Finite-risk reinsurance is still a source of concern anduncertainty for the property-casualty industry. Although numerouscompanies have settled their investigations related to finitetransactions and their accounting treatment since this issue firstcame under fire late in 2004, other inquiries are stillpending.

More recently adding fuel to the fire was the FinancialAccounting Standards Board's proposed “Bifurcation of Insurance andReinsurance Contracts for Financial Reporting,” which was availablefor comment over the summer.

FASB was seeking input from buyers and sellers of insurance andreinsurance contracts, as well as from financial statement users,about the possible bifurcation of accounting for such contractsinto “insurance” and “deposits” for financial reportingpurposes.

This includes what is commonly known as “finite risk” contracts,as well as any insurance and reinsurance contracts that do not“unequivocally transfer significant insurance risk”–such as groupaccident and health insurance. Not surprisingly, the feedback toFASB was overwhelmingly against the proposal and in support of thecurrent framework.

Finite-risk reinsurance is a form of reinsurance that explicitlyconsiders the time value of money, in addition to the expectedamount of loss payments in nominal dollars.

The insurance risk assumed by a finite-risk reinsurer iscontractually limited so that the reinsurer's range of possiblelosses is relatively narrow. Typically, purchasers of finite-riskreinsurance are driven less by risk transfer and more byrisk-financing objectives (although finite-risk transactionscontain elements of both) as a means to improve current periodearnings, smooth earnings, effectively discount reserves and/orenhance capital.

Determining whether an arrangement is finite-risk reinsurance ortraditional reinsurance can be difficult, as there are manycomponents of the arrangement to consider. There are no brightlines in making the determination as to whether the transferredrisk of loss is undoubtedly certain or not.

To further complicate the issue, it is often not the merepresence, or absence, of the components that is the primedeterminant, but the relative presence, or absence.

In practice, there are several rules of thumb as to whatconstitutes significant insurance risk.

For a long time, the “10/10 rule” was considered sufficient,meaning there is at least 10 percent probability of at least a 10percent loss. In other instances, it has been argued that thestandard is 15/15.

As a practical matter, the standard is ultimately what thecedant's auditors and regulators allow, which can vary fromjurisdiction to jurisdiction and even from company to company.

Thus, it can be very difficult to standardize a rules-basedapproach for a process that will always involve some level ofsubjective judgment.

As such, any change to the accounting for finitecontracts–however well meaning–will likely not catch flawedanalyses of the “significant risk transfer” required under FASBStatement No. 113 if company management uses grossly conservativeassumptions designed specifically to mislead auditors or others inorder to obtain reinsurance accounting treatment.

While the current principles-based accounting guidance (FAS 113,SSAP 62) is generally reasonable in determining if risk transferhas taken place, one of the problems is that the test for risktransfer is binary.

If a company meets the test, it accounts for 100 percent of thecontract as reinsurance. Likewise, if it does not meet the test,then the entire contract is accounted for as a deposit.

In theory, it may be preferable to bifurcate the accounting forinsurance contracts, so that if there is 10 percent risk transfer,then 10 percent of the contract is accounted for as reinsurance andthe remaining 90 percent receives deposit (investment) accountingtreatment.

However, as a practical matter, it can be very difficult toimplement consistently across companies that have finite contractscovering losses emanating from multiple accident years and multiplelines of business in such a way that will increase financialstatement reliability, comparability and overall usefulness.

As such, it would be more appropriate that in cases wherereinsurance accounting treatment is granted, yet there is not 100percent risk transfer, the company should be required to disclosestandardized, key account metrics that provide more detailedinformation to users that allows for a better understanding of thecontracts in place.

Such an expansion of disclosures would help to improve thetransparency and understandability of financial statements withoutadding an unnecessary burden to the company. For example, theNational Association of Insurance Commissioners issued newreporting requirements for additional reinsurance disclosure thatwas effective for year-end 2005. (See sidebar.)

The use of finite-risk reinsurance, even when adhering to boththe letter of the law and accounting guidance, can be misleadingand distort financial statements.

A company should be analyzed based on its real economicposition, regardless of the accounting used. So to the extent thatthe financial statements and related disclosures allow users tobetter understand a company's true financial position, they aremore reliable and useful.

Favorably, the scrutiny that the industry experienced fromprosecutors and regulators over the last several years has reduceddemand for such finite-risk products and has resulted in manycompanies commuting their finite-risk contracts as more of themarketplace and regulators started to systematically “back out” thefinancial statement benefit of the arrangements, reducing theincentive to maintain such contracts.

As the heat begins to subside somewhat on finite-risk issues, wewill have to wait and see to what extent FASB decides to proceedwith this proposal and the broader risk-transfer project,particularly in light of the almost universal opposition to thebifurcation proposal from all interested parties.