Definition
In finance, retrocession refers to the practice where an asset manager or service provider, such as a bank or financial consultant, receives a portion of the commission paid to a third party for referral of business. These payment arrangements may take place between brokers, insurance companies, asset managers, or other financial service providers. However, some view retrocession as controversial due to potential conflicts of interest and lack of transparency.
Key Takeaways
- Retrocession is a practice in the finance and insurance industry where a company transfers some or all of the risks it has assumed to another company, often in an effort to spread out risk and protect against major loss.
- The company that retrocedes the risk is known as the cedent, while the company which accepts the ceded risk is called the reinsurer. The cedent pays a premium to the reinsurer in return for this risk coverage.
- In a broader investment context, retrocession can also refer to the commission or fees that an asset manager pays to a third party for introducing a client or bringing new business. It’s crucial to clarify these fees because they could potentially influence financial advice or decision-making.
Importance
Retrocession is an important term in finance, specifically in the insurance sector, as it refers to the practice of one reinsurance company transferring portions of risk to other reinsurance companies.
This systematic redistribution of risk allows companies to protect themselves from catastrophic losses, maintain solvency, and better manage their capital efficiency by spreading the risk of loss around.
It also helps in maintaining stability in the insurance sector during periods of large-scale unexpected or catastrophic events.
Hence, understanding retrocession is crucial for managing risks and ensuring financial sustainability within the insurance industry.
Explanation
Retrocession serves a critical role in the financial and insurance sectors, particularly in the reinsuring process, as it provides an instrumental risk management strategy. The primary purpose of retrocession is to further spread the risk originally transferred from an insurance company to a reinsurance company. This is done when the reinsurance company reassigns a portion of the risk it has assumed to another reinsurance entity, known as retrocessionaire.
This way, it can protect itself from potential significant financial losses due to vast insurance claims. Retrocession is therefore quite essential to the stability and sustainability of reinsurance companies, especially during catastrophic events that would lead to financial strain. Moreover, the use of retrocession also serves to optimize capital efficiency within reinsurance companies.
It can allow for greater underwriting capacity, enabling companies to take on more business and ultimately enhance their growth without disproportionately accumulating risk. This improved risk diversification also benefits policyholders, ensuring policy claims can be met without financial disruptions. Even though this process may seem complicated, with a chain of risk transfers, it ultimately provides a critical safety net for the insurance industry.
Thus, retrocession not only supports the reinsurance companies but reinforces the overall insurance ecosystem.
Examples of Retrocession
Retrocession primarily refers to the practice where insurance companies distribute certain parts of their risks to other companies, usually in the reinsurance sector. Here are three real world examples:
Catastrophe Insurance: Due to the high risk and potential for enormous claims following a catastrophic event like a hurricane, flood, or earthquake, insurance companies will often utilize retrocession to protect themselves. For instance, an insurer in Florida might retrocede hurricane risk to a reinsurance company to limit their own exposure.
Retrocession in Health Insurance: Health insurers, like those dealing with major health problems and life-threatening illnesses, may also depend on retrocession. The insurer takes on a significant amount of risk when it guarantees expenses related to chronic diseases that require costly treatments. By retroceding a part of their policies, these companies can mitigate their risk exposure.
Large scale Infrastructure Projects: Insurance companies covering large projects such as the construction of bridges, highways, or high-rise buildings often seek to mitigate their risk through retrocession. The potential financial risk associated with these projects can be extremely high, so insurers will often retrocede a portion of this risk to reinsurers. The original insurer retains a portion of the risk and premium but shares the larger possibility of a significant loss.
Frequently Asked Questions About Retrocession
What is Retrocession?
Retrocession is a practice in the finance sector where a mutual fund or asset manager pays part of its management fee to financial advisors or distribution networks as commission. This is commonly used in the Swiss banking industry.
Why is retrocession used in finance?
Retrocession is primarily used for sales promotion and client motivation. It encourages third parties to push a financial institution’s products and services to potential customers.
Is Retrocession legal?
Yes, retrocession is legal however, it is controversial due to potential conflicts of interest. It is regulated by financial authorities and all retrocessions must be disclosed to the investor in some jurisdictions.
What is the impact of Retrocession on investors?
Retrocession can lead to a conflict of interest between the investor and the financial advisor. This is because the financial advisor may recommend products or services that offer higher retrocessions, rather than those that are most suitable for the investor.
Related Entrepreneurship Terms
- Reinsurance: Reinsurance is another central finance term associated with retrocession as it refers to the process where an insurer transfers a part of its risk to another insurance entity.
- Ceding Company: This term refers to the insurance company that procures the reinsurance, passing on its risk to the reinsurer, or in the case of retrocession, to the retrocessionaire. This is a vital term within the scope of retrocession.
- Retrocessionaire: The insurance company that takes on the risk from the reinsurance company during a retrocession deal is known as the retrocessionaire.
- Treaty Reinsurance: A type of reinsurance in which the reinsurer agrees to accept all risks of a pre-defined type from the ceding company.
- Facultative Retrocession: A type of retrocession where the reinsurer can decide whether they want to accept the risk from the reinsurance company. This discretion is on a case-by-case basis.
Sources for More Information
- Investopedia: A comprehensive online financial education platform that offers detailed, easily-understandable definitions of various finance terms including retrocession.
- Accounting Tools: A resource site providing in-depth information and learning materials on financial and accounting terms.
- Law Insider: An extensive database of legal documents that could have examples and detailed explanations of financial terms like retrocession in real-world contracts.
- The Financial Dictionary: An online dictionary providing definitions of common financial terms and concepts, including retrocession.
