First published: Insurance Regulation & Accounting - Issue 27 [1st August 2005]

"We do not want to be caught napping on this", the FBI is reported to have said as it jumped on the bandwagon of investigating finite reinsurance deals in the United States of America. Financial crime it is, to buy or sell an insurance or reinsurance contract which does not comprise "sufficient risk transfer". Phooey!

This new shibboleth owes its existence to some sloppy thinking by accountants. It has, regrettably, been adopted by regulators in the United States. The Financial Services Authority here is fortunately constrained by clear precedents in English law and hesitates to follow Eliot Spitzer, the New York Attorney-General in subjecting deals to what, ultimately, is the wrong analysis.

The problem can be traced back to 1992 when the Financial Accounting Standards Board in the US intervened to prevent insurers effectively discounting reserves and thereby improving their balance sheets by the use of financial reinsurance. These financial arrangements were to be accorded the treatment appropriate to reinsurance only if the counterparty was assuming "significant insurance risk" which, it was said, meant that it had to be "reasonably possible that the reinsurer may realise a significant loss on the transaction". This was soon converted by the accounting profession into a rule of thumb that there was at least a 10% probability of a loss equal to 10% of the premium.

That such a rule of thumb was needed ought to make accountants pause, to reflect upon whether or not this approach was fraught with inherent difficulty. Certainly the International Accounting Standards Board could see that there was no compelling logic in this formulaic approach. But the Board did not go further in its analysis. When International Financial Reporting Standard 4 - Insurance Contracts was promulgated in March 2004, the requirement for a transfer of "significant insurance risk" was carried over into the IFRS definition of an insurance contract. This is now defined as "a contract under which one party (the insurer) accepts a significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder". Furthermore, the insurance risk has to pre-exist the contract and not be financial in nature. In IFRS 4, financial risk is defined as "the risk of a possible future change in one or more of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index or other variable, provided in the case of a non-financial variable that the variable is not specific to a party to the contract".

But despite the clarification as to what constitutes a "financial risk", the definition is bereft of guidance as to what constitutes acceptance of "significant insurance risk". In practical terms, accountants and auditors are left to assess this, in circumstances where the IASB has deprecated the use of the previously adopted rule of thumb.

But any interpretation of risk transfer which is based upon probability of a loss to the insurer in respect of any single insurance transaction is completely at variance with English legal conceptions of what constitutes a contract of insurance. The first objection, at a level of practicality, is that accountants and auditors take no account, in their approach, of a very important incident of many insurance contracts, namely the subrogation rights which accrue to the insurer upon payment of a loss. It is perfectly possible for an insurer to "lose" money, in terms of having to pay a loss which exceeds the premium, only to recoup the entirety of that loss upon a successful exercise of subrogation rights.

Secondly, as a matter of principle, the term "risk transfer" does not feature in any of the leading cases in English law. English courts have rightly taken a minimalist approach and declined to lay down any comprehensive, prescriptive definition. But there is appellate authority for the proposition that, although the provider could never make a loss, because his maximum liability was only the aggregate of premiums paid, plus investment income less administrative costs, the contract was nevertheless insurance. In the words of Holmes LJ in the Irish Court of Appeal in 1910: "If the policies I have seen represent the usual transactions of the company, I could not imagine a safer business... The persons insured by the policies that have been before the court may lose, but cannot gain; and the large business done by the defendant company shows how the thrifty poor may be misled by the glowing language of a clever canvasser. Still, notwithstanding the absence of all risk to the defendant company, I am disposed to regard the policies as assurances upon human life".

Similar conclusions have been reached both by the Federal Court of Australia and the High Court of New Zealand and these were all cited with approval in 1995 by the Court of Appeal in Fuji Finance Inc -v- Aetna Life Insurance Co Limited, where it was stated that a contract under which the insurer runs no real risk of financial loss is nonetheless a contract of life insurance if money is payable on a contingency depending upon the duration of human life.

The FSA signs up to the implications of this case law by stating, in sub-paragraph (3) of paragraph 6.6.2 of its Guidance on the Identification of Contracts of Insurance, that the insurer's risk of profit or loss from insurance business is not a relevant descriptive feature of a contract of insurance. They content themselves with saying that "transfer of risk" means the assumption of an enforceable obligation by the insurer to pay money (or respond in some other way) to the occurrence of an uncertain event. It will be noted in passing that this is an absolute test. Either the insurer has assumed an obligation or he has not. There is no room for investigation as to whether or not the risk transfer is "sufficient".

Accountants and auditors need to recognise that there is a significant difference between the position adopted by the FSA and the approach endorsed by IASB in its commentary on IFRS 4. It is of course right that accountants and auditors should look to the substance of a transaction. Auditors (and regulators) need to be alert to the difference between transactions which effect an improvement to a company's financial strength in absolute terms and those which do so only temporarily. Third parties who deal with companies on the basis of their financial statements expect that those financial statements present a true and fair view of the company's financial position. But the logical error consists of muddling up the two analyses. A transaction may be a contract of insurance or reinsurance without effecting in absolute terms an improvement of the financial position of the policyholder or ceding insurer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.