Patent Futures

Finite risk insurance and reinsurance as an example of how inventive minds work in the insurance industry and the boundaries that inventiveness may push.

Finite risk is a subset of a broader class of alternative risk transfer and financing techniques sometimes abbreviated as ART. As we will see, it is the interplay between "risk transfer" and "financing" that creates the regulatory and rating agency concerns.

Start with the understanding that an insurance benefit, in general, protects an insured from potential financial consequences related to a contingent event. A contingent event is an event that is uncertain with respect to its occurrence, timing, or severity. Most insurance we are familiar with, let's call that traditional insurance, removes the financial uncertainty caused by the occurrence or severity of a contingent event. Timing is distinct from occurrence as used in the definition of a contingent event in that it relates to the distribution of occurrences of events over time rather than to the occurrence of a single event in any particular period of time.

For example, accidents will happen. The involvement of any one individual in an accident (i.e. the occurrence of an accident with respect to that individual) in any particular year is uncertain. That's why individuals might buy insurance. When a large enough number of individuals are insured for accidents, an insurer can expect, though not be certain, that accidents within their block of insureds will, in each year or quarter, be close to some average. And, over a number of years or quarters it can be expected (though again, no certainty) that highs and lows will further average out. The timing risk the insurer faces is that the insurer cannot be absolutely certain that claims in each period will come close to the expected average even if they average out over time. This statistical claims fluctuation can have an undesirable effect on the insurer's financial statement in a year in which the fluctuation goes the wrong way.

What is called finite risk insurance (or more typically reinsurance since it is usually offered to other insurance companies) is a form of insurance that focuses on the timing part of contingent risk and minimizes to the largest extent possible the occurrence and severity parts of contingent risk. Therefore, it is called "finite" since the occurrence and severity elements of contingent events (often referred to as traditional insurance risk) are made certain, or finite, with respect to occurrence and severity in the design of the product.

What's left, of course, is the timing or distribution of the claim events over time. Therefore, the insurer or reinsurer providing finite risk coverage does not have to worry about occurrence or severity elements of contingent events to any great extent. Essentially, what they are doing is providing an insurance contract which allows the transfer of the financial consequences of claims from one accounting period to another - either forward or backward in time - and, therefore, they are addressing the timing element of contingent events. Time value of money is then one of the most important factors in the calculation of premiums or charges for finite risk coverage.

To those who place little or no value on the traditional risk transfer aspects of finite risk coverages (e.g. regulators and rating agencies), this looks a lot like a loan and debt and not risk transfer insurance at all. And, their concern is that financial statements are being distorted through its use. In fact, NY Attorney General Eliot Spitzer has issued subpoenas seeking information from reinsurers on non-traditional insurance products like finite risk insurance and reinsurance. Fitch Ratings, when possible, backs out the impact of finite risk reinsurance on financial statements before analysis.

Basically, invention provides a solution to a problem. Finite risk and the other types of alternative risk transfer products, solve a timing or distribution problem associated with contingent events. In broad terms, even what is considered traditional risk insurance spreads the financial consequences of the occurrence and severity elements of contingent events over time. In effect, the premium the insured pays for the insurance substitutes a manageable, budgetable amount paid in installments over time for the financial consequences resulting in the year or quarter in which the contingent event occurs - if it occurs. The key, of course, is the "if". That is the main element of what is considered traditional insurance.

The key to finding acceptable forms of alternate risk transfer may lie in finding an inventive way to alleviate concerns that it is not really "risk transfer" and, therefore, not insurance. Perhaps one step in this process would be to re-title it as "timing risk" transfer insurance and emphasize that "timing" across years is a primary component of insurable contingent events. Our guess is that future invention in this insurance/reinsurance product category lies along those lines.