What Is Finite Reinsurance?
Finite reinsurance, also known as finite risk reinsurance, is a category of reinsurance that cedes a finite or limited amount of risk to the reinsurer. By transferring less risk to the reinsurer, the insurer receives coverage on its potential claims at a lower cost than with traditional reinsurance. Risk reduction is from accounting or financial methods, along with the actual transfer of risk to another company.
Insurance companies use finite reinsurance to spread the risk they assume in writing insurance policies. A reinsurance policy allows the insurance company to transfer some of that risk to the reinsurer. Unlike most reinsurance contracts, however, a finite reinsurance contract includes the time value of money. These contracts spread the risk over a very specific period of time—often over several years. They also take into account the potential investment income earned during that time.
- Finite reinsurance allows insurance companies to spread a finite or limited amount of risk to a reinsurer.
- Reinsurance is commonly referred to as "insurance for insurance companies" because it helps insurance companies manage the risks associated with claims resulting from large, catastrophic events.
- The main advantage for insurance companies purchasing finite reinsurance is that they receive coverage for potential future claims at a relatively low cost.
- A disadvantage of finite reinsurance is that the coverage may be so limited in scope and laden with restrictions that the purchasing company may not be able to receive reimbursement for claims.
Understanding Finite Reinsurance
Finite reinsurance is reinsurance that a primary insurer or ceding company purchases from the reinsurer or the assuming insurer. Reinsurance is finite when it only covers specific risks and specific conditions. The reinsurer does not pay the primary insurer if the specified conditions are unmet.
An insurer will usually set aside a claims reserve, which is the amount of money they may expect to pay out to a percentage of claims should they realize a particular risk. Only when the set-aside amount does not adequately cover the payouts will the reinsurer cover the risk. This provision limits the potential risk to the reinsurer, and the lowered risk will lead to a less expensive finite reinsurance policy for the ceding company. The set-aside amount is usually invested in government bonds and provides income for applying towards potential claims.
Reinsurance is insurance for insurers or stop-loss insurance for these providers. Through this process, a company may spread the risk of underwriting policies by assigning them to other insurance companies. The primary company, which originally wrote the policy, is the ceding company. The second company, which assumes the risk, is the reinsurer. The reinsurer receives a prorated share of the premiums. They will either take on a percentage of the claim losses or take on losses above a specific amount.
Typical reinsurance often has a cap on reimbursements for a single event to the primary insurer. For ordinary situations, this cap is much larger than the primary insurer should need. But for an unusually large or calamitous event, such as a hurricane or other catastrophe, the primary insurer may need to pay claims to numerous policyholders.
In some cases, a primary insurer that faces an enormous number of claims due to a calamitous event will exceed the reinsurance cap, potentially causing the insurer to go bankrupt.
Advantages and Disadvantages of Finite Reinsurance
The main advantage to the purchaser of finite reinsurance is it is a relatively cheap form of financial protection. The reinsurer receives a limited amount of risk to assume the duties of being a reinsurer. Each participant in the policy can feel like they are getting a bargain, but the financial risk is shared evenly between them.
A disadvantage of finite reinsurance is that it is limited in coverage scope so that it may be useless to the purchasing company. If the buyer fails to meet all conditions, the finite reinsurance policy will not pay. This limitation may cause a loss not only of the amount of money spent to purchase the finite reinsurance policy but also of the claims the buyer must pay policyholders. It could be especially damaging if the buyer did not intend to pay claims without receiving reinsurance reimbursement.
Finite reinsurance has been a vehicle for fraud. In the 1980s, primary insurers were paying premiums which were the same cost as the finite insurance payout limits. These buying companies were able to deduct this premium where they would not have been able to deduct the direct payment of a claim. Accounting Standards Codification (ASC) Topic 944 (formerly FAS 113) was designed to put limits on the fraudulent usage of finite reinsurance. Since then the business model for reinsurance companies has evolved, with some reinsurers focusing more on creating structured and customized reinsurance solutions for primary insurers.