Why Do Finite-Risk Deals Raise Eyebrows?

That the reporting entity has an underwriting file that documents the economic intent of the transaction and the risk-transfer analysis to back up the accounting treatment. The underwriting file must be available for regulatory review.

The New York Insurance Department also is requiring additional disclosure of finite-risk transactions in annual statements.

The Reinsurance Association of America notes that regulators also are advocating that a specific risk-transfer threshold be adopted for the treatment of reinsurance in annual statements and that reinsurance contracts be divided into insurance (risk transfer) and financing elements. In other words, regulators want to be sure that if the deals are being recorded as "insurance" contracts, they actually transfer risk and aren't just monetary loans or deposits.

Although finite reinsurance transactions are grabbing the headlines lately, this particular species of reinsurance has been around for some time. There are a number of different types of finiteor financialreinsurance, many of which are well-suited for particular types of exposures, such as credit risk or warranty programs.

Keeping in mind that while the reinsurance contracts drawing regulator interest may vary from those described here, finite-risk reinsurance has been defined as an alternative risk-funding technique that uses time to generate the funds necessary to pay losses. Traditional reinsurance is mainly concerned with transferring underwriting risk from the ceding insurer to the reinsurer.

Finite-risk reinsuranceas its name "finite" impliesis financial reinsurance that in its pure form provides little, if any, risk transfer. These contracts typically are designed to be fully funded over time and typically are concerned primarily with investment risk, timing risk, or both.

There are various types of finite-risk reinsurance, some of which address retrospective losses and others which address prospective losses. Typical retrospective contracts include loss-portfolio transfers, retrospective aggregate treaties and adverse loss-development arrangements.

Under a loss-portfolio transfer, the ceding company transfers financial responsibility for a specific block of reserves for known losses. If the treaty limit is equal to the amount of reserves at the time of transfer, the reinsurer is not assuming underwriting risk.

It follows that, when the treaty limit is higher than the amount of losses ceded, some underwriting risk is being transferred. The risk of inadequate reserving is transferred to the reinsurer.

In addition, the reinsurer typically is assuming timing and investment risk. This is because the ceding premium is predicated on reserved losses being paid out over a certain period of time and investment returns meeting a certain threshold amount. If losses turn out to be paid at an accelerated pace, or if investment returns fall short of what was anticipated, the reinsurer may end up paying more than contemplated in the premium.

However, some loss-portfolio transfer arrangements include internal limits on how much the ceding insurer can collect during specified payout periods and other limitations may be placed on the premium based on investment recovery. Given the peculiarities of individual transfers, it would seem that some loss-portfolio transfers could be structured with very little, if any, risk of any kind actually being transferred.

Retrospective aggregate treaties differ somewhat from loss-portfolio transfers, transferring incurred but not reported reserves as well as known losses. Adverse loss-development contracts cede only a specified amount of adverse reserve development and not the actual reserves.

Prospective aggregate treaties, while still written over a multiyear period, deal with losses that occur after the effective date of the contract. This type of contract may be called a spread-loss treaty because it allows the ceding company to spread specified losses over the term of the treaty.

In exchange for its premium, the reinsurer agrees to reimburse the ceding company for aggregate losses in excess of the cedant's retention in any year within the treaty period. Loss payments are taken from the accumulated premium fund, which is paid by the cedant, and the reinsurer may be required to pay losses up to the treaty limit even if accumulated premiums are insufficient. If this happens, the reinsurer typically will be able to make up the difference from future premiums. In essence, the ceding company eventually pays its own losses.

The question of whether underwriting, timing and/or investment risk is transferred may depend upon the treaty limits and the limitations that are contained within it.

The stated purpose of prospective aggregate treaties is to stabilize the cedant's results over time. Financial or finite quota-share treaties permit the insurer to cede a percentage of its business to the reinsurer, and a ceding commission is paid.

Unlike traditional quota-share treaties, financial quota-share arrangements generally provide that the reinsurers premium adequately cover losses the reinsurer has to pay. Thus, little if any risk may be involved.

Excess premium may be returned to the cedant under a profit-sharing arrangement, and the contract may require the ceding insurer reimburse the reinsurer in later years for losses paid in excess of the premiumnet of ceding commission and investment earnings on the premium. The dollar amount of losses payable also may be limited under the treaty, again raising the question of whether any risk is being transferred.

These types of financial, or finite, reinsurance transactions often have raised the eyebrows of regulators as well as accounting and tax professionals. The current situations being reported seem to question the motivation behind the dealswere they structured to improperly enhance financial statements and deceive regulators?

New York Circular Letter No. 8 acknowledges that there are "legitimate uses of finite reinsurance (such as the transfer of interest rate risk and of timing risk)" but also notes that the transactions can "distort the underwriting and surplus positions of insurers entering into them when there is no actual transfer of risk or the transaction is accounted for improperly."

In other words, there may be legitimate uses of finite reinsurance, and not all creativity is bad. But the misuse of such products will not be tolerated.

Diana Reitz is managing editor of FC&S Online, the National Underwriter Company's online source for coverage interpretation and analysis. She may be reached at dreitz@nuco.com.

Reproduced from National Underwriter Edition, April 15, 2005. Copyright 2005 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.