VideoFar from being motivated by a desire to smooth income, most executives use it as "a way to take a reserve against a loss credibly," he contends. "If you just set cash aside for a loss, investors are suspicious you might spend it on something else."
The arrangement "leads to a higher quality of earnings than if the firm doesn't reserve for a major loss or just tries to set money aside internally," according to Culp, who notes that having finite coverage can shield companies from charges of setting up "cookie jar" reserves to inflate future results.
Another advantage is that the coverage can help companies that don't want to buy traditional insurance to fix the cost of hard-to-quantify exposures over a span of years. Barile, the consultant, says that in the late 1990s, he worked on an arrangement to insure gambling casinos against a loss of revenue resulting from a downturn in the Las Vegas economy, for example. Such a risk, he notes, could include the possibility of a terrorist attack — an extremely difficult exposure for traditional insurers to price.
Further, finite insurance can come in especially handy in covering severe risks that are outside the core functions of a company, observes Culp. For instance, chemical marketers and distributors could incur latent pollution liabilities that might not crop up for many years. "To assure investors that they have credibly managed any such losses, finite is a good answer," he adds.
With merger activity heating up of late, corporate negotiators could also rediscover finite arrangements as a way to grease a deal. In the past, a self-insured company facing many workers' compensation claims could overcome resistance to a merger by "selling" its loss portfolio to a finite-risk insurer, says Barile. By transferring the claims to the insurer, a suitor or a target could present itself as liability-free.
Transfer or Restate?
Despite its benefits, however, finite coverage carries with it the distinct risk of a restatement. Under generally accepted accounting principles, payment from an insurance company isn't an "insurance" recovery for accounting purposes unless the policy transfers some risk to the insurer. If a policy doesn't transfer risk, it's a financing arrangement in which all premiums are treated as deposits.
CFOs and risk managers should be particularly careful to account properly for finite policies that insure past events rather than future probabilities, experts say. Auditors and the Internal Revenue Service have frowned on such retroactive policies because it's hard to determine whether risk has actually been transferred, says Joel Chansky, a principal in the Boston office of Milliman Inc. At the same time, for example, "no one knows the ultimate value of workers' comp liabilities or claims reserves, so there is risk there," the consultant adds.
To make sure that enough of a peril is transferred, risk managers can blend different kinds of coverage into the policy, according to Chansky. They might, for instance, combine a prospective earthquake exposure for 2005 with known workers' compensation claims from 2004. In that case, the quake hazard might provide a risk-transfer justification lacking in the workers' comp losses.
Other potential accounting foul-ups can occur in connection with the use of finite coverage by a company's captive insurance subsidiary. Under a typical arrangement, the captive might insure the company's cheaper workers' compensation claims itself and buy finite-risk reinsurance to cover the more expensive losses, says Keith Buckley, a group managing director with Fitch Ratings.
Since captives are subsidiaries, their results are typically reported together with those of the parent company. If the captive's reinsurance arrangement is found to not involve enough risk transfer, the parent company would have to make an adjustment "to take all the losses into the income statement at one time again," notes Buckley.
Compounding the risk of restatement for all finite deals is the currently vague definition of "risk transfer." While a "10/10" rule — a 10 percent probability of a 10 percent loss of premium — is most often used, the standard is ultimately "what auditors and regulators say it is," according to a Fitch Ratings report issued late last year. Some clarity might be on the way, however. Earlier this month, the Financial Accounting Standards Board reportedly announced that it would look into what risk transfer actually means when it comes to finite coverage.
It's the lack of risk transfer, then — and not the much-dreaded label of "earnings management" — that turns out to be the greatest threat to finite insurance. Merely using the product to make financial results look better might not be a deal killer, according to Michael Moriarity, director of the capital markets bureau of the New York Insurance Department.
If a finite arrangement transfers enough risk, "it can smooth earnings," he says. "There's nothing wrong with that."
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