Finite insurance is one of those situations where logic takes you to a place that doesn't feel right. It is a logical "extention" of the traditional reinsurance contract in that it limits the prospect that the premiums paid will be either too much or too little with reference to the losses paid. In the classic "two way deal", the contract is for a specific period, at the end of which the parties settle up, so that the claims plus the fee equals the premiums any interest earned. The ceding party spreads the losses evenly over the period, and the reinsurer ends up with the agreed margin. It is not much of an extension to realize that with this device, losses can be (and have been) insured after they have been incurred. The fact that a portion of the losses for the period are already known makes no economic difference to the reinsurer, and the insured hopes to avoid reporting the loss in the current period.

The pure two way deal is too transparent to pass muster as traditional reinsurance, and with proper accounting the losses hit the ceding company's books in the period incurred, not as the premiums are paid. To avoid this result, finite insurance deals evolved to provide a patina of underwriting risk, omitting the agreement to pay more premium if necessary, but setting it high enough so that a refund will probably be due the ceding company. The contract may also combine or "blend" a fully insured unrelated risk with the finite segment, enhancing the risk in the total basket. The issue becomes whether enough underwriting risk is present. The accounting rules are complicated, but in essence there must be "substantial" or "significant" transfer of underwriting and timing risk, and the reasonable possibility of significant loss to the reinsurer.

A reinsurance agreement with substantial finite characteristics can be very useful. Traditional reinsurance transfers profit along with risk to the reinsurer, and for most companies a higher retention, i.e. self insurance, would be desirable if it didn't have the prospect of a big loss in one quarter. After all, what do you really use reinsurance for, except to spread your losses over a number of periods? For example, suppose your current retention on a life is $250,000. What would you be willing to retain if you could spread your claims evenly over 5 years, regardless of the year in which incurred? A million dollar claim is not so worrisome if you don't have to book it all in the quarter incurred. Both traditional and finite reinsurance solve the problem of unacceptable fluctuations in surplus or earnings. With traditional reinsurance your premiums are almost certain to exceed your losses over any extended period, so there is little real risk (beyond timing risk) to the reinsurer. Some might consider the accounting debate over risk that is ethereal in the real world a matter of angels and pins.

This section includes some thoughts on securitization of life insurance cash flows, which can accomplish some of the same purposed as finite insurance, but which, as a practical matter (finding a buyer) may be exposed to some of the same regulatory problems. Special-purpose entities, the mechanism legitimately used to implement securitization, were made infamous by Enron, are discussed here, along with some speculation on how AIG may have benefited from the use off-shore entities, which were purportedly independent insurance companies but which were effectively controled by AIG. It seems likely that these reinsurers will be considered VIEs, variable interest entities, under current accounting interpretations. The VIE is an expansion of the former SPE rules that require consolidation of the results of the entity with the financials of the entity benefiting from those results.

Notes

Discussion

Traditional reinsurance, finite insurance, financial reinsurance, funding reinsurance, blended reinsurance; the terms are supposed to relate to the insurance risk transferred to the reinsurer, but are not reliable indicators. I will just use "finite insurance" to include any arrangement where the contract provides for some form of settling up at the end of the agreed term. With traditional reinsurance the term is indefinite, and while the reinsurer is usually successful in keeping the cumulative premiums in excess of the losses, there is nothing in the contract that prevents the ceding company, if it gets ahead of the reinsurer, from moving to another carrier. And there is no limit, in theory, to the size of the bag the reinsurer can be left holding. The other extreme, in finite insurance, is the "two way" deal, where the parties settle up at the end, so the premium paid is equal to the losses paid, adjusted for interest and fees.

Illinois Captive & Alternative Risk Funding Insurance Association: Finite Risks Definition: These products involve a transaction between an insurer and insured in which the insured does not actually transfer much or any risk of loss per occurrence to the insurer. The insured pays a premium that constitutes a pool of funds for the insurer to use to pay losses. If losses are lower than the premium, the insurer returns most or all of the premium to the insured. If the losses exceed the premium, the insured pays additional premium to the insurer.
How It Works: The insurer provides a standard insurance policy, but modifies the limits and deductibles in a specific way. The total limit and retention, on a per-occurrence and aggregate basis, are a function of the total premium. The insurer computes total premium as the losses that will be paid, discounted for investment income. The insurer issues the policy and segregates the premium, net of fees, into a dedicated account for the insured. The account accrues interest which belongs to the insured, net of an insurer fee. If at the end of the policy period funds remain in the account, the insured may claim them. If at some point during the policy period losses exhaust the account, the insured either pays additional premium, or the transaction ends.

The risk to the reinsurer can also be limited by "side agreements", outside of the insurance contract, and generally kept confidential. See the discussion by Advisen of the suit against General Re from the Reciprocal of America transaction, involving unreported side agreements that are said to have protected General Re from excess losses.

The KPMG Insurance Insider noted that undisclosed side agreements "are typically necessary to make the transactions work". It also noted that "The acceptable amount of risk transfer has been commonly understood to be at least 10 percent of the total policy value."

There are few, if any, finite insurance contracts structured as two way deals, or even that transfer only timing risk. The desire is usually to account for the reinsurance as traditional, which requires the transfer of some definite amount of underwriting risk. The calculation becomes how to include enough risk to get the transaction by the auditors, and to still include enough certainty for the reinsurer that the premium (enhanced by the fee) will exceed the losses.

Once you have a structure that the reinsurer is comfortable that it will come out ahead by the end of the contract period, it is no great leap to realize that it doesn't make any difference whether the future losses are estimated, or have already occurred. All that means is that, for example, of the estimated losses over a 5 year period, the losses for the first year are known. You add the known loss to the estimate for the rest of the period, and you know what the premiums should be.

Buying the insurance after the loss has been incurred goes against instinct, but is perfectly consistent with the finite insurance concept. The problem is, of course, that it removes an existing loss from the books, making the effect of the transaction, and the motive, rather obvious. The theoretical issue is whether there is enough transfer of risk for the remaining period to qualify the transaction as traditional insurance. The practical issue is whether anyone will have the chutzpah to try it in the future.

Is finite insurance a valid legal product with proper uses, or is it a fraudulent transaction with the sole purpose of smoothing or manipulating earnings or balance sheet items reported to the public? The investigations by the New York Attorney General, and others, and the $80 million settlement by AIG, plus the extensive newspaper coverage, have probably chilled this type of product, at least for the near term. What management will at this point enter into a transaction that is bound to raise questions concerning the degree of risk transferred, the dominant business purpose, or simply those from directors or regulators who are not familiar with what is actually involved in finite insurance, aka financial reinsurance, aka non traditional insurance products. For an excellent discussion see The Alternative Insurance Market: A Primer.

The essential element of finite insurance is a contract for a specific period, after which the amount by which the premiums paid exceed the losses and the fee of the insurer is owned by the insured. Whether or not the contract actually transfers risk is determined by the relationship of the agreed premiums over the period to the aggregate limitation on the total losses payable. For example, suppose that the insured agrees to pay a premium of $1 million a year for 5 years, and the aggregate loss payable over the period is $5 million. While there is a transfer of timing risk, there is no transfer of underwriting risk. The same conclusion can be reached if there is no aggregate loss limitation, but the total contractual premiums greatly exceed the expected losses. While it can be argued that there is in theory a risk of loss on the part of the insurer, as a practical matter it will be necessary to look to the other business purpose of the transaction to determine its propriety. It can be anticipated that the "valid business purpose" arguments that come from this will be analogous to those you see in the tests of transactions that reduce taxation.

This is an important point. These transactions have the effect of spreading losses or expenses over the period of the contract, and thus smoothing earnings or inflating assets (that would be depleted by immediate recognition of the loss) that are reported to the public. Is that a valid business purpose, in these Sarbanes Oxley days? There is enough doubt to prevent these cases from getting to the courtroom, as the defendants have an understandable need to settle.

For an excellent defense of the business purpose of finite insurance used by insurance companies, see Finite Risk in the Post-Enron Environment, Journal of Reinsurance. The article notes the two primary accounting standards governing finite insurance, Statement 113, which requires the transfer of underwriting risk and timing risk (the 9A test) and the reasonable possibility of significant loss to the reinsurer (the 9B test),
Contracts that do not result in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed generally do not meet the conditions for reinsurance accounting and are to be accounted for as deposits.

and EITF 93-6, which requires that changes under multiple year treaties due to past experience must be accrued at the same time as the underlying experience. The NAIC rules follow this GAAP guidance. The author states that within a year or so after the rules became effective in 1993 insurance companies and their auditors had developed industry practice and interpretations, but that these were "turned upside down" by the Enron scandal. He suggests that the standards are once again becoming settled and that finite risk reinsurance is again growing. The article is dated Fall, 2002, so it is post Enron but pre Spitzer. It is also early to consider the impact of Sarbanes Oxley.

Note that statutory accounting for reinsurance is covered by SSAP #61 and ASOP No. 11. The actuaries currently have an exposure draft outstanding on the later. The NAIC Reinsurance Study Group has taken up the question of finite insurance, per the newsletter of NAMIC, which comments:
The risk-transfer question or definition at the heart of distinguishing banking from insurance lies in both statutory accounting authority and generally accepted accounting principles (GAAP) and lacks bright-line characteristics.

Sometimes you can learn more about the problems by reading the articles defending the mechanism, than from those attacking it, sort of a damning by faint praise result. Finite Insurance: Is the Criticism Warranted, on the IRMI site, is revealing.

Accounting for the Risk: Know the Difference between Reinsurance Contracts from the Pennsylvania CPA Journal makes a distinction between "finite insurance" and "financial reinsurance" and the resultant application of the accounting rules.

The current problems may reach a number of other insurance companies, including Buffet's, according to Peter Eavis, for Street.com.

Two insurance company collapses often mentioned in connection with financial reinsurance are Independence Insurance Company and HIH Insurance Company. The HIH problems were alleged to be partly obscured by the use of reinsurance, particularly with its acquisition of FAI Insurance which had a huge finite reinsurance contract. An interesting "small world" aspect were the hundreds of millions of losses in its film finance insurance business, which it had assumed was covered by reinsurance with New Hampshire Insurance Co, the AIG subsidiary targeted lately, and Independence Insurance Company of London, the other collapse referred to above.

Every insurance company purchases reinsurance above its retention. That is certainly not finite insurance but what is the purpose? If the company keeps all the risk, or sets its retention too high, a run of losses substantially above average can impact its surplus (asset) unduly or have an undue effect on that year's financial statements. "Unduly" as used here is, in most cases, determined as a matter of taste or preference of management or the board. But for the concern for significant fluctuation of earnings, most companies could profit by increasing their retention.

So what is the difference between normal reinsurance and financial reinsurance? How different is the transfer of underwriting risk, as opposed to timing risk? If your reinsured losses get ahead of your premiums, the reinsurer is going to raise your premiums. In theory you could move to a different reinsurer to leave the loss with the old carrier, but any new carrier is going to look at your loss experience before quoting. In practice you stay with the old carrier indefinitely, and the premiums average out to cover the losses plus the profit to the reinsurer. The net effect was that you smoothed out your loss experience. Reinsurance is not going to become a profit center for you. This universal practice clearly has enough transfer of risk to qualify the transaction as insurance. It appears that timing risk qualifies the transaction, as that is the transfer of underwriting risk for a single year, but not for the duration of the relationship?

Perhaps some of the difference is in the cosmetics on finite insurance. The web sites of the major carriers make no bones about the purpose being to smooth earnings or bolster the balance sheet. When you say that, you are becoming a target. I am sure that this will change, and if any carrier remains in the business, there will be some lipstick on this pig.

Retaining the maximum workable self insurance is usually a profitable approach to risk management. You can retain more risk if you can spread your losses over a number of years. A major benefit of finite insurance is that it accomplishes that by stabilizing the underwriting results. You can retain even more risk with a basket aggregate program, which provides a single aggregate retention for a number of exposures. You buy a single finite insurance policy that fixes your expense to the annual premium, covering all of the exposures.

This sounds like a valid business approach to risk management, not like smoothing earnings or earnings management. And yet if the premium exceeds the average expected annual loss by a large margin, and you receive back anything left over the losses and the insurers fee at the end of the period, you can question whether there has been anything but a transfer of timing risk.

Finite insurance is also used to transfer losses that have already occurred. This can allow the insured to account for the loss over a period of years instead of the year in which it occurred. If a loss is incurred that will cause cash flow over a number of years, the company would normally be required to reserve the expected payments in full. Premiums for insurance, however, are accounted for in the year paid, even if the insurance contract requires premiums to be paid over a number of years. There is no reserve required for the future premium obligation.

"Finite-risk programs can also be designed to serve retrospective purposes. Over several years, corporations that self-insure or retain risk may accumulate substantial liabilities on their balance sheets. These liabilities may hinder them from seizing business opportunities and also impose an administrative burden. A loss-portfolio transfer (LPT) allows a company to improve its balance sheet by closing the book on such liabilities. A corporation can improve its operating ratios and free bank lines that could be used for operating purposes. An LPT may also enable a company to operate leverage and generate surplus, while enhancing its standing in the eyes of rating agencies, stockholders and others. "

What has actually happened of course is that the insured has exchanged one future obligation, the loss payments, for a different future obligation, the insurance contract. The accounting rules require a reserve for the first obligation, but not the second. This is sounding pretty flaky. While a company should be entitled to arrange things favorably to it as long as it follows the rules (as in tax law), but the problem is that the future obligation disappears from the financial statements. The answer may be to footnote these arrangements, but that does not appear to be the current practice.

An article posted September 2002 in Risk Transfer discusses the expanding market for alternative risk transfer utilizing the financial insurance vehicle. Noting that the typical arrangement has the insured setting aside 75 to 90% of the coverage limits over the term of the contract in an experience account, no actual risk transfer will occur unless the losses exceed the fund. The insured ultimately pays all or most of ceded losses. The article notes the increasing scrutiny by regulators asking:
" whether this sort of arrangement, used primarily for balance sheet enhancement, might not amount to a sort of regulatory or accounting arbitrage, which takes the form of an unfunded or semi-funded reinforcement for the insurer’s balance sheet, which is unlikely to actually be a pure capital injection from the reinsurer. "

The article also cites a Pennsylvania class action which "alleges that the defendant, an insurance holding company, intentionally made materially false and misleading statements by leading investors to believe its financial condition was better than it actually was, due in part to large premiums due under a financial reinsurance contract.

So what is the bottom line on financial insurance? If a footnote disclosed that the insured had decided to self insure certain exposures, and had arranged to pay for any losses evenly over a 5 year period to make sure any one year didn't disrupt operations, that sounds pretty good. Hard to criticize sound risk management. However, if the complaint accuses the company of arranging to keep any large or unusual loss from appearing in the financial statements, and further not disclosing the obligation to pay large premiums for the next 5 years, it doesn't sound so good

Assuming that the current attacks do not completely chill the use of financial insurance, the regulators and the courts are going to have a tough time drawing the line between permissible sound business purpose and account abuse. It is fairly safe to suggest that retrospective use will fall on the abuse side of the line, since it involves the direct elimination of a reserve that should already exist on the financials. But what about stabilizing the loss experience prospectively?

Unfortunately, I would guess that this will be an instance of bad money driving out good. The user that is not in serious need for the smoothing of loss experience will avoid the vehicle as just not worth the brain damage. The users with less sanguine purposes, who feel the need to do serious financial engineering, will still resort to it, if they can find a carrier.

Hard cases make bad law. The complaint in SEC v.Brightpoint and AIG reveals a flagrant situation. When losses in a division mushroomed, management turned to the "Loss Mitigation Unit" of a AIG sub. The result was a backdated policy with an aggregate loss limit of $15 million and a three year premium total of $15,302,400.

LMU offered "insurance" products specifically designed to "smooth" the financial statement impact of losses sustained by AIG clients. Brightpoint and AIG negotiated the terms of a $15 million "retroactive" insurance policy that covered all of the extra UK losses. The parties agreed to combine this "retroactive coverage" with prospective fidelity coverage (together, the "Policy") in an effort to avoid scrutiny from Brightpoint's auditors (the "Auditors"). The "cost" of the $15 million "retroactive coverage" to Brightpoint was about $15 million, which Brightpoint was to pay in monthly "premiums" over the prospective three-year term of the policy. The Policy, finalized in January 1999, enabled Brightpoint to record in 1998 an insurance receivable of $11.9 million, which Brightpoint netted against the total UK losses of about $29 million,

Given the facts as stated in the complaint in Brightpoint, you would expect the reversal of the accounting once the auditors were alerted to the situation, and the resultant regulatory problems. The case was settled with a $10 million payment by AIG and $450,000 by Brightpoint.

More surprising is the SEC position that would frustrate all retroactive insurance"

Second, the policy could not look like retroactive insurance, i.e., insurance designed to cover a loss already quantified and known, because Brightpoint might then be required to expense the full $15 million "premium" immediately. Under GAAP, the insured is obligated to recognize the full premium expense associated with a retroactive policy at the time it recognizes the benefits of the policy.

If that is correct under GAAP, it is hard to see the point of retroactive insurance. An insurer is not going to cover an existing loss for less than the loss, so throwing the entire premium into the year of the loss is not going to smooth the financials. Since these cases are just now developing, we should know pretty soon. MBIA has received subpoenas from the SEC regarding a retro which helped avoid taking a $170 million loss in 1998. See this Herb Greenberg article and this one, which details the MBIA transaction.

The subsequent MBIA development was reported in The Street.com as follows: MBIA announced it was restating earnings for the past seven years after an internal investigation found "likely" evidence of an "oral agreement" that effectively changed the terms of a 1998 insurance transaction. The previously undisclosed side agreement effectively limited the transfer of risk in the transaction and meant that a $70 million insurance recovery was really a disguised loan.

While it is difficult to put your finger on exactly what Sarbanes Oxley adds to the chill on finite insurance, most would agree that it does. The adopting release of the SEC rules on SOX 303 includes an example of conduct it considers might constitute Improper Influence on Conduct of Audits: Providing an auditor with an inaccurate or misleading legal analysis.

Retroactive finite insurance, covering a loss that has already occurred and which will otherwise be reflected immediately in the financial statements, is not going to survive the emphasis in SOX on fraud prevention and detection. Brightpoint is an extreme case. Deciding that it is embarrassing or inconvenient to report a loss, and devising a way to spread it over future years, is always going to look like fraud, even if the loss is one which is conventionally covered by insurance. In Brightpoint, the loss accrued in obsolete inventory, and it had already been determined that there was no coverage in its regular policies.

In the Brightpoint complaint, the SEC made a specific allegation that aspects of the finite insurance contract were inserted with the intent to mislead the auditors. That would be the expected result of any provisions that exaggerate the transfer of risk. I would expect that any management that is considering the use of finite insurance must anticipate a full explanation to the auditors, inclusion of the explanation in extensive footnotes, careful review by the audit committee, guarded legal opinions, and in the end, rejection by the board as just not worth the brain damage.

It seems appropriate to briefly discuss securitizaton of life insurance premiums and assets belongs in this section, as it can accomplish many of the objectives of the use of finite insurance, and may face some of the same regulatory challenges.

For an early "securitization" of agent balances, see my discussion of the sale of balances to a bank. On the reasoning stated below, that transaction would probably not pass muster today.

For an excellent discussion of basics of securitization, plus its application to life insurance, see Securitization of Life Insurance Assets and Liabilities, Cummins, Wharton Financial Institutions Center:

In many instances, the firm can reduce its leverage, manage risk, and otherwise enhance its overall financial strength by entering into securitization transactions. One important reason for this is that securitization can be used to create off-balance sheet entities that house assets and liabilities, with favorable capital structure implications for the originator. A number of the insurance securitization transactions discussed below have accomplished this objective.

See also Life Insurance Securitization Expanding,

To securitize an asset, or more accurately, the cash flow stream from an asset, you segregate it and then sell interests in the stream. The most common transactions involve the transfer of assets such as high yield bonds or accounts receivable to a special-purpose entity which then issues several tranches of bonds, converting the assets to securities. The few uses of securitization unique to the life insurance industry have so far mostly involved securitizing blocks of business. For a detail analysis of uses and potential uses, see Cummins, cited above.

The purpose here is to look at what a life insurance company would probably wish to accomplish by securitizing a block of policies, and to avoid, and how accomplishing this might lead to the type of regulatory problems we have seen with finite insurance. The challenge to a rapidly growing life company is not running out of cash, but failing to maintain adequate surplus. This has been exacerbated by the introduction of Regulation XXX, but the front end loading of acquisition expenses this has always created a challenge for a company capable of producing significant amounts of new business.

Coinsurance with a reinsurer can solve the surplus problem for any portion of the business which you are willing to give away. Unfortunately, to the extent you coinsure you become just an agency for the other company. You would prefer to find a way to keep the business on your own books. In addition, depending upon the deal you negotiate, you may find most or all of the profit on your sales efforts going elsewhere.

If you could securitize a block of your existing or new business for its full fair value, the present value of the future profits, that would be a good deal. You keep the administration, realize the profit now, and the business and reserves go on some else's books.

Perfect. Except it doesn't work that way. The future of a block of business, particularly your new business, is highly uncertain, and a buyer will have to receive either a risk return that is likely to be higher than the profit you built into the product, or "credit enhancement" to reduce the risk that the cash flow from the block will fail to meet projections.

So how do you give credit enhancement? You could guarantee the return on the business, or elements such as the persistency. That might have washed with the accountants and actuaries some time back (they originally bought that there was no reserve requirement on a universal life secondary guarantee, didn't they?). But look a little closer at the transaction.

You take all of the policies you sold last year and transfer them to a trust (ignore for now the transfer problems). The trust then issues three tranches of asset backed securities, the total face of all being equal to what you think the FMV of the block is. Tranche A is structured to yield 4% and receives the first cut of all the cash flow net of administration fees and costs. Tranche B expects a 7% yield but doesn't receive any payments until A is paid off. Tranche C gets all the residuals after A and B receive back their investment and yield. Tranche C should be a good investment, but the risk is so concentrated and opaque that buyers are unlikely. So you acquire it and retain it in the originating company. To gauge whether retaining the equity tranche will run afoul of the accounting rules governing Variable Interest Entities (the post-Enron expansion of the SPE definitions) consider the discussions below.

There are of course other credit enhancement approaches. In the more usual ABS, the CBO, the banker assembling the bonds will sometimes agree to part of its fee will be contingent upon each tranche receiving at least principle in full. Might the insurer agree that it would charge no administration fee in any period where the cash flow was off schedule? And perhaps defer a portion of it until the end? Administration cost would constitute 15 to 20% of the total cash flow, so it is strong enough to take significant risk out of the deal, even to the equity tranche.

In my view, if you can get someone to take the equity tranche without crossing the line into some sort of guarantee or buyback, or giving away too much overcollaterization, you have a valid deal.

When we engineered the sale of agent balances to a bank circa 1980, we conceived of it as a variation of floor plan financing. The balances were sold without recourse, with the provision that all of the credits to the account from commissions (which were vested) would be paid to the buyer, affecting a repurchase of the balance by the company. Since we never sold more than the top half of any account, or more than a limited number of months worth of renewals, as a practical matter there was no possibility of the bank not receiving payment in full. Had we envisioned the transaction as securitizing the commission flow to the balance account, we would have seen that we were retaining the equity tranche.

The transaction essentially changed the fully secured portion of agent balances to certificates of deposit of the buyer bank. Over time this was challenged by more than 20 state insurance departments, always on the theory that the CDs must have been pledged to secure the funds paid by the bank. Since that was not the case, to which the bank repeatedly attested, no challenge ever succeeded. We fully disclosed the transactions in our statutory statement, with some pride of authorship. We will never know whether an argument that we had retained the full equity in the balances sold, the equity tranche, would have defeated the alchemy.

For a life insurance company the usual purpose of securitization, finite insurance, and the other devices would be surplus enhancement rather than earnings smoothing. Dr. Cummins noted in a telephone discussion that in the several securitization transactions the practice was to secure the approval of the insurance department, and to fully disclose in the financial reports. That should settle any regulatory concerns that have been so far expressed about these vehicles.

The unique regulatory situation for publicly held life companies, filing both GAAP and Statutory statements, implies you should be able to have your cake and eat it too. Full disclosure on your GAAP statement doesn't undercut the surplus enhancement on your Blue Book, and if that is recognized by your insurance department you would appear to have satisfied both audiences.

As noted above, disclosure in the notes to the statutory statement may bring a number of inquiries from non-domiciliary states.

Enron brought the special-purpose entity to public awareness, but the device has been around for a long time. The report by the investigative committee of the Enron board contains a readable history of its uses of SPEs. For a discussion of valid uses, see this article.

A transferor must consolidate an SPE in which it has a controlling financial interest. An accounting ruling in the mid 50s focused on the ownership of voting control. That was an easy test to circumvent while maintaining control, so the now defunct 3% rule had been added by the time Enron designed JEDI, Chewco, et al. Under the 3% test the sponsor could escape consolidation if the equity ownership of an independent third party was at least 3% of the total capitalization of the SPE. Enron did not legitimately comply with that standard for several reasons, the difficulty of finding real investors, the necessity for terms that no independent party would accept, and the interest of the CFO to personally profit from the transactions. Still, it would have been nearly as easy to circumvent the 3% standard and the voting control standard in most situations.

After Enron the standards evolved rapidly. While you can find mention of the rule now being 10% instead of 3%, that is not right. The 10% is a presumption only, and a negative one at that. If the equity is less than 10% the presumption is for consolidation. Regardless of the percentage, the true interests of the parties and the nature of the transaction will control.

EXHIBIT 2 of Accounting for Special Purpose Entities Revised: FASB Interpretation 46(R)- CPA Journal Online - July 2004, provides the history of PRE-ENRON STANDARDS DEALING WITH ACCOUNTING
FOR OFF–BALANCE-SHEET ARRANGEMENTS

EITF Issue 90-15, “Impact of Nonsubstative Lessors, Residual Value
Guarantees, and Other Provisions in Leasing Transactions”
EITF Issue 96-21, “Implementing Issues in Accounting for Leasing
Transactions Involving Special Purpose Entities”
EITF Topic D-14, “Transactions Involving Special Purpose Entities”
EITF Issue 96-16, “Investor’s Accounting for an Investee When the Investor
Has a Majority of the Voting Interest but Minority Shareholders or
Shareholders Have Certain Approval or Veto Rights”
EITF Issue 96-20, “Impact of FASB Statement No. 125 on Consolidation of
Special Purpose Entities”
SFAS 125, “Accounting for Transfer and Servicing of Financial Assets and
Extinguishment of Liabilities”
SFAS 140, “Accounting for Transfer and Servicing of Financial Assets and
Extinguishments of Liabilities”

The Guidelines effectively treat an entity that is the primary beneficiary of a VIE in a similar manner to that which would be required if the primary beneficial controlled the VIE in a traditional manner.

With the introduction of the VIE, consolidation depends not only upon control, but also on something akin to beneficial interest. Very generally, if the sponsor/transferor is the primary beneficiary of the gains and losses in the VIE, the entity should be consolidated.

The AIG investigations appear likely to extend these concepts to its relations with several offshore entities in which it has no equity, but which are either run by retired officers and directors of AIG, or are otherwise effectively controlled by and used for the benefit of AIG .

An example of how such entities can improve the looks of financial statements was Coral Re, which the Delaware insurance regulators concluded was not an independent reinsurer, but rather an arm of AIG. AIG was forced to forgo approximately $100 million of reinsurance credits owed from Coral, which had been an asset on AIG's books. So the transactions had created $100M of gain on AIG books and a $100M loss at Coral, which probably had a negative net worth.

Most of that business moved to Union Excess of Barbados.

Some of the commentary on the new rules asserts that the terms VIE and SPE can be used interchangeably. That is not correct. In the classic securitization, the SPE has the resources to complete its mission, and the gains or losses fall to the investors, not the transferor. That would not be a variable interest entity, by definition. Likewise, the offshore reinsurers used by AIG are clearly not SPEs, but are almost certain to be considered VIEs the results of which will be required to be consolidated with AIG.

Secondly, FIN 46 applies to SPEs that do not meet the qualifying SPE criteria. So before you tick that SPE box, you first have to decide whether or not your SPE is a Variable Interest Entity (VIE). It's not a VIE if the total equity investment is sufficient to finance activities without additional financial support and that is not necessarily 10%-- it might actually even be less.... In addition, it's not a VIE if equity investors have a direct or indirect ability to make decisions through voting or similar rights. Or they have an obligation to absorb expected losses and the right to receive residual returns. Tavakoli Structured Finance October 2003.

A lightly or completely unregulated offshore reinsurer which you control can be helpful to your financials in a number of ways. Reinsuring blocks can remove the required reserves from your books, without creating corresponding reserves in the reinsurer if it has lower requirements. If it turns out that the reserves were excessive, you have inexpensive reserve relief and probably an adjustment coming. If it turns out that the losses exceed the reserves, you can choose when to settle up with the reinsurer, or maybe not settle up at all if nobody cares.

With most of its SPEs, Enron never bothered to have any outsider involved, other than the CFO and his associates. When Enron needed to "sell" assets it essentially sold them to itself, with the funds for the SPE coming from bank loans guaranteed by Enron or backed by its stock. Don't miss Conspiracy of Fools. Unbelievable.