Mass. Tightens Rule on Finite Reinsurance; States Consider Change in Accounting Rules

While the National Association of Insurance Commissioners is considering changing the accounting rules for finite reinsurance transactions, Massachusetts is proceeding with a tightening of its own reporting requirements.

Massachusetts Insurance Commissioner Julianne Bowler said her state will now require that the chair of the audit committee for an insurance company sign off on any finite reinsurance contracts, including certifying that there are no informal or side agreements that might affect such reinsurance.

“We need to be assured that the reinsurance contract we review is the entire contract,” noted Bowler, referring to reports of insurers and reinsurers making informal agreements that essentially unwind the reinsurance deals or turn them into financing without regulators’ knowledge.

“Finite reinsurance is not evil unto itself. It’s when the accounting isn’t right and when there are side agreements that undo it that it becomes a problem. Side agreements are fraudulent if not disclosed,” she added.

She said she hopes the added requirement that the chair of the audit committee sign off on the finite reinsurance schedule submitted to the department will put added pressure on make company management to ask more questions about what is going on and that all rules are being followed.

“We need these financials to be fairly presented. The department can’t tell if there is a weakness not shown on paper. Side agreements are a problem,” Bowler said.

Finite reinsurance has come under scrutiny by regulators looking into how American International Group used and reported finite reinsurance it purchased from General Re back in 2000. It appears that the reinsurance may have been used to boost reserves as opposed to being used to transfer real risk as is statutorily required for it to be reported as an insurance transaction.

Bowler heads an NAIC committee looking into policy issues surrounding finite reinsurance. Meanwhile, a separate NAIC working group is considering whether states should modify the accounting rules in what is known as bifurcation. Under this change, insurers could report the real risk transfer portion of any finite reinsurance agreement, which is sometimes as low as one percent, as insurance, but they would be required to report the rest of the contract as financing. This change could make finite reinsurance less attractive, Bowler acknowledged.

Bowler said her staff has been asked on occasion to review finite reinsurance contracts for its licensed insurers concerned over losses to make sure they pass the risk transfer test and that they have even reversed one contract.

“We know our companies very well,” said Bowler, who holds regular meetings with boards of her state’s domestic insurers to discuss corporate governance. “I have the utmost respect for the integrity of our Massachusetts insurance companies.”

But she said this additional sign-off requirement is one more check in the system to certify that what is reported is the truth. State insurance regulators should ask questions about any transaction that has a material effect on a company’s finances but this becomes difficult if insurers misrepresent the facts, according to the regulator.

Massachusetts is not the only state to take steps to improve reporting on finite reinsurance. In March, the New York State Insurance Department decided to require CEOs to verify that any finite reinsurance contracts their companies have are correctly reported.

New York change
CEOs of New York insurers will be required to sign off under oath that all reinsurance contracts they enter into contain documentation on their economic intent and a risk transfer analysis. They will also have to include a statement indicating that neither written nor oral agreements are in effect that would potentially alter a contract’s terms.

New York officials said that while there are legitimate uses of finite reinsurance, these transactions “can distort the underwriting and surplus positions of insurers entering into them when there is no actual transfer of risk or the transaction is accounted for improperly.”

As a financing arrangement, insurers may use finite reinsurance to protect themselves from interest rate risk and timing risk. Insurers’ concern about interest rate risk involves potential losses because of interest rate fluctuations. Concerning timing risk, insurers want to hedge against variations in the timing of their future loss payments.

“Policyholders, investors, and regulators need assurances that insurers’ finite reinsurance contracts are completely transparent,” Superintendent Howard Mills stated upon issuing the Circular letter No. 8 with the new requirements. He said the change should help to restore confidence to the regulatory process.