Finite Risk Insurance

What Is Finite Risk Insurance?

Finite risk insurance is an insurance transaction in which the insured pays a premium that constitutes a pool of funds for the insurer to use to cover any losses. The insured does not actually transfer much or any risk of loss per occurrence to the insurer. If losses are lower than the premium, the insurer returns most or all of these charges back to the insured. If, on the other hand, the losses exceed the premium, the insured is required to pay an additional fee to cover them.

How Finite Risk Insurance Works

Under standard insurance arrangements, the insured transfers a liability associated with a specific risk to an insurer in exchange for a premium or fee. The insurer maintains a loss reserve with its own funds and is able to keep any income that it makes.

Finite risk insurance is an alternative risk transfer type of insurance product with features of both excess insurance and self-insurance. Finite risk insurance allows the insured to spread out payments for losses over time while retaining the ability to receive a refund of some of its premiums and investment income if losses are less than anticipated.

The insurer provides a standard insurance policy but modifies the limits and deductibles in a specific way. On a per-occurrence and aggregate basis, the total limit and retention are a function of the total premium, which is computed as the losses that will be paid discounted for investment income.

The insurer issues the policy and segregates the premium, net of fees, into a dedicated account that accrues interest for the insured. If at the end of the policy period funds remain in the account, the insured may claim them.

Conversely, should losses exhaust the account at some point during the policy period, the insured either pays an additional premium or the transaction ends.

Premiums are invested in an interest accruing account, often based offshore for tax relief, which the insurer can then tap into to pay any costs it might incur from claims.

Benefits of Finite Risk Insurance

Companies may rely on finite risk insurance to cover liabilities that have long durations. While they might save money by self-insuring for these risks, particularly if there are no losses, a finite risk insurance contract provides an element of risk transfer. 

A business could enter into a finite insurance agreement to cover excess losses over other policies, including its own self-insurance strategy, and may use these products for warranties and environmental, pollution, and intellectual property risk. By entering into a multi-year agreement, the insured can better match the amount of money it sets aside for liability protection to the estimated liabilities that it expects to face.

Criticism of Finite Risk Insurance

Finite risk insurance has generated some controversy in the past. Critics claimed it functions more as a loan and can hide the true condition of insurers, helping them manipulate and smooth their earnings.