Finite reinsurance is the latest target of Eliot Spitzer in the US, but now the FSA is becoming interested in UK insurers, says Michael Faulkner

' What links fallen AIG chief executive Maurice 'Hank' Greenberg, investment guru Warren Buffett and FSA top man John Tiner? The answer: finite reinsurance.

In recent weeks a storm has been whipped up in the US over the use of this complex financial instrument. AIG is under investigation by the American authorities for allegedly using finite reinsurance to flatter its financial statements, costing Greenberg his job.

And General Re, a reinsurance subsidiary of Buffett's Berkshire Hathaway, has been caught up in the frenzy amid allegations that it underwrote the reinsurance deal with AIG. The company is now being investigated over this and other deals.

Will there be a further high profile casualty?

This side of the Atlantic, the issue is also on the lips of the FSA. At the recent ABI conference, Tiner warned delegates that the FSA would be clamping down on improper finite reinsurance deals.

And last week, he wrote to insurance company chief executives asking them to furnish information on their company's use of these arrangements.

But is this rather high-powered financing arrangement something that should only be of concern to actuaries, regulators and finance directors?

In short, no. The problem that the regulatory authorities in the US and UK have is that finite reinsurance deals or any other type of financial engineering can be used to mask or 'smooth' an insurer's financial results making them look better than they are.

Solvency concerns
For brokers and insurance buyers concerned about the solvency of their insurers, the improper use of finite reinsurance is something that should be of concern. The collapse of Australian insurers HIH has been linked to finite reinsurance arrangements.

"A company could be in financial difficulties, yet appear to be in good financial shape," warns one financial expert.

That is not to say that the use of finite reinsurance arrangements is always a bad thing, as the FSA is at pains to point out.

Used appropriately it can be a "valid method of strengthening a firm's solvency position", says the FSA. The problem occurs when they are used improperly to obscure the underlying financial condition of a firm.

How much finite reinsurance is being used in the UK general insurance market is uncertain. It was certainly prevalent in the Lloyd's market during the 1980s and, says one market insider, contributed significantly to the "success and failure" of a number of syndicates.

Better insight
But the FSA has no figures available on its use, although in 2001 in the life insurance market £14.2bn worth of financial engineering deals took place.

An FSA spokesman says the regulator's current interest in the matter is to establish its prevalence in the general insurance market. "We want to get a better insight into it, which will inform future work," he says.

A consultation paper is expected later in the year looking at the best way to supervise the use of financial engineering. Whether the impropriety that is suggested has taken place will be uncovered in the UK remains to be seen. But the FSA has in the past taken enforcement action against individuals and firms for distorting their financial results with financial engineering.

The stone is being turned. What will be underneath? IT

What is finite reinsurance?
Finite reinsurance is essentially a low-cost loan that is designed to cap a company's exposures in a more profitable manner than traditional reinsurance.

In effect an insurer with finite reinsurance might have a claim in one year and receive payment under the policy, but it will have to repay that back over coming years. Thus the liability for the claim is masked in the short term, but will eventually be felt over time as the claim is repaid.

Whether it can truly be described as insurance is debatable, as the amount of balance sheet risk that the reinsurer accepts is typically small compared to a traditional insurance contract.

Under FSA rules, insurance companies must make capital assessments that accurately reflect the risks faced by that firm. This should include the impact of any finite reinsurance arrangements.

Nonetheless, the regulator is concerned that without proper disclosures, finite deals can result in misleading accounts.

"It is sometimes claimed that they may be entered into primarily for this purpose, rather than for bone fide commercial reasons," says the FSA.

The regulator has pledged it will take

"very seriously" instances of a company obscuring its financial position using these arrangements.