Will the ongoing scrutiny of financial reinsurance products prompt a more coordinated approach by regulators? ask Gillian Eastwood and Ayleath Clyne

The determination of regulators to crack down on financial fraud continues. Most recently, the FBI's financial crimes section has announced its intention to review the financial reinsurance arrangements entered into by US-based insurers. This is a continuation of a long series of hard line approaches in this area by authorities and regulators worldwide.

In Australia, substantial jail sentences have been imposed on former HIH directors. In New York, attorney general Eliot Spitzer's far ranging probe of the insurance industry's use of financial reinsurance has put the issue in the public domain. The spotlight has firmly focused on the ability of companies to use limited risk transfer policies to manipulate financial results, thereby potentially misleading investors, policyholders and regulators.

The accounting practices in this area are now being reviewed in the UK and Europe as well as the US and Australia.

However, while financial reinsurance is currently something of a corporate and regulatory "hot potato" it can be, and has been, used as an effective mechanism for the management of risk within an insurance company. Indeed, even in the context of trenchant criticism of the misuse of financial reinsurance by the Australian Royal Commission for Inquiry into the collapse of HIH, the commission recognised that there was a legitimate use for such products.

WHAT ARE THE MAJOR CONCERNS?

In the aftermath of the accounting scandals in 2001 and 2002, the need for increased protection for stakeholders has become paramount. Within the insurance market, the desire for transparency and stability comes not only from investors, but also from the ultimate consumers of insurance products. Financial reinsurance raises concerns because of its inherent ability to assist in the manipulation of a company's balance sheet. Moreover, the sophisticated arrangements by which it is implemented can make its misuse difficult to detect even by auditors and regulators.

The principal problem with financial reinsurance is that it is relatively easy to disguise or misrepresent its affect on corporate accounts. While many of its advocates say it can allow companies to represent their financial position more accurately, or to avoid having to take unfavourable positions in a hard market, this nonetheless requires it to be accounted for properly.

In theory, the accounting concepts are relatively simple - only if there is a real transfer of risk should the contract be accounted for as a genuine reinsurance arrangement in the company accounts and in regulatory solvency requirements.

REGULATING FINANCIAL REINSURANCE

Determined individuals can make detection of malpractice notoriously difficult despite the best efforts of auditors and management. A classic example is when a "side letter" recording a different or modified arrangement from that appearing on the face of the documentation supplements the basic contract. The main documents may then be provided to the regulator and auditors if required, whilst the side letter is kept separate and not disclosed. Arrangements of this type were identified in the investigations into the businesses of both HIH and Equitable Life.

Even more difficult are the "unwritten agreements" that have historically been made between certain parties to financial reinsurance contracts.

Arrangements that appear relatively straightforward have in fact been fundamentally changed in character by "understandings" between the parties.

It is difficult to see what steps regulators can take to prevent the blatant flouting of reporting obligations in this way. The only possibility is to ensure that the reporting requirements of such arrangements are set out in the most explicit terms, and to couple this with strong penalties for breaching these requirements.

A further problem is that the standards by which an arrangement is considered to achieve a "real transfer of risk" are not defined, nor are they universal.

The Australian Prudential Regulation Authority is proposing to use a "broad, principles-based definition" which focuses on whether there is a risk of "significant" loss from the arrangements, a significant range of possible adverse outcomes negated under the arrangements or whether there are requirements placed on the insurer to mitigate losses experienced by the reinsurer.

This has the benefit of flexibility, but at the expense of certainty.

On the other hand, accounting standards in the US currently favour the "10% chance of a 10% loss" methodology. Again, the application of this standard requires mathematical analysis and is not a straightforward solution.

The market as a whole does not yet have any consistent standards in this area. And while it might be one thing to expect an experienced underwriter or broker to understand the effects of a financial reinsurance policy, that will not necessarily be the case for all members of an audit team.

Furthermore, overly tight restrictions on financial reinsurance could make insurers operating within a particular market uncompetitive.The UK Financial Services Authority (FSA) in particular has recognised that it needs to factor in the attitudes of regulators in other jurisdictions if it is to ensure that companies operating in the London market remain competitive on a global scale. Policymakers in Germany have expressed similar views. A hard-hitting approach by one regulator might well see demand by policyholders move to other markets in order to obtain the most competitive products.

WHY NOW?

There has not been a global co-ordinated move by regulators to reassess the use of financial reinsurance, but there has been a consistency in timing. Partly this has been driven by the on-going scrutiny of general standards of corporate governance but it has also resulted from insurance specific concerns, prompted by events such as the HIH collapse in which the "audacious" use of financial reinsurance contracts played a role in the ultimate demise of the group. In the UK, the FSA issued a consultation paper on the use of financial engineering in 2002, although the recommendations contained within it were not implemented. The collapse of Independent Insurance and the difficulties facing Equitable Life have brought the issue to the forefront of industry and regulatory attention.

A COORDINATED APPROACH

There are signs that, although global consistency is unlikely, regulators across different jurisdictions recognise the desirability of a level playing field. Within the EU, the Reinsurance Directive sets out a definition of finite reinsurance (although it is questionable whether it matches the market's understanding of the term) and provides a minimum standard for regulation within member states.

In North America, the National Association of Insurance Commissioner's (NAIC) property and casualty reinsurance study group has recently approved several proposals, including requirements such as the reporting to state regulators of any financial reinsurance agreement that has the effect of altering policyholders surplus by more than 3%, or which represents more than 3% of ceded premium or losses. The proposals also encourage individual states to adopt NAIC requirements in an attempt to create a universal model and individual regulators in the US now appear to be supporting moves for a unified approach, with several, including those in New York, indicating that they are prepared to favour the NAIC approach.

The accounting industry has also taken steps to achieve consistency across borders, with the International Accounting Standards Board working on accounting standards that would apply across jurisdictions.

WILL THERE BE CHANGE?

The headline hitting jail sentences and the use of investigators clearly sends out a message to the insurance industry that change isafoot. But a completely harmonised approach across jurisdictions seems unlikely.

Within jurisdictions, the differing demands of particular insurers, including the fundamental differences between life and non-life insurers mean that there is probably no one size fits all solution. Nevertheless, the apparent willingness of some state regulators in the US to adopt the NAIC proposals instead of their own is a sign that a more coordinated approach between regulators is on the agenda.

There is no doubt that the use of financial reinsurance products in the future will be the subject of closer scrutiny. It remains to be seen whether the management of insurers will continue to have an appetite for these products that will attract additional regulatory scrutiny of their business.

- Gillian Eastwood is a partner and Ayleath Clyne a senior associate in Freshfields Bruckhaus Deringer's contentious insurance and reinsurance group.