Institutional Insurance Market Is Changing.... BIG TIME!!!
The market for institutional insurance and reinsurance is undergoing traumatic changes partly as a result of the on-going SEC and NY State Attorney General probes regarding finite reinsurance. The accounting for (re)insurnace contracts never quite really fit into the FASB and Generally Accepted Accounting Principles ("GAAP") framework. As a result, the accounting profession and financial executives of insurance/reinsurance companies adopted a set of guidelines that never were quite codified.
For instance, in the FASB world, believe it or not, there is no definition of what is an insurance contract. Therefore, the practioners have adopted the practice that an agreement is a contract of insurance if there is at least a chance of a 10% loss occurring 10% of the time. How those two numbers are calculated is the proverbial "devil is in the details." A slight shading of an assumption (or model input) can often dramtically change the resulting loss distribution and/or frequency of occurance. Hence, two different insurers looking at exactly the same insurance event can come up with dramtically different terms, captial requirements, insurance premiums, and so forth.
The insurance and reinsurance industry also has been a proverbial back water in the world of financial services. As a result, the changes that the securites markets have undergone in the last two decades are only just beginning to be implemented in the property/casualty world. This includes the old tradition of agreeing to a contract of insurance and then having up to nine months to get all of the insurance underwriters to agree to policy terms and to draft a final insurance document. Contrast that with the security and derivative markets where substantially all terms are written out in draft form before price is finally set and then the final documents signed.
The finite reinsurance contract was used as a way of smoothing out unexpected loss results. However, to get those contracts to conform to accounting standards, such contracts often included either oral or written side agreements between the two parties promising to make the other whole at some point in the future. That practice is now ceasing with the rule changes announced last week by the NY State Insurnace Department. The net result of this change is that insurance financial results are going to be reported as being much more volatile than has been reported in the past.
The NY Insurance Department changes are described in this March 30th article from the Insurance Journal. The article reads as follows:
N.Y. Toughens Reporting on Finite Reinsurance
March 30, 2005
The New York State Insurance Department has decided it will require insurers' chief executive officers to verify that any finite reinsurance contracts their companies have are correctly reported.
The CEOs will be required to sign off under oath that all reinsurance contracts they enter into contain documentation on their economic intent and a risk transfer analysis. They will also have to include a statement indicating that neither written nor oral agreements are in effect that would potentially alter a reinsurance contract's terms.
Officials hope this will assist in verifying that insurers with finite reinsurance contracts are utilizing the correct accounting treatment. Some insurers including American International Group have come under scrutiny for alleged improper use of finite reinsurance to manipulate financial reporting results. New York officials said that while there are legitimate uses of finite reinsurance, these transactions "can distort the underwriting and surplus positions of insurers entering into them when there is no actual transfer of risk or the transaction is accounted for improperly."
As a financing arrangement, insurers often use finite reinsurance to protect themselves from interest rate risk and timing risk. Insurers' concern about interest rate risk involves potential losses they could realize because of interest rate fluctuations. Concerning timing risk, insurers want to hedge against variations in the timing of their future loss payments. If finite reinsurance is accounted for as a traditional reinsurance product, however, the capital and income of the companies involved can be manipulated.
"Policyholders, investors, and regulators need assurances that insurers' finite reinsurance contracts are completely transparent," Acting Superintendent Howard Mills stated upon issuing the Circular letter No. 8 (2005) with the new reporting requirements. "The Circular Letter we've issued today is a tough, necessary step that will help to restore confidence to the regulatory process. The insurance department is confident that the letter's requirements will also prevent insurers from using finite reinsurance contracts as a way of hiding their company's true financial condition."
The text of the Circular Letter No. 8 (2005) reads as follows:
The Department is concerned about the improper use of finite reinsurance to manipulate financial reporting results. While the Department recognizes there are legitimate uses of finite reinsurance (such as the transfer of interest rate risk and of timing risk), these transactions can distort the underwriting and surplus positions of insurers entering into them when there is no actual transfer of risk or the transaction is accounted for improperly.
Therefore the Department will now require as part of its examinations of insurers, the Chief Executive Officer to attest, under penalty of perjury, that with respect to cessions under any reinsurance contract, that:
(I) there are no separate written or oral agreements that would under any circumstances, reduce, limit, mitigate or otherwise affect any actual or potential loss to the parties under the reinsurance contract; and
(II) for each such reinsurance contract, the reporting entity has an underwriting file documenting the economic intent of the transaction and the risk transfer analysis evidencing the proper accounting treatment, which is available for review.
In addition, the Department will require increased disclosure of finite risk transactions in the annual statement, including the attestation described above.