A good plan gone awry: finite risk covers started out as a good idea—a product that filled a gap in the traditional marketplace, particularly for certain kinds of unusual risks, such as terrorism. Problems have arisen, however, because some have elected to use—or rather, abuse—finite covers in order to smooth earnings without really transferring any risk

Risk & Insurance, July, 2005 by Patricia Vowinkel

It wasn't all that long ago that finite risk covers looked like a savvy way of handling some difficult risk and balance-sheet problems.

Finite risk covers provided companies with an elegant way to manage exotic risks, shed unwanted liabilities and improve the quality of their earnings. For companies unable to find insurance in the traditional market, they were a smart answer.

Finite risk covers, however, are now embroiled in controversy. The New York Attorney General, the Securities and Exchange Commission, insurance regulators and the FBI have been investigating possible abuses of finite risk reinsurance that may have distorted financial statements and misled investors about earnings.

The insurance industry is developing clearer guidelines for the proper use of finite risk transfer. The intense scrutiny, however, could make finite covers less attractive and discourage insurers and, other companies from using them.

"There's certainly a greater reluctance to approach finite risk now than there was before," says Christopher Culp, a senior fellow in financial regulation with the Competitive Enterprise Institute in Washington, D.C., and an adjunct professor of finance at the University of Chicago's Graduate School of Business.

"Some of that may be inappropriate in the sense that finite has a lot of constructive, legitimate uses, and for companies not to use it when they should, just because of some media and regulatory scrutiny, is not fair to their own shareholders," says Culp, who is also the author of a forthcoming book on structured finance and insurance and is the author of The ART of Risk Management.

Defined very crudely, a finite risk product is insurance in which the insurance company's downside is limited and the insured party participates in its own positive claims experience, Culp says. To achieve both ends, the total premium in a finite program is typically a significant proportion of the maximum possible claim.

Finite risk covers were developed in response to a need, says Andrew Barile, an insurance and reinsurance consultant with more than 40 years experience in the insurance industry and president of Andrew Barile Consulting Corp. Inc. in Rancho Santa Fe, Calif.

"The key here is, when we invented all this stuff, we were doing it on the basis of providing real insurance solutions to these particular corporate problems," he says.

The traditional insurance marketplace often is unable to provide coverage for certain kinds of unusual risks, such as terrorism. Finite risk covers can help when the traditional marketplace can't, Barile says.

Another advantage to using a finite risk cover, says Culp, is that a company earmarks money to pay off future liabilities and that keeps it from using the money for other purposes.

"Their alternative is to just have that money sloshing around on their balance sheet, which in some cases they may not be able to recognize as a reserve from an accounting standpoint," he says.

"Investors don't treat that sort of thing very credibly--it's a cookie jar," Culp adds. "It's much more credible to give it to a triple-A insurance company and say: 'Don't you dare give it back until I have to pay down this loss.'

"So in that sense, they're actually useful for enhancing the quality of earnings and credibly taking a reserve against an exotic risk," Culp says. "Environmental, asbestos, silicosis--all those sorts of risks--are what finite was made for dealing with."

THE PROBLEM

Problems arise, however, when finite risk reinsurance covers are not disclosed properly to regulators and investors, and when they are used so that a company can smooth its earnings without really transferring any risk.

The controversy comes down to the question of risk transfer. To discount their loss reserves, and therefore increase surplus and boost the bottom line, finite covers must transfer risk. If no risk is transferred the transaction must be accounted for as a loan, which is balance-sheet neutral.

"We find the abuses on these finite deals is that they are transferring a very small amount of risk and most of the deal is just to do this discount," says Joseph Fritsch, director of insurance accounting policy at the New York Insurance Department and the chairman of the National Association of Insurance Commissioners' property casualty reinsurance study group and the statutory accounting principles working group.

Although finite risk covers do help to manage earnings, that's not the issue. "There's nothing wrong with smoothing earnings," Fritsch says. "It's just if your intent is never to transfer risk, then there shouldn't be the smoothing of earnings because you're just going to get it back no matter what."

Indeed, to hide the fact that little or no risk was being transferred, some companies failed to disclose the real terms of the finite risk transaction. Instead, they disclosed one set of terms to regulators to gain the favorable accounting treatment, but kept secret "side agreements" that changed the terms of the deal so that no risk was really transferred.