In last year's Global Reinsurance risk edition, I wrote about the challenges facing corporate financial executives in seeking innovative insurance and financial solutions to their financial problems. I focused on one of the solutions within the financial engineering process, a finite risk insurance program, and described its characteristics and benefits. This year I would like to provide a more detailed description of how a finite risk transaction might work.

What is finite risk?

Finite risk combines various financial disciplines, including insurance, cash flow management, corporate finance, and asset/liability matching. First of all, finite risk is insurance. Insurance means that, by entering into the transaction, the insurer will run the risk of losing money in the event of a claim. In exchange, the insurer receives a premium. If we stopped there, we would have something that looked just like any other insurance program.

In finite risk, however, we combine insurance with finance. The premium paid by the insured will not only compensate the insurer for the risk of loss but also provide a source of funds to finance the payment of losses. If there is no loss event, a portion of the premium can be returned to the insured through commutation. In short, both the insurer and the insured have a stake in the results of the program.

Why would a company agree to share in the results?

Companies can have several typical motivations for entering into finite transactions:

  • Obtain insurance for coverages and limits not typically available in the market.

  • Stabilize cash flows over time.

  • Provide for profit sharing if loss experience is favorable.

  • Allow for tax efficient treatment.

    How would finite risk work in real life?

    By way of example, ABC Company has incurred a number of product recall events for the past several years. As a result, they are responsible for notifying customers and paying the replacement cost of the product and/or offering a refund. ABC Company believes it has an exposure of between $100 million and $150 million in nominal dollars over the next five years. ABC Company has disclosed this exposure in its financial statements. The effect on the company has been manifold :

  • The fluctuations in timing and amounts of the payments to customers have played havoc with cash flow management.

  • Several potential merger and acquisition suitors have been scared away by the exposure.

  • The quarterly change in the estimate of the exposure has created significant tension with the board of directors.

  • The company has recorded a liability for book purposes but cannot deduct it for tax purposes.

    ABC Company has approached XYZ Insurance for a solution. XYZ Insurance believes that a finite program under which the insurer agrees to pay for all claims up to a limit over the next five years would help solve these problems.

    How would the transaction work?

    ABC Company would provide details about the payment of product recall claims over the past 10 years. From that data and an understanding of the circumstances under which products were distributed and recalled, XYZ Insurance would develop a range of possible payout patterns. XYZ Insurance would compute the present value of those payout patterns and, using probability software, determine the likelihood of those results to varying degrees of confidence. Based on its analysis, the insurer might offer to be responsible for all payments related to product recall claims over the next five years up to a maximum of $150 million for a premium of $95 million, subject to sublimits. Based on the timing or amount of actual claims, the insurer could lose a substantial amount of money. The analysis of probabilities, however, tells the insurer that in all likelyhood it won't. In fact, the insurer is betting that the present value of the actual future payouts is less than $95 million.

    While ABC Company understands that the insurer could lose money, it also wants to share in the possibility that the result could be better. Accordingly XYZ Insurance includes a commutation provision in the deal. XYZ Insurance agrees to pay ABC Company the value in an experience balance (e.g., 85% of the premium less claims plus interest) if ABC Company commutes the contract during the five-year period. Let's say, for example, that three years into the transaction, experience has been better than expected, i.e., the claims are being paid slower and in lower amounts than expected. ABC Company also decides that the motivations that existed for the transaction no longer exist due to other changes in operations. It elects to commute the policy. The commutation releases the XYZ Insurance from all future obligations and in return it makes a payment to ABC Company equal to the value in the experience balance which in this case would be $55,324. [See chart above - assume all claims are paid at the end of the year.]

    In this example, ABC Company achieved its goal of dealing with its product recall exposure in a cost efficient manner. They also had the flexibility to commute the contract when circumstances changed after several years and to receive a substantial payment that shared in the positive claims experience.

    What finite risk is not

    Understanding what finite cannot do is almost as critical as understanding what it can do.

  • Finite risk is not just a bank account - Finite risk will entail frictional costs, including the profit and costs of the insurer (e.g., legal, risk charges, capital charges, etc.), and premium and depending on applicable laws, taxes. If a company's motivation is nothing other than just purely setting up a fund, there are probably cheaper ways to meet that goal.

  • Finite risk cannot cover uninsurable events - Finite risk programs are issued as insurance policies. As a result, the underlying coverage must cover insurable risks - events that are fortuitous in nature and impact the company directly.

  • Finite risk is not for every size transaction - Finite risk transactions, due to their uniqueness, often have higher frictional costs than other typical insurance transactions. Accordingly, the cost of doing the deal will generally be higher on a proportionate basis if the finite risk premium is small.

  • Given the uniqueness of finite risk programs, businesses are advised to consult with their legal, tax and financial advisors.

    Why finite risk is unique

    Finite risk is attractive because of the flexibility it provides. Let's take our example. We could have added variations to the transaction at almost every step.

  • Premium - While most premiums are paid up front, they can be paid over time especially if one of the company's motivations is to stabilize cash flows. Credit issues would need to be addressed.

  • Coverage - Above we described a product recall cover. Coverage for finite can be as traditional as boiler and machinery or as unique as asbestos, work stoppages, unauthorized trading, or patent and copyright infringement. The list is endless. As long as the insurer can gain enough information to form an opinion as to the likelihood and amount of potential claims. There can also be multiple coverages included in the same policy.

  • Term - Three to ten year terms are most typical. Less than three years mitigates many of the program benefits. More than ten years is often difficult to predict for most risks but available for certain types of risks such as environmental.

  • Commutation - The availability of commutation is often a key selling point of these programs. There are, however, certain accounting and tax considerations, and many contracts exclude commutation clauses. If commutation does exist, there are many possible variations on the notional balances. The investment return on funds in the account can be either a floating or fixed interest rate. It can also be another type of return such as one linked to an equity index or other measurable return.

    As the worlds of insurance and finance converge, products such as finite risk are a natural byproduct. Finite risk is one of the many solutions to managing risk in the new global marketplace. The key to developing a successful program, however, is knowing what your company's needs are. If the circumstances are right, the finite risk approach will adapt to you.

  • David Fields is senior vice president, AIG Risk Finance.