What is Finite Risk Reinsurance? A Definitive Explanation

Recent insurance industry investigations have begun to put prior finite reinsurance transactions under a microscope, creating the need to re-examine this reinsurance product, but more importantly determine its role in the future.

Just exactly what is finite risk reinsurance? It must be understood that it is a broad category of various types of reinsurance agreements, all of which significantly limit the reinsurer’s exposure (especially underwriting risk) to a maximum limit (thus, the concept finite).

In other words, the buyer of this type of reinsurance must be aware that there is a finite reinsurance limit, a cap, or other term used to describe a maximum reinsurer’s limit.

When we discuss finite risk reinsurance, it is necessary to restrict the agreement or transaction to two parties, a ceding insurer, and an assuming reinsurer, each of which is licensed to assume risk. This perspective will confine its discussion only to finite reinsurance, and not take into consideration corporations who have purchased finite insurance agreements.

Financial reinsurance agreements transfer financial risks that could affect the insurance company’s realization of future profits by protecting the insurance company’s bottom line from such threats as the loss of income through deterioration of the company’s loss reserves.

The ceding insurer (buyer of finite re) transfers a risk, typically characterized as an asset risk, a credit risk, or a loss payment timing risk. FASB’s accounting gives the ceding insurer a strong incentive to transfer an element of underwriting risk, as well. Determining risk transfer and more importantly meeting the latest risk transfer requirements will challenge those preparing for the future of finite risk reinsurance.

The seller of finite risk reinsurance (assuming reinsurer’s exposure) is protected by an aggregate limit on the amount of assumed risk. This “cap” on the reinsurer’s ultimate liability is the first important characteristic of financial reinsurance.

A second key characteristic of financial reinsurance is that it offers the financial reinsurer a low risk margin. The financial reinsurer often has the contractual right to cut its losses and retire from the agreement through a commutation provision, that is, a cancellation provision that permits the assuming reinsurer to recover its paid losses before the ceding insurer can invoke its right to share profits under a profit sharing provision.

Structuring the commutation clause agreeable to insurer and reinsurer is another challenge for the future of finite risk reinsurance.

Financial reinsurance agreements are also characterized by the reinsurers crediting the ceding insurance company, in the pricing of such covers, with estimated amount of investment income that is expected to be generated by the reinsurance premium to be ceded.

This is why we continue to see hedge fund operators in the offshore domiciles becoming active in the reinsurance business. Offshore reinsurers owned by hedge funds have a significant advantage over the traditional reinsurers, especially with no legacy issues.

The fourth characteristic is the use of profit commissions, that is, payment by the financial reinsurer to the ceding insurance company during the term of agreement in the event of favorable loss experience.

A simplistic profit commission clause extracted from an actual retroactive aggregate excess of loss agreement reads as follows:

“In the event that the Company (buyer of finite reinsurance) shall not have exercised the commutation option herein before contained and the Company’s losses under this Agreement do not exceed the reinsurer’s (seller of finite reinsurance) income under this Agreement, the reinsurer shall pay to the Company a profit commission in the amount of the difference between 85% of the reinsurer’s income and the ultimate losses hereunder. A contingent calculation of the profit commission hereunder shall be made at December 31st … of each year, and annually thereafter and a final calculation shall be made upon termination of this Agreement.”

As you can see, the finite reinsurer in the example above is looking to make a 15 percent profit margin on the transaction. As a buyer, do you look for a finite market that would want only a 10 percent margin, perhaps a hedge fund? More future perspectives to consider.

Many attempts have been made to put financial reinsurance agreements into categories, usually because there was an initial purpose and/or need by the buyer of financial reinsurance. As I pointed out in my first textbook on the subject, A Practical Guide to Financial Reinsurance, this reinsurance product is not without substantial controversy.

The foreign owner of U.S. insurers wants to withdraw from the U.S. insurance company market (i.e., Commercial Union, Royal, etc.) goes into the reinsurance market to buy:

The creativity of our reinsurance business needs to come up with a solution for this event: foreign insurers want to exit the United States, and dispose of their liabilities. Use the above reinsurance products, or call them by other names, “adverse development coverage,” “stop loss reinsurance,” and how about “insurance management errors and omissions coverage?” The new term could be structured risk reinsurance.

In 1995, I said, “The merger and acquisition of property/casualty insurance and reinsurance companies is developing as a principal area for expansion in finite reinsurance. Major corporate transactions using specific forms of financial reinsurance have been consummated by industry leaders …”

What I was referring to was the beginning of the end for many U.S. reinsurance companies, poorly managed and inadequately capitalized, which would be exiting the business with future loss liabilities that we would need a solution for.

How many active reinsurance companies in 1995 are no longer active today? In fact, another future perspective to consider is the reinsurance industry for U.S. insurers, as buyers, is no longer in the United States but in Europe and Bermuda.

There are other important perspectives to consider, all of which will require detailed examination. We cannot simply say, under generally accepted accounting principles, payment from a reinsurance company is not a “reinsurance” recovery for accounting purposes unless the reinsurance agreement transfers some risk to the reinsurer. We cannot simply say, if a reinsurance agreement does not transfer risk, it is a financing arrangement in which all premiums are treated as deposits.

Many of the reasons for buying financial reinsurance are true today, as they were in 1995:

The future perspective must be “proactive” and “transparent,” to use 2005 terminology. The ability to present a body of documentation to support the purchase of this type of reinsurance will go a long way in preventing the negative consequences that can result.

Andrew J. Barile is an insurance industry con-sultant and the author of A Practical Guide to Finite Risk Insurance and Reinsurance. His Web site is www.abarileconsult.com. E-mail him directly at: abarile@abarileconsult.com.