Finite Re: A Valuable Tool for Today%apos;s Risk Market

Companies' reasons for entering into a structured reinsurance deal can include, among others:

1. A company's experience may be much better than average, making reinsurance too expensive.

2. A company's experience may be much worse than average, making reinsurance extremely expensive or even unavailable.

3. A company may want to exit a line of business.

4. A company may be unable to increase writings or take larger retentions because of capital constraints.

I will now look at these circumstances more in detail:

o When reinsurance is too expensive

Primary insurers with better-than-average results naturally feel they should pay less for reinsurance. On the other hand, reinsurers, who use good risk to offset their bad risks, are reluctant to offer their clients large discounts.

In this scenario, primaries with good experience have several options: They can pay more than they feel they should; they can retain more of their own risk; or they can take advantage of structured reinsurance products that can reward their good business practices. If their performance turns out to be as good as it has in the past, a structured reinsurance contract will entitle them to a significant share of the contract's profits.

o When reinsurance is not available

Structured reinsurance also enables primary insurers with less-than-average performance to obtain coverage when they normally might not be able to get it at all.

The appeal to the reinsurer of writing coverage for less-than-average performers is the fact that they can set an aggregate limit thereby limiting their exposure. Clients, meanwhile, are willing to cede higher premiums in the belief that they will improve their performance and in the end, via profit sharing, lower their actual cost of reinsurance.

o When exiting a line of business

Structured contracts are attractive to primary insurers seeking to exit a line of business.

By purchasing loss portfolio transfers or adverse development covers, they can bring third-party capital to an unprofitable or unwanted line of business and focus on their core competency. Better still, the reinsurer, in addition to assuming much of the risk, will also oversee the claims-handling function.

? When capital is constrained

Many primary insurers find themselves in the position of paying for past mistakes before they can take advantage of a favorable business environment; raising reserves and/or writing off positions that have eroded their capital base. As a result, the primary insurers are turning down good business because they can't meet certain statutory and ratings agency guidelines regarding writings to surplus.

But with the help of a reinsurer, the capital-constrained insurer can obtain an excess-of-loss or quota share contract–more typically quota share–which offers significant coverage and allows the primary to de-leverage and get closer to the preferred ratios the ratings agencies and regulators want to see.

Moreover, because of the underwriter's belief in the high quality of the new business being written, the primary insurer can accept an aggregate limit set at a level it believes is very unlikely to be reached. By accepting the limit, the primary insurer reduces the reinsurer's margin and significantly boosts profit-sharing when compared to terms offered by the traditional reinsurance market.

The structured excess or structured quota share enables the primary insurer to write new business, enjoy the attractive economics, satisfy regulatory and ratings agency requirements, and add incremental profit to the balance sheet.

Structured reinsurance contracts in which premiums are withheld also enable primary insurers to retain investable assets and reduce their exposure to reinsurance recoverables. The recognition of the investment income in the contract terms also gives customers comfort that the time value of money is explicitly recognized in the reinsurance pricing.

With all these benefits, it is no wonder that structured reinsurance has been widely used. Lately, however, it has become the subject of much controversy. Several states' attorneys general, insurance commissioners and officials at the Securities and Exchange Commission believe some insurers have used structured reinsurance as a way to misrepresent their balance sheets and appear financially healthier than they actually are.

In some cases it appears that contracts represented as structured reinsurance were actually loans with no risk transfer. But when used properly, structured reinsurance should satisfy the requirements of regulators and ratings agencies, and remains an important risk mitigation tool.

Regulators and ratings agencies have existing guidelines for the use of structured reinsurance. Specifically, two conditions must be satisfied: first, that the reinsurer is assuming significant risk; and second, that the reinsurer has a reasonable probability of significant loss. The rule of thumb is 10 percent probability of loss of 10 percent of the premium.

Structured reinsurance also requires compliance with special accounting standards (EITF 93-6) that consider factors such as the accrual of liabilities and assets to and from the reinsurer, premium adjustments should there be loss experience, and the provision for refunds if contract experience is favorable.

As for ratings agencies, A.M. Best now specifically requests information on structured reinsurance as part of its rating process, and increasingly, rating agencies, auditors and regulators are asking to review reinsurance contracts.

Indeed, New York, Florida and now the National Association of Insurance Commissioners have recently proposed rules that require the chief executive officers and chief financial officers of primary insurers entering into structured contracts to attest that there is a genuine transfer of risk.

The lines between traditional and structured reinsurance continue to blur. Traditional reinsurance no longer offers the broad and unlimited coverage forms of the past, and structured reinsurers are building more risk transfer into their products.

Despite greater regulatory, accounting and ratings agency scrutiny, structured reinsurance will remain a valuable complement to traditional reinsurance because clients will always want, and in many cases need, alternatives.

Dan Malloy, based in New York, leads the Financial Solutions practice for reinsurance brokerage Benfield Inc. He has more than 20 years of reinsurance experience, including 10 years of finite/structured reinsurance underwriting.

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(With Mr. Malloy's photo)

Flag: Alternate Reinsurance

Head: In Support of Finite, Structured Reinsurance

Finite or structured reinsurance has been under scrutiny recently, but it "will remain a valuable complement to traditional reinsurance because clients will always want, and in many cases need alternatives," says Benfield's Dan Malloy.

Mr. Malloy points out that finite reinsurance helps carriers when traditional reinsurance is too expensive, when carriers are exiting a line of business, or when capital is constrained.

Art Caption:

Under the glare of public scrutiny, U.S.-based reinsurers that offer finite reinsurance are feeling the consequences–from drying-up demand to costly subpoenas.