What Does Retrocession Mean?
Retrocession is when one reinsurance company has another insurance company assume some of its risks. Like many other types of insurance, this is done for a fee and to reduce the overall risks.
Reinsurance companies transfer risks under retrocession agreements to other reinsurers for reasons similar to those that cause primary insurers to purchase reinsurance. As such, reinsurance companies commonly participate in retrocession in order to prevent the chances of being unable to meet their financial obligations in the event that a disaster occurs and causes many claims to be filed at once.
Even reinsurance companies sometimes need help covering their risks. If a reinsurance company feels that it is too exposed, then it may use retrocession to transfer some of its risks to another reinsurer. Events like tornadoes, hurricanes, monsoons, tsunamis, earthquakes, and acts of war can all cause a tremendous amount of claims to be filed at once. The retrocession is especially helpful for circumstances like these.
This is because it helps the reinsurer from being overexposed to claims. An example of this is when a reinsurance company has a significant amount of risk in an area known for high winds and feels there may be too much risk associated with claims due to wind damage. This helps spread the risk so that no one insurance company will take a significant loss or financial obligations they cannot handle.
Insuranceopedia Explains Retrocession
The simplest way to think of retrocession is when a reinsurer wants to pass on a very large risk to someone else.
Imagine for a minute that a customer wants a $30 million life insurance contract and has a valid reason for this. The insurance adviser is eager to close the deal, as is the life insurance broker and the insurance company. The reinsurer on the other hand may now have a big problem they need to address. A policy of this value and risk has surpassed the reinsurer's comfort level. The reinsurer then has the option to go to a pool of life insurance companies and asks these companies if they are willing to share in the risk.
If we assume that there are ten other companies in the pool, then in the event of a claim there will then be ten companies all sharing different amounts of the risk. In this situation, no one company has to pay the total bill itself making the risk more comfortable for the reinsurer.
While retrocession insurance companies provide a certain level of capacity for each pool in which they participate. They also have certain rules, restrictions and defining principles in the pool. These rules can vary to some degree, but generally have an upper limit that cannot be exceeded. Over the years the need for retrocession pools has been growing as larger risks have come into the market with large financial exposure.