Finite Risk Insurance
Finite risk insurance is a type of insurance in which the insured pays a premium that serves as a pool of cash for the insurer to use in the event of a loss. If the losses are less than the premium, the insurer will refund most or all of the expenses to the insured. If the losses, on the other hand, exceed the premium, the insured must pay an additional cost to cover them.
How Finite Risk Insurance Works
The insured transfers a liability connected with a specific risk to an insurer in exchange for a premium or charge under normal insurance arrangements. The insurer keeps a loss reserve with its own money and is free to keep any profits.
Finite risk insurance is a risk transfer product that combines elements of excess insurance and self-insurance. Finite risk insurance allows the insured to spread out payments for losses over time while still having the option of receiving a return of some premiums and investment income if losses are less than expected.
The insurer offers a typical insurance policy with specific limits and deductibles. The total limit and retention are per-occurrence and aggregate functions of the total premium, which is calculated as the losses that will be paid discounted for investment income.
The insurer writes the policy and deposits the premium, net of fees, into a special account that earns interest for the insured. If monies remain in the account at the end of the policy period, the insured may claim them.
If the account is depleted at any point throughout the policy duration, the insured must either pay an additional premium or the transaction is terminated.
Types of Finite Risk Insurance Products
Because these policies are tailored to the needs of each individual client, they are not as widely distributed as other insurance products. The major types of finite risk insurance products include Loss Portfolio Transfers (LPT), Adverse Development Coverage, Spread Loss Coverage, and Finite Quota Share Reinsurance.
Loss Portfolio Transfer
A loss portfolio transfer is a reinsurance arrangement in which an insurer cedes policies to a reinsurer. These are frequent policies that have already suffered losses. A reinsurer assumes and accepts an insurer's existing open and future claim liabilities through the transfer of that insurer's loss reserves in such a transfer.
Adverse Development Coverage
ADC, also known as retrospective excess of loss cover (RXL), is a finite risk product in which a reinsurer agrees to provide excess-of-loss coverage for losses on a retrospective liability that exceed the cedant's current reserves or planned retention. In other words, they do not allow businesses to combine pre-loss financing with excess-of-loss protection. Rather, the reinsurer promises to compensate the cedant for any losses that exceed an attachment point equal to a predetermined retention level.
Spread Loss Coverage
Spread loss coverage is a type of reinsurance in which premiums are paid during prosperous years to develop a fund from which losses are repaid during less profitable years. This reinsurance has the effect of keeping a cedent's loss ratio stable over time.
Finite Quota Share Reinsurance
Finite quota share reinsurance, also known as financial quota share reinsurance, is a type of reinsurance contract in which the ceding business is responsible for a percentage of the claim's loss. An intriguing aspect of these products is that the ceding firm is not needed to pay a deductible before coverage begins because that company will always be liable for a portion of the loss.
Benefits of Finite Risk Insurance
Companies may rely on finite risk insurance to cover long-term liabilities. While they may save money by self-insuring for certain risks, especially if no losses occur, a finite risk insurance contract provides some risk transfer.Â
A company might sign into a finite insurance arrangement to cover excess losses over other policies, including its own self-insurance approach, and these products could be used for warranties as well as environmental, pollution, and intellectual property risk. The insured can better match the amount of money set aside for liability protection to the projected obligations by engaging into a multi-year arrangement.
Criticism of Finite Risk Insurance
In the past, there has been some debate about finite risk insurance. Critics stated it acts more like a loan and can conceal insurers' genuine financial situation, allowing them to control and smooth their earnings. Given that finite transactions account for the time worth of money, allowing the ceding insurer to monetize its loss reserves, it is easy to see how this may be readily changed to benefit the party.
Some firms will collaborate with insurers while failing to disclose the real scope of the transaction to independent authorities and regulators. As a result, the finite risk industry regards some finite risk products as not only unethical but also unlawful. They undoubtedly have the potential to be, depending on how the items are utilized and the amount to which what is concealed. However, the same can be stated of other insurance products.
The Bottom Line
Finite risk insurance is a difficult-to-define product that is frequently criticized due to its malleability. Some believe that such products are utilized to manipulate a balance sheet in order to reflect a higher profit without truly transferring risk. Finite risk insurance contracts, on the other hand, can be regarded as viable and advantageous as long as both parties stay honest about the liabilities.