Risk Management

Pru Settles “Sham” Finite Insurance Case

SEC charges Prudential's Prupac property and casualty units with writing contracts with General Re that had no economic substance.
Stephen TaubAugust 6, 2008

Prudential Financial Inc. settled Securities and Exchange Commission civil charges that Prudential improperly reported over $200 million in income as the result of “sham” finite reinsurance contracts.

Without admitting or denying the commission’s allegations, Prudential agreed to settle the charges, agreeing to be permanently enjoined from further violations of certain securities rules. The company was not required to pay a fine or make any other payments, however.

According to the SEC, from December 1997 through December 2002, Prudential’s former property and casualty subsidiaries, known as the Prupac companies, entered into finite reinsurance contracts with General Reinsurance Corp. that had no economic substance and no purpose other than to build up and then draw down on an off-balance sheet asset, or “bank,” that Gen Re held for Prupac.

The complaint said the contracts were shams written to look as if they met the requirements to qualify for reinsurance accounting. In fact, they were subject to an oral side agreement that effectively eliminated any risk to either party and made such accounting improper, the SEC alleged. It said that Prupac built up the bank in 1997, 1998 and 1999 and then, in 2000, 2001 and 2002, drew down on the bank and improperly recorded the repayments as income.

In 2001 Prudential became a public company, and the inaccurate financial statements became a part of its annual, quarterly and current filings, the SEC noted.

The complaint alleged that the improper accounting practices began in 1997, when Prudential and Gen Re negotiated a riskless reinsurance contract under which Prupac paid Gen Re $50 million. The contract was entered into in the final days of the coverage period, but backdated to appear as if it had been agreed to before the coverage period began. The SEC said that the understanding between the parties was that Gen Re would credit Prupac with interest at the one-year Treasury bill rate and also collect a fee on the money it held.

“It was further agreed that the relationship would be riskless,” the Commission added. If Gen Re lost money in the early years of the relationship, when its exposure on the purported reinsurance contracts was greater than the amount in the bank, Prupac would make Gen Re whole, it elaborated. The parties kept track of where they stood in the relationship by means of a ledger, called an “Experience Account Balance,” which showed payments made into the bank, less fees, plus interest, and less payments out.

According to the complaint, the improper accounting practices within the Prudential division resulted in an overstatement of Prudential consolidated pretax income for 2000, 2001, and 2002 by $57 million, or 9 percent; $75 million (25 percent); and $38 million (146 percent) respectively.