Finite reinsurance has become the target of widespread media criticism lately while investigations of questionable practices spread across the insurance industry. As CEO of a brokerage firm that played an active role in developing regulatory standards for determining the legality of finite reinsurance, I'm deeply troubled by abuses of this legitimate, useful mechanism. Finite reinsurance was not created to allow insurance companies to mislead shareholders by disguising loans as reinsurance. Unfortunately, some in our industry have been guilty of this practice. Misuse of finite reinsurance to cook the books must be stopped. At the same time, we must not allow rightful concern over abuses to destroy a legal device that is vital to a healthy reinsurance industry in the present era of escalating catastrophes.
The capital base of the global reinsurance industry in 2004 was some $338 billion. This represented less than half of the estimated $700 billion in capital supporting the global property/casualty insurance industry. Unlike banks, insurers and reinsurers have no collateral to support the risks they take. These companies depend entirely on their "surplus," or net worth, plus reserves to pay claims, expenses, and dividends to shareholders.
Reinsurance companies protect insurance companies from unpredictable losses that could bankrupt companies, leaving policyholders bare. Who could have predicted that four major hurricanes would sweep across Florida last year? No underwriter or actuary contemplated the hijacking of airliners to fly into the World Trade towers causing nearly 3,000 deaths and some $32 billion of insured losses. Dynamic development in the southeast and coastal Florida rocketed hurricane insurance losses from Hugo at $4.2 billion in 1987 to Andrew at $ 15.5 billion in 1992, to last year's estimated $ 23 billion from Charley, Frances, Ivan, and Jeanne.
Principles of "Payback" Because catastrophe reinsurance typically covers losses above the average, the reinsurance industry bore the brunt of these disasters. In the old days, the principle of "payback" enabled reinsurers to take extraordinary risks knowing that through increased premiums in future years they could recover losses over a period of time. Recognition of the principle of "payback" enabled reinsurers to provide continuing coverage without interruption in good years and bad.
Then in the '80s, traditional understandings, or "gentlemen's agreements" between insurance companies and their reinsurers with regard to continuity of coverage began to break down. The industry was hit by more frequent and severe catastrophes along with unanticipated liabilities such as asbestos and environmental pollution. Reinsurers no longer could rely on long-standing relationships to protect them from the threat of insolvency resulting from a major catastrophic event. As a result, traditional reinsurers began to restrict terms and conditions of coverage severely and to withdraw from underwriting certain risks.
It was in this difficult environment that the concept of finite risk reinsurance was developed and refined. Finite risk policies can be written for a multi-year term, typically three/five years, which could permit recoupment of some of the losses sustained by the reinsurer. The critical element of legitimate, finite risk reinsurance is risk transfer and the degree to which the reinsurer is at risk throughout the term of the contract. The reinsurance company must take reasonable risk or else the policy cannot qualify as reinsurance. Properly employed, finite risk protection is a win/win transaction for insurer and reinsurer. The insurance company is guaranteed continuity of coverage. The reinsurance company hopes to recoup the losses taking place in a single year while at the same time assuming quantifiable risk over the full term of the contract. If it is legitimate finite risk, the reinsurer can still lose real money over the entire term of the contract.
Risk Transfer Standards
I was privileged to represent the reinsurance industry in 1993 before the Financial Accounting Standards Board and the Securities Exchange Commission in connection with their review of finite reinsurance. After careful study, FASB accounting rules and risk transfer standards for finite mechanisms were established, and companies like ourselves developed Dynamic Financial Analysis (DFA) to quantify risk transfer and adherence to accrual accounting criteria. Today, we combine DFA with the most sophisticated modeling software to estimate probable maximum losses for clients and to measure the cost effectiveness of alternative reinsurance mechanisms including finite reinsurance.
In order to assure our clients that finite risk protections proposed by U.S. RE met all regulatory requirements for risk transfer, we submitted one of our finite protections to the New York Insurance Department in 1994. The Department approved and actually signed off on the terms of coverage for a particular client.
Without finite risk policies, some reinsurers would be unable to take on the catastrophic risks. Insurance consumers would suffer. This could well create a ripple effect that would have serious consequences for the economy. That's why we encourage industry critics to understand the importance of finite reinsurance while they rightfully demand that abuses be wiped out.
Tal P. Piccione
Chairman and Chief Executive OfficerFinite reinsurance has become the target of widespread media criticism lately while investigations of questionable practices spread across the insurance industry. As CEO of a brokerage firm that played an active role in developing regulatory standards for determining the legality of finite reinsurance, I'm deeply troubled by abuses of this legitimate, useful mechanism. Finite reinsurance was not created to allow insurance companies to mislead shareholders by disguising loans as reinsurance. Unfortunately, some in our industry have been guilty of this practice. Misuse of finite reinsurance to cook the books must be stopped. At the same time, we must not allow rightful concern over abuses to destroy a legal device that is vital to a healthy reinsurance industry in the present era of escalating catastrophes.
The capital base of the global reinsurance industry in 2004 was some $338 billion. This represented less than half of the estimated $700 billion in capital supporting the global property/casualty insurance industry. Unlike banks, insurers and reinsurers have no collateral to support the risks they take. These companies depend entirely on their "surplus," or net worth, plus reserves to pay claims, expenses, and dividends to shareholders.
Reinsurance companies protect insurance companies from unpredictable losses that could bankrupt companies, leaving policyholders bare. Who could have predicted that four major hurricanes would sweep across Florida last year? No underwriter or actuary contemplated the hijacking of airliners to fly into the World Trade towers causing nearly 3,000 deaths and some $32 billion of insured losses. Dynamic development in the southeast and coastal Florida rocketed hurricane insurance losses from Hugo at $4.2 billion in 1987 to Andrew at $ 15.5 billion in 1992, to last year's estimated $ 23 billion from Charley, Frances, Ivan, and Jeanne.
Principles of "Payback" Because catastrophe reinsurance typically covers losses above the average, the reinsurance industry bore the brunt of these disasters. In the old days, the principle of "payback" enabled reinsurers to take extraordinary risks knowing that through increased premiums in future years they could recover losses over a period of time. Recognition of the principle of "payback" enabled reinsurers to provide continuing coverage without interruption in good years and bad.
Then in the '80s, traditional understandings, or "gentlemen's agreements" between insurance companies and their reinsurers with regard to continuity of coverage began to break down. The industry was hit by more frequent and severe catastrophes along with unanticipated liabilities such as asbestos and environmental pollution. Reinsurers no longer could rely on long-standing relationships to protect them from the threat of insolvency resulting from a major catastrophic event. As a result, traditional reinsurers began to restrict terms and conditions of coverage severely and to withdraw from underwriting certain risks.
It was in this difficult environment that the concept of finite risk reinsurance was developed and refined. Finite risk policies can be written for a multi-year term, typically three/five years, which could permit recoupment of some of the losses sustained by the reinsurer. The critical element of legitimate, finite risk reinsurance is risk transfer and the degree to which the reinsurer is at risk throughout the term of the contract. The reinsurance company must take reasonable risk or else the policy cannot qualify as reinsurance. Properly employed, finite risk protection is a win/win transaction for insurer and reinsurer. The insurance company is guaranteed continuity of coverage. The reinsurance company hopes to recoup the losses taking place in a single year while at the same time assuming quantifiable risk over the full term of the contract. If it is legitimate finite risk, the reinsurer can still lose real money over the entire term of the contract.
Risk Transfer Standards
I was privileged to represent the reinsurance industry in 1993 before the Financial Accounting Standards Board and the Securities Exchange Commission in connection with their review of finite reinsurance. After careful study, FASB accounting rules and risk transfer standards for finite mechanisms were established, and companies like ourselves developed Dynamic Financial Analysis (DFA) to quantify risk transfer and adherence to accrual accounting criteria. Today, we combine DFA with the most sophisticated modeling software to estimate probable maximum losses for clients and to measure the cost effectiveness of alternative reinsurance mechanisms including finite reinsurance.
In order to assure our clients that finite risk protections proposed by U.S. RE met all regulatory requirements for risk transfer, we submitted one of our finite protections to the New York Insurance Department in 1994. The Department approved and actually signed off on the terms of coverage for a particular client.
Without finite risk policies, some reinsurers would be unable to take on the catastrophic risks. Insurance consumers would suffer. This could well create a ripple effect that would have serious consequences for the economy. That's why we encourage industry critics to understand the importance of finite reinsurance while they rightfully demand that abuses be wiped out.
Tal P. Piccione
Chairman and Chief Executive Officer
U.S. REviews Summer 2005 Chairman's Corner
