Reinsurance and other forms of risk transfer: financial reinsurance and alternative risk transfer (ART): transfer of risk
There are many kinds of financial reinsurance products. Terms used in the past include time and distance, retrospective aggregate cover, loss portfolio transfer (see GIM8100), prospective aggregate cover, spread loss cover, financial quota share, and finite risk. Some of these kinds of policies have fallen out of favour as commercial needs and accounting standards have changed. However, they all involve the transfer of different kinds of risk from the insured to insurer, or from cedant to reinsurer.
Such risks include:
- Underwriting risk. This flows from the uncertainty as to the ultimate amount of the payments that will need to be made in settlement of claims. Inherent in the concept of underwriting risk is the idea that the events giving rise to the claim payments must be fortuitous and outside the control of the parties to the insurance contract.
- Timing risk. This is the risk that arises from uncertainty about the time at which payments will have to be made under the contract. Because money has a time value an earlier payment is more onerous to the payer than a later one.
- Investment yield, or market risk. This is the risk that the investment return that is actually earned on the net funds passing under the contract will differ from the expected amount.
- Expense risk. This is the risk that the insurers or reinsurers operating expenses may exceed the amounts expected when the premium was established.
- Counterparty, or credit risk. This is the risk that a counterparty obligor will prove unable to meet its obligations. It is more an inevitable consequence of entering into the contract, rather than a risk transferred by it, although credit default swaps may be written specifically to cover counterparty risk.
Paragraphs 248 to 264 of the 2005 ABI SORP (Statement of Recommended Practice) contain details of the accounting treatment of reinsurance contracts, in terms of the assets and/or liabilities that are created by the contract, and the transfer of either or both of underwriting risk or timing risk. International standards may vary here. The US authorities will not accept that a contract meets the definition of insurance unless both underwriting risk and timing risk are transferred. The question as to whether or not a contract is, as a matter of law, a contract of insurance may not be decisive in relation to its tax consequences. The legal form of a contract will be less important than whether or not the contract performs the economic function of insurance. The examples in the following GIM paragraphs are not exhaustive but they demonstrate the wide range of financial services products which incorporate varying degrees of the transfer of different types of risk.
GIM1020+ contains more on the meaning of insurance.