When Gray Becomes Black-and-White

Bernard Condon and Carrie Coolidge
Posted April 25, 2005

While no charges have been filed, the case against Hank Greenberg hangs on the actuarial concept of risk transfer. When AIG sold reinsurance coverage to General Reinsurance, was there much chance it would lose money on the deal? That's not so easy to answer.

The key section in the Gen Re contract exposes AIG to as much as $100 million of losses should claims come in higher than the $500 million it received in Gen Re premiums. But these are for payments stemming from workers' comp losses already incurred, not future ones. In other words, a good actuary could perhaps have looked at the claims data and had a very clear notion of how much AIG was going to pay out on the policy and when. David Bradford, executive vice president of insurance consultancy firm Advisen Ltd., and an expert in "finite" reinsurance (policies that cap potential losses), estimates it would take "at least 25 years" for claims on this postloss, retroactive policy to be paid out. By then, he says, the interest earned on the bulk of the $500 million premium, guaranteed by Gen Re at 3% annually, would likely cover the $100 million extra hit.

To book reinsurance premiums as revenue, the Financial Accounting Standards Board says, there must be a "reasonable" chance of "significant" losses; anything less must be recorded as a loan. But what do "reasonable" and "significant" mean? One commonly used rule of thumb: at least a 10% risk of at least a 10% loss. Even if this transaction failed utterly in that regard, it is far from clear whether Greenberg knew it did.

Another rub: unwritten and nonbinding agreements common in the reinsurance industry that have the effect of lowering risk to the reinsurer by allowing it to wriggle out of a deal without a loss, in the event claims skyrocket. Greenberg says he's not aware of any side agreements in this case, according to a source who has spoken with him. Can Eliot Spitzer prove otherwise?

Of course, Greenberg could be nailed on more than just the Gen Re deal. A source close to AIG says that since Spitzer began turning the screws, every day it finds "20 more little items that have to be looked at," albeit virtually all too tiny to move the needle on AIG's books. The company has already confessed it secretly controlled two offshore reinsurers but improperly left them unconsolidated in its financials. AIG concedes that a restatement involving a third offshore reinsurer, Union Excess, could lead to a $1.1 billion writedown, part of a possible $1.8 billion in charges.

Whatever happens to Greenberg, finite reinsurers have been scattering like roaches. In November, when Spitzer and the Securities & Exchange Commission started minting subpoenas, Platinum Underwriters of Bermuda (net premiums last year: $1.7 billion) canceled a finite policy on its books in order to avoid "unwelcome scrutiny," forsaking $22 million in quarterly earnings on a deal that "easily met and exceeded" the standards for risk transfer. In February Renaissance Re (net premiums: $1.3 billion), also of Bermuda, said it would restate three years of financial statements, in part, to undo accounting for a piece of finite reinsurance.

Analysts and rating agencies worry about a wave of writedowns by companies that decide to unwind contracts--simply to avoid investigation. Most vulnerable: those with retroactive deals, like AIG's with Gen Re. U.S. commercial insurers have $26 billion worth on their books, or 17% of their net worth.

Deals between insurers are sometimes canceled midstream by invoking contract clauses or through negotiation. But in a climate of paranoia, investors are more likely to sell first and ask questions later. Shares in Fairfax Financial, a Toronto insurer with a $2.4 billion market cap and loaded with finite deals, dropped 14% in four trading days after Merrill Lynch downgraded the stock to a "sell" in March. The analyst, Bradley Smith, fretted that "a number" of finite deals had been unwound--even though Fairfax had reported the moves six months earlier.

Lots of other insurers rely heavily on finite insurance to boost their reported results, says a Fitch Ratings report. Among them: CNA Financial, Kemper and the Brandywine subsidiary of Ace, the insurer run by Hank Greenberg's son Evan. Atlantic Mutual in New York last year unwound $67 million of retroactive finite reinsurance, one-fifth of its net worth. (The company says industry jitters played no part.) Finite reinsurance is still legal, but for a company regulated in New York, state rules now require executives to attest under oath that their deals actually transfer risk.

"If you're a primary insurer entering into a finite deal, you probably want to hold off until it's clear what qualifies," says Standard & Poor's analyst John Iten. "The market is shrinking."

And how. Inter Ocean Re, a Bermuda reinsurer trafficking mostly in finite deals, announced last month that it was closed for new business.

Copyright 2005 by Forbes.com

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