Retrocession (noun, abbr: retro).

Just as reinsurance is insurance for insurers, retrocession is reinsurance for reinsurers. It is the cover at the very top of the risk transfer food chain, the protection of last resort. It is the playground of only a handful of companies, and the number involved has shrunk dramatically since multiple storms in Europe in 1999 disproved the theory that hurricanes hardly happen.

For example, the retro market collectively paid claims of about $1bn in respect o losses arising from Lothar - half the reinsured total. That year the market's combined ratio was pushed up by a loss ratio of about 250%, hit by 13 natural catastrophes including eight hurricanes, one tornado, three earthquakes, and one flood. All that just after pricing had bottomed out in 1998.

Although retro comes in many forms, after a battering like 1999 the cover is available from only a few sources - less than two dozen. Gone are the good old days of the London market excess of loss frenzy, when everyone reinsured everyone else with an unabashed eagerness so uninhibited that several retrocessionnaires - particularly syndicates at Lloyd's, but also company market players - found when the claims rolled in that they had reinsured portfolios which included their own ceded risks. The resulting spiral of disaster is still being unwound. Inevitable biennial proposals (such as Grant Thornton's 'Project Corkscrew') to call a halt to the whole thing and have one big reckoning are inevitably hindered by a few retrocessionnaires who worry that they will lose out.

Almost all of Europe's retrocessionnaires are now out of the business.

On the continent, retro has practically become a dirty word. Axa Re for a time was the largest retrocessionnaire in the world (a position now usurped by Berkshire Hathaway), but after the big losses at the turn of the millennium, Axa Re became a shadow of its former self, its former leaders now redistributed to other Parisian reinsurers. A handful of US and Bermudian risk carriers dominate today's little retro market, but with only about 80 buyers world-wide, including individual Lloyd's syndicates, there is little need for a large diversity of suppliers. Besides, ample availability of retrocession has a tendency to force down reinsurance prices, which has an inevitable knock-on effect on insurance markets.

Retrocessionnaires' influence over reinsurance market pricing should not be underestimated. The mechanics are the same as the supply and demand equation in reinsurance markets, but the top-down influence is even greater.

When reinsurers' comfort levels reach unjustified levels because natural catastrophes, for example, can no longer affect them beyond retrocession attachment points, they are even more inclined to offer cover to primary underwriters who may feel even more comfortable. While the arbitrage buck stops with the ultimate retrocessionnaire, there is always somebody willing to take a larger gamble in a hardening market.

Innovative measures

Increasingly the gamblers are capital market players, usually hedge funds.

The catastrophe bond concept has not been wildly successful as a source of traditional reinsurance capacity, but it has been extremely popular (in a relative way) among reinsurers who have used catastrophe bonds as a source of retrocession. Swiss Re has been an enormous issuer, along with Munich Re, Hannover Re, Converium, SCOR, and even Central Re of Taiwan.

Prices of cat bonds - which leave nothing to interpretation, and thus have clear-cut payment parameters - are moving further away from traditional retro prices, as investors gain confidence in the issuers' modelling abilities.

Parametric triggers (rather than indemnity) have become de rigueur in reinsurers' cat bond issues.

Meanwhile, another source of capital markets capital is playing in the retro markets: the hefcore, or hedge fund collateralised reinsurance.

A number of funds have been offering industry loss warranty-type retrocession through hefcore structures, which mechanically are similar to a traditional catastrophe bond, but which do not involve the issue of tradable, agency-rated paper. Instead, the hedge find acts as retrocessionnaire, but in a way that is friendly to the capital markets - creating a true blending of financial cultures.

Despite the innovations, traditional reinsurers still account for the vast bulk of the retrocession market, which is divided roughly equally between conventional and finite-type programmes. Smart money is still interested in the market, although it is very, very cautious in ensuring that its accumulations do not grow too large. One successful retrocessionnaire has been Renaissance Re, the savvy Bermuda reinsurer that keeps on making money. A few years ago Dave Eklund, chief underwriting officer, described the retro market as "extremely inefficient ... You get a wide spread between the winners and losers, perhaps wider than any other market." Yet RenRe has successfully, carefully, underwritten retro business, and remained firmly among the winners.

The stupid money doesn't last long, and the losers lose very badly. A quick visit to the graveyards of Australia reinsurance will illustrate this. Companies such as New Cap Re, GIO Re, and ReAC have now been almost entirely forgotten, but the last time the retrocession market began to soften they had a big appetite for the business, and everybody knew their names.