My question today was whether I would write about this whole finite insurance thing or buy Berkshire Hathaway (NYSE:BRK.a) (NYSE:BRK.b) stock.

I chose the former, just because I think this is an important non-story that the media, in its endless quest for the next wayward giant, is getting very, very wrong.

Warren Buffett's insurance holding company took a bit of a beating on Friday in the wake of a Wall Street Journal piece titled "Investors Worry Insurance Probes May Snare Berkshire," by Gregory Zuckerman. The gist of the story was that there is a product known as "finite" insurance, of which Berkshire Hathaway is a big seller.

What is finite insurance, you ask?

Well, like any insurance, finite insurance is all about transferring risk, or exposure to liabilities. In these cases, we're talking about retroactive insurance, which insurers write on events that have already happened. That's right -- the loss-generating event has already taken place, and the insurance company comes in and says "yeah, we'll write a policy on that." Why on earth would an insurer want to do that?

Remember, insurance is all about the transfer of risk, so there must be a variable element here. That element is usually the size, speed, or flow of the payout. So when the hurricanes hit Florida in late summer, property/casualty insurers with policies in the state knew that there was some amount they would have to pay at some point in time. What they didn't know was a) the full amount, b) when they'd have to pay, or c) the cash flow impact (meaning if they have an eventual $1 million in exposure, is $100,000 paid in the first month, with the bulk being paid three years down the road, or the opposite?). I've made the example using a natural disaster, but the event could be anything -- legal claims, even a business downturn. If there is a variable element, it is at least conceivable that an insurer would be interested.

There's another part of insurance coverage, and this is what has regulators and the indomitable New York Attorney General Eliot Spitzer investigating these products: their accounting treatment. Insurance proceeds are counted as income. So if company X has a $1 million policy against an event, and the event takes place, in that quarter it gets to claim $1 million in income. So you can see, perhaps, how an insurance policy written on a past event could be an attractive vehicle for abuse. Company X, being a public company, doesn't want a big hit against its earnings from an event that happened in the current quarter, so it takes out a policy against the event, pays a massive premium (which receives favorable accounting and tax treatment) and voila! Company X has an insurance gain that offsets its operational loss.

This is perfectly legal if and only if there is an actual transfer of risk from the buyer to the insurer. If there is not, it's not an insurance policy; it's a loan. To see what this looks like in action, take a peek at the complaints against AIG (NYSE:AIG) and the policy it underwrote for Brightpoint (NASDAQ:CELL), which the company allegedly used to simply hide losses from shareholders. Read more about this in my article "AIG Lies Down With Dogs."

Let's just hang 'em all
So in the midst of the recent industry scandals, made most lurid by Spitzer's claim that the wrongdoing in the insurance business touched almost every type of participant, in every line of underwriting, one big question has been whether Warren Buffett and Berkshire Hathaway are going to be touched by scandal. Buffett has spent decades cultivating his squeaky-clean image, and has done so by being, well, squeaky-clean. But Berkshire has been implicated in insurance scandals before, most notably in Australia, where General Re, a Berkshire subsidiary, provided retroactive insurance to HIH Insurance, which collapsed in 2001. An Australian investigator determined that these policies were designed to give the appearance of risk transfer where there was actually none. It should be noted that this policy, whatever the facts about its appropriateness, was written before Berkshire acquired GenRe in 1998.

Let's cut to the chase: These policies are horribly complicated. People tend to think of insurance as being a plain vanilla product, but in reality there are as many different types of products as there are customers. And unless one of the parties is terminally stupid, then each of these contracts should have a dynamic tension. The insurance company wants to be adequately compensated for its risk, while the customer wants to keep its premium payments as low as possible. Berkshire Hathaway's Ajit Jain is masterful at determining what premiums are needed to compensate the company for the risk. But the problem comes in accounting. At what point, particularly for a policy with a guaranteed loss, is the premium so high that no real transfer of risk takes place? You think you can crack open the Great Big Book of Everything and find the definitive answer? You cannot. Accounting is not exact, though in the hands of journalists looking for their Watergate or Enron moment, or ambitious prosecutors, it can be made to seem that way.

That's what makes such an article so infuriating. Berkshire has "been linked to a series of activities that have received criticism" -- those activities being its practice of writing retroactive insurance. That is a legitimate practice. Is it possible that customers have abused attributes of retroactive reinsurance to hide losses? Yes, it's already happened, including what took place at HIH. Is it also possible that insurance companies have intentionally marketed these policies in ways that abuse their true purpose? That's what the Brightpoint case at AIG was all about. Is it also possible that there are rogue underwriters at any insurance company, including Berkshire Hathaway and its subsidiaries, selling finites that have no purpose other than to help companies smooth earnings? The only prudent answer here, without specific evidence to the contrary, is "yes, it is possible."

But how does that correspond to an article that specifically calls out Berkshire Hathaway, when there has been no question of wrongdoing at the company? Other companies are being investigated for misusing finites. So? If someone manages to rob a bank in Omaha using nothing but a ham sandwich, does that mean that Warren Buffett is automatically under suspicion if he likes the occasional ham sandwich?

What we're talking about is a business that accounts for about 2% of Berkshire's business. It's also a line that Buffett specifically wrote about in the company's annual report, describing how Berkshire is writing policies that will certainly generate an underwriting loss for the company but will give it access to massive amounts of float cash that it can invest. It's also a business that, by its very nature, sounds a little sketchy -- insuring for events that have already taken place.

I don't get the Journal's decision to focus its article on Berkshire. I mean, sure, in the news-sellin' business, there isn't a much greater talisman than Warren Buffett. I wrote a crazy spoof one time about Buffett brushing his teeth that attracted thousands of readers. Buffett sells copy.

Surely it has done something wrong?
That doesn't mean that an article using conjecture that since Berkshire is involved in a business that has come under suspicion that Berkshire might come under suspicion is responsible. Nor is it in any way knowable, as Zuckerman claims, that there is a definitive causation between the whiff of scandal and the short-term movement in Berkshire stock. These are legitimate products, ones that Berkshire Hathaway has openly and proudly acknowledged selling. Now that there's a whiff of scandal, we have open theorizing on whether Berkshire is guilty of anything. Heck, it isn't even innocent of anything.

Back to the accounting question -- why companies would want to use such insurance to hide operational problems in the first place. If an insurance company is knowingly selling products to companies that are being used to hide financial problems, and there is financial damage to shareholders, that insurance company can and should have big legal troubles. But there seems to be way too much demand for the accounting in any situation to be ironclad, else there is a villain. If insurance is being used to take advantage of an accounting loophole, if the framework for disclosure of non-standardized contracts such as these isn't sufficient to give the reader sufficient information, then FIX THE ACCOUNTING GUIDELINES.

Brightpoint wasn't any healthier after the AIG policy helped it clean up its balance sheet in 1998; it just looked better. But what ought to be clear is the difference between proper use of finite insurance and improper use -- if it is then we end up with a Berkshire, which as far as anyone claims has done nothing wrong, being insinuated into a probe for frauds that happened elsewhere.

I love The Wall Street Journal, and I've found Zuckerman's columns to be very good in the past. But this one wasn't right -- it took an unknowable in what has happened to the share price (not much), combined it with the whiff of scandal, and wondered whether Berkshire was going to feel heat for doing something that is completely legal, above board, and sanctioned. If there is a hint of evidence of Berkshire, or even one of its underwriting employees, providing loans to companies packaged as finite insurance, then let the presses roll. But that's not where we are, and that's not what the Journal article posed to present. That's just a smear job.

Bill Mann's favorite smear is lox. He holds a beneficial interest in Berkshire Hathaway. Interested in companies that are clawing their way back from the edge of ruin? That's fertile ground for Philip Durell at the Motley Fool Inside Value newsletter. Afree trialis yours for the asking.