Despite all the bad press finite reinsurance remains an integral part of the insurance industry, insists Nigel Allen

Finite products have been the subject of a witch hunt since Eliot Spitzer announced that his team was expanding its investigation into this area of the market. Fear of the "unknown" has spawned a rash of bad publicity and has seen the popularity of this extremely versatile and effective product plummet, with the last few months bearing witness to a flood of restatements, as insurers and reinsurers trawl through financial records rooting out any contracts deemed to have insufficient risk transfer, or showing evidence of side agreements. Restatements in 2005 have included AIG, Converium, ACE and Renaissance Re - a restatement that saw the departure of CEO James Stanard.

However, whether it be the National Association of Insurance Commissioners (NAIC), the UK Financial Services Authority (FSA), the EU Council or the International Association of Insurance Supervisors (IAIS), all organisations assessing the use of finite reinsurance concur that such products have an important role to play in the financial stability of the industry, whether that be to up capacity in a favourable underwriting environment or to guard against adverse loss development.

The IAIS, in its "Guidance paper on risk transfer, disclosure and analysis of finite reinsurance", released in October 2005, stated that finite reinsurance transactions are perfectly acceptable, except "those that do not have significant transfer of insurance risk and are not accounted appropriately".

As Patrick Devine, a partner in the regulatory group at Reynolds Porter Chamberlain, makes clear, finite products are an extremely valuable tool in the industry's arsenal, and adds that even where there is intent to deceive, "this does not mean to say that there is anything wrong with the contract itself".

A defining moment?

But are we any closer to establishing what finite reinsurance actually is? While the IAIS highlights the fact there is no global definition of finite reinsurance, it describes the term as encompassing "an entire spectrum of reinsurance arrangements that transfer limited risk relative to aggregate premiums that could be charged under the contract." However, does this not mean that just about all forms of reinsurance could fall under the scope of finite reinsurance?

Jeff Berg, vice president and senior analyst at Moody's, agrees with the IAIS and says that "by adding the word finite before the word reinsurance you are not really changing the definition of reinsurance that much", concluding that the only type of reinsurance which can be considered 100% finite free is pure quota share. In contrast, the EU Reinsurance Directive does include a definition of finite reinsurance, one which encompasses the transfer of significant underwriting risk and timing transfer risk where the maximum loss potential exceeds the premium over the lifetime of the contract, and includes either: explicit and material consideration of the time value of money, or provisions moderating the balance of economic experience between the two parties over time to achieve the target risk transfer.

The IAIS report also provides supervisors with a series of clear warning signs for questionable reinsurance transactions, which it says should warrant further analysis. These indicators include:

- Disparate lines of business included within a single treaty;

- Contracts which do not appear commercially sensible from the standpoint of the insurer or reinsurer (eg are there side agreements which change the meaning?);

- Contracts placed without following the cedant's normal process and guidelines for reinsurance;

- Contracts placed very close to the end of the financial year and covering that year or earlier years (eg is the aim to disguise a bad result for that year?);

- Inconsistencies or gaps in the dating of the documentation. (eg has an agreement been backdated to give the appearance that it was reached before the end of a reporting period?); and

- Blended covers - when they cover a combination of a single contract with a normal reinsurance arrangement. When this is done, the two covers should be evaluated separately.

Opening up the books

Transparency has become a key element in the drive towards "cleaning up" the finite market. In the UK, following industry consultation, the FSA has issued proposals which would require insurers in the Lloyd's and general insurance markets to provide details in their annual returns of financial reinsurance transactions where the credit taken for those transactions "is not commensurate with the economic value added after taking account of the level of risk transferred" and where there is existence of an agreement (such as a side agreement) which could render the agreement null and void. Such companies would also be required to provide a detailed breakdown of the purpose of any "financing agreements".

The FSA proposals, which would take effect from 1 April 2006, will see insurers being required to fully analyse the impact of any reinsurance agreement on their present and future financial position. Additional information will be required, as of 31 December 2006, on all finite contracts, with details to be included of the financial effect of the contract on the company's capital. Michelle Everitt, manager of compliance, Lloyd's General Counsel Division, said at the end of last year in a document to the market, that Lloyd's syndicates would be required to report this information centrally to the market, which will in turn pass it on to the FSA in the form of aggregated syndicate data.

This push for greater transparency is mirrored across the Atlantic in the June 2005 NAIC approval for greater disclosure by insurers and reinsurers in their regulatory reports. The disclosure requires insurers to report to the authorities any instances of finite reinsurance agreements that change policyholders' surplus by over 3%, or over 3% of ceded premiums or losses. Furthermore, the disclosure requirements place the onerous task on both the CEO and CFO of signing an attestation form confirming that risk transfer has occurred and that there are no side agreements.

"Many of the issues regarding finite products," explains Patrick Devine, "have arisen out of the accounting treatment and ultimately that is down to the International Accounting Standards Board (IASB) and the treatment of contracts of insurance for accounting purposes." It is imperative, he adds, that the industry regulators and accountants work together to establish accounting procedures which are not only "workable", but are also not "overly technical".

The US Financial Accounting Standards Board (FASB) recently released an update on its project into effective risk transfer in the insurance industry. Bifurcation of insurance contracts is seen as a key element of this project, requiring that contracts be broken down into their financing and insurance components, with clear accounting if each. At its 20 December meeting, the FASB confirmed that it would continue to develop approaches for bifurcation and intended to issue an invitation to comment in the first quarter of 2006.

The IAIS makes clear in its risk transfer paper that what the guidance is not intended to do is prescribe public accounting requirements, but adds that the association is involved in the IASB's Insurance Contracts (Phase II) project. Phase II is the follow-up to IFRS 4, which saw the IASB introduce accounting procedures for insurance contracts, and will see the board "take a fresh look at financial reporting by insurers".

While the board is not set to issue its discussion paper on Project II until the end of 2006, it has already taken note of the activities of its US counterpart the FASB, and said that it will "consider whether some or all insurance contracts should be unbundled (bifurcated)", adding that IFRS 4 requires unbundling in some cases and permits, but does not require it in others.

Not a finite problem

The issue of finite reinsurance has long been a regulatory bugbear, regularly resurfacing in the aftermath of yet another accounting scandal. However, the repercussions of the current regulatory onslaught will clearly be the greatest of any that have gone before, as its fallout is already being felt across the globe. But while few are happy with the fact that this has been triggered by Eliot Spitzer and his team, most commentators concur that the regulatory overhaul will almost certainly be positive for the sector. But it should be acknowledged that what this process is seeking to achieve is a better understanding of the product itself, the parameters in which it should be used, and how it should be accounted for. This is not an attempt to prevent the use of the product, or to restructure the product. The legitimate use of finite reinsurance has served this market well and it should continue to do so.

- Nigel Allen is editor of Global Reinsurance.

RISK TRANSFER STAYING WITHIN THE LAW

A recent example of a step to remove any confusion as to what constitutes legitimate and illegitimate finite transactions came when US RE president and CEO Tal Piccione requested a response from the New York Insurance Department on the use of multi-year catastrophe excess of loss reinsurance contracts in the context of the ongoing finite investigation. In a written response from the department, Joseph Fritsch, director of insurance accounting policy, stated that the department was not seeking to prevent the legitimate use of finite risk, and clarified that, "catastrophe protection formatted on a multi-year basis and cancellable by both the cedant and reinsurer on an annual basis, in which the premium and limits of the entire term are pre-established at the outset including industry insured loss triggers and a cancellation penalty is not impermissible pre se. The presence of these elements in contracts does not preclude the contract from being properly accounted for as reinsurance."