An Issue of Use or Abuse?
Adjusting for Financial and Finite
Reinsurance
Steven Ader, Director
Finite Reinsurance Origin and Spectrum
of Usage
 At its inception in the 1980s, finite reinsurance products were
traditional insurance products modified to reduced the cost to
the ceding company through profit sharing features in
exchange for limiting the potential liability of the reinsurer.
 Often called financial reinsurance or financial engineering,
finite reinsurance evolved, in the most extreme cases, as a
financial engineering mechanism to improve or stabilize an
insurer’s income statement or balance sheet where the
accounting does not reflect economic reality.
 Finite reinsurance contracts, when abused, act as a low-cost
loan flying below regulatory radar, although authorities are
actively investigating companies that use finite reinsurance as
an accounting mechanism to mask economic reality.
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Seeing Through The Smoke and Mirrors:
Reflecting Economic Reality
 In extreme cases, finite reinsurance increases earnings
and capital even though the transaction economics
indicate otherwise
 S&P will adjust its view of an insurer when finite
reinsurance is used to bolster earnings and capital
when the economics of these transactions indicate that
appropriate risk transfer and loss absorption has not
taken place
 Some transactions lessen the impact of losses in
current years while in subsequent years, full or
substantially full reimbursement will be made through
increased premium levels, additional commissions,
and/or higher interest rate levels for funds withheld
S&P will adjust its view of an insurer's earnings and
capital to reflect economic reality
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Broadening Our Effort to Identify
Difficult to Detect Transactions
Standard & Poor's has always looked for finite reinsurance, but
now we have established codified procedures by which we do so
S&P has in the past and will continue to adjust its view of an
insurer when finite reinsurance is used to bolster earnings and
capital when the economics indicate that risk transfer and loss
absorption have not taken place
S&P has identified and disclosed in our releases the impact of
finite reinsurance transactions for which the accounting is not
rooted in economic reality
In these instances, S&P will adjust its view of an insurer's earnings
and capital to reflect economic reality
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Legitimate Uses of Finite Reinsurance
 These contracts act as a mechanism for the primary,
or ceding insurer, to protect against volatility while
retaining greater risk and alternatively paying a lower
premium to the reinsurer
 Quite commonly, these are contracts that legitimately
protect the ceding insurance company by reducing
its volatility of earnings or volatility of capital through
a contract where the reinsurer accepts valid risk
transfer
When we see these types of contracts we do not make
any adjustments in our analysis if the accounting for
the transaction matches up to the true economic
transfer of risk
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Attributes of Finite Re Contracts
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The external reinsurance agreement is retroactive.
The external reinsurance agreement receives different
accounting treatment under different methods of accounting
(Statutory, GAAP, Internal accounting, etc.)
The external reinsurance agreement has or is being
questioned by auditors and/or regulatory bodies regarding
the classification (prospective or retrospective) or accounting
treatment.
The company views the external reinsurance agreement as
one made for financial engineering purposes (i.e. the delaying
the recognition of losses or smoothing of them over a period
of time)
The reinsurance agreement is supplemented by a side letter
or verbal agreement that alters the carrier’s risk exposure
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Attributes of Finite Re Contracts
 The company believes it is probable (>50%) that the external
reinsurance agreement will be commuted.
 External reinsurance agreement makes material use of deficit
accounts or experience refund accounts
 External reinsurance agreement accompanies by retrocession
of portion of risk to original cedent or affiliate
 The external reinsurance agreement remains in effect for more
than 1 year
We are requesting that insurers forward copies of the contracts
containing these attributes with the accounting entries. In
addition, we are requesting the same for the top 5 contracts
underlying the funds held balances
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Appendix
Tools used in Structuring a Finite
Transaction
Commutation Clause Affording the Ceding Carrier the option of canceling
the contract and receiving a substantially full refund of premium.
Clause results in a material capping of reinsurer’s profit potential. Raises
a question when the accounting benefit materially exceeds reinsurer’s
maximum profit
 Present value approach is used in determining the economic triggering
point of the commutation provision which is then compared to actual
contract developments.
 If actual circumstances indicate that the contract would likely be
commuted, no economic benefit is derived from the contract. Therefore
any accounting benefit is eliminated from our analysis of earnings
and/or capitalization and depending on materiality, reflected in our
ratings.
 If actual circumstances would not lead to a commutation, then the
economic benefit of the transaction of the transaction, in present value
dollars, is compared to the accounting of the contract.
Profit sharing clause is also used to cap reinsurer’s profit potential.
Same question applies when accounting benefit materially exceeds
reinsurer’s profit potential.
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Tools used in Structuring a Finite
Transaction
Interplay of finite quota share clauses materially limit economic
outcomes while realizing the accounting benefit conferred by
quota share accounting treatment.
1- Sublimits on exposures for certain classes of business, limiting reinsurer loss
2- Aggregate loss ratio caps, limiting reinsurer loss
3- Deductibles requiring the ceding company to pay a certain level of first losses
incurred on the business subject to the quota share agreement, limiting
reinsurer loss
4- Loss corridors reducing the assuming company’s risk exposure for a range
of specific loss ratios, limiting reinsurer loss
5- Experience account, commutation, or profit sharing clauses, limiting
reinsurer profit
Standard and Poor’s evaluates the economic behavior of these
contracts by applying the historical performance of the book of
business to the contract terms.
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An Issue of Use or Abuse?
Adjusting for Financial and Finite
Reinsurance
Steven Ader, Director