Finite Insurance: Is the Criticism Warranted?
December 2004
With all of the financial and nonfinancial
press writing stories during the past few months, and with certain law enforcement
individuals trying to reshape our industry, I thought it appropriate to discuss
in brief the world of finite insurance. It is unfortunate that this unique risk
transfer tool has drawn a fair amount of criticism, most of which has been either
unfounded or a result of those who frankly have no idea of the dimensions of
this coverage form.
by Peter
M. Polstein
To simplify matters, let's quickly and clearly separate the difference between
finite insurance/reinsurance and other risk related products that provide a
financial mechanism for a loss event, or those transactions which may provide
a guarantee on financial transactions or a hedge against certain financial losses
that do not qualify under accounting standards as an insurable event. As in
the case of more traditional forms of insurance/reinsurance, finite transactions
serve a legitimate business purpose as they:
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Have the capacity to transfer some limited and measured amount of insurance
risk.
-
Can be utilized to improve the capacity of a ceding party.
-
Provide for a methodology to exit certain lines of business.
-
Provide some measure of leverage relief.
What makes finite transactions unique is that they explicitly take into account,
as part of the underwriting process, the time value of money, which could—under
a reinsurance transaction—permit the ceding insurer to monetize its value of
loss reserves. As long as the finite transaction is in compliance with accounting
rules, there is nothing illegal with taking advantage of the ancillary benefits
that finite structures provide.
The Finite Insurance Process
The transaction is really a fairly simple process. The underwriter evaluates
projected losses, the reporting and payment pattern of the losses, prevailing
market interest rates, and determines the discounted value of the expected losses
being transferred. Some additional measure of risk exposure, when meeting accounting
standards, is included in the transaction, and a risk load is charged by the
finite underwriter for that amount of additional risk.
There are finite transactions which may contain so called "two-way" retrospective
rating provisions (known as swing plans) whereby the client would pay additional
premiums if losses were unfavorable, but would enjoy return premiums for favorable
experience.
As opposed to a finite transaction, financial insurance/reinsurance generally
does not have sufficient risk transfer to meet accounting standards, thereby
making it ineligible to be considered insurance. In other words, it is simply
a risk financing mechanism, rather than a risk transfer.
There is yet another category which can simply be named exotic transactions.
These provide various forms of financial guarantees, hedges against financial
risk events, and for the most part do not meet accounting standards.
The History
Finite and financial insurance/reinsurance transactions first appeared in
the early 1970s, and by the mid 1980s, were being used by a considerable number
of what was then a significant risk client base. During that timeframe, not
all of the transactions had the risk transfer ingredient. The question of authenticity
relative to these transactions became established in mid-1993, with additional
guidelines relative to the rules for accrual at subsequent dates.
The Problem
Unfortunately, what has created a "black eye" within the finite community
has been the inappropriate and at times illegal use of these products by a number
of corporations in consort with the insurance marketplace. Many of these transactions
lacked transparency where the client failed to adequately disclose the true
nature of the transaction to independent actuaries, auditors, and regulators.
Finite Insurance as a Unique Tool
The use of finite insurance/reinsurance is truly a unique tool, although
the quantity of risk transfer is both limited and measured. It is unique, though,
because it can provide a client with a transaction that is normally outside
of the traditional scope of the insurance/reinsurance marketplace.
As an example, assume that a small offshore reinsurance company has been
approved to underwrite specific business. The problem might be that the layer
on which the reinsurer wishes to participate may limit its surplus to such a
degree that it would curtail the amount of business written and maintain what
would otherwise appear to be a reasonable net premium to surplus ratio.
While not advocating an unreasonable amount of leverage, the use of finite
insurance might allow for additional written premium while continuing to maintain
a prudent position. Here is an example of where a finite transaction could work
to the benefit of the offshore reinsurer.
Assume that each and every risk underwritten by the reinsurer has some amount
of retention by the insured. The reinsurer will out of necessity limit its overall
risk taking ability, yet by virtue of a finite transaction, be capable of not
only increasing their initial capacity, but move a significant portion of their
required surplus to the finite underwriter.
This is accomplished very simply by having the reinsurer cede to the finite
underwriter a substantial portion of the gross earned premium covering a specifically
negotiated layer of coverage. The finite underwriter would then cap their aggregate
at a given point, usually a percentage of the agreed annual premium, as well
as discount a portion of the annual premium dependant upon risk.
Where is the risk transfer? It is in the discounted value of the gross premium,
as compared to the aggregate limit assumed by the finite underwriter. The finite
underwriter may offer aggregate limits capped at say 110 or 115 percent of the
agreed premium. The cap would be negotiated subject to the expected payout of
the risk.
Additionally, the non-risk costs for these transactions are usually limited
to a small percentage for the management fee, that percentage—or underwriter's
margin—being a function of the risk assumed and potential interest earned. Interest
is usually to the account of the insured, on a negotiated basis, and depending
on the method of investment crediting, can be held in various methods.
Back to our offshore insurer. In this example, the reinsurer is now in a
position to be the excess layer underwriter, which should limit its potential
risk. Obviously, this also limits its overall profitability, but in the early
stages of the business, this is relatively unimportant. One possible consideration
which might mitigate this would be a profit share based on the overall loss
experience.
Usually, these transactions are limited in time. They can be dissolved by
agreement at any time between the ceding company and the finite underwriter
by the use of a portfolio transfer back to the ceding company. Such transfer
requires the originating company to accept all risk at a given point in time,
and the acceptance of the retained premium, less any loss and costs.
It really doesn't make any difference per se, if this is a reinsurance or
direct insurance transaction, as long as it meets the accounting standards for
risk transfer.
Conclusion
As I stated initially, it is a pity that this interesting and unique form
of transactional risk transfer, offered by any number of legitimate finite underwriters
in this marketplace, has met with the barrage of criticism found in the media
during the past months.
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