customers, and the reinsurer remains fully liable to the insurer whatever happens further along the chain.
How retrocession works
Retrocession contracts use the same forms as ordinary reinsurance. A reinsurer may arrange a standing programme in the manner of treaty reinsurance, covering a whole portfolio for a year, or may place a single very large acceptance on its own. Cover can be proportional, as in quota share reinsurance, where the retrocessionaire takes a fixed share of premiums and losses, or non-proportional, as in excess of loss reinsurance, where it pays only when losses exceed an agreed level.
Much retrocession is bought against natural catastrophes such as hurricanes and earthquakes, because a reinsurer's book gathers these exposures from many insurers and one event can produce claims from all of them at once. Because the retrocessionaire is far removed from the underlying policies, catastrophe retrocession is often written on an index or industry-loss basis: the contract pays according to a published estimate of total market losses from an event rather than the buyer's own claims. This is quicker to settle but leaves the buyer with basis risk if its own losses differ from the index.
The retrocession market
The market is small relative to reinsurance as a whole and has relatively few sellers. Large reinsurers retrocede to one another, and syndicates at Lloyd's of London have long been active on both sides. Since the 2000s a growing share of capacity has come from investors outside the insurance industry, through instruments grouped as insurance-linked securities:
- Collateralised reinsurance. A fund posts cash or securities equal to the full limit of the contract, so the buyer does not depend on the seller's credit standing.
- Sidecars. Investors take a proportional share of a reinsurer's portfolio through a dedicated vehicle for a limited period.
- Catastrophe bonds. A catastrophe bond pays investors a coupon and returns their principal unless a defined event occurs, in which case the money goes to the sponsor.
Prices for retrocession tend to move more sharply than those for reinsurance. After years with heavy catastrophe losses, capacity is withdrawn and prices rise; the higher cost is then passed back down the chain to insurers.
Risks and supervision
The main concern is counterparty risk: the retrocedent must pay its own cedents even if a retrocessionaire fails. Reinsurers therefore set limits by counterparty and by credit rating, and often require collateral. A second concern is accumulation. When reinsurers retrocede to each other, the same loss can travel around the market and return to a firm that thought it had passed it on. The best-known case was the London market excess of loss "spiral" of the late 1980s, in which catastrophe losses circulated repeatedly among Lloyd's syndicates and companies and proved far larger for some participants than expected.
Supervisors treat retrocession like other outward reinsurance. Under Solvency II it can reduce a reinsurer's Solvency Capital Requirement where it transfers risk effectively, with a charge for the possibility of counterparty default. Insurance supervisors also monitor the links it creates between firms as a possible source of systemic risk. Expected recoveries from retrocessionaires are estimated as part of claims reserving.
Other meanings
In asset management, particularly in Switzerland and other parts of continental Europe, retrocession refers to something different: a commission that a fund manager or product provider pays back to a bank, adviser or distributor out of the fees charged on a client's investment. Because such payments can bias advice, they are restricted in several jurisdictions. Under MiFID II, firms giving independent advice or managing portfolios on a discretionary basis may not keep them, and Swiss courts have held that they belong to the client unless the client has validly waived them. In the Islamic insurance sector the equivalent of reinsurance and retrocession is retakaful.