What is financial engineering in the context of general insurance business?
Briefing Note 1 (BN001/2005)
17 March 2005
Financial engineering is an umbrella term that in this context is used to refer to types of reinsurance arrangements where typically the transfer of risk is small relative to the premiums and the accounting effect may be very different from the economic effect of the contract. Their use can therefore result in misleading accounts and it is sometimes claimed that they may be entered into primarily for this purpose rather than for bone fide commercial reasons.
Our concern is with the risk that contracts or arrangements may be used by firms to artificially increase capital resources as presented on their balance sheet, or otherwise obscure the underlying financial position of a firm, and thus mislead consumers, regulators and other users of the firm's financial statements
Is financial engineering permitted by the FSA?
The FSA's rules and guidance do not prevent insurance firms from using financial engineering. However we do require details of reinsurance contracts to be disclosed, as necessary, for a proper understanding of the nature of the contract. This is particularly applicable for financial engineering. The FSA requires firms to hold adequate and suitable financial resources and to deal in an open and honest manner with their regulator.
What work has the FSA carried out on financial engineering?
In the Tiner Report published in December 2001, the FSA announced that it would review the use of financial engineering by the UK insurance sector. Consultation Paper 144, A new regulatory approach to insurance firms' use of financial engineering, was published in July 2002. More recently the General Insurance Newsletter of December 2004 reminded firms of the need to have appropriate systems and controls for their business. It also stated that the FSA would not hesitate to take enforcement action against firms found to have used financial arrangements to distort their results.
The development of the Individual Capital Assessment (ICA) framework for general insurers requires a realistic assessment of a firm's assets and liabilities. A firm's ICA will require a realistic assessment of a firm's risks and the extent to which reinsurance covers these. Reinsurance that provides only very limited protection against adverse developments should not materially reduce the firm's ICA.
Letter sent to insurance firms on 16 March 2005
The FSA is considering whether the most effective way to regulate firms' use of financial engineering is through greater disclosure. We plan to consult on this approach later this year. We are also undertaking specific supervisory work to establish the extent to which financial engineering is used by regulated firms. The letter, sent by the FSA to general insurance firms that have an FSA relationship manager, asks those firms to provide the following information:
- the extent to which the firm makes use of financial engineering;
- the systems and controls that the firm has in place to subject such transactions to adequate scrutiny;
- to confirm that the firm does not engage in financial engineering transactions that would put the firm at risk of breaching regulatory requirements; and
- to confirm that the firm's individual capital assessment explains the extent to which financial engineering has been used, for what purpose and the impact on both assets and liabilities.
View the letter to insurance firms
