Next Up for Spitzer: Funny NumbersBy Gretchen Morgenson
The New York Times
November 21, 2004
Eliot Spitzer, the New York attorney general, has already exposed insurance industry secrets like bid-rigging and hidden commissions. Now he is training his spotlight on an even murkier part of that universe: the buying and selling of insurance policies that artificially bolster companies' financial statements.
The policies in question are known as finite insurance or financial reinsurance. They are sold as ordinary insurance policies, which allow companies that buy them to receive favorable accounting treatment - smoothing out losses on their books, for example.
To critics, however, the policies are structured less like insurance and more like loans. At heart, they say, finite insurance is simply a form of financial engineering that masks the strength or weakness at the companies that buy them. As such, its use has probably had a much greater impact on investors and customers than other industry practices that Mr. Spitzer has singled out.
The deals offer an especially rich vein for investigators to mine, industry analysts say. And last week, Mr. Spitzer sent out a flurry of subpoenas to insurers - including Ace Ltd., the St. Paul Travelers Companies and Zurich Financial Services - about policies they may have sold to help customers eliminate or offset losses that would have hurt their financial results. The Securities and Exchange Commission and the Justice Department are also scrutinizing financial engineering products sold by insurers. All three companies said they were cooperating, but they declined to comment further.
By far the biggest customers for such policies are insurers themselves, so investigators will be looking at how these companies may have used these contracts to make their books look better. As regulators unravel these arrangements, industry analysts say, they are likely to discover a labyrinth of deals among insurance companies that are often routed through tax havens in Bermuda or the Caribbean.
Given the complexity and secrecy of such deals - they are often not disclosed on insurers' financial statements and require a good bit of detective work to find - cases related to them may not come to light for some time. But industry analysts who have uncovered some of the arrangements on their own in recent years say that their use is widespread.
No one knows for sure how large the market is for such policies. Robert Arvanitis, president of Risk Finance Advisors, a corporate finance advisory firm in Westport, Conn., that specializes in insurance, estimates that in any given year, $50 billion of all insurance premiums involve policies with some kind of finite element.
Some of the policies have been sold to companies like Honeywell, the diversified technology giant, and Brightpoint Inc., a cellphone maker. But most of these deals are struck among insurance companies. The arrangements allow insurers to bolster their net worth or surplus, a figure that investors check when weighing an insurer's financial soundness. Indeed, some deals have masked declining financial positions at both life and property-casualty insurance companies that later failed or are now on the edge.
Finite insurance benefits customers in several ways. For one thing, it allows a company to avoid having to record a loss as a lump-sum deduction from its books; instead, it can spread out the loss over a predetermined period. For another, the insurance premium that companies pay for the policy is tax deductible. And if the loss a company anticipates never materializes, policy holders even get back some of the premium they paid.
FOR the companies that buy the policies, not having to report a loss means that their surplus - the crucial measure of their soundness and the figure that decides how much new business can be written - does not take a hit. This is why finite insurance often shows up on the books of weaker insurers.
The trouble is that buyers of such coverage are mortgaging their future earnings power. In effect, they are giving up the investment income they would have earned on the money they used to pay the policy's premium. That is something investors in insurance stocks would clearly want to know about.
The biggest risk in such a policy, however, emerges when a regulator or auditor decides that it is not really insurance, in which true risk is transferred from one party to another, but a financing arrangement in which the premium paid by the company buying the coverage is seen as a deposit or a loan. In such a case, the beneficial accounting treatment disappears.
"As users of financial statements, we believe that the volatility of an insurer's accounting results should reflect the volatility of the underlying economic results," said Michael J. Barry, a managing director at Fitch Ratings, a ratings agency in New York that holds a negative view of these policies. "But most finite insurance results in a disconnect between those two." As a result, Fitch tries to discount the financial effect of such deals when it assesses insurers' financial positions.
Finite insurance has been around since the 1960's, but the first company set up specifically to sell such policies, Centre Reinsurance, was started more than 20 years later. In 1988, Guy Carpenter, a reinsurance subsidiary of Marsh & McLennan, was instrumental in creating Centre Re. To some degree, the finite insurance products that Centre Re and others began to sell in the 1990's simply represented a way for the industry to formalize what insurers had been doing informally for decades.
But it wasn't until the late 1990's that finite insurance took off. At that time, too many insurers were chasing too few customers, and premiums and profits were in decline. It was, in industry parlance, a soft insurance market.
Hoping to increase the amount of premiums they took in, insurance companies became highly creative about the financial reinsurance products they were selling. At the time, financial services firms were acquiring insurance companies and integrating them into their operations. Perhaps inevitably, finance and insurance began to converge.
In a June 2001 discussion about finite insurance that appeared on Guy Carpenter's Web site, Michele Fleckenstein, a managing director at the company and head of its Finite Specialty Initiative, said its finite programs were growing more than 25 percent annually in previous years.
She explained why: "Companies are facing escalating pressure, both internally and externally, to protect their business plans and achieve forecasted results. The need for these covers stems from the extreme pressure that companies face to make planned results and not have any surprises."
To be sure, all insurance is designed to ameliorate the effects of negative "surprises" - say, fires or floods. But increasingly, the types of surprises that finite insurance was intended to mitigate were those that led to volatile company earnings or asset write-downs.
In January 1999, Reliance Insurance introduced a product it called Enterprise Earnings Protection Insurance. Reliance executives said the policies were designed for midsize companies interested in protecting their earnings from situations like a disruption in the supply chain or a loss of important customers.
It is not clear exactly how much of this insurance was sold. Reliance failed spectacularly in 2001, under a mountain of debt.
The American International Group, one of the world's largest insurance companies, is often at the forefront of developing new insurance products. In 1997, it created a policy that combined traditional insurance with coverage of financial risks and sold it to Honeywell. A double-barreled policy, it covered both Honeywell's currency risk and its more traditional risks, like increased workers' compensation claims. The policy eliminated Honeywell's need to hedge its currency risks with derivative contracts that were costly and not tax deductible, the way insurance premiums are. Derivatives are financial instruments whose values are based on another asset.
The policy, as described on an A.I.G. Web site, is called a Coin, for commodity embedded insurance. Among its benefits, according to the site, is the "attractive tax and accounting treatment" that may be available in "this blended insurance program." It also "protects earnings from unexpected or unintended losses," the site says.
But the coverage of possible currency losses by the policy resembled a derivative contract, as the Financial Accounting Standards Board said in 2001. It ruled that if the program involved little risk, it was not insurance and would have to be treated as a derivative contract and applied to its books. That would have eliminated the appeal of the policy.
Accounting rule makers, however, leave it up to the company to determine whether and how much risk is involved. So companies using such blended products may have been encouraged to overstate the risk to achieve the desired accounting treatment.
Joe Norton, an A.I.G. spokesman, said Honeywell was the only company to buy a Coin. The contract ran for two and a half years, he said, and had a significant risk transfer component. He said Coins had not been marketed since 1999, and that it was an oversight that its description had not been removed from the Web site. An official at Honeywell did not return a phone call seeking comment.
A.I.G. also sold Brightpoint a different kind of finite insurance that helped that company hide $11.9 billion in losses in 1998, running afoul of the S.E.C. The insurer paid $10 million to settle the matter with the S.E.C., neither admitting nor denying wrongdoing. But when regulators announced the settlement of the case in September 2003, they said A.I.G. helped mislead investors by selling Brightpoint a "new 'insurance' product that A.I.G. had developed and marketed for the specific purpose of helping issuers to report false financial information to the public."
This is the defining characteristic of finite insurance, according to Mr. Arvanitis at Risk Finance Advisors. "Anything that ultimately reduces the loss borne but doesn't change the accounting, or when there is a disconnect between the accounting for risk and actual incidence of risk, that is finite," he said. "Essentially, you're saying you made money and you didn't."
As such, the most severe threat inherent in financial reinsurance is to investors who buy insurance stocks and to consumers who buy coverage from insurance companies. In both cases, finite insurance can mask problems at insurers.
As the analysts at Fitch have noted, insurers who are in distress are often heavy users of finite insurance. For example, in 2001, the Kemper Insurance Companies executed two large finite transactions, known as retroactive policies, that covered losses already incurred.
In a 2002 report, Fitch analysts noted that the effect of these transactions reduced Kemper's surplus by 15 percent. "Without the aid of various financial engineering tools," the report noted, Kemper's surplus would have declined to $1.12 billion at year-end 2001 from the $1.5 billion the company reported in its financial statements.
After a failed expansion plan and severe downgrades by financial ratings agencies, Kemper began exiting the business in 2003.
OF course, it is unclear what regulators will find as they delve more deeply into financial reinsurance. If companies misled auditors by claiming true risk transfer simply to get favorable insurance bookkeeping treatment, they could be subject to civil suits accusing them of accounting irregularities. David D. Brown IV, the head of investor protection in the New York attorney general's office, is in charge of the insurance investigation.
But even if their accounting proves to have been accurate, that may not be the end of it. With finite insurance high on regulators' radar screens, it is now much more likely that some companies holding the policies will undo them to avoid attracting the attention of prosecutors, creating more problems for an industry that is already up to its neck in trouble, thanks to Mr. Spitzer.
This month, Platinum Underwriters Holdings canceled a financial reinsurance transaction that it had struck with Berkshire Hathaway. Platinum's executives said that increased regulatory interest in finite insurance had compelled them to re-examine the deals they had made.
It is also possible that new sales of these policies will simply sputter. Either way, the implications for buyers and sellers of the insurance would be huge.
"There is a sniff test here," said Mr. Barry of Fitch Ratings. "Are the buyers and sellers of the insurance exposing themselves to operational risk? Is there a regulator who will come in and say, 'I don't like this transaction, and you have to unwind it?' There are consequences."
Copyright 2004 The New York Times Company