Finite Risk Insurance

What Is Finite Risk Insurance?

Finite risk insurance is an insurance transaction in which the insured pays a premium that constitutes a pool of funds for the insurer to use to cover any losses. If losses are lower than the premium, the insurer returns most or all of these charges back to the insured. If, on the other hand, the losses exceed the premium, the insured is required to pay an additional fee to cover them.

Key Takeaways

  • Finite risk insurance is a transaction in which the insured pays a premium that constitutes a pool of funds for the insurer to use to cover any losses.
  • The insurer issues the policy and segregates the premium, net of fees, into a dedicated interest-accruing account.
  • If at the end of the policy period funds remain in the account, the insured may claim them.
  • Conversely, if at some point losses exhaust the account, the insured either pays an additional premium, or the transaction ends.
  • Finite risk insurance is frequently the recipient of criticism, but it should be applied on a case-by-case basis, not to finite risk insurance as a whole.

How Finite Risk Insurance Works

Under standard insurance arrangements, the insured transfers a liability associated with a specific risk to an insurer in exchange for a premium or fee. The insurer maintains a loss reserve with its own funds and is able to keep any income that it makes.

Finite risk insurance is an alternative risk transfer type of insurance product with features of both excess insurance and self-insurance. Finite risk insurance allows the insured to spread out payments for losses over time while retaining the ability to receive a refund of some of its premiums and investment income if losses are less than anticipated.

The insurer provides a standard insurance policy but modifies the limits and deductibles in a specific way. On a per-occurrence and aggregate basis, the total limit and retention are a function of the total premium, which is computed as the losses that will be paid discounted for investment income.

The insurer issues the policy and segregates the premium, net of fees, into a dedicated account that accrues interest for the insured. If at the end of the policy period funds remain in the account, the insured may claim them.

Conversely, should losses exhaust the account at some point during the policy period, the insured either pays an additional premium or the transaction ends.

Premiums are invested in an interest accruing account, often based offshore for tax relief, which the insurer can then tap into to pay any costs it might incur from claims.

Types of Finite Risk Insurance Products

Finite risk insurance products are not as easily disseminated as other insurance products because these types of products are tailored to the need of each individual client. Loss Portfolio Transfers (LPT), Adverse Development Coverage, Spread Loss Coverage, and Finite Quota Share Reinsurance are identified as the main types of what are considered to be finite risk insurance products.

Loss Portfolio Transfer

A loss portfolio transfer is when an insurer cedes policies to a reinsurer and is considered a reinsurance contract. These are often policies that have already incurred losses. In such a transfer, a reinsurer assumes and accepts the existing open and future claim liabilities of an insurer through the transfer of that insurer's loss reserves.

Adverse Development Coverage

Adverse development coverage (ADC), which is sometimes called retrospective excess of loss cover (RXL), is a finite risk product in which a reinsurer agrees to provide excess-of-loss coverage for losses incurred on a retrospective liability that exceed the cedant's current reserves or planned retention. In other words, they do not provide firms with the opportunity to combine pre-loss financing with their excess-of-loss protection. Instead, the reinsurer agrees to compensate the cedant for any losses above an attachment point equal to a defined retention level.

Spread Loss Coverage

Spread loss coverage is a form of reinsurance under which premiums are paid during profitable years to build up a fund from which losses are recovered in years that are lower performing. This reinsurance has the effect of stabilizing a cedent's loss ratio over an extended period of time.

Finite Quota Share Reinsurance

Finite quota share reinsurance, or financial quota share, is a reinsurance treaty in which the ceding company is responsible for a portion of the loss associated with the claim. An interesting facet of these products is that the ceding company is not required to pay a deductible before the coverage begins as that company will always be responsible for a portion of the loss.

Benefits of Finite Risk Insurance

Companies may rely on finite risk insurance to cover liabilities that have long durations. While they might save money by self-insuring for these risks, particularly if there are no losses, a finite risk insurance contract provides an element of risk transfer. 

A business could enter into a finite insurance agreement to cover excess losses over other policies, including its own self-insurance strategy, and may use these products for warranties and environmental, pollution, and intellectual property risk. By entering into a multi-year agreement, the insured can better match the amount of money it sets aside for liability protection to the estimated liabilities that it expects to face.

Criticism of Finite Risk Insurance

Finite risk insurance has generated some controversy in the past. Critics claimed it functions more like a loan and can hide the true condition of insurers, helping them manipulate and smooth their earnings. Considering that finite transactions take into account the time value of money which could allow the ceding insurer to monetize its value of loss reserves, it is not difficult to see how this could be easily adjusted to benefit the party.

Some corporations will work in tandem with the insurers, where the corporation will fail to disclose the true extent of the transaction to independent authorities and regulators. This has resulted in the finite risk business viewing some finite risk products as not only unethical but downright illegal. Depending on how the products are used and the extent of what is covered up, they certainly have the potential to be. However, that can be said of other insurance products as well.

Why Are Finite Risks Not Considered Insurance?

Finite risks are not considered insurance because they do not qualify as transferring an adequate amount of risk. They can be construed as financing risk assumptions as opposed to clear-cut transfers of risk. The rule is that over 10% of the risk must be transferred, otherwise, it is considered a noninsurance transaction.

What Types of Risk Does Insurance Cover?

Most insurance companies will only cover pure risks. Pure risks are those that embody most or all of the main elements of insurable risk. These elements are "due to chance," definiteness and measurability, statistical predictability, lack of catastrophic exposure, random selection, and large loss exposure.

What Is the Difference Between Insurable and Uninsurable Risk?

Uninsurable risk is a condition that is unknown and considered unacceptable by the insurance company, while also being against the law. These can also be considered events or people that will, in most scenarios, end in a loss to the insurance company. Conversely, insurable risks are risks that an insurance company deems acceptable, and will offer coverage for.

What Is the Difference Between Risk Peril and Hazard?

These are used interchangeably in everyday life, but not in the insurance industry. A peril is a potential event or factor that can cause a loss. A good example would be a fire that consumes a building. A hazard is something that could make the loss worse, such as a gas can next to the furnace, or a failure to maintain the correct tire pressure on your car. A hazard is something that has the capability to make a peril worse.

The Bottom Line

Finite risk insurance is a hard-to-define product that is often criticized due to its malleable nature. Some think that such products are used to adjust a balance sheet to show greater profit without actually transferring risk. However, as long as both parties remain transparent about the liabilities, finite risk insurance transactions can be considered viable and beneficial.

Article Sources
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