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Thursday, 25th April 2024 |
| What is finite reinsurance? |
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| Finite reinsurance, also known as ‘financial reinsurance’ or ‘non-traditional insurance products’, has come under increasing scrutiny from various regulators in recent months. Raj Parker and Nathan Wilmott explain what finite reinsurance is, when it is used and why a number of regulators are currently investigating the use of these products. |
A finite reinsurance contract is a reinsurance contract by which risk is transferred to the reinsurer, but with risk transfer usually being limited in some way. Generally, finite reinsurance costs less than traditional reinsurance.
Finite reinsurance contracts may also differ from other reinsurance products in term and pricing structure. Finite reinsurance contracts frequently cover periods of three to five years, unlike a traditional reinsurance policy, which will usually be renewed annually. A finite reinsurance contract may also have ‘dynamic’ pricing, that is, the premium payable by the reinsured varies according to its claims record.
Companies have traditionally used finite reinsurance contracts to lay off risks where traditionally structured reinsurance is unavailable. In the post-September 11 climate of high traditional reinsurance premiums, many companies turned to the finite reinsurance market to obtain cover.
There are various different types of finite reinsurance products available in the market:
• Prospective stop loss cover, where the ceding company limits its losses to a certain predetermined loss ratio. These products are designed to help the reinsured protect its planned results and reduce earnings volatility. They have prospective effect.
• Structured multi-year property cover, where the ceding company limits its losses to a certain predetermined loss ratio in a given year. These products allow the cedant company to spread its loss over multiple years, reducing earnings volatility and reinsurance costs. They have prospective effect.
• Finite risk quota share cover, where the reinsurer shares in the profit or loss of a business up to an agreed percentage. This agreed percentage can be structured to meet the insurer’s needs from a profitability, growth and capital perspective. These products allow the cedant company to make the best use of surplus funds given strong expected growth and profitability. They have prospective effect.
• Loss portfolio transfer products, where incurred losses (outstanding claims reserves) are transferred to a third party. The ceding company transfers its outstanding reserves to the reinsurer, generally at a discounted level. These products allow the cedant company to limit or exit its exposure to a certain line of business. They have retroactive effect.
• Adverse loss development cover (retrospective excess of-loss cover), where the ceding company is protected against adverse reserve development on old liabilities.
These products allow the cedant company to limit its exposure for a specific book of business, or to make acquisitions. They have retroactive effect.
Finite reinsurance and the regulators
The regulators’ primary concern about finite reinsurance contracts is that companies must not be allowed to use them illegitimately to smooth their earnings or otherwise distort their financial results. Generally, reinsurance contracts are treated as insurance contracts for accounting purposes. The concern is that if there is inadequate risk transfer under a finite reinsurance contract, that contract should properly be accounted for as a loan, rather than an insurance contract. Regulators are also particularly keen to discourage the use of sideletters that materially alter the terms of the contract. |
Raj Parker is a partner and Nathan Wilmott is an associate in Freshfields Bruckhaus Deringer.
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| Article appeared in the October 2005 issue.
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