In the wake of investigations of insurance industry practices, regulators, rating agencies and even some industry executives have started questioning the use of finite risk products, esoteric reinsurance transactions used to help finance hard-to-place risks and protect reinsurers from endless losses.

And as probes by New York Attorney General Eliot Spitzer and others continue, some are starting to wonder whether other types of nontraditional risk financing products-such as captives, loss-portfolio transfers and some self-insurance programs-will also become suspect.

In the meantime, virtually everyone connected to the industry is bracing for the impact of this scrutiny on the insurance market overall.

It's a lack of understanding on the part of outsiders that is causing those inside the industry to question themselves, suggested Andrew Barile of Andrew Barile Consulting Corp. Inc. in Rancho Santa Fe, Calif. "We all bought loss-portfolio transfer agreements, and they were put to bed," Mr. Barile said. "But now, I guess what's happened is, Mr. Spitzer has shocked enough people, and when he actually has the proof of the bid rigging, the industry is getting confused and mixing up all kinds of negative things, and so, consequently, everybody's in an uproar looking at everything again."

Bermuda-based Platinum Underwriters Holdings Ltd. announced earlier this month it was canceling a finite risk reinsurance contract out of concern that it might be perceived as improper.

Since then, Platinum, Bermuda-based ACE Ltd. and Swiss Reinsurance Co. all have received subpoenas from the U.S. Securities and Exchange Commission for documents relating to "certain nontraditional, or loss mitigation, insurance products." Platinum said it expects to receive a similar request from Mr. Spitzer's office. ACE and Swiss Re already have. All three said they are cooperating with the investigations. New York-based American International Group Inc. recently said it is in settlement talks to resolve a federal grand jury's investigation into a retroactive coverage transaction involving cell phone distributor Brightpoint Inc. of Plainfield, Ind.

"Maybe the bar hasn't changed, but the perception is that the bar could change," said Steven Bolland, president of New York-based reinsurance intermediary Gill & Roeser.

"All of these transactions go for a significant number of years. If the bar changes and if you have to unwind them, then suddenly it gets significant. If you're worried about it, maybe terminate and redo," Mr. Bolland said. But "if you've done things properly, there shouldn't be any issue," he said. "Most responsible reinsurers don't want to have their contracts unwound, so they wouldn't sell a product that would come under scrutiny."

The rating agencies, though, say they've always been skeptical of finite risk and have stepped up their scrutiny of such deals since the collapses of Australia's HIH Insurance Ltd., Long Grove, Ill.-based Kemper Insurance Cos. and other insurers.

Fitch Ratings "has been very vocal in the past about our reservations with finite risk reinsurance. Our analytical practice has generally been to reverse the impact of these arrangements when conducting our reviews of the buys of these products," said Michael Barry, an analyst in Fitch's North American Insurance Group who hosted a Nov. 17 teleconference addressing the issue.

In an Oct. 29 report, Fitch predicted finite risk reinsurance could be the next target in the widening investigations.

An end to finite deals?

Fitch warns of three possible outcomes: investigators may find illegal activities to which they would react, there may be a more stringent application of accounting guidance or even rule changes or the investigations may taint the product line and make it less attractive in the future.

It is this last scenario that has put many people connected to the insurance industry on guard.

"It is a very valid, useful form of coverage, and it would be a terrible shame if people's perception is that it's somehow crooked. There have obviously been some deals that haven't met the standards. But as long as the standards (are met) and everybody understands that, it's a terrific tool available to the market," said Mr. Bolland.

"I'm not saying all finite reinsurance goes away," said Steve Dreyer, a managing partner at Standard & Poor's Corp. in New York. "But there is going to be some carve-out of these activities that's going to be deemed to be improper, and I'm sure eventually the industry will adapt or maybe the capital markets or somebody will develop something to take its place. Maybe the banks will come in. But for at least some period of time, I would expect more volatility."

Complexity complications

A major contributor to the problem is the esoteric nature of finite risk contracts, industry experts say.

The first finite risk contracts were fairly cut and dried, used primarily by reinsurers to cap their exposure to long-tail liabilities, hence the term "finite," explained Mr. Barile.

Over time, though, they evolved and are now used to extend the reporting of losses over longer periods, as with spread loss contracts; to transfer books of business that are in runoff, as with loss-portfolio transfers; or to cover losses that have already occurred, as with retroactive reinsurance agreements.

In some instances, commercial insurance buyers themselves are bypassing primary insurers and using finite risk to finance captives and self-insurance programs.

"A finite policy for a captive is an alternative to borrowing from a bank, issuing stock or assessing members to put more capital into the company," explained Dan Malloy, executive vp in Benfield Inc.'s alternative risk solutions group in New York.

Finite coverage is also used to finance loss-portfolio transfers when a captive has decided to cease writing a line of business, he added.

When faced with runoff situations, "managements are very interested in looking for adverse development cover or loss-portfolio transfer where the day-to-day handling of those claims is taken over by a third party," he said. "They want to be able to say to their shareholders across a wide range of outcomes that they have finality."

Risk transfer concerns

As insurers, reinsurers and insurance buyers found creative uses for finite risk, the amount of actual risk transfer in some of the contracts diminished, which is what is causing such a stir, some observers say.

"Why are these products there? Because the industry developed them to get around the restrictions on the simple products," said Mr. Dreyer. "For example, a time-and-distance arrangement, which is effectively a loan, may incorporate some low-probability risk transfer to meet regulatory scrutiny" and be booked as reinsurance, he said.

Retroactive reinsurance is even more suspect, according to Bob Partridge, who is also a managing director at S&P in New York.

"You could certainly write a retroactive policy that includes risk transfer. You don't know if there is the significant event of adverse development. The losses keep going. But if it is a closed amount, then it becomes much, much more suspect," Mr. Partridge said.

A finite risk contract must contain two elements in order to be viewed as true reinsurance, said Don Thorp, senior director at Fitch Ratings, during the teleconference.

First, there must be "a significant amount" of risk transfer. The industry has adopted "the 10/10 rule" as the standard, meaning that there must be at least a 10% probability of a 10% economic loss of premium, he explained.

Second, it must be "reasonably possible" that the reinsurer will assume some loss, "and that means `not remote,"' Mr. Thorp said.

"If the contract has no apparent risk transfer, it is not accounted for as reinsurance and there is no change to written or earned premiums or incurred losses," he said.

If it does pass the accounting test, though, then how it is accounted for depends on whether it is prospective or retroactive.

"Prospective is accounted for in the same manner as other insurance or reinsurance," Mr. Thorp explained. "But with retroactive, there are some differences-the cedent does not change reported written premium, earned premium or incurred losses and the gain recognized is segregated in a special surplus account."

"There's a fairly clear road map in place since 1993 which lays out how you should account for transactions that you enter into to determine whether it's reinsurance or not-FAS 113," said Benfield's Mr. Malloy, referring to the accounting standard promulgated by the Financial Accounting Standards Board to address finite risk transactions.

"If transactions are structured correctly and accounted for correctly and exposed correctly, structured reinsurance, finite reinsurance is a very viable and positive alternative," he said.

However, "if transactions are being misrepresented through people looking to mischaracterize what they were doing, then I think that stakeholders-the shareholders, the regulators, the rating agencies-have a bona fide issue," Mr. Malloy said.

Some observers say that many finite risks deals made several years ago that met the muster of auditors and regulators and rating agencies at the time are being targeted now because of the perception created by the fall of Enron Corp. and other companies that corporate corruption is widespread.

"As an industry, we need to take lessons from Enron," said Elliott M. Kroll, a partner in the reinsurance practice of law firm Herrick, Feinstein L.L.P. in New York. The key lesson is, Mr. Kroll said, that it doesn't matter any more whether a deal complies with generally accepted accounting practices or statutory accounting rules. "What matters is, is it deceptive?" he said.

"It's incumbent upon the audit committee to look to management and ask them, `Do we have any of these transactions? Has anyone gotten an independent opinion as to disclosure and deception?' Maybe they'll unwind the deal, or maybe it can be salvaged with additional disclosures," he said.

"There's no such thing as a free lunch. You're trying to get some balance-sheet relief. There's nothing in and of itself wrong with off-balance sheet (transactions). The question to ask is, `Is the accounting treatment deceptive, and is it disclosed?"' Mr. Kroll said.

And even though the finite risk accounting issue was seemingly addressed with FAS 113 in 1993, "product structures were much simpler in nature, much more straightforward and there were rules and regulations put around those product structures. The old time-and-distance policies were simply doing a discount," said Mr. Partridge of S&P.

Since then, "the world has evolved. Risk management has gotten much more sophisticated in the industry; the levels of risk being covered are handled in a much more sophisticated way. And it's those nuances that are now being called into question," he said. "The products have changed, and the nature of this risk transfer has changed."

"The whole thing comes under this rubric that all of these industry practices that we all would agree are legal and many of us would argue are ethical, but the appropriateness is being called into question," said S&P's Mr. Dreyer.

"Mr. Spitzer said he views the whole island of Bermuda and other offshore venues skeptically, and I think that anything they're involved in will be perceived as being behind some sort of veil of secrecy and, therefore, suspect," he said.

"Let's face it, there's a lot of opaqueness in the transactions in this entire industry, and that applies to personal lines, commercial lines, life insurance, property/casualty, everywhere," Mr. Dreyer said.

"This is the thing that worries us. If something complex and/ or offshore makes it bad, then this industry in for a heap of trouble, because they have a lot of both," said Mr. Dreyer. "And that is the primary reason we have a negative outlook on the sector from a credit ratings perspective. We just don't know where the bottom of this stuff is."