March 15, 2004

Finite Insurance and Reinsurance:

An Advisen Primer

An Advisen QuickNote

Key Points: So-called finite risk insurance and reinsurance products have come under investigation by the SEC, the New York Attorney General, and the National Association of Insurance Commissioners. The products, which have been implicated in the failure of several insurance companies, are believed by investigators to be used to mask the true financial condition of some companies.

The purpose of insurance is to transfer certain liabilities from a policyholder to an insurer. A home burns to the ground and, since the homeowner paid for insurance coverage, an insurance company shoulders the expense of rebuilding it. Underlying the concept of insurance are certain basic principles; the event causing the insured loss is fortuitous – that is to say that it is unexpected and unintended from the standpoint of the insured – and that the event occurs at some point in the future relative to the inception of the policy. It is also presumed that the insurance company assumes risk – that a realistic loss scenario under the policy would cost the insurer far more than the premium paid for the coverage.

The current investigation of so-called "finite" or "finite risk" insurance and reinsurance products by regulators and law enforcement agencies focuses on contractual agreements that pass for insurance coverage, but violate one or more of the basic principles of insurance. Investigators are particularly concerned about insurance and reinsurance contracts where little or no actual risk is transferred, hence the designation "finite risk."

Under one type of finite risk agreement, the policyholder pays a premium for coverage much like a traditional insurance contract, but also commits to reimburse the insurer for any loss paid under the agreement. For example, the policyholder may pay $100,000 for $1 million of coverage. If the insurer pays the full $1 million in claims, the policyholder is obligated to pay back some or all of the insurer's $900,000 loss. A company may buy such a product to “smooth” losses over time – to redistribute a loss in one year over several subsequent years. Under current accounting rules, the policyholder probably should account for the transaction as if it were a loan from the insurer. However, with carefully crafted contracts that closely resemble traditional insurance agreements, some policyholders feel justified in – or at least emboldened to – account for the transaction as if it were traditional insurance.

Regulators and law enforcement officials are concerned that companies use these and similar sorts of agreements to disguise financial problems. Their concerns are fueled by several recent insurance company failures where finite risk reinsurance agreements – similar types of transactions, but between an insurance company and a reinsurer – have been implicated.

Taisei Fire & Marine Insurance Co. Taisei Fire & Marine belonged to an aviation insurance pool managed by Fortress Re, a reinsurance managing agent in North Carolina. The pool insured all four of the planes involved in the September 11^th terrorist event. Fortress Re had purchased reinsurance for the pool, a significant portion of which was provided through an arrangement that required reinsurers to be reimbursed for losses through future premium payments. Taisei’s portion of the September 11^th losses totaled $604 million, forcing the company into bankruptcy.

Another pool member, Sompo Japan Insurance, Inc. (formerly Nissan Fire & Marine Insurance Co. Ltd.), won a ruling against Fortress earlier this year. Sompo claimed that it was unaware that most of the reinsurance protection purchased by Fortress was of the financial variety, and that Fortress improperly accounted for the proceeds from the financial reinsurance, treating them as if they were conventional reinsurance recoveries. An arbitration panel ruled that Fortress's two principals had committed fraud by using misleading accounting in connection with the financial reinsurance transactions, and ordered them to pay more than $1 billion. Sompo and a third pool member, Aioi Insurance Co, have filed a $2 billion suit against Fortress's auditor, Deloitte & Touche LLP. They claim that Deloitte failed to tell them of huge hidden liabilities that Fortress had incurred on their behalf.

HIH. The $A5.3 billion collapse of HIH in 2001 sent shock waves throughout the Australian insurance industry and led to fraud charges against several executives^. The three indicted executives were senior officers with FAI Insurance Ltd, a company acquired by HIH shortly before its collapse. They were charged with fraud in connection with a reinsurance agreement that allegedly disguised the true financial condition of FAI and contributed to the fall of HIH. The reinsurance transaction relied on side agreements that required future premium payments to offset any losses under the core contract.

Reciprocal of America. A recent suit alleging abuse of financial reinsurance was filed in the U.S. District Court of Tennessee, Western Division. Virginia and Tennessee regulators are suing General Reinsurance Corp. for allegedly selling "sham" reinsurance to Reciprocal of America (ROA), a medical malpractice insurer located in Richmond, Va. that is in insolvency proceedings. The suit alleges the reinsurance agreements were designed to fool regulators into believing the carrier was financially sound when it wasn't.

The lawsuit charges that ROA assured regulators that its units had access to millions of dollars in reinsurance through General Re. But, according to the complaint, what were booked as recoverables under reinsurance agreements were actually loans, thanks to "non-contractual" understandings in a 1998 finite reinsurance agreement and two subsequent "unreported side agreements" in 2000 and 2002. These agreements allegedly protected Gen Re from excess losses. The regulators claim that ROA misrepresented the agreements, allowing them to think ROA had more reinsurance protection than it did. They are seeking recovery of those payments. General Re plans to fight the allegations.

The Securities and Exchange Commission is one of the regulatory agencies investigating financial reinsurance transactions. Their investigation dates back to 2003 when the Commission levied a $10 million fine against American International Group (AIG) concerning a transaction with mobile phone distributor Brightpoint Inc. At that time the SEC's director of enforcement, Stephen Cutler, characterized financial insurance and reinsurance as potentially being “vehicles to commit financial fraud,” and vowed that the SEC “will pursue insurance companies and other financial institutions that market or sell so-called financial products” used to mask the true financial condition of a company.

More recently, New York Attorney General Eliot Spitzer launched his own investigation, which is being coordinated with the SEC investigation. Insurers and reinsurers that have received subpoenas to date include CNA, Ace Ltd., Platinum Underwriters Holdings Ltd., MBIA Inc., St. Paul Travelers Cos., Swiss Re, Zurich Financial Services Group, and Berkshire Hathaway Inc.'s subsidiary General Re Corp. The recent resignation of AIG CEO Maurice "Hank" Greenberg is attributed in part to Mr. Spitzer's investigation of AIG as both a seller of finite insurance products as well as the buyer of such a product from General Re, allegedly to cover up deficiencies in AIG's loss reserves. The National Association of Insurance Commissioners also has held hearings concerning finite risk transactions to determine whether the use of some finite risk products should be challenged.

This QuickNote was written by David K. Bradford, Executive Vice President, 212-897-4776, dbradford@advisen.com.