To understand financial reinsurance, one must first not only understand the concept of reinsurance but also the difference between contracts of reinsurance and loans.

Reinsurance in its most simple form is not dissimilar to the practice of a bookie laying off bets in circumstances where the bookie feels overexposed to the risk he has taken on in a particular race. The bookie effectively reduces his exposure by spreading the risk with other bookies. Similarly an insurance company may reduce its exposure by insuring (or reinsuring) a proportion of its portfolio with a reinsurance company.

Under a traditional reinsurance contract the insurer pays the reinsurer a premium which is non refundable regardless of whether there is a loss or not. In the event of a loss to the portfolio the insurer is entitled to recover 100 per cent of the loss. In other words there is 100 per cent risk transfer of the proportion of the portfolio reinsured with the reinsurer.

The traditional reinsurance contract is accounted for as a contract of reinsurance and, in the event of a loss, full credit can be taken in the profit and loss account for reinsurance recoveries. In simple terms the insurer is entitled to show the positive effect the reinsurance recovery has on the profit and loss.

A financial reinsurance contract on the other hand is a hybrid between a contract of reinsurance and a loan.

The fundamental difference between traditional and financial reinsurance is that a proportion of the recoveries made relating to a financial reinsurance contract have to be paid back over a period of time to the reinsurer. Consequently recoveries under a financial reinsurance contract may not be able to be accounted for as reinsurance recoveries unless the contract provides for sufficient risk transfer.

Currently a financial reinsurance contract will be regarded as a loan if there is less than 10 per cent probability of a loss of more than 10 per cent. Anything less than this is an unacceptable and any recoveries relating to this contract must be accounted for as a loan.

Provided a financial reinsurance contract carries sufficient risk transfer, these contracts may be used as a cushion as they enable an insurer to ameliorate the impact of a particularly bad year on its profit and loss account.

The allegations relating to the financial reinsurance contracts we have read about in the press recently suggest the contracts did not provide for sufficient risk transfer.

If substantiated, these allegations suggest the financial reinsurance contracts misrepresented the true financial position of the insurer – reinsurance recoveries in these circumstances ought to have been accounted for as loans, which would have resulted in a significantly poorer financial result than shown in the profit and loss account.

Financial reinsurance contracts have been around for a long time but in light of recent history are currently out of favour with the market.

Malcolm Steingold is CEO of Aon Re Asia Pacific