New rules of disclosure

The FSA recently issued a final notice against John Byrne (former chief executive of the alternative solutions business unit of the General Re Group), relating to his involvement in a number of financial reinsurance arrangements, which the FSA said were used by various insurers and reinsurers to disguise their true financial position.

The FSA's action sends some important messages to the insurance industry on the use of financial reinsurance. It demonstrates the FSA's seriousness in dealing with the misuse of financial reinsurance and highlights the level of international co-operation that now exists between regulators in dealing with this problem.

Michelle Bramley, a practice development lawyer at Freshfields Bruckhaus Deringer and an expert in this field, says: "The FSA has so far declined to define ‘financial reinsurance', in part because of the wide range of transactions the phrase is used to describe. Financial reinsurance is often more easily identified by its purpose than its characteristics. Its principal purpose is generally to improve the financial position of the insured or reinsured, for example, by improving or smoothing a (re)insured's profits or strengthening the (re)insured's balance sheet, rather than to transfer risk."

The FSA has repeatedly warned that while financial reinsurance may be used legitimately, it can also be used to mask firms' true financial position if not disclosed and accounted for properly.

The FSA sent a ‘Dear CEO' letter to UK general insurers in March 2005, asking for information on financial reinsurance arrangements they had entered into. David Strachan, the FSA's sector leader for insurance at the time, said: "The use of financial reinsurance is an issue that the FSA has been examining for some time. Our research has shown that its use is not widespread. Whilst there can be perfectly legitimate reasons for using financial reinsurance, its use should be properly disclosed. The proposed rules will provide greater clarity about firms' use of financial reinsurance."

Strachan added that the FSA's work had identified a small number of contracts that warranted further examination. "Where we find firms have made improper use of such contracts or not made a full disclosure of financial reinsurance contracts or arrangements, we will take action." Strachan kept to his word.

Proposed changes
Furthermore, in October 2005, the FSA proposed changes to the FSA Handbook requiring firms to provide additional information on financial reinsurance arrangements in their annual financial statements, which it proposes to make effective on 31 December this year.

It also proposed guidance that insurance firms should analyse the full effect of reinsurance agreements on their financial position, and identify and address all risks relating to those agreements.

The FSA plans to make this guidance effective in October. However, the enforcement action against Byrne related to financial reinsurance transactions that took place between 1998 and 2001. Byrne arranged and structured a number of financial reinsurance arrangements between General Re companies and other insurers and reinsurers.

The FSA took the view that these arrangements did not have sufficient risk transfer legitimately to be accounted for as conventional insurance.

However, as General Re's counterparties had accounted for them as conventional insurance, this enabled those counterparties to mislead regulators, auditors, tax authorities, the insurance market and, in certain cases, listing authorities and investors as to their true financial position. Bramley adds: "The FSA concluded that Byrne knew that the counterparties were likely to use the financial reinsurance arrangements in this way and therefore prohibited him from performing any controlled function in relation to any regulated activity for five years, on the basis that his role in these arrangements demonstrated that he was not a fit and proper person to perform such activities."

Critical guidelines
As the FSA has not provided a definitive list of characteristics for financial reinsurance arrangements, those with which Byrne was concerned (the subject of the enforcement action) provide useful guidance on the type of arrangements that may need to be disclosed and accounted for as financial reinsurance.

Bramley notes that these arrangements had a range of characteristics that restricted the transfer of risk to General Re from its counterparties. She lists these as follows:

• Terms that meant there was no real transfer of risk. For example, one reinsurance contract provided cover only above a sum in excess of the insured's liability under the original contracts of insurance. Another provided for the payment of additional premium in the event that a claim was made under it.

• Side agreements eliminating or reducing risk transfer. In one transaction, side letters providing that no claims would be made under a number of contracts of reinsurance were agreed. The premiums paid under these contracts of insurance were then used to cover General Re's liability under another contract of insurance with the same insured.

• Circular arrangements. In one arrangement, General Re reinsured a client reinsurer in one financial year, and was itself reinsured by the client reinsurer in the following financial year.

• Contracts entered into at the end of their terms. In one arrangement, a contract was signed when it was practically certain that no losses would arise under it.

• Backdating of contracts of insurance. In one case, a contract of reinsurance was backdated to conceal the date it was actually signed.

• Depositing of money with General Re by an insurer to discharge liabilities. One arrangement involved a subsidiary of an insurer effectively depositing money with General Re to discharge liabilities of its parent.

• Differing accounting treatment of transactions by insurer and reinsurer. In one arrangement, General Re accounted for the transaction as a deposit or loan, while the insurer accounted for it as reinsurance.

So the conclusion here was that financial reinsurance arrangements that were the subject of the enforcement action were entered into for a wide range of potentially illegitimate purposes.

Profits overstated
These included: enabling an insurer to overstate its profits by accounting for a financial reinsurance arrangement as conventional reinsurance; enabling an insurer to continue to trade in circumstances where, had the financial reinsurance arrangement been properly accounted for, prudential requirements might have prevented this; injecting regulatory capital into an insurer by accounting for a financial reinsurance arrangement as conventional reinsurance.

There was also the issue of avoiding paying tax by removing sums from an insurer's accounts and returning them through other contracts of reinsurance, and enabling one company to commute certain liabilities of another company in a way that concealed the true source of the funds.

It is significant that Byrne was disciplined by the FSA, notwithstanding that General Re accounted for the transactions properly. The FSA found that Byrne knew the transactions were likely to be misused by General Re's counterparties to deceive third parties and consequently ‘aided and abetted' that deceit.

The implications
Bramley says: "In future, firms and individuals should make sure that they understand - and clearly document - the purpose of any financial reinsurance arrangements they enter into or arrange, and satisfy themselves that the arrangements will not mislead others about their financial position."

The Byrne decision demonstrates that insurers, reinsurers and brokers involved in financial reinsurance arrangements should ensure that they have adequate systems and controls in place to ensure that they are aware of the financial reinsurance in which they are engaged, the purposes for which it is being used and the way in which it is accounted for and disclosed by themselves and their counterparties.

Bramley adds: "Firms and individuals involved in the illegitimate use of financial reinsurance are likely to find themselves the subject of enforcement action, and should consider whether any such arrangements should be notified to the FSA under Principle 11."