What it means
The chain runs in three steps. A household or business buys insurance from an insurer, the insurer buys reinsurance to protect itself against large or clustered claims, and the reinsurer buys retrocession to protect itself in turn.
The purpose is the same at every level: spread exposure so that no single earthquake, hurricane or industrial disaster can exhaust one balance sheet. Reinsurers writing catastrophe business are especially exposed to correlated losses, so retrocession is how they cap the worst outcome and free up capital to keep writing new business.
Retrocession takes the same structural forms as ordinary reinsurance. A quota share cedes a fixed proportion of premium and losses, while an excess of loss contract responds only above an agreed attachment point, which is more common for catastrophe protection.
The party ceding the risk is the retrocedent and the party accepting it is the retrocessionaire. Ceding commission usually flows back to the retrocedent to compensate it for the acquisition costs it originally paid.
The nuance regulators worry about is the spiral. If risk is passed around a small group of reinsurers, a single large catastrophe can come back to a firm several times over through different contracts, so tracking ultimate exposure rather than contract-by-contract exposure is essential.
Capital markets have become an important source of retrocession capacity in their own right. Investors fund collateralised vehicles that take on catastrophe risk for a premium, which reduces the reliance on a small circle of traditional reinsurers and lowers the risk that one firm's failure spreads through the chain.
In practice
Real-world examples.
Example
A reinsurer with heavy exposure to coastal storm risk buys an excess of loss retrocession attaching at $250,000,000. A severe hurricane season produces $400,000,000 of claims, and the retrocessionaires absorb the $150,000,000 above the attachment point.
Example
A specialist aviation reinsurer approaches its internal limit on a single manufacturer's fleet. It retrocedes 30% of that concentration to two other reinsurers so it can continue quoting on new aviation business.
Example
A capital markets desk structures a retrocession backed by investors rather than another reinsurer. The investors post collateral into a vehicle, earn the premium if no qualifying catastrophe occurs, and lose principal if one does.
Think of it
“Retrocession is reinsurance for reinsurers-passing risk one more level.
Formula
Calculation
Under a quota share retrocession: ceded premium = assumed premium x ceded share; retained premium = assumed premium - ceded premium + ceding commission; recovery on a loss = gross loss x ceded share.
A reinsurer has assumed a property catastrophe book generating $10,000,000 of premium and retrocedes 25% of it on a quota share basis, receiving a ceding commission of 15% on the premium it passes on.
Ceded premium = $10,000,000 x 25% = $2,500,000.
Ceding commission received = $2,500,000 x 15% = $375,000.
Net retained premium = $10,000,000 - $2,500,000 + $375,000 = $7,875,000.
If a storm season produces $40,000,000 of gross losses on that book, the retrocession recovery is $40,000,000 x 25% = $10,000,000, leaving the reinsurer with a net loss of $40,000,000 - $10,000,000 = $30,000,000.Case study
Seen in the real world.
Meridian Re is a fictional reinsurer invented for this illustrative example. It had assumed $600,000,000 of catastrophe limits across a coastal region and its own capital model showed that a one-in-two-hundred-year event would consume more than half its equity.
The underwriting committee bought a retrocession programme attaching at $180,000,000 with a limit of $220,000,000, paying $26,000,000 in premium for the year. It also mapped every underlying contract to check that its retrocessionaires were not themselves reinsuring the same coastal exposures back to Meridian through other treaties.
A major storm two years later caused $310,000,000 of gross losses. Meridian retained $180,000,000 and recovered $130,000,000, an outcome painful but survivable, and its rating was affirmed within the month. The committee's own conclusion was that the exposure mapping had been at least as valuable as the cover itself.
Watch out
Common mistakes.
- Using retrocession and reinsurance as interchangeable words. Reinsurance protects an insurer, while retrocession specifically protects a reinsurer.
- Assuming ceded risk is gone for good. If the retrocessionaire fails to pay, the retrocedent still owes the full amount to the party below it in the chain.
- Measuring exposure contract by contract rather than in aggregate. The same catastrophe can reach a firm through several separate treaties, which is how spirals build up unnoticed.
Questions
People also ask.
Who ultimately bears the loss in a retrocession chain?
Whoever retains the risk at the end of the chain, which may be a reinsurer, a retrocessionaire or capital markets investors backing a collateralised vehicle.
Is retrocession expensive?
Pricing swings hard with recent catastrophe experience, and capacity can tighten sharply after a bad season, which pushes rates up across the whole market.
Does retrocession affect what a policyholder pays?
Indirectly yes, because the cost of protection at each layer feeds through into the reinsurance and primary premiums charged below it.
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