When is an insurance contract not an insurance contract? This is no trick question, but a matter exercising the minds of insurers and regulators around the world. It has arisen because of the spotlight US regulators have shone on a relatively obscure enclave of the global insurance industry - so-called finite reinsurance.
American International Group, the world's biggest insurer, is currently facing an inquiry over whether it properly accounted for some of its reinsurance contracts in order to bolster its financial position. Finite reinsurance is used where traditional reinsurance cover is unavailable or prohibitively expensive. But there is a question mark over how it should be accounted for by reinsurers.
The difficulty is that finite reinsurance contracts contain elements of financing and insurance. Whether they should be accounted for as insurance or financing has tended to depend on whether the risk of a financial loss occurring is transferred to the reinsurer. If it is, then the contract should be thought of as reinsurance, and accounted for accordingly.
If not, then the contract should be thought of as financing. Typically, this would be a loan, although who would do the lending would depend on the precise nature of the contract.
A rule of thumb - used by auditors - stipulates that for a transaction to qualify as reinsurance, there must be a 10 per cent chance of a loss amounting to 10 per cent of the coverage bought.
Take three examples.
• An insurer pays a reinsurer $1,000 for the ability to recover up to $10,000 in the event of claims under the policy. The reinsurer could potentially have to pay out up to $10,000 and it has no way of recovering any of the money it pays out from the insurer. As for the insurer, it makes a large recovery in the event of a significant claim arising, and gets nothing back if a claim does not occur. Risk has clearly been transferred and the contract should be accounted for as reinsurance.
• An insurer pays $1,000 in premiums for up to $10,000 of cover over five years. If a loss occurs, the insurer would be able to recover this amount from the reinsurer. But it would be required to pay an additional $9,000 in premiums - the difference between the original premium and the loss - over the five-year period. If no loss occurs, then most of the insurer's premium would be refunded. No risk is transferred - the contract is more a mechanism to smooth losses. So it should be accounted for as a loan from the reinsurer to the insurer. Under this treatment, in the event of a claim, the insurer would show the amount recovered in cash. But it would also have a liability to repay this amount. An insurer pays $1,000 in premiums to cover losses of up to $10,000. But if a loss does not occur, the insurer is refunded half of its premium. So there is a partial transfer of risk. The way to deal with contracts such as this, which include elements of both insurance and financing, would be a form of "unbundling" or "bifurcation". This option, currently being considered by the US Financial Accounting Standards Board, would split a reinsurance contract into its constituent parts. Any part that did transfer risk would continue to be accounted for as insurance. Any part that did not, would be accounted for as financing.
Accordingly, half the original $1,000 premium would be shown on the balance sheet as money owed to the insurer. This is because it would be repaid either through a recovery in the event of a claim or a refund of the premium in the event of no claims arising. The other half of the premium would flow out of turnover because this would be lost if no claim arose.
Also, when deciding whether a contract should be classified as reinsurance, account should be taken of the substance or purpose of a transaction. According to Hitesh Patel, head of insurance markets at KPMG, the following questions should be asked: "What are the economics of a contract? Why has someone entered into a contract, with a risk element and a loan element?" He also suggests that an "unbundling" should be accompanied by a further three elements: a strong definition of what is meant by an insurance or reinsurance contract; a prohibition on insurers taking an upfront gain on transactions that seek to recognise the difference between the claims laid off through a reinsurance policy and the premium paid for this; and a recognition that any assets and liabilities arising from an insurance or reinsurance policy should be properly accounted for.
No approach is fail-safe, but such measures should help ensure that transactions treated in accounts as reinsurance contracts are exactly that.