The U.S. Justice Department, New York Attorney General Eliot Spitzer and the Securities Exchange Commission all have launched investigations to determine if companies have used finite reinsurance to manipulate their financial statements.These regulatory authorities claim insurers have used finite reinsurance agreements as a way to smooth earnings reports, thereby deceiving investors and regulators.

Dozens of insurers have been brought into the investigations, including companies such as AIG, XL Capital, RenaissanceRE Holdings, Assurant Inc., Partner RE Ltd., Bristol West and General Electric Co.

Part of the problem with finite reinsurance and its accompanying accounting methods is that it has always been somewhat controversial, according to Andrew Barile, president of Andrew Barile Consulting Corp., Rancho Santa Fe, Calif.

Although there is no clear definition of finite reinsurance, it is generally a blend of traditional reinsurance and financing. The agreements limit the risk assumed by the reinsurer.

The U.S. Accounting Standards Board stipulates, however, that for such a contract to classify as finite reinsurance, the reinsurer has to assume significant insurance risk and there has to be a reasonable possibility that the reinsurer may realize a significant loss from the deal.

Therein lies the rub. The fact that there is no commonly accepted definition of "significant risk" makes navigating the regulatory waters particularly challenging, Barile says.

"The regulators have not defined what significant risk means," he says. "Plus, the regulators are making statements that insurance companies are doing these things to smooth their earnings. But 10 years ago, the reason these finite insurance products came out were to smooth the earnings of a company. That's what finite reinsurance products were designed for."

Due to much confusion in the industry, the National Association of Insurance Commissioners (NAIC), Kansas City, Mo., is attempting to provide guidance. In response to the investigations, an NAIC study group approved enhanced disclosure requirements for insurers that use finite reinsurance. The proposed disclosures would require an insurer to report to state insurance regulators any finite reinsurance agreement that has the effect of alternating policyholders' surplus by more than 3% or that represents more than 3% of ceded premium or losses. In addition, reporting requirements regarding contract terms and management's intention in entering a contract have been added to improve transparency.

Despite guidance from the NAIC, the negative attention on finite reinsurance has already had an impact on the industry. For instance, reinsurance premiums at Hanover Re, one of the world's largest reinsurers, slumped 51% between March and June of this year.

Fallout from the regulatory mayhem, however, could become much worse, according to consultant Barile. With regulators clamping down on the finite reinsurance business, costs could be passed on to corporations and individuals instead, he predicts.

"As loss ratios get higher, the finite reinsurance kicks in and the finite reinsurance company takes the loss on its book. As a result, the primary insurer does not have to take corrective action right away," he says.

But if finite reinsurance is not an option, the primary insurer will have to pass the costs on to corporations and individuals, he predicts.

"It's a simple equation. If losses are greater than premiums, the insurance company has to lay it off on someone. If it can't lay it off to the finite reinsurer, then the only choice is to pass the cost off onto consumers via higher rates," Barile says.

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