3.4 Finite Risk Insurance - A Combined Approach
It is a hybrid involving risk transfer through an insurance contract and internal financing of risk. Finite risk insurance and financial reinsurance both involve risks which are limited by an aggregate limit across the policy so that the insurer has a limited liability (hence the term "finite"). They both attempt to "smooth" the peaks and valleys of losses for the insured and the insurer by redistributing these losses over a period or a series of fiscal periods. Finite risk products are tailored for each bank and reflect its own unique risk transfer needs. Therefore, no two programs are alike. Indeed, even definitions of what constitutes "finite risk" differ based on the proposed use of the techniques involved. However, finite risk contracts do share several common features.
3.4.1 Loss Severity and Frequency
Finite risk works best in situations where a severe loss is possible. A typical finite risk prospect is an organization which has a high severity/low frequency loss situation (i.e an "upstream" professional liability loss from overseas derivative trading) for which inadequate insurance coverage is available in the conventional market or the cost of the coverage is prohibitive.
Frequently, a bank will use a single-parent captive to front a finite program to fill the middle layer of operational risk - above the self-insurance used for smaller recurring losses and below commercial insurance used for catastrophe cover - although some insurers have used finite insurance on top of self insurance and handled the upper layer of risk through a captive.
An example of how a finite risk program can handle a high severity/low frequency situation might be that of an investment banking firm which has developed a new series of global derivative trading products. To fully exploit the potential market the firm wishes to spin off this function as a separate operating subsidiary through an Initial Public Offering (IPO). However, investors are concerned that, given current liability issues involving derivative trading products, the proposed firms professional liability exposures are inadequately covered, since they fear that a professional liability loss in the first year of the IPO would drive insurance premiums to a prohibitive level and/or severely deplete capital. To address this issue, a program is structured utilizing both finite and conventional insurance. The finite portion consists of a five year program with a guaranteed premium for the underlying primary finite layer. For coverage in excess of this primary finite layer, commercial insurance is used since premium rates in the excess layers are less than using the finite market. This program gives the firm precisely what it needs during the critical IPO phase - maximum transfer of risk with a guaranteed premium level for five years. In addition, if there are no significant losses over the period of the finite contract, the firm will receive a return of premium at the end of that time.
3.4.2. Multi-Year Duration
One of the primary attributes of any finite insurance program is the ability to address the financing of liabilities over a multi-year period, thereby minimizing the impact of a severe loss in a single year. In addition, finite programs also minimize the "financial costs" of insurance - the cost of going into the market year after year to renew policies and being subject to market cycles. It also help building and strengthening long-term relationships with insurer. Since going into the market on an annual basis is highly inefficient, finite programs are designed to maximize the allocation of premiums to loss payments and minimize their use for transaction costs and overheads. '
3.4.3 Profit Sharing
One of the most attractive aspects of finite insurance programs is the possibility of premium reduction through the return premium mechanism. In return for limitation of liability through an aggregate cap and for a guarantee of premiums over a specific period of time, the insurer agrees to share underwriting profits with the insured in the event of favourable loss performance.
3.4.4 Disadvantages
As with all approaches to managing operational risk. finite risk insurance has certain drawbacks:
Risk Management Expertise - To effectively blend the internal and external financing elements necessary in a successful finite risk program, it is necessary that management clearly understands the nature and magnitude of the bank loss exposures and is willing to pav for a significant portion of these exposures through self-insurance. Banks' must have a very clear view of the financial resources they will need for these programs. Since these programs are multi-year in nature, a bank must be certain about its future period cash flows and how much cash it wants to devote to the program. Otherwise finite risk management programs simply will not work more effectively with structuring the program than will normal conventional insurance.
Cost - Since finite programs are typically structured for three to five years, they may represent a higher initial cost both in terms of guaranteed premiums and costs associated with structuring the program than will conventions insurance. They are certainly more expensive than self insurance. In addition, failure to control losses over the period of the contract may result in no return of premium one of the primary advantages of finite programs,