Retrocession business remains an effective risk transfer tool, and its use is on the up

The property retrocession marketplace has stabilised after recent withdrawals and consolidation amongst both buyers and writers. Demand for retrocession protection remains strong; indeed, companies which, to date, have bought little retrocessional cover have now begun to consider its advantages, resulting in several new buyers entering the market during the first half of 2004. The rationale for purchasing is changing, however, with clear differentials appearing between larger and smaller entities.

The larger, well-capitalised reinsurers could reasonably withstand the impact of a significant catastrophe loss without purchasing retrocessional cover. However, they continue to buy such cover (in some cases increasing the limits purchased) for three core reasons: to lock-in recent record profits; to manage rating agency expectations; and to aid their overall capital management processes.

The last three years have seen the majority of property reinsurers report record profits, mainly due to the absence of any major catastrophes coupled with rising insurance and reinsurance premiums. Organisations - particularly the new Bermudians which have had profitable property reinsurance books since their incorporation - are now looking to hedge against the potential volatility to their earnings which a major catastrophe loss would cause.

Additionally, the financial strength rating downgrades affecting the larger reinsurers in 2003 have focussed all reinsurers on the positive effects of retrocession purchasing from a rating agency capital adequacy ratio viewpoint. This is a consideration not only for current ratings, but also for the effect that recoveries under a retro programme may have on ratings after a significant catastrophe loss. Retrocession is also a tool which many reinsurers use as part of their overall capital management process.

The writing of catastrophe-exposed reinsurance ties up a significant amount of capital as measured by any method of calculation of risk-based capital, and this issue can be significantly alleviated by the purchase of retrocession.

For smaller reinsurers and Lloyd's syndicates, the drivers toward purchasing may be somewhat different. The management of bottom-line volatility is paramount to such firms if their capital providers are to allow them to remain in business after a loss. Added to this are the realistic disaster scenario calculations for Lloyd's syndicates which require reinsurance mitigation to achieve a coherent business plan.

Thus buyers' evaluation of the value of risk transfer, whether for capital management, volatility reduction or rating considerations, is becoming a far more intricate process. Retrocession purchasing is now often orchestrated at board level, as the decision not only depends on pricing versus perceived expected losses, but also the effect of such purchase on the profit and loss account and balance sheet.

Retrocession writers have also evolved considerably over recent years.

Business can no longer be placed based on information containing purely incomes and historical losses: modeled information showing all exposed aggregates and occurrence exceedance probabilities is now part of standard information requirements. The provision of this information frequently turns out to be favourable to the buyer as their retrocessionnaires can reduce any loading for uncertainty in their pricing.

The modeling approach also highlights the number of exposed territories and the probability of loss associated with those territories, which can vary significantly between accounts. This enables a more technical approach to pricing, the corollary of which is that those writing retrocession have to allocate capital to their own writings, even if the exposures are at a remote probability level, and this tends to lead to value for the buyer tailing off at the remote return periods.

Prices are unlikely to move significantly during the remainder of the year or at the 2005 renewal unless a major loss impacts the incumbent reinsurers, and terms and conditions are likely to remain similar. It seems likely that the newer companies will continue to enter the market as they expand their underwriting horizons. Underwriters of finite retrocession are likely to address accounting issues through the restructuring of treaties to include more risk transfer, although the decline in popularity of these structures is expected to continue, with conventional and more blended products taking their place. The capital markets are likely to continue their role in providing remote loss cover with effective pricing and security, but will remain complementary to traditional retrocession purchasing, whilst industry loss covers still remain popular as a means of obtaining cover where such is not readily available on a traditional platform (e.g. for retrocessional writings).

However, despite the availability of other forms, the most effective risk transfer available remains retrocession coverage, and thus the market continues to thrive.