S&P Report Explains Financial-Engineering Probe

November 17, 2004

Standard & Poor’s has issued a bulletin “in response to media reports that the New York Attorney General, the SEC, and other authorities are initiating new investigations of insurance companies in connection with the alleged abuse of financial engineering products.”

S&P said the report “seeks to clarify unfolding developments and discuss how these issues are incorporated into its rating process of insurance companies and insurance brokers. The report, entitled, ‘Credit FAQ: Financial Engineering Explained,’ treats the new investigations as separate from earlier investigations of insurance companies for alleged bid rigging, and it does not question the legality of financial engineering.”

Details in the report list “four instances in which Standard & Poor’s has identified specific financial reinsurance transactions.” It defines financial engineering products as including financial-risk reinsurance or finite-risk reinsurance, and notes that they “have been marketed as insurance products by many reinsurance companies over the decades.”

In explaining how the products work, S&P noted: “Buyers sometimes use these instruments for the management of reported financial results. This form of coverage combines the transfer of a finite limit of risk with a profit-sharing relationship between the reinsurer and the client. The issue is that some clients are suspected of using this type of insurance to transfer losses off their balance sheet or increase their capital on an accounting basis under GAAP or under statutory accounting while the economics of these transactions would indicate that appropriate risk transfer and loss absorption have not taken place.”

“If financial-engineering products are used to smooth earnings or otherwise distort the appearance of the financial results of an insurance company or other corporation, these transactions could be considered cause for civil or criminal actions,” stated S&P credit analyst Thomas S. Upton. “Those insurance and reinsurance companies that have sold these products—as well as those organizations that brokered such products—are likely to come under investigation.”

Although S&P did site four specific financial reinsurance transactions, it said that, “a comprehensive list of all buyers and sellers of such insurance products would not be possible.” This is “an indication of the pervasiveness of these products, they are sold by a wide range of financial institutions in addition to reinsurance companies.”

The bulletin also noted that the buyers include insurance companies, other types of financial institutions, and even nonfinancial service providers and that they are frequently difficult to detect. “Without clear standards for reporting such transactions, the degree of disclosure varies widely from one company to another,” Upton observed.

The report is available on RatingsDirect, Standard & Poor’s Web-based credit research and analysis system. If you are not a RatingsDirect subscriber, you may purchase a copy of the report by calling (1) 212-438-9823 or send an e-mail to: research_request@standardandpoors.com.

Was this article valuable?

Here are more articles you may enjoy.