Shady Business on the Side

Insidious side letters

By By Thomas D. Gober, CFE, and Leslie N. Bailey, CFE

Undisclosed agreements - side letters - between an insurance company and a reinsurer can hide egregious and fraudulent transactions from regulators, investors, and consumers. Here's how to find them.  

An insurance company executive faces tremendous pressure as Dec. 31 approaches especially because the company's balance sheet has deteriorated below the financial ratio red-flag alerts.1 Worsening the situation is the fact that the executive has already cooked the books so much that the asset page has no room left for "fluffing up." The home office building has already been reappraised by a cousin who helped surplus it by $900,000. And the executive continues to admit $3 million in notes receivable from an affiliated company at full value even though the affiliate hasn't been able to pay the interest, much less principal, for three years. If he inflates any more assets, the regulator is likely to smell a rat and move to shut him down.

The controller brings the executive the company's Risk Based Capital (RBC) ratio calculation results on Dec. 21, and with the RBC comes bad news. The RBC ratio is 189 percent but it must be at least 200 percent or the state insurance commissioner will be forced to take regulatory action to protect the company's policyholders. The only way to get the RBC above 200 percent is to create surplus. A traditional loan won't work because the payable back to the lender is a liability that offsets the cash infusion from the loan; assets go up, but liabilities go up as well. Consequently, surplus isn't increased.

The desperate executive e-mails a friend and colleague who is a vice president at a large reinsurance company and explains the situation. The executive needs an "off the balance sheet loan" that provides a cash infusion, or at least the appearance of one, without having to book the associated liability. But the infusion must appear to have no strings attached so the regulator won't become suspicious. The executive promises the perfect solution: the two key executives can enter into what appears to be a "plain vanilla" reinsurance contract that, on its face, transfers millions of dollars of risk from the insurance company to the reinsurer. In secret, the parties agree to enter into a side letter that actually spells out the true terms of the reinsurance contract. The undisclosed side letter reveals the true nature of the contract - it's actually an "off the balance sheet loan." For obvious reasons the two parties swear the side letter to secrecy.

At midnight on Dec. 31, the reinsurance contract combined with the undisclosed side letter has done the trick. RBC comes in at 203 percent, and bonuses are handed out. Several weeks later the executive, out of fear and guilt, pulls up the incriminating e-mails exchanged with his colleague and carefully deletes them. What he didn't know was that his hard-working IT director backed up the entire computer system on Dec. 31 and stored the back-up tape safely offsite.


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