Buffett Insurance Deals Warrant Spitzer Scrutiny

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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.