Finite reinsurance (noun). Finite is the incongruous adjective used to describe a special sort of reinsurance arrangement sometimes known more aptly as financial reinsurance. In contrast to its nomenclature, insurers which buy finite policies may feel like they have to pay for the privilege in future years ad infinitum, while the reinsurers which issue the treaties could find that claims are notified in a seemingly endless cascade.
Once considered non-traditional, finite reinsurance (euphemistically known as 'unfunded cover') is now commonplace. It describes a structure which turns around the concept of reinsurance. Under a conventional reinsurance contract, the buyer pays now in exchange for a promise from the seller to pay later. Under a finite contract, however, the buyer makes a promise to pay later, in exchange for a promise from the seller to pay sooner, then the seller pays, then the buyer returns the favour some time in the future, in instalments stretching over the years.
The intention of finite reinsurance, as espoused by numerous speakers on the reinsurance conference circuit of the mid and late 1990s, is to smooth fluctuations in the cedant's financial fortunes by taking certain liabilities off the insurer's balance sheet and putting them elsewhere. However, sceptical direct underwriters have been heard to describe the process as 'mortgaging the future', and worse, detractors have described this perfectly benign class of transactions as a form of 'financial engineering'. One such cynic, writing in the Australian Financial Review, stated that such deals "are of concern when they are used by companies as disguised loans rather than true reinsurance deals."
Even when used as risk transfer instruments, in the post-Enron era any sort of off-balance-sheet deal is subjected to increased scrutiny by regulators (when they can see them), and viewed with a certain scorn by shareholders who (understandably, perhaps) feel they are not being presented with a true picture of the cedant's fiscal health. Nonetheless, finite structures made huge inroads in the last half of the last decade, particularly as the supply of conventional reinsurance began to dry up. Brokers and reinsurance underwriters were known to have suggested to hapless directs that if they wanted some of the latter, buying into a modicum (or a lot) of the former would ease the placement.
It is clear that the take-up of finite structures was significant. In a study of the impact of finite deals on reported total claims related to the World Trade Center loss, Fitch, the ratings agency, noted that the true extent of gross WTC claims may never be known, because a significant proportion of the loss (Fitch ventured $6bn) has been pushed off the sector's balance sheets by finite reinsurances, and disappeared into an accounting black hole.
The magical vanishing of WTC claims attracted little supervisory attention, but certain finite deals caused a storm of controversy. Notable are some written for the cataclysmically mismanaged Australian insurers HIH and FAI. The Royal Commission that followed the HIH collapse heard that in a 'side letter', the insurers relinquished their right to make claims under certain finite contracts. Their fiscal fortitude (or meekness), already shrouded in opacity, was further obfuscated. It seemed to fool even the insurers' management.
Alas for its proponents, finite reinsurance products present an inherent design flaw. When insurers swim in a sea of liability, they are apt to reach for the finite lifeboat. However, insurers overboard are the least likely to be able to pay the premiums they owe in the years after the collect-now, pay-later contracts are struck. On the other side of the coin, reinsurers which suddenly find they face a spate of claims under seemingly low-risk finite reinsurance contracts may, after a nasty loss, collapse under the weight of magically reappearing liabilities. At least one post-WTC example proves the theory.
Two things are certain. One is that run-off managers, reinvigorating the carcasses of defunct reinsurers, will be chasing post-claim premiums with a tenacity matched only by the reluctance the likes of the HIH receivers will display when asked to fund the company's historic finite reinsurance recoveries. The other certainty is that finite cover will continue to be sold indefinitely.