One of the particular difficulties of running an insurance company is that its financial results - and hence its profitability - tend to be uneven from one year to the next. Since insurance companies want, above all else, to produce consistent results, they are always attracted to ways of hoarding this year's profit to pay for next year's possible losses. Financial reinsurance is one means by which insurance companies can smooth their results.
A pure fin re contract tends to cover a multi-year period, during which the premium is held and invested by the reinsurer. It is returned to the ceding company - minus a pre-determined profit-margin for the reinsurer - either when the period has elapsed, or when the ceding company suffers a loss.
Fin re therefore differs from conventional reinsurance because most of the premium is returned whether there is a loss or not: little or no risk-transfer has taken place.
History
Fin re has been around since at least the 1960s, when Lloyds syndicates started sending money overseas as reinsurance premium for what were then called roll-overs - multi-year contracts with specially-established vehicles in tax-light jurisdictions such as the Cayman Islands. These deals were legal and approved by the UK tax-authorities. However they fell into disrepute after some years, partly because their tax-avoiding motivation became obvious, and partly because of a few cases where the overseas funds were siphoned-off or simply stolen.
More recently, the high-profile bankruptcy of the HIH group of insurance companies in Australia revealed that highly questionable transactions had been propping-up the balance-sheet for some years prior to failure. To be clear, although fin re contracts were involved, it was the fraudulent accounting for those contracts - and not the actual use of fin re - which was the problem. As of June 2006, General Re and others are being sued by the HIH liquidator in connection with the fraudulent practices.
The regulator's perspective
When looking at the financial position of a Life insurer, the company's assets and liabilities are measured. The difference is called the 'free assets' of the company. The greater the free assets relative to the liabilities, the more 'solvent' the company is deemed to be.
There are different ways of measuring assets and liabilities - it depends on who is looking. The regulator, who is interested in ensuring that insurance companies remain solvent so that they can meet their liabilities to policyholders, tends to under-estimate assets and over-estimate liabilities.
In taking this conservative perspective, one of the steps taken is to effectively ignore future profits. On the one hand this makes sense - it's not prudent to anticipate future profits. On the other hand, for an entire portfolio of policies, although some may lapse - statistically we can rely on a number to still be around to contribute to the company's future profits.
Future profits can thus be seen to be an inadmissible asset - an asset which may not (from the regulator's point of view, anyway) be taken into account.
A banker's perspective
If a bank were to give the insurer a loan, the insurer's assets would increase by the amount of the loan, but their liabilities would increase by the same amount too - because they owe that money back to the bank.
With both assets and liabilities increasing by the same amount, the free assets remain unchanged. This is generally a sensible thing, but it's not what financial reinsurance is aiming for.
The reinsurer's perspective
In setting up a financial reinsurance treaty, the reinsurer will provide capital (there are a number of ways of doing this, discussed below). In return, the insurer will pay the capital back over time. The key here is to ensure that repayments only come out of surplus emerging from the reinsured block of business. The benefit of this surplus-limitation comes from the fact that in the regulatory accounts there is no value ascribed to future profits - which means the liability to repay the reinsurer is made from a series of payments which are deemed to be zero.
The impact is that there is an increase in assets (from the financing), but no increase in liabilities. In other words, financial reinsurance increases the company's free assets.
Different accounting regimes
It's important to be clear that financial reinsurance has an impact on the regulatory balance sheet only - which itself already provides a distorted view of a company's solvency. Financial reinsurance, certainly for life insurers, has no impact on their GAAP accounts. It does not disort a company's shareholder-reported profits.
A lot of the bad press around financial reinsurance is because of inappropriate designs and incorrect accounting for the transaction. It is not a problem of financial reinsurance itself.
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