Finite reinsurance has long proved a major headache for rating agencies and regulators alike

Operating in a perceived no-man's land between insurance and deposit accounting according to some of its detractors, finite transactions have recently found themselves sitting in the regulatory crosshairs on both sides of the Atlantic.

In January, Eliot Spitzer said, "In addition, as part of a joint investigation with the SEC, we have recently begun examining the sale and purchase of finite insurance products by insurance companies." Since then the flood gates have opened, with more and more state commissioners and regulators announcing that they have subpoenaed a growing number of companies requesting information relating to finite transactions. Interestingly, Fitch Ratings, commenting in October 2004 in the immediate aftermath of the initial investigation announcement, considered whether those involved might "stumble across other practices that may raise eyebrows", stating that it believed the number one suspect was "finite risk insurance/reinsurance".

A convoluted past

Finite risk reinsurance can be traced back to the Lloyd's market of the 1960s and 1970s. Some pinpoint its origin as being the "rollover" covers purchased by syndicates in the 1960s. The purpose of such contracts, however, far from being a form of reinsurance, was to counter the high personal tax rates which Names were subject to, and were subsequently banned in the 1980s.

Others say that, while once again traced back to the Lloyd's market, finite transactions emerged out of the "time and distance" policies which began in the 1970s. Such policies were used as a means of bypassing restrictions relating to discounting loss reserves. According to Fitch, "these retroactive agreements provided recoveries for cedants for specified structured payout schedules that did not correspond to actual loss payments." Such contracts spread to the US and were cited as a key factor in the decision by the Financial Accounting Standards Board to implement FAS 60 (Accounting and Reporting by Insurance Enterprise) in 1982, which was then incorporated into FAS 113 (Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts). This effectively put an end to the accounting of such transaction as reinsurance.

Nevertheless, whatever the history of finite transactions is the market's concern is now for the future of these products.

An uncertain future

The direct impact of the ongoing enquiries is difficult to measure. There are already suggestions that the interest of the regulators in finite transactions has led to a corresponding decline in the interest of market practitioners in such products, which is hardly surprising. The announcement in April that Inter-Ocean and its reinsurance subsidiaries had entered voluntary run-off may reflect this decline in finite interest, a factor which AM Best flagged up when it placed the companies on negative watch in February, highlighting concerns over its ability "to generate deal flow". Add to this the increased accounting procedures which will almost certainly be required and the likelihood that regulators will insist that a greater degree of risk transfer be embedded in such transactions and the appeal of finite may dwindle.

However, finite transactions have come under similar scrutiny in the past and have emerged relatively unscathed, such as in the aftermath of Enron. They have adapted to the regulatory climate they inhabit and it is expected that these unique products will do so again to survive the current change in temperature.

Topics