S&P reports on “financial engineering” investigations

Following on media reports in the U.S. of an investigation into potential abuse of “financial engineering” products, Standard & Poor’s has issued a report which cites four companies who could be targets of such an investigation.Bermuda-based ACE Ltd. disclosed this week that it received subpoenas from the U.S. Securities Exchange Commission (SEC) and New York Attorney General Eliot Spitzer regarding what it terms “non-traditional, or loss mitigation, insurance products”. AIG has also acknowledged being the target of a federal investigation over the alleged sale of “income-smoothing” products, S&P notes.S&P says it has reported on four instances where it considered reporting of financial engineering-type arrangements to be either incorrectly applied to financial results or a negative factor for companies. These instances include: Argonaut Group Inc., Liberty Mutual Insurance Co., CNA Financial Property/Casualty Group and Atlantic Mutual Insurance Co. None of these companies, nor ACE, is accused of wrongdoing, it is important to note. S&P is simply noting that in its assessment of the financial strength of the four companies, their use of such reinsurance transactions caused concerns on the part of the rating agency. S&P notes that the investigation into financial engineering appears to be separate from that into broker compensation issues. Financial engineering products include financial-risk reinsurance or finite-risk reinsurance, and in and of themselves are not suspect. The issue stems from how such arrangements are reported in financial results, i.e., if they are used to “smooth earnings or otherwise distort the appearance” of results. S&P explains, “this form of coverage combines the transfer of a finite limit of risk with a profit-sharing relationship between the reinsurer and the client. The issue is that some clients are suspected of using this type of insurance to transfer losses off their balance sheet or increase their capital on an accounting basis under GAAP or under statutory accounting while the economics of these transactions would indicate that appropriate risk transfer and loss absorption have not taken place.”S&P analyst Thomas Upton notes that the full impact of an investigation into the use of these products is difficult to assess because disclosure of such transactions is limited. “Without clear standardsfor reporting such transactions, the degree of disclosure varies widelyfrom one company to another.”