Reinsurance regulation: Not so sure

On 11 October the Financial Service Authority announced that it was proposing
new rules to govern financial or finite reinsurance arrangements that in its
view served to obscure or conceal the true financial performance of an insurer.

“Typically [finite insurance is] used to improve, or sometimes to smooth
reported profits, or to improve the reported balance sheet position,” said the
FSA.

This may be entirely legitimate, but the UK financial services regulator is
concerned about misuse of such arrangements.

Since 9/11 there has been an increase in the use of self-insurance
arrangements and particularly of offshore captive insurance vehicles by
corporates, especially in the US, but also in the UK and in the rest of Europe.
However, a spokesman for the FSA told Financial Director that these do
not fall within its supervision if based offshore.

But new accounting standards could require greater transparency in the
future. The International Accounting Standards Board is currently working on two
projects which could have an impact. By the end of 2006 it expects to produce
discussion documents on consolidation and on the use of insurance.

Wayne Upton, the IASB’s research director, says that it is concerned about
two areas. The first is the use of so-called captives because if they are part
of a larger corporate entity there may be arguments for reflecting their
contribution in its consolidated accounts if this is not being done already.
Second, there is the question of risk transfer. Is this really taking place or
is a captive merely being used as a financing vehicle by its parent? Upton
stresses that this is not to imply that the use of captives and self insurance
arrangements is improper. Indeed, he reiterates that they have a valuable role
to play, especially where the regular commercial insurance markets cannot
provide risk coverage sought by a corporate.

Meanwhile, the use of captives and other insurance vehicles among large
multinationals has accelerated.

David Hertzeel, a partner at City law firm Davies Arnold Cooper and chair of
the focus group on captives and risk finance at AIRMIC (The Association of
Insurance and Risk Managers), cites research by insurance brokerage and
consulting services group Aon that premium income of captives rose from $6.6bn
(£3.8bn) in 2000 to $9.3bn in 2004.

He points out that following 9/11 premium rates for certain risks rose
sharply, retentions increased and limits were slashed.

In this environment, it makes a great deal of sense for corporates to switch
their insurance business to captives, which could meet their coverage needs more
economically.

He does not think it likely that there will be significant changes to
regulatory regimes or to tax charges, which would alter this scenario in the
foreseeable future.

In a hypothetical example, a corporate may set up a captive insurance vehicle
in, say, Bermuda, Dublin, Guernsey or another domicile. Its parent can analyse a
risk to its business, quantify its probable losses from historic data and pay a
premium to its captive, which will enable it to pay likely claims. The corporate
gains tax relief for its premiums and investment income from the premiums
invested by the captive until they are needed to meet claims. Meanwhile, it can
demonstrate that it has taken adequate and effective steps to cover a risk
facing its business.

David O’Connor, senior consultant at Tillinghast Towers Perrin in Dublin,
poses the question of whether a captive is really doing what it is supposed to
do for its owner. If the intention is merely to dress up the balance sheet, or
smooth profits, then it may not be. “Its purpose should be to improve risk
management. Build a better connection between the risks that are being run and
the funding that is in place to cover them.

“Bear in mind that the insurance sector can cover a proportion of the risks
that businesses run. If you take business interruption, or other risks, which
are borne by entities and not necessarily covered by traditional insurance
companies, it may be appropriate to fund and manage them within a captive
operation… There are lots of points of focus that a captive can address that the
traditional insurance industry can’t.” He adds that other risks that fall into
this category can be operational risks, property, casualty and human resource
risks.

While, therefore, captives and other forms of self-insurance have a
significant contribution to make to corporate risk management O’Connor concludes
that we should assume that such vehicles will be subject to the same regulatory
scrutiny as those used specifically by the insurance sector. Therefore, the
FSA’s recent move may herald a tighter regime for corporate insurance
arrangements in due course, and financial directors and risk managers may do
well to watch closely what results from the regulator’s activities in the
current context.