Expert Explains Finite Reinsurance Needs

Expert Explains Finite Reinsurance Needs

By Daniel Hays

NU Online News Service, April 26, 11:10 a.m. EDT?Despite the controversy raised by recent investigations, finite reinsurance deals when done properly serve a valid purpose and will remain as an important niche in the marketplace, according to an expert in the field.

"I see this area continuing as an important subset under whatever clarified guidelines emerge," commented Dan Malloy.

Mr. Malloy, executive vice president of ART solutions with Benfield Group's New York Office, used his knowledge of structured reinsurance in February to provide a briefing on the topic for regulators at the National Association of Insurance Commissioners meeting.

According to Mr. Malloy, finite reinsurance arrangements account for somewhere between three and 10 percent of the reinsurance market, but while he said the number of transactions is "miniscule" they tend to be larger.

This is because rather than providing a carrier with coverage for a single line for a single year such contracts may cede the risk from multiple lines in an insurer's portfolio over multiple years.

Arrangements of this sort come under regulatory scrutiny, he explained, when they fail to meet the requirements of the Federal Accounting Standards Board Regulation 113.

Accounting rules require that for a contract to be recorded as reinsurance, it must be reasonably possible that the reinsurer will realize a significant loss on the contract. Accountants have adopted a rule of thumb to interpret the rule, requiring that a transaction carries a 10 percent probability of loss of 10 percent, of the premium to the reinsurer, evaluated on a discounted basis.

Mr. Malloy said that if the FASB finite reinsurance risk percentage rules promulgated in 1993 are not met, then the primary insurer must keep reserves sufficient to cover the losses subject to the contract, since proper risk transfer credit cannot be taken for ceding the risk. In other words, the primary insurer gets less favorable accounting treatment and cannot net down premiums and reserves that would be ceded to the contract if it were a reinsurance contract.

He added that if the insurer takes credit for buying reinsurance, but the reinsurer doesn't have risk?the economics are still sitting with the [reinsurer's] client and they haven't gotten rid of the downside."

Further, said Mr. Malloy, if the primary insurer is basically keeping all the exposures, the insurer is "misstating the risk position and understating its leverage."

Explaining the market for reinsurance, Mr. Malloy said that insurers are more comfortable accepting reinsurers' tighter coverage limits on a big predictable book of business encompassing several lines over a longer period.

Compared with the traditional reinsurer, who wants to do a single line over one year, the finite reinsurer reduces the possible volatility of results. With greater data from examining multiple lines over multiple years outcomes fall between a much tighter range. "The coverage based on the entire portfolio smoothes out some of the peaks and the troughs," he related.

As an example, Mr. Malloy said a finite reinsurer would look at a total book over three years, which would have less volatility than an individual line. The reinsurer would offer a cap of x amount of dollars and reduce the cost if there is a favorable loss outcome. "So the client says I'll accept your limit on liability and get a big profit share."

He said that 99 years out of a 100, the insurer is never going to hit the finite insurance maximum."

When it comes to finite insurance "people aren't doing it just for accounting" said Mr. Malloy.

In his presentation to the NAIC, he pointed out that use of structured transactions may be attractive to insurers for several reasons, including:

? They recognize economics of long tail lines of business

? They deal with company experience that is better than average, making reinsurance "too expensive."

? They allow a company to increase writings or take larger retentions in favorable underwriting environments.

? They work for a company with historic experience that is much worse than average making ?reasonably' priced reinsurance unavailable.