The Uses and Abuses of Finite Risk Reinsurance

Christopher L. Culp and J. B. Heaton

Journal of Applied Corporate Finance, 2005, vol. 17, issue 3, 18-31

Abstract: Finite risk reinsurance has become the subject of investigations, litigation, and possibly new regulation. This article provides an overview of finite risk solutions and products, describing their main features and their legitimate role in helping (mainly) industrial companies manage timing, funding, and insurance risks. Finite risk solutions generally take the form of structured insurance products designed to help companies manage risks often regarded as exotic or “tail” risks, such as environmental or asbestos liability. Although such products are underwritten by insurance or reinsurance companies, they typically involve limited risk transfer (hence the name “finite risk”) while providing the insured companies with a means of pre‐funding their expected losses, or what is often called “pre‐loss financing.” Of course, companies could choose to self‐insure such risks by establishing a reserve for future losses. But finite risk provides a more credible and transparent alternative—one that reassures investors both by capping the liability and eliminating the possibility for manipulation of reserves. Abuses of finite risk products usually concern the degree to which transactions are accounted for, disclosed, and represented to investors as achieving “significant risk transfer” when there is little or no such transfer. In the authors' words, “Users of finite should ask themselves whether the transaction helps the financial statements clearly represent the true economic income and risks of the business and, if not, then consider not doing the deal.”

Date: 2005
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