Best: No Ratings Changes from Finite Reinsurance Probe

November 19, 2004

A.M. Best Co. has released a statement indicating that it “does not anticipate the re-evaluation of ratings as a result of the increased scrutiny of finite reinsurance transactions by regulators and other interested parties in the insurance industry.”

Best explained: “Finite reinsurance is a broad term used to describe reinsurance transactions that include limited risk transfer. It can refer to a standard quota share reinsurance contract in which a percentage of premium and losses are transferred to a reinsurer, with the loss being transferred limited to a specified level.

“Finite reinsurance can also refer to financial reinsurance, or the transfer of a known loss, with the only uncertainty being the timing of the loss payment and the amount of future investment income that can be earned on the related assets. The key point is that the risk transfer is ‘finite'”.

The rating agency noted that the insurance industry has long used these types of contracts in varying forms in the management of balance sheet risk, earnings and leverage. “On an accounting basis, these transactions are evaluated within the insurer’s audit process to determine if they reach a required level of risk transfer from the ceding company to the reinsurance company. Depending on the view of risk transfer, the contracts are accounted for differently,” Best said.

Best also noted that its “analysis of finite reinsurance transactions incorporates an assessment of risk transfer and a view of economic capital based on consistent accounting treatment, the coverage restrictions and A.M. Best’s expectations of profitability.”

The rating agency did indicate that it intends to make changes in how such contracts are treated. “For those contracts that are in place primarily to recognize future investment income,” Best said it would “remove the assumed benefit and view capitalization based on a consistent discount rate and loss payout pattern in the same manner that statutory discount is treated.”

It noted that “this assessment of risk transfer is similar to other opinions A.M. Best’s analysts must make on loss reserve adequacy, the recoverability of deferred acquisition costs and the economic value of various assets.The assessment of all of these issues is aggregated within A.M. Best’s overall view of capitalization, which is combined with our expectations of future earnings and review of the insurer’s business profile to determine the final rating. The expectation of future earnings is based on the profitability of business written after eliminating the impact of finite reinsurance.”

Moreover, the bulletin stressed, “the key issue in the use and evaluation of finite reinsurance is disclosure.” Best said that through its “Supplemental Rating Questionnaire and meetings with insurance company management,” it does request information relating to finite reinsurance contracts being used by rated companies. “In those cases where the information is disclosed, A.M. Best considers these transactions in our rating analysis,” it added, but Best also stressed that it “does not audit an insurer’s financial records or statements.”

Topics Profit Loss Reinsurance AM Best

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