Finite-risk reinsurance is a form of reinsurance that explicitly considers the time value of money, in addition to the expected amount of loss payments in nominal dollars.

The insurance risk assumed by a finite-risk reinsurer is contractually limited so that the reinsurer's range of possible losses is relatively narrow. Typically, purchasers of finite-risk reinsurance are driven less by risk transfer and more by risk-financing objectives (although finite-risk transactions contain elements of both) as a means to improve current period earnings, smooth earnings, effectively discount reserves and/or enhance capital.

Determining whether an arrangement is finite-risk reinsurance or traditional reinsurance can be difficult, as there are many components of the arrangement to consider. There are no bright lines in making the determination as to whether the transferred risk of loss is undoubtedly certain or not.

To further complicate the issue, it is often not the mere presence, or absence, of the components that is the prime determinant, but the relative presence, or absence.

In practice, there are several rules of thumb as to what constitutes significant insurance risk.

For a long time, the “10/10 rule” was considered sufficient, meaning there is at least 10 percent probability of at least a 10 percent loss. In other instances, it has been argued that the standard is 15/15.

As a practical matter, the standard is ultimately what the cedant's auditors and regulators allow, which can vary from jurisdiction to jurisdiction and even from company to company.

Thus, it can be very difficult to standardize a rules-based approach for a process that will always involve some level of subjective judgment.

As such, any change to the accounting for finite contracts–however well meaning–will likely not catch flawed analyses of the “significant risk transfer” required under FASB Statement No. 113 if company management uses grossly conservative assumptions designed specifically to mislead auditors or others in order to obtain reinsurance accounting treatment.

While the current principles-based accounting guidance (FAS 113, SSAP 62) is generally reasonable in determining if risk transfer has taken place, one of the problems is that the test for risk transfer is binary.

If a company meets the test, it accounts for 100 percent of the contract as reinsurance. Likewise, if it does not meet the test, then the entire contract is accounted for as a deposit.

In theory, it may be preferable to bifurcate the accounting for insurance contracts, so that if there is 10 percent risk transfer, then 10 percent of the contract is accounted for as reinsurance and the remaining 90 percent receives deposit (investment) accounting treatment.

However, as a practical matter, it can be very difficult to implement consistently across companies that have finite contracts covering losses emanating from multiple accident years and multiple lines of business in such a way that will increase financial statement reliability, comparability and overall usefulness.

As such, it would be more appropriate that in cases where reinsurance accounting treatment is granted, yet there is not 100 percent risk transfer, the company should be required to disclose standardized, key account metrics that provide more detailed information to users that allows for a better understanding of the contracts in place.

Such an expansion of disclosures would help to improve the transparency and understandability of financial statements without adding an unnecessary burden to the company. For example, the National Association of Insurance Commissioners issued new reporting requirements for additional reinsurance disclosure that was effective for year-end 2005. (See sidebar.)

The use of finite-risk reinsurance, even when adhering to both the letter of the law and accounting guidance, can be misleading and distort financial statements.

A company should be analyzed based on its real economic position, regardless of the accounting used. So to the extent that the financial statements and related disclosures allow users to better understand a company's true financial position, they are more reliable and useful.

Favorably, the scrutiny that the industry experienced from prosecutors and regulators over the last several years has reduced demand for such finite-risk products and has resulted in many companies commuting their finite-risk contracts as more of the marketplace and regulators started to systematically “back out” the financial statement benefit of the arrangements, reducing the incentive to maintain such contracts.

As the heat begins to subside somewhat on finite-risk issues, we will have to wait and see to what extent FASB decides to proceed with this proposal and the broader risk-transfer project, particularly in light of the almost universal opposition to the bifurcation proposal from all interested parties.