FINITE RISK REINSURANCE

(May 2022)

What is the difference between reinsurance and finite risk reinsurance? The basic answer is fairly simple.

Traditional Reinsurance	Finite Risk Reinsurance
Traditional reinsurance involves either the partial or the total transfer of potential loss exposure from one insurance entity to another. With traditional reinsurance, due to the details found in a particular agreement and the contract terms, limits and premiums, it is fairly easy to quantify the level of loss exposure that is transferred from the ceding party to the reinsuring party.	Finite risk reinsurance arrangements usually last several years (rather than a single arrangement which is re-evaluated and re-negotiated at renewal) and, more significantly, consider the impact of the time value of money. The major differences are that only a limited (finite, measurable) amount of risk is transferred to a reinsurer and the transaction focus is on managing finances.

Risk Transfer

Classifying a transaction as reinsurance depends upon the insurer paying an appropriate (proportionate) premium to the reinsurer in exchange for the transfer of the applicable risk. If the level of the transferred risk is significant, then the transaction qualifies for treatment as a financial asset. If no transfer (or ceding) of a risk of loss occurs (or if the level of risk transferred is insignificant), then the transaction must be treated as a loan, which makes it a financial liability.

The question of adequate or qualifying level of risk transference is problematic. The following are excerpts from Statement of Statutory Accounting Principles (SSAP) No. 62. It provides some guidance regarding whether a transaction involves a valid risk transfer. According to that rule, under a * valid agreement:

"a. The reinsurer assumes significant insurance risk under the reinsured portions of the underlying insurance agreements; and

b. It is reasonably possible that the reinsurer may realize a significant loss from the transaction."

SSAP 62 also states that:

· A reinsurer shall not have assumed significant insurance risk under the reinsured contracts if the probability of a significant variation in either the amount or timing of payments by the reinsurer is remote.

Example: Acme Casualty enters into a reinsurance contract for its non-standard auto book with Negligible Re. Negligible agrees to reinsure 40% of Acme’s book. The contract is effective March 1, 2021. However, a payment provision stipulates that Negligible is not obligated to make any payments for losses experienced by policies it has assumed until March 1, 2027. In this instance, an inadequate transference of risk has occurred and the contract would have to be treated and listed as a loan rather than reinsurance.

· The ceding entity's evaluation of whether it is reasonably possible for a reinsurer to realize a significant loss from the transaction shall be based on the present value of all cashflows between the ceding and assuming companies under reasonably possible outcomes, without regard to how the individual cashflows are described or characterized.

* Source: Excerpted from "Property and Casualty Reinsurance Study Group of the Accounting Practices and Procedures Task Force" report on finite risk from the NAIC Website.

Note: Various accounting and other rules on this topic are subject to significant change. It is critical to thoroughly research current rules and provisions for the most accurate information.

Finite or Financial Reinsurance

Rather than managing risk by primarily focusing on its transfer to another entity, finite reinsurance’s primary goal is managing a business’s capital by transferring exposures related to interest rates and timing. Compared to traditional reinsurance, the risk of loss (losses exceeding ceded premium) faced by the party accepting the transferred risk is smaller. Such reinsurance contracts have a further hedge. The reinsurer often acquires a right to limit its loss exposure via commutation. Other considerations that make finite reinsurance less risky to a reinsurer than traditional contracts are that there is specific agreement on investment income to be expected for the contract’s duration and the contract is subject to an aggregate limit which places a cap on maximum possible losses.

Finite reinsurance is often used when a given loss exposure is considered too expensive to reinsure; for providing an excess layer of protection for self-insurance situations; handling insurance line run-offs or for risks that are considered too hazardous for the traditional reinsurance market. A major reason for its use is that its cost can be negotiated and then set for several years, removing the possible cost volatility that can be found with traditional reinsurance which is, usually, renegotiated annually (reflecting loss experience).

Other terms for finite reinsurance bear this out as it is also called financial reinsurance, loss-mitigation reinsurance and non-structured reinsurance.

Finite Risk Reinsurance Methods

Methods may be categorized as “finite” if limited risk transference contract terms facilitate the arrangement. There are two categories, Prospective Finite Reinsurance (Pre-Loss Funding) and Retrospective Finite Reinsurance (Post-Loss Funding).

Prospective Finite Reinsurance

Prospective Aggregate Contracts - Under such agreements, the reinsurer has a contractual obligation to pay the ceding insurer a series of future payments to handle future losses. The agreement typically includes a payment schedule and a maximum, aggregate limit that may be paid by the reinsurer.

Example: Effective July 15, 2021, Acme Casualty enters into a prospective aggregate contract with Lackadaisical Re. The contract schedule is as follows:
Date	Payment	Total Possible Paid (Cumulative)
7/15/2024	$2,000,000	$2,000,000
7/15/2025	$2,000,000	$4,000,000
7/15/2026	$2,000,000	$6,000,000
7/15/2027	$2,000,000	$8,000,000
7/15/2028	$2,000,000	$0 (see contract aggregate limit)
Contract Aggregate Limit		$8,000,0000

Prospective Aggregate Excess of Loss Contracts - Under such agreements, also known as spread of loss contracts, the reinsurer has a contractual obligation to pay the ceding insurer for losses that exceed an annual net level of losses. The reinsurer provides this coverage in exchange for predetermined annual premium. The premium is paid into an “experience account” and interest earned in that account is used to cover required loss payments. However, if the interest earnings are insufficient, the ceding insurer has to make up the financial shortfall. This form of contract is effective in smoothing out potentially volatile loss activity.

Retrospective Finite Reinsurance

Loss Portfolio Transfers (LPT) - While a loss portfolio transfer (LPT) usually involves auto, commercial liability or workers compensation obligations, they may involve other lines of business. Essentially an LPT involves Company A that has a current obligation to handle possible losses for a book (or multiple books) of business, agreeing to pay a negotiated series of premiums to Company B in exchange for Company B assuming Company A's applicable liabilities. The negotiated premiums are at a fixed amount and over a fixed period of time. This feature allows the company that makes the transfer to gain certainty over a liability that, prior to the transfer, may have been unpredictable. Gaining such certainty is a chief advantage of participating in an LPT. Of course, the level of uncertainty will be reflected in the total cost of any negotiated arrangement.

Other advantages include improving a company's financial attractiveness to entities that are interested in buying or merging with the company that has made an LPT. An LPT may also allow the transferring company to gain a significant tax advantage by eliminating a long-term liability and/or by having the LPT premium treated as risk transfer.

Note: The possible financial benefits to a company contemplating an LPT are so strong that, unfortunately, they provide a strong incentive for improper arrangements. In order to gain legally valid balance sheet and/or tax liability relief, expert financial parties should be involved to make sure that an LPT is properly structured and implemented.

Retrospective Aggregate Contracts - This is similar to an LPT with a major difference. While an LPT is structured to only handle reported losses, a retrospective contract handles reported losses as well as Incurred But Not Report (IBNR) Losses. These contracts are well-suited for handling long-tailed loss exposures. The ceding insurer is protected for losses occurring on a specific portfolio of business for an agreed upon aggregate limit. An estimated schedule of loss payments (subject to their discounted value) is used to determine the contract’s premium.

Adverse Development Covers - An adverse development cover (ADC) is a method to address the financial burden represented by loss reserves on long-tailed liabilities. An insurer, as is the case with any business, wishes to be forward-looking, having the ability to seek advantageous opportunities or to more effectively use its financial assets. An ADC allows an insurer to free-up capital that has been frozen on its balance sheet. Often such reserves have to do with liabilities involving work comp, medical malpractice, other professional-oriented loss exposures or iconic, volatile sources of loss (for example, asbestos, environmental liability, etc.)

Arranging for an ADC requires expertise that is rarely held by a regular insurer, so specialists are engaged to study an identified block of reserves. Such specialists will analyze long-tailed reserves and help prepare a proposal that will allow an insurer to approach reinsurers that offer ADCs.

Specialty insurers will underwrite the reserve situation considering various elements such as the specific exposures involved, length of time that the reserves have been in place, predictability, etc.

If found desirable, the parties will then arrange coverage specifics, paying for losses that exceed the agreed volume that remains as the insurer’s reserves.

The ADC agreement then allows the insurer to redeploy capital, net of the ADC premium, for other purposes.

Blended Covers

This term refers to a single product that consists of a combination of insurance (and/or reinsurance) and other risk management techniques. It was developed as a way to hedge against the exposures created on the primary insurance level by multi-year/multi-line products. This surplus level protection is best accomplished by combining (blending) insurance and non-insurance methods.

A (de)Finite Problem

While finite contracts can be very useful, particularly for entities that self-insure, for those with volatile, long-tail liabilities and entities that are in a run-off mode (operations or product discontinuance), the haphazard use of such programs can be dangerous. An entity's ability to operate properly in the long-term can be threatened if poorly designed contracts are used, or if care is not taken to deal with financially viable partners. Such contracts are now being increasingly and more thoroughly scrutinized by both insurance regulators and accounting/auditing groups since finite risk products are frequently used to distort financial operating results.