retrocession

If an insurer can pass risk to a reinsurer, what does a reinsurer do when it has taken on more risk than it wants to keep? It does the very same thing one level up: it buys reinsurance of its own. Retrocession is reinsurance bought by a reinsurer. The reinsurer ceding the risk is the retrocedant, and the company taking it on is the retrocessionaire. It is risk-passing at the next storey of the tower, the way a wholesaler buys from a manufacturer and a retailer buys from the wholesaler.

Mechanically, retrocession works exactly like ordinary reinsurance — it can be proportional or excess of loss, treaty or facultative — but its purpose is to let reinsurers manage their own accumulations, especially of catastrophe risk. A reinsurer that has written cat cover for hundreds of primary insurers may find itself dangerously concentrated on, say, Florida hurricane; it retrocedes part of that peak exposure to spread it further. This is how a single catastrophe's cost gets diffused across an ever-wider circle of capital around the globe, rather than piling up on one balance sheet.

Retrocession has a notorious hazard called the spiral. Because reinsurers reinsure each other, the same underlying loss can pass round and round a chain of companies, each ceding to the next, and a participant can unknowingly end up reinsuring a layer that ultimately contains its own ceded risk coming back. The London market's LMX spiral of the late 1980s did exactly this, amplifying a few real catastrophes into a tangled web of recoveries that nearly broke parts of the market. The honest lesson: retrocession spreads risk usefully, but opaque, circular chains can secretly concentrate it again — knowing where your risk ultimately rests matters as much as ceding it.