Life insurance companies and reinsurers love a bit of jargon, so what is retrocession and how do companies use it? Mick James explains
Before we get to retrocession, it is worth understanding the relationship between insurance companies and reinsurers. Most UK insurance companies use a number of reinsurers to protect themselves from the effects of large mortality shocks or for balance sheet reasons.
The following scenario explains how this happens: imagine a customer coming to an insurance company and asking for a £100,000 life insurance policy over a 20-year term. The insurance company underwrites the risk and is happy to accept it at a cost of £10 a month for the duration of the 20-year term, and so it issues the policy documentation. If the customer dies, the insurance company is now ‘on the hook' for a £100,000 payout, meaning it must reserve capital for this eventuality.
The insurance company wants to use its capital for other things, so it decides to sell the risk to a reinsurer. Typically the reinsurer will take on 90% of the risk, as it will want the insurance company to maintain its underwriting standards, and nothing helps this like knowing you have some ‘skin in the game'.
Each month the customer pays the insurance company their £10 and the firm then pays the reinsurer around £4 to carry the risk. The insurance company keeps the other £6 to cover its own risk costs as well as the cost of setting up the policy and paying adviser commission.
If the customer dies, the reinsurer pays the insurance company £90,000 and the insurance firm chips in the remaining £10,000 to settle the claim. Essentially it's like a bookie laying off bets, but on a grand scale, as life insurance companies typically have a contract in place that automatically binds the reinsurer into taking all of the new business it writes.
The reinsurers are usually global entities, whereas many life insurance companies are national entities. This means that if there is a commuter plane crash or a large-scale fire, a national life insurance company may be hit by a spike in claims that will damage their balance sheet. The global reinsurer, on the other hand, is unlikely to be hit as hard, as these same incidents won't have occurred in every region where the reinsurer does business, so this shock event will be smoothed through its portfolio.
What is retrocession?
So if that's what reinsurance is all about, what is retrocession? At its simplest, retrocession is where a reinsurer wants to pass on a very large risk to someone else.
Imagine a case where a customer wants a £30m life insurance contract and has a valid reason for this. The adviser is keen to close the deal, as is the life insurance company, but the reinsurer may now have a problem, as the value of the risk has surpassed its level of comfort.
Although the reinsurer will be comfortable it can pay the claim, it won't be comfortable about the large impact on its quarterly profits if the claim comes in. What the reinsurers then do is to go to a pool of life insurance companies and ask these companies if they are willing to share in the risk. In the event of a claim there may then be something like ten companies all sharing different amounts of the risk, but no party has to foot the total bill itself.
Retrocession companies provide a certain level of capacity for each pool in which they participate. Some can also be active reinsurers. Retrocessionaires will often participate in pools for more than one reinsurer, and for this reason they need to know that their total retentions and capacity will not be exceeded.
Retrocession pools will usually have certain rules, restrictions and defining principles, which are likely to vary to some degree. However, there will always be one main rule common to all, known as the Jumbo Limit.
The Jumbo Limit is a limit included in the contracts (treaties) between the companies that protect the reinsurer/retrocessionaires from having to automatically accept individual lives with large amounts of insurance already in place throughout the industry. This is defined as the sum of all insurance already in force and to be placed on a life, in all companies for
all purposes.
Within this Jumbo Limit, consideration will also be given to the ultimate amounts for increasing plans. This is included to ensure the ultimate total death benefit, the amount paid out upon death for an insured, does not exceed the Jumbo Limit.
It is important to remember the Jumbo Limit is not the amount of capacity available to the reinsurer. Capacity is determined by how much the reinsurer is willing to take onto its own books plus how much the retrocession companies within the pool are willing to take. This total capacity will be lower than the Jumbo Limit.
The reinsurer will usually have the authority to automatically accept an application up to the total pool capacity as long as the Jumbo Limit is not breached. If the insurance requirement of the customer exceeds the pool capacity, the reinsurer will have to submit the risk to the retrocessionaires for facultative review.
Reducing capacity
Many of the retrocession companies within the automatic pool are small and do not have specific underwriting expertise, and therefore do not wish to participate in facultative offers. In such circumstances it is not unusual for capacity to be reduced.
For example, let's say a football player asks for £15m of life insurance cover where there is no indexation of the benefit. His IFA is delighted to help and they decide to place the business with the Hodgson Insurance Company.
The insurance company is happy to retain 10% of the business up to a maximum of £200,000 and the reinsurance company is bound by its contract to accept the business up to a £6m limit. Within the agreement between the reinsurer and Hodgson Insurance Company, the Jumbo Limit is set at £25m, and as the footballer has no more cover in the market, the retrocession pool is happy to take on the additional risk of £8.8m.
If the footballer already had £18m of cover placed in the market then the Hodgson Insurance Company would only be able to offer him £7m of additional cover. The footballer may be able to get more cover but this would have to be arranged on a facultative basis, and that is a whole different story.
Over the past two years RGA has seen retrocessionaires' appetite growing as larger risks have come into the market. Strong risk controls and large case underwriting have helped fuel this confidence and we expect to see limits rising in the medium term.
Mick James is business development manager at RGA UK Services
