An Issue of Use or Abuse? Adjusting for Financial and Finite Reinsurance

1. An Issue of Use or Abuse? Adjusting for Financial and Finite Reinsurance Steven Ader, Director

2. Finite Reinsurance Origin and Spectrum of Usage • At its inception in the 1980s, finite reinsurance products were traditional insurance products modified to reduced the cost to the ceding company through profit sharing features in exchange for limiting the potential liability of the reinsurer. • Often called financial reinsurance or financial engineering, finite reinsurance evolved, in the most extreme cases, as a financial engineering mechanism to improve or stabilize an insurer’s income statement or balance sheet where the accounting does not reflect economic reality. • Finite reinsurance contracts, when abused, act as a low-cost loan flying below regulatory radar, although authorities are actively investigating companies that use finite reinsurance as an accounting mechanism to mask economic reality.

3. Seeing Through The Smoke and Mirrors:Reflecting Economic Reality • In extreme cases, finite reinsurance increases earnings and capital even though the transaction economics indicate otherwise • S&P will adjust its view of an insurer when finite reinsurance is used to bolster earnings and capital when the economics of these transactions indicate that appropriate risk transfer and loss absorption has not taken place • Some transactions lessen the impact of losses in current years while in subsequent years, full or substantially full reimbursement will be made through increased premium levels, additional commissions, and/or higher interest rate levels for funds withheld • S&P will adjust its view of an insurer's earnings and capital to reflect economic reality

4. Broadening Our Effort to Identify Difficult to Detect Transactions • Standard & Poor's has always looked for finite reinsurance, but now we have established codified procedures by which we do so • S&P has in the past and will continue to adjust its view of an insurer when finite reinsurance is used to bolster earnings and capital when the economics indicate that risk transfer and loss absorption have not taken place • S&P has identified and disclosed in our releases the impact of finite reinsurance transactions for which the accounting is not rooted in economic reality In these instances, S&P will adjust its view of an insurer's earnings and capital to reflect economic reality

5. Legitimate Uses of Finite Reinsurance • These contracts act as a mechanism for the primary, or ceding insurer, to protect against volatility while retaining greater risk and alternatively paying a lower premium to the reinsurer • Quite commonly, these are contracts that legitimately protect the ceding insurance company by reducing its volatility of earnings or volatility of capital through a contract where the reinsurer accepts valid risk transfer When we see these types of contracts we do not make any adjustments in our analysis if the accounting for the transaction matches up to the true economic transfer of risk

6. Attributes of Finite Re Contracts • The external reinsurance agreement is retroactive. • The external reinsurance agreement receives different accounting treatment under different methods of accounting (Statutory, GAAP, Internal accounting, etc.) • The external reinsurance agreement has or is being questioned by auditors and/or regulatory bodies regarding the classification (prospective or retrospective) or accounting treatment. • The company views the external reinsurance agreement as one made for financial engineering purposes (i.e. the delaying the recognition of losses or smoothing of them over a period of time) • The reinsurance agreement is supplemented by a side letter or verbal agreement that alters the carrier’s risk exposure

7. Attributes of Finite Re Contracts • The company believes it is probable (>50%) that the external reinsurance agreement will be commuted. • External reinsurance agreement makes material use of deficit accounts or experience refund accounts • External reinsurance agreement accompanies by retrocession of portion of risk to original cedent or affiliate • The external reinsurance agreement remains in effect for more than 1 year We are requesting that insurers forward copies of the contracts containing these attributes with the accounting entries. In addition, we are requesting the same for the top 5 contracts underlying the funds held balances

8. Appendix

9. Tools used in Structuring a Finite Transaction • Commutation Clause Affording the Ceding Carrier the option of canceling the contract and receiving a substantially full refund of premium. • Clause results in a material capping of reinsurer’s profit potential. Raises a question when the accounting benefit materially exceeds reinsurer’s maximum profit • Present value approach is used in determining the economic triggering point of the commutation provision which is then compared to actual contract developments. • If actual circumstances indicate that the contract would likely be commuted, no economic benefit is derived from the contract. Therefore any accounting benefit is eliminated from our analysis of earnings and/or capitalization and depending on materiality, reflected in our ratings. • If actual circumstances would not lead to a commutation, then the economic benefit of the transaction of the transaction, in present value dollars, is compared to the accounting of the contract. • Profit sharing clause is also used to cap reinsurer’s profit potential. Same questionapplies when accounting benefit materially exceeds reinsurer’s profit potential.

10. Tools used in Structuring a Finite Transaction • Interplay of finite quota share clauses materially limit economic outcomes while realizing the accounting benefit conferred by quota share accounting treatment. • 1- Sublimits on exposures for certain classes of business, limiting reinsurer loss • 2- Aggregate loss ratio caps, limiting reinsurer loss • 3- Deductibles requiring the ceding company to pay a certain level of first losses incurred on the business subject to the quota share agreement, limiting reinsurer loss • 4- Loss corridors reducing the assuming company’s risk exposure for a range of specific loss ratios, limiting reinsurer loss • 5- Experience account, commutation, or profit sharing clauses, limiting reinsurer profit • Standard and Poor’s evaluates the economic behavior of these contracts by applying the historical performance of the book of business to the contract terms.

11. An Issue of Use or Abuse? Adjusting for Financial and Finite Reinsurance Steven Ader, Director