As the regulatory furore surrounding finite reinsurance shows little sign of abating, Nigel Allen asks whether finite transactions have become too risky to handle?

The Florida insurance regulation commissioner, Kevin McCarty, announced on 20 April that he had subpoenaed 17 companies for information relating to finite reinsurance activities. The companies were: ACE Tempest, Acordia Re, AIG Reinsurance, Alea London Ltd, Benfield Re, BIG Re, Chubb Atlantic Reinsurance Specialist Ltd, E&S Reinsurers Ltd, Guy Carpenter, Hannover Re Ltd, Hannover Ruckversicherungs-Atiengellschaft, Jardine Sayer, National Indemnity Company of the South (a subsidiary of Berkshire Hathaway), National Union Fire Insurance Company of Pittsburgh, PA (a subsidiary of AIG), Partner, Reinsurance Company of the US, Swiss Reinsurance American Corporation and Transatlantic Reinsurance Company (a subsidiary of AIG). This is quite a list. But just how widespread is this problem, why does it appear to only be coming to light now - particularly as finite contracts came under such close scrutiny in the aftermath of Enron, and just how will the environment for such products change?

Crossing the finite line

Finite reinsurance is completely legal - let this not be forgotten. It is only when such a product is corrupted to serve a purpose other than that which it was originally created for that it becomes an issue. Fitch Ratings, in its special report "Finite Risk Reinsurance", described it as "a form of reinsurance that explicitly considers the time value of money in addition to the expected amount of the loss payments in nominal dollars." The risk transferred to the finite risk reinsurer is limited in the contract, restricting the degree of potential loss to the reinsurer. "The primary emphasis is on risk financing rather than risk transfer," the report stated, "although finite risk transactions contain elements of both." The ceding company can use such "risk financing" to achieve an accounting benefit similar to loss reserve discounting.

The rating agency added that such contracts often include a "retrospective or dynamic pricing mechanism" which can see the ceding company refunded some of its premium if there is limited or no loss, or made pay further premium payments if large losses are experienced.

In fact, according to a report by the National Association of Mutual Insurance Companies and the Reinsurance Association of America, finite contracts are "generally more structured than so-called 'traditional' reinsurance contracts" as they are more specific in terms of the risk being transferred. The report also highlighted the increased scrutiny which such contracts receive from rating agencies and regulators alike in order to ascertain the purpose of the contract and to ensure that it is being correctly accounted for.

The problem arises when questions are asked over what is considered to be an acceptable level of risk transfer to warrant the transaction being accounted for as an insurance one, rather than simply a financial one. To achieve a level of risk transfer deemed acceptable for accounting as insurance, the finite reinsurance transaction should see the reinsurer incur a minimum of a 10% probability of a 10% loss on the policy (the 10-10 rule), although this is very much a "rule of thumb" (in the US some suggest that this is now the 20-20 rule). FASB Statement No 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, issued in 1993, introduced the need for some form of transfer of underwriting risk and timing risk onto the balance sheet of the reinsurer.

Where risk transfer does not occur then the transaction cannot be reported as insurance, and becomes effectively a loan, with the purpose of the transaction being one of enhancing the company's financial standing rather than transferring risk off their balance sheet. In such circumstances, rating agencies and regulators alike state that this muddies the financial waters and makes it difficult to ascertain the solvency of the particular company, as it can be used to conceal gaps in the balance sheet. A number of regulators have recently pointed that finger of blame at such transactions, particularly in the case of the now defunct HIH, saying that finite transactions enabled the Australian insurer to gloss over its financial cracks allowing it to stay afloat when it should actually have sunk years before it finally disappeared below the water.

Then add to this the so-called "side letter" and the waters are not just muddied, they become stagnant. A side letter is a secret written or oral agreement between the buyer and the seller that acts almost as a means of "crossing your fingers behind your back" when the official contract is signed. It is an "unofficial" agreement which sits behind the original contract and ensures that, despite what the official document states in relation to "risk transfer", the element of risk will either be partially or completely eliminated.

In the firing line

On 14 February, AIG announced that it had been subpoenaed by the SEC and NYAG in relation to "investigations of non-traditional insurance products and certain assumed reinsurance transactions and AIG's accounting for such transactions".

At the centre of the investigation is an "assumed reinsurance transaction" involving an AIG subsidiary and General Re (part of the Berkshire Hathaway Group). The transaction concerned two tranches of $250m each, the first transacted in December 2000 and the second in March 2001. AIG reported that, as a result of these "each of consolidated net premiums written and consolidated net loss reserves increased by $250m in each of the fourth quarter of 2000 and the first quarter of 2001". While the first tranche was commuted in November 2004, the second remains on the group's books. AIG has now acknowledged that the documentation relating to this transaction was "improper", stating that as there was no actual transfer of risk, it should not have been reported as insurance. In a reccent announcment, the group confirmed that as a result of "risk transfer matters", shareholder equity is expected to drop some $1.2bn.

General Re is also the subject of other ongoing investigations. General Reinsurance Corporation has received a number of subpoenas in relation to an investigation into Reciprocal of America (ROA). ROA was placed into receivership on 29 January 2003 with unpaid liabilities exceed $450m. General Re provided the company with reinsurance cover for over 20 years. Recently, two former employees pleaded guilty to committing insurance fraud, admitting to concealing and misrepresenting the financial deterioration of the company through fraudulent accounting techniques when compiling ROA's records and reports to the Virginia Insurance Commissioner, and reports and statements to ROA's board of directors and subscribers/insureds, according to the US Department of Justice.

General Re is also in the crosshairs of the liquidators of both FAI Insurance Ltd and HIH Insurance Ltd. The liquidators have accused General Re Australia (GRA) and Kolnische Ruckversicherungs Gessellscheft (KA) of assisting FAI in accounting for transactions entered into by FAI with GRA in May and June 1998 as reinsurance when they were not, a deception which they state was a factor in the collapse of HIH. The Australian Prudential Regulatory Authority announced in April that it had launched an investigation into particular reinsurance practices involving GRA and would examine its "complex financial products in relation to financial and finite reinsurance and the marketing and promotion of those products." Warren Buffet has made clear that while a side letter was involved in the HIH transaction, this was entered into well before Berkshire acquired Gen Re.

MBIA has also joined the ranks of those under the finite spotlight. The group recently announced that following an internal investigation it would restate its financial statements for 1998 to 2004. The restatements concern a $70m reinsurance arrangement relating to MBIA-insured bonds issued by Allegheny Health, Education and Research Foundation (AHERF). The transaction, entered into in September 1998, involved MBIA and Zurich Re (N America) (a subsidiary of Converium). Axa Re Finance provided Converium with excess of loss cover. However, the internal investigation found evidence of an additional oral agreement between Axa Re and MBIA, which saw MBIA agree to reassume the credit risk of Axa Re's AHERF exposure before October 2005, which it did in Q4 2004. According to Fitch, MBIA has now concluded that the risk transferred was not significant enough to warrant the transaction being classed as "reinsurance", but rather should have been recorded as a deposit. Axa Re has also been subpoenaed.

Regulating finite

With full regulatory weight being brought to bear on finite reinsurance, it is not unfeasible that such a product could end up being regulated out of the market. While there is uncertainty at the moment as to how regulators on either side of the Atlantic will tackle this problem, the issue appears to be not so much with the product itself, but how it is being used and reported.

State authorities in the US have been quick to react to the finite issue, with Howard Mills, New York's Acting Superintendent of Insurance announcing that CEO's will now be required to attest, under penalty of perjury, in relation to cessions under any reinsurance contract that:

- there are no separate written or oral agreements that would under any circumstances, reduce, limit, mitigate or otherwise affect any actual or potential loss to the parties under the reinsurance contract;

- for each such reinsurance contract, the reporting entity has an underwriting file documenting the economic intent of the transaction and the risk transfer analysis evidencing the proper accounting treatment, which is available for review.

Similarly, the Florida Office of Insurance Regulation has announced a planned change to the regulation of finite and "other risk limiting reinsurance agreements", which will require domestic insurers to make additional disclosure in relation to such transactions and comply with the disclosure requirements for credit for reinsurance.

The National Association of Insurance Commissioners has charged the Property and Casualty Reinsurance Study Group with the task of ascertaining whether the accounting procedures and rules governing finite transactions are adequate. Improved disclosure requirements will be proposed to help regulators accurately categorise such transactions. A number of proposals are currently being considered, including "bifurcation", a process by which the reinsurance contract would be divided into those parts deemed to involve acceptable levels of risk transfer, which could then be accounted for as insurance, while those parts deemed not to have crossed the risk line would be accounted for as financing. The group has also proposed that investigations should be widened to look at other parties to the contract, such as brokers.

On the other side of the Atlantic, the EU Reinsurance Directive, which seeks to harmonise the regulation of European reinsurers, is the focus of most of the finite reinsurance attention. Under the directive as it currently stands, Article 44a (1) states that it is up to each particular member state to establish the provisions required to govern "financial reinsurance", such as:

- mandatory conditions for inclusion in all contracts issued;

- sound administrative and accounting procedures, adequate internal control mechanisms and risk management requirements;

- accounting, prudential and statistical information requirements;

- the establishment of technical provisions to ensure that they are adequate, reliable and objective;

- investment of assets covering technical provisions in order to ensure that they take account of the type of business carried on by the reinsurance undertaking, in particular the nature, the amount and the duration of the expected claims payments, in such a way as to secure sufficiency, liquidity, security, profitability and matching of its assets;

- rules relating to available solvency margin, required solvency margin and the minimum guarantee fund that the reinsurance undertaking shall maintain in respect of finite reinsurance activities.

The directive calls upon those member states to provide the European Commission with details of these provisions once they have been laid down.

An end in sight for finite?

Finite reinsurance has come under the regulatory spotlight on a number of occasions in the past, particularly after the collapse of Enron. However, despite such scrutiny, finite contracts continue to play an important role in the insurance industry. While many column inches have been devoted to the darker side of finite transactions, it is questionable whether the extent of the problem warrants such extensive coverage. While investigations involving Hank Greenberg and Warren Buffett are guaranteed crowd pullers, all in all the extent of the problem seems to be fairly limited at this stage. Finite has long proved a bugbear for both rating analysts and regulators and as such has received very close attention over the years. But as in the past, the focus of calls for change is not on the product itself, but rather on the accounting procedures which apply to finite transactions and the degree to which the purpose of the contract can be easily discerned.

While the appeal of finite products has certainly dimmed under the current glare of the regulatory beam, with some suggesting that this was a factor in the recent decision to place Inter-Ocean, the Bermuda-based finite risk reinsurer, in voluntary run-off, few believe that such products have reached the end of the line.

- Nigel Allen is editor of Global Reinsurance.

EU Reinsurance Directive

Amendment 18


(nc) Finite reinsurance means reinsurance under which the explicit maximum loss potential, expressed as the maximum economic risk transferred, arising both from a significant underwriting risk and timing risk transfer, exceeds the premium over the lifetime of the contract, for a limited but significant amount, together with at least one of the following two features:

(i) explicit and material consideration of the time value of money;

(ii) contractual provisions to moderate the balance of economic experience between the parties over time to achieve the target risk transfer.

(At the time of writing this amendment had not been finalised)


The International Association of Insurance Supervisors is in the process of compiling a supervisory guidance paper in response to the abuse of finite risk reinsurance. The paper would include:

- Definition of finite risk reinsurance

- How risk transfer should be assessed, what constitutes adequate transfer

- Types, characteristics and examples of finite risk reinsurance policies

- Benefits and problems with these policies

- Accounting and disclosure

- Supervisory approaches

Following a consultation period, the paper will be proposed for adoption by IAIS members at the IAIS Annual General Meeting in October 2006.