We are now aware that reinsurance companies are created especially for taking up risk from other insurance companies. Most people believe that this is the end of the value chain. This means that the risk stays on the books of the reinsurance company till it is extinguished. However, this is not the case.
Reinsurance companies do not necessarily have to hold every risk that they have on their books. In fact, it is quite common for reinsurance companies to share their risks with other reinsurance companies. This process is called retrocession. In this article, we will have a closer look at what retrocession is and what the benefits of retrocession are.
What is Retrocession?
As mentioned above, retrocession is the transfer of risk from one reinsurance company to the other. The reasons for entering into a retrocession contract are the same as the ones for purchasing a reinsurance contract in the first place.
It is important to note that reinsurance companies can share their risks with another reinsurance company or they can decide to share their risks with an entire pool of reinsurance companies. This is generally done when the reinsurance risk being undertaken is so large that it passes the risk threshold of reinsurance companies.
Benefits of Retrocession
Reinsurance companies undertake retrocession for a wide variety of reasons. Some of the important reasons behind retrocession have been included in this article.
- Faster underwriting: The reinsurance business is highly competitive. This means that reinsurance companies have to ensure a faster turnaround time in order to ensure that prospective customers are served promptly. Failure to do so could lead to loss of business. Now, since reinsurance companies have to manage a faster turnaround time, they tend to take on more risks than they anticipated.
Retrocession is a mechanism that can be used to lessen the risk burden. This allows the reinsurance company to underwrite faster without being afraid of being stuck with the wrong kind of risks.
- More competition: The number of reinsurance companies that can insure a very large risk is limited. Hence, if a large company wants to reinsure its exposure, it might find very few counterparties. Lesser competition could lead to higher premiums. However, retrocession allows smaller reinsurance companies to also participate in this process.
A smaller reinsurance company can underwrite the exposure of a large client and then can decide to use retrocession to split their exposure at the backend with several other reinsurance companies. This creates a situation where there is increased competition in the industry and the consumers have more options.
- Reserves Management: Just like banks, reinsurance companies also have to maintain a certain amount of reserves on their balance sheet. In most countries, a minimum amount has to be maintained which depends upon claims already made as well as other factors. Now, since claims made changed dynamically, the reserves also need to change dynamically. As a result, reinsurance companies find themselves in a position wherein they have excess reserves. Alternatively, there could also be a shortage of resources.
The concept of retrocession creates a secondary market wherein companies can buy and sell exposures in order to help them manage their regulatory obligations better.
- Strategic Business Decisions: Retrocession also provides reinsurance companies with the flexibility to make better strategic decisions. For instance, it is possible that a reinsurance company has been undertaking extensive exposure in the Latin American market. However, the management of the company decides that they want to exit the Latin American market. In such cases, they do not have to sell their entire company to a third party. Instead, using retrocession, they can sell each and every exposure to the highest bidder.
Similarly, if a reinsurance company wants to enter a new geographical market, they do not have to undertake customer acquisition by selling reinsurance policies one at a time. They can use the retrocession market to build exposure which helps them get a head start in the market. Hence, it can be said that retrocession provides reinsurance companies with the flexibility they need in order to make strategic decisions.
- Capacity Management: Retrocession is also important for the reinsurance company when it has to undertake more business. Retrocession, along with other insurance structures such as sidecar allows the company to offload its existing risk to other reinsurance companies. This allows them to undertake new risks and generate more revenue for themselves.
- Dynamic Risk Management: Retrocession allows reinsurance companies to dynamically manage their risks. This means that these companies can run their risk management models and then if the suggested action is to reduce a certain amount of risk, then the same can be done via retrocession. For instance, the reinsurance company may realize that they have taken over a lot of flood risk in North America. In such cases, they can decide to offload some of that risk using retrocession.
The bottom line is that retrocession is an important tool that is strategically used by reinsurance companies today. In the future, it is only likely that the market will become more developed and liquid.
