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Buffett Insurance Deals Warrant Spitzer Scrutiny

Peter Eavis

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If Eliot Spitzer really wants to clean up the insurance industry, he should look into an insurance-like product that has been used again and again to cook companies' books.

Financial reinsurance is the name most frequently given to the product. It has been sold by some of the biggest names in the insurance business -- including companies run by Warren Buffett. It has played a key role in masking weaknesses at a number of companies that have later collapsed, leaving huge, previously undisclosed losses and depriving ordinary people of coverage.

By its very nature, financial reinsurance is so open to abuse that any investigation of such deals could easily turn up eye-popping revelations at many large insurance companies. The product is deeply mistrusted by insurance regulators, and U.S. and state accounting rules have been written to prevent chicanery.

But all indications are that financial reinsurance is still a problem. As reluctant as insurance regulators might be to see the New York attorney general on the scene, only he may have what it takes to rid the industry of this toxic product.

Token Deals

So what exactly is financial reinsurance? Normal reinsurance is simply the insurance of insurance.

An insurance company wants to lay off some of the risk that it has on its books from potential claims, so it pays a premium to a reinsurer, which agrees to cover a certain amount of losses. The critical fact to remember here is that with kosher reinsurance, the two parties are making a bet that involves real risk. An authentic reinsurance deal will involve the real possibility that the reinsurer stands to lose money on the deal and the reinsured stands to make it, or vice versa.

With abusive forms of financial reinsurance, the reinsurance company structures the deal in such a way that it stands to lose no money -- or perhaps just a token amount, to give the appearance of risk transfer if regulators were to take a look. In fact, the company buying the financial reinsurance is merely getting a loan. That is, it's paying premiums (interest) for a paper pledge of a fixed amount of reinsurance payments (the principal). In many cases, the reinsurer never hands over any money at all. Instead, the reinsured company merely claims that the reinsurer will pay up -- and gets to book an asset on its balance sheet, thus boosting its capital.

Of course, in reality the deal should result in a liability, because there is no risk transferred. But financial reinsurance deals can be structured so that the reinsurance company's illusory pledge to pay claims will be offset very closely by the reinsured company's payments. In essence, the reinsurance company is merely renting out its balance sheet, or providing financing.

Regulators and the Financial Accounting Standards Board, or FASB, spotted this abuse some years ago. Rules are in place to avoid the creation of false capital by financial reinsurance deals that don't truly transfer sufficient risk. However, recent allegations suggest that companies manage to get around the regulators and accounting rules.

Lunch Table

Currently, the most explosive allegations involving financial reinsurance focuses on General Re, a subsidiary of Buffett's Berkshire Hathaway (BRK.A Quote - Cramer on BRK.A - Stock Picks). The state insurance commission of Virginia is alleging in a suit filed in the U.S. District Court of Tennessee, Western Division, that a number of companies, including General Re, conspired to cover up financial difficulties at a now-collapsed Richmond, Va.-based malpractice insurer called Reciprocal of America, as well as a related company.

Among a range of allegations, the suit charges that General Re entered into a type of financial reinsurance maneuver to make Reciprocal's capital look stronger than it actually was. The commission found that the two firms were insolvent in June last year. Their collapse has left thousands of doctors and lawyers with $200 million in unreimbursed claims.

According to press reports earlier this year, Richard McCarty, General Re's assistant general counsel, said that the company didn't believe it, or its employees, did anything wrong in its dealings with Reciprocal. McCarty didn't return a call to his Stamford, Conn., office Wednesday.

The Tennessee insurance commission is also suing General Re and others. In its suit, it says that General Re used "secret side agreements" to reduce its exposure to Reciprocal, but this reduction allegedly wasn't disclosed publicly. "This is 'Enron,' the insurance industry version," the lead lawyer for the Tennessee commission said earlier this year.

Down Under

And this isn't the only odd-looking financial reinsurance deal to bring the spotlight onto a Buffett company. Berkshire's National Idemnity did a financial reinsurance deal that allegedly helped disguise serious problems at a now-defunct Australian insurance company called FAI.

Soon after the financial reinsurance deal, Australia's largest insurance company, HIH, bought FAI, whose problems helped bring about HIH's dramatic collapse in 2001. An Australian judicial investigation reveals in lurid detail the critical role that Ajit Jain, still a senior executive at Berkshire, played in the deal. Buffett showered Jain with praise soon after his involvement in the Australian deal was reported, and is said to remain very close to the executive.

Financial reinsurance also appears to have played a big role in a huge dispute between a group of Japanese insurance companies and a now-collapsed aviation insurance company called Fortress Re, which was based in Burlington, N.C.

In December last year, an arbitration panel ordered Fortress principals to pay one of the Japanese insurers over $1 billion in damages. The Japanese insurers had alleged that Fortress misrepresented its financial health, partly by using financial reinsurance to make it look like it had laid off risk, when in fact it hadn't.

Financial reinsurance is also heavily used by large U.S. subsidiaries of Canada's Fairfax Financial (FFH Quote - Cramer on FFH - Stock Picks). This column has often argued that the product may have been used by Fairfax to make its financials look better than they really are. While Fairfax's U.S. state regulators do seem in the course of normal business to have had a good look at some of its financial reinsurance deals, it's not clear why some have gotten the capital treatment that they have. Fairfax didn't respond to a request for comment.

Clearly, Spitzer isn't going to want to get bogged down in arcane insurance accounting. But if incriminating emails come his way from insurance insiders -- as they have from whistleblowers from firms in other sectors -- he shouldn't be that surprised if they concern financial reinsurance. There's much to suggest that abuses connected with financial reinsurance could dwarf anything seen so far in Spitzer's insurance crusade.