Fighting Fire With Fire

The auditing firms are really concerned about their own E&O [errors and omissions], so they spend quite a bit of time trying to make sure that the reinsurance transactions theyre signing off on clearly pass the auditing hurdles of transferring risk, he said in an interview.

I have heard people say that Sarbanes-Oxley and the auditors will try to get rid of finite, but I dont think thats going to happen, he said. Finite contracts do contain a lot of risk transfer, as evidenced by the losses that some reinsurers have experienced.

Guy Carpenter and all the brokers in this market are very careful to make sure all the contracts that [theyre] helping get placed are valid reinsurance contracts and [that] they contain sufficient risk transfer and meet all the accounting guidelines, he said.

Oscar Tymon, senior vice president for Centre Re in London, said most finite re deals are reactive. Most of the things that have been done in the alternative industry are a reaction to a problem in the industrypeople couldnt get coverage, or it was too expensive, or perils were excluded.

Immediately after Sept. 11, there was a great shortage of aviation capacity, he said. So there was room there to put together individually structured deals to help provide capacity that wasnt available from the traditional market, he said.

Further, he added, the whole liability area at the moment is ripe for some sort of tailored structured approach because certain coverage is very hard to obtain. He cited the example of the U.S. malpractice crisis where both insurance and reinsurance coverage is very difficult to get hold of. So individually tailored structures are probably going to be a growth area.

In defining finite re contracts, or what he calls structured programs, Mr. Tymon said, they are individually tailored, problem-solving approaches to a particular risk situation.

There is nearly always an aggregate limit of liability (for the reinsurer) over the term of the contract as well as a per year aggregate, he said. Also, most contracts contain some form of profit sharing and typically span multiple years because the reinsurer helps to manage volatility, he added.

In order to be as flexible as possible, the policies are typically written net, without retrocessional cover being purchased by the reinsurer. So, in other words, the gross and net capacity are the same, he said, noting that the policies are typically written 100 percent by one carrier.

Mr. Darby said most of the finite re products he has seen over the past 18 months have been in the area of surplus relief.

Its our environment right now, he affirmed. Weve come out of a long period of very soft pricing, and primary companies are trying to take advantage of the harder market and write more business although they may be surplus constrained.

Some companies havent necessarily increased their exposure, but their premium relative to their surplus has now gotten to the point where they look leveraged, Mr. Darby said. When A.M. Bests looks at them or when the regulators look at them, they may get concerned about leverage, so were seeing interest in de-leveraging their balance sheet by ceding off premium through surplus relief type products, mostly structured quota shares, he said.

Such products may have a sliding scale ceding commission or some kind of aggregate loss cap, which are the two most common features he sees in a quota share arrangement that makes it classified as a finite arrangement.

Further, Mr. Darby said, he also sees loss portfolio transfers. Thats where an insurance company decides it wants to cede a block of reserves to the assuming reinsurer, he said.

One reason for doing such a deal could be because the insurer has exited a line of business or is trying to put a box around its liabilities because it has had issues with adverse loss development, he explained.

Mr. Darby noted that adverse development cover can be especially useful to facilitate an acquisition. The selling company will often buy an adverse development cover to essentially protect the reserve position for the acquiring company, he said.

Whats interesting is that under the accounting regulations, the acquiring company will get favorable accounting treatment in the event that there is development of the reserves into that adverse development layer, he said.

Effectively, when you buy one of these covers at the time of an acquisition, you get to take credit for any adverse development right away, as opposed to scheduled over time, Mr. Darby explained. It can be a pretty powerful tool for a company that is looking to be acquired to help them appear more attractive to a potential bidder.

While there is a valid use of finite re for smoothing volatility, Mr. Darby said he is seeing fewer of these transactions as a result of concerns from auditors.

Mr. Darby cited the example of an insurance company that decides to take a higher retention because the traditional reinsurance market has gotten very expensive. The insurer has a concern about having a $10 million retention on every claim, with only $30 million of surplus, he said, explaining that the insurer doesnt want one claim to take out that much of its surplus in any one year.

The insurer might try to buy a cover that would help it absorb that loss over several years, he said. There is a valid reason why that contract would be useful and would still be purchased, but were not doing a lot of those [contracts] these days.

He explained that the lack of activity in this area is due to the concerns of auditors after the Enron scandal and just a general feeling that nobody wants to enter into a contract that would be seen as smoothing earnings.

Mr. Tymon said there is debate in the industry about the use of stop-loss covers, which is coverage to protect loss ratios.

At the end of the day, the investment community is looking for smooth, predictable results, he said during a recent speech at a seminar held by the International Underwriting Association in London. I suspect in three years time, when we may or may not be in slightly less favorable underwriting conditions, the analysts will look more favorably on those companies that have been consistently and reliably profitable than those that havent, he said.

Mr. Tymon told National Underwriter that any reinsurance structures have to be properly accounted for and measured.

Dave Powell, principal, reinsurance for Towers Perrin in London, was less sanguine about the use of such stop-loss policies. These covers have been called the crack cocaine of the non-life industry, he said during the IUA seminar.

He explained that these covers are highly addictive to management. Were talking about coverage that protects the loss ratio prospectively where the discounting of reserves, the discounting of the income stream, is a major component of the pricing, he said.

Effectively, they bolster current net income at the expense of the future, he said. Youre borrowing future investment income to enhance todays results.

Once this process is started, it becomes addictive because you need to improve your underwriting to avoid buying another one next year, he said. As you continue to buy them, you create a larger and larger drain on future income.

Mr. Powell said he didnt mean to imply that these covers dont have a purpose and that there arent situations where theyre warranted.

But when I put on my financial analyst hat, it makes it very difficult to understand a company and how it might relate to its peer group.

This means these products can be less than transparent, he emphasized.

There is some inherent volatility to the business, he said, and its not necessarily a good thing to disguise that. It is what it is and investors should be aware of that, Mr. Powell stressed, noting that by artificially smoothing results, a company represses the rate of return it deserves for the business it has conducted.

Reproduced from National Underwriter Edition, July 7, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.