Paul Sanchez
Finite risk insurance is a type of insurance contract that transfers the risk of loss from the insured to the insurer for a stated period. These contracts are subject to specific liability limits and include a commutation feature, which refunds the insured if the loss experience is better than expected. The insured pays a premium that covers any losses, and if the losses are lower than the premium, the insurer returns the remaining funds. Conversely, if the losses exceed the premium, the insured must pay an additional fee. Finite risk insurance is often criticised for its unethical and illegal nature, as it does not qualify as transferring an adequate amount of risk.
| Characteristics | Values |
|---|---|
| Type of insurance | Alternative risk transfer type of insurance product with features of both excess insurance and self-insurance |
| Risk transfer | Limited risk transfer |
| Premium | Constitutes a pool of funds for the insurer to cover losses; if losses are lower than the premium, the insurer returns the remaining amount to the insured; if losses exceed the premium, the insured pays an additional fee |
| Premium in blended finite risk insurance | Must be less than the present value of a conservative estimate of loss experience |
| Additional premium provision | Requires the insured to pay the insurer a calculable amount as a result of losses paid or incurred under the contract |
| Commutation provision | Verbal or written agreement that allows the policyholder to commute the policy, implying that all liabilities and rights created by the contract are extinguished in return for the balance of an experience account |
| Experience account | Provision in an insurance or reinsurance contract that forms the basis of an explicit or notional fund that can be used to calculate the amount due under an additional premium provision |
| Notional loss experience account | Created at the Inception Date, for use in evaluating amounts due under the commutation provision, and updated annually |
| Loss Portfolio Transfers (LPTs) | Type of finite reinsurance where the policyholder transfers outstanding claims to the insurer |
| Finite reinsurance | Cedes a finite or limited amount of risk to the reinsurer; the insurer receives coverage on its potential claims at a lower cost than with traditional reinsurance |
| Time value of money | Emphasized in the contract |
| Risk retention | Insurers maintain a loss reserve with their own funds |
| Risk financing | Combined with risk transfer in the contract |
| Refund | If loss experience is better than expected |
| Investment income | Earned on the insured's premium payments; part of this is rebated to the insured |
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What You'll Learn
Finite risk insurance transactions
In finite risk insurance, the insured pays a premium that constitutes a pool of funds for the insurer to use to cover any losses. If the losses are lower than the premium, the insurer returns most or all of the charges to the insured. Conversely, if the losses exceed the premium, the insured is required to pay an additional fee to cover them. The premium is invested in an interest-accruing account, which the insurer can tap into to pay for claims.
Finite risk insurance is often criticised for functioning more like a loan and potentially manipulating the earnings of insurers. It is also said to provide limited coverage, which may render it useless for the purchasing company. However, it can be useful for companies to cover liabilities with long durations, and it allows the insured to spread out payments for losses over time.
There are several types of finite risk insurance products, including Loss Portfolio Transfers (LPT), Adverse Development Coverage, Spread Loss Coverage, and Finite Quota Share Reinsurance. LPTs, for example, involve the insurer ceding policies to a reinsurer, assuming the existing and future claim liabilities. Finite reinsurance is a category of reinsurance that cedes a finite or limited amount of risk to the reinsurer, allowing insurance companies to spread the risk they assume.
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Loss portfolio transfers
LPTs allow insurers to remove liabilities from their balance sheets, strengthening their financial position. They also enable insurers to transfer risk and timing risk, as well as investment risk. The latter refers to the risk that the reinsurer will generate less investment income if losses from claims are paid faster than expected.
Reinsurers benefit from LPTs as they can use the reserves to generate investment income, often at a significant profit. They also do not take on underwriting risk. LPTs can also help reinsurers handle claims more efficiently, which can increase their profitability.
Insurers use LPTs to immediately monetize any reserves they have set aside to pay out claims. This is particularly attractive if the insurer has over-reserved due to inaccurate actuarial models.
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Adverse development coverage
Finite risk insurance is a type of insurance that allows the insured to spread out payments for losses over time. It also allows them to receive a refund on some of their premiums and investment income if losses are less than anticipated. This type of insurance is often criticised for its malleable nature and the fact that it can be manipulated to smooth earnings.
LPTs are a type of finite reinsurance where the policyholder transfers outstanding claims to the insurer. This is a retrospective form of insurance where the policyholder pays a premium corresponding to the net present value of the outstanding claims, plus administrative expenses, risk capital, and profits. The insurer assumes the risk of unexpectedly rapid claims settlements, which could result in lower investment income earnings potential.
ADC facilitates mergers and takeovers as the insured company can offload both the timing and reserves development risk. The acquiring company can assess the target company without performing actuarial due diligence, and the existence of ADC improves analysts' and rating agencies' views of the acquisition by reducing the potential volatility of financial results.
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Additional premium provisions
Finite risk insurance is a type of insurance that covers liabilities that have long durations. It is a transaction in which the insured pays a premium, which is invested in an interest-accruing account, that the insurer can use to cover any losses. If there are funds remaining in the account at the end of the policy period, the insured may claim them. If losses exceed the premium, the insured must pay an additional fee to cover them.
"Additional premium provision" refers to a provision in the contract that requires the insured to pay the insurer a calculable amount due to losses paid or incurred, excluding provisions for additional premiums due to changes in exposure or policy audits. This provision is based on a function of premium, insurer charges, losses paid or payable under the contract, subrogation proceeds, and interest rates.
The additional premium provision is calculated using the "experience account", which takes into account the premium, insurer charges, losses paid, subrogation proceeds, and interest rates. The experience account can be notional, using estimated values, or based on the actual loss experience of the insurer.
In the context of finite risk insurance, the additional premium provision ensures that the insured is responsible for covering losses that exceed the premium through additional payments. This provision is separate from the initial premium payment and is based on the actual losses incurred during the policy period.
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Commutation provisions
An experience account, in the context of finite risk, refers to a provision in an insurance or reinsurance contract that uses a function of premium, insurer charges, losses paid or payable under the contract, subrogation proceeds, and interest rates to form an explicit or notional fund. This fund is then used to calculate the amount due under an additional premium provision.
For example, a notional loss experience account is created at the inception of a finite risk insurance policy. This account is used to evaluate amounts due under the commutation provision and is updated annually on the last day of each calendar year as long as the policy remains in effect. The notional loss experience account is determined by payments of ultimate net loss made by the insurer as of the immediately preceding loss payment date, plus interest income on any positive daily balance.
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Frequently asked questions
Finite risk insurance is an insurance transaction in which the insured pays a premium that covers any losses. If the losses are lower than the premium, the insurer returns the remaining funds to the insured. If the losses exceed the premium, the insured is required to pay an additional fee to cover them.
Loss Portfolio Transfers (LPT), Adverse Development Coverage, Spread Loss Coverage, and Finite Quota Share Reinsurance.
Finite risk insurance is an alternative risk transfer type of insurance product with features of both excess insurance and self-insurance. It allows the insured to spread out payments for losses over time while retaining the ability to receive a refund of some of its premiums and investment income if losses are less than anticipated.
Finite risk insurance provides an element of risk transfer, allowing companies to cover liabilities that have long durations. It also provides a means of pre-funding expected losses, or "pre-loss financing".
Finite risk insurance has been criticised for functioning more like a loan and potentially manipulating the earnings of insurers. Finite reinsurance, a type of finite risk insurance, has also been criticised for being too limited in scope, potentially making it useless for the purchasing company.
