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Saved by the light: regulators and the industry hope that new disclosure requirements will eliminate shady finite reinsurance contracts and keep the product viable.

The recent flurry of subpoenas concerning Finite or structured reinsurance contracts has led regulators to an important realization: There's a lot they don't know about this corner of the market.

In an attempt to get a better handle on these types of transactions, the National Association of Insurance Commissioners worked quickly to put forward new reporting requirements that will go into effect with the 2005 annual statements. While companies may complain about the additional administrative burden, the NAIC hopes the new reporting requirements will shed some light into this area of the market, and help regulators weed out potentially illegitimate deals.

Problem Child

Finite reinsurance is a type of reinsurance that transfers a finite or limited amount of risk to the reinsurer, according to the NAIC. Risk is reduced through accounting or financial methods, along with the actual transfer of economic risk. By transferring less risk to the reinsurer, the ceding insurer receives coverage on its potential claims at a lower cost than traditional reinsurance.

Dozens of insurers have said they've been subpoenaed by state and federal authorities looking into finite transactions. The investigations followed industry leader American International Group's agreement to pay $126 million to resolve a set of claims filed by the U.S. Securities and Exchange Commission and federal regulators over AIG's structured finance deals with Brightpoint Inc. and PNC Financial Services Corp.

While traditional reinsurance is a way for insurance companies to share risk and future losses, finite reinsurance, which is also called structured finance, can even be used to cover losses that have already happened. The unknown risk in that case can be the ultimate amount of claims to be paid or the time it takes to resolve all the claims.

Regulatory authorities have discovered, however, some finite reinsurance transactions in which there was no risk, no "unknown" component. These contracts acted more like a loan, not an insurance contract. Without the risk element, the contracts need to be accounted for like a loan, not insurance.

Even worse, regulators say they've found cases in which companies made illegal side agreements connected to the bogus finite reinsurance contracts. One such case is a lawsuit that regulators in Virginia and Tennessee have filed against Berkshire Hathaway's General Re, alleging the company was complicit in the demise of Richmond, Va.-based malpractice insurer Reciprocal of America by using a side agreement to shift risk back to ROA.

Also, two General Re employees have pleaded guilty for their alleged roles in the transaction between AIG and General Re, in which AIG was able to book $500 million in reinsurance reserves--S250 million in the fourth quarter of 2000 and $250 million in the first quarter of 2001--through a transaction in which AIG ostensibly assumed $500 million of reinsurance risk from Cologne Re Dublin.

The Justice Department contends no actual risk transfer occurred with the deal, an assertion AIG admitted in its recently filed Form 10-K annual statement with the SEC.

"Recent regulatory developments have highlighted the concern that finite reinsurance has been used improperly on occasion. There are legitimate uses of the product, but there have been problems," said Bryan Fuller, senior reinsurance manager for the NAIC. "Misrepresenting of the insurers' financial position to regulators, policyholders, investors and other stakeholders calls into question the adequacy of corporate governance and accountability. So we decided to develop these regulations."

The NAIC had planned to discuss the proposed regulations at its annum fall meeting in New Orleans, which was canceled due to the heavy damage New Orleans received during hurricanes Katrina and Rita. But during a telephone conference on Oct. 14, the states' top insurance regulators approved the new regulations.

"This will effectively give regulators and other people more information about how large this issue is in the industry as a whole, in a financial amount, as well as allow regulators to look into more detail to make sure these transactions are accounted for in an appropriate way," Fuller said.

No Definition

Companies have been disclosing the flow of premiums to reinsurers on Schedule F of the annual statements, but have not been asked to detail individual contracts--until now. "You can look at the overall premiums and losses flowing between two entities, but it could be 10 contracts between the two parties," Fuller said.

Part of the uncertainty over finite reinsurance is that there's no clear standard definition for what it is, Fuller said. So the first step the regulators took is to ask companies to detail any contract that has certain components that can be associated with finite reinsurance. (See "Additional Disclosure" below.)

After identifying these contracts with provisions that are associated with finite reinsurance, companies will then have to spell out what financial impact these contracts have, and what the companies' balance sheets would look like with and without them in place.

"We want to know what transactions need to be looked at in more detai," Fuller said.

Some say the regulators have cast their nets too wide.

"I applaud the additional disclosure. I applaud the improved transparency the NAIC is trying to bring to this," said Dan Malloy, executive vice president of ART Solutions for Benfield Group. "But a lot of these issues will include traditional contracts."

Fuller said that could indeed be the case.

"The consistent message from the regulatory community is because there have been some very high profile problems with these transactions, regulators want to [use] as wide a net as possible in the beginning, evaluate them, and then modify what we require in the future," Fuller said. "It's never been seen as 'this is the end of what we're going to do.' This is just the first step in terms of assessing the impact on the industry."

The second prong of the regulations will require chief executive officers and chief financial officers to sign a statement, a la Sarbanes-Oxley, attesting that these contracts have been accounted for correctly and that no side agreements related to the transactions were made.

"At least they took the disclosure route rather than prohibiting" any type of transaction, said Bob Zeman, senior vice president for industry and regulatory affairs for the Property Casualty Insurers Association of America. "There's a lot of very valid finite transactions that benefit everyone involved and will make the industry work better. There's been very few so-called 'bad actors.'"

Fuller said companies have questions on implementing the new disclosure requirements, but overall, the industry has been supportive.

"They want to get something done that will be out there in public. The industry contention is that the vast majority of contracts are perfectly legitimate and serve a legitimate business purpose. I don't think regulators disagree with that; they just want more detail," Fuller said.

Some estimate the finite reinsurance market represents 5% to 10% of the total reinsurance premium, but Fuller said: "If you can't adequately define what finite reinsurance is, then it's difficult to capture what percentage of the market it is. A contract doesn't ever say 'this is a finite reinsurance agreement' on the front page."

Let the Light In

William G. Passannante, an insurance attorney with the law firm Anderson Kill & Olick, who often represents policyholders, said more disclosure is better than less. He quoted U.S. Supreme Court Justice Louis Brandeis, who said: "Sunlight is the best disinfectant."

"But perhaps the regulations aren't as strong a response as warranted," Passannante said.

The NAIC had considered requiring companies to divide finite reinsurance accounting into two parts, accounting for the insurance and the financial component separately. The industry fought this bifurcation proposal. "It's an interesting concept, but in practice, it would be virtually impossible to do," Zeman said.

Still, Passannante said the additional disclosure alone would have an impact.

"Looking in from the outside, some of these finite risk deals that subsequently blew up because they had no risk transfer" were not insurance at all, Passannante said.

Moving Forward

Most said the new regulations will not dampen the number of finite transactions.

For instance, Malloy of Benfield said he hasn't seen a reduction in the number of structured transactions.

"If we are emerging to a consensus of what constitutes a bona fide transaction, clients will enter into these structured transactions where they see economic benefits," Malloy said. "What we are seeing is reinsurers are putting more risk into the transactions with the knowledge that these things are likely to be disclosed the way they should be."

Additional regulations may be pending.

Other regulatory and advisory agencies, including the American Academy of Actuaries and the Financial Accounting Standards Board are working on risk transfer models and accounting definitions. Also, the International Association of Financial Supervisors recently has adopted a guidance paper on risk transfer disclosure.

U.S. regulators will begin to get a clearer picture of the finite reinsurance landscape in March, when the 2005 annual statements, including the new disclosure statements, begin to come in.

"Once we get those filings, then we'll be able to look at and evaluate the impact of some of these transactions on the industry, and how big a part of the industry they are," Fuller said.

Key Points

* Ceding companies will have to make new disclosures of finite reinsurance contracts beginning with the year-end 2005 financial statements.

* CEOs and CFOs will be required to attest that their companies have completed no improper reinsurance contracts.

* Various other national and international regulatory bodies are looking at stepping up regulatory demands for finite contracts.

Additional Disclosure

The National Association of Insurance Commissioners will require companies to disclose transactions that could be considered finite reinsurance. The 2005 year-end annual statements now include the following additional requirements:

A company must reveal if it has ceded risk under any contract (or multiple contracts with the same reinsurer) for which the underwriting result is 3% or more than its year-end policyholders' surplus, and it accounted for the contract as reinsurance, and the contract has one or more of the following features:

* A contract term of longer than two years that can't be cancelled;

* A limited or conditional cancellation provision;

* Aggregate stop loss coverage;

* Unconditional cancellation rights for either party (except if triggered solely by a decline in credit of the other party);

* Reporting or payment of losses is permitted less frequently than quarterly; or

* The written premium ceded to the reinsurer is more than 50% of the reinsurer's direct plus assumed premium, or 25% or more of the written premium ceded to the reinsurer has been retroceded back to the company or its affiliates, except in the case of certain inter-company pooling or captive arrangements.

If a company has such contracts, it must disclose:

* A summary of contract terms;

* A brief description of management's intent and the economic purpose of the contract; and

* The aggregate financial statement impact of all such contracts on the balance sheet and income statement.

Companies also will have to disclose if they have any ceded reinsurance contracts that were accounted for differently under statutory and General Accepted Accounting Principles and why this has occurred.

Attestation

Chief executive officers and chief financial officers will have to attest under penalties of perjury with respect for all ceded reinsurance contracts that to the best of their knowledge and belief:

* There are no separate written or oral "side agreements" to any contracts that could reduce, limit, mitigate or otherwise affect any actual or potential loss under the contract;

* For each contract entered into, renewed or amended on or after Jan. 1, 1994, for which risk transfer is not reasonably considered to be self-evident, there is documentation concerning both the economic purpose of the transfer and a risk transfer analysis showing proper accounting treatment;

* That the company had adequate controls to monitor these contracts.

Source: Property Casualty Insurers Association of America

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Title Annotation:Reinsurance/Capital Markets
Comment:Saved by the light: regulators and the industry hope that new disclosure requirements will eliminate shady finite reinsurance contracts and keep the product viable.(Reinsurance/Capital Markets)
Author:Green, Meg
Publication:Best's Review
Geographic Code:1USA
Date:Jan 1, 2006
Words:1996
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