When Does Share Insurance Cease to be Insurance?

The crisis now facing credit unions is best solved not with an “insurance” mindset but a capital one, keeping credit unions operating and growing.


The following is an excerpt from a longer, in-depth article featured in the December issue of Callahan's Credit Union Report:

Just before Thanksgiving, the FDIC released financial statements showing it was "in the red," that is, out of net worth. The NCUA, pointing to models that estimated losses of as much as $3.7 billion in the corporate credit unions, concluded as much about the NCUSIF back in January.

The term "insurance" is applied to both funds, but there's a world of difference between the two. The FDIC is a premium-based fund with no capital except retained earnings. Very quickly in the financial crises of last fall, government officials realized that the FDIC as insurer could never address the systemic risk facing the banking system, that the situation required capital. This arrived in the form of TARP funds, which were then disbursed to stabilize both the weak and the strong.

Over $200 billion of capital was injected into the banking system, of which $71 billion has already been repaid. The $200 billion is more than four times the pre-crisis assets of the FDIC. Officials understood that an insurance model based on premium assessments -- no matter how many premiums are paid -- will not resolve a systemic crisis.

Why the Insurance Approach Fails in a Crisis

Systemic financial collapse is not an actuarial event. Unlike auto, fire, theft, or homeowner's insurance, there is not a pool of unrelated, relatively small losses that can be modeled and then collectively underwritten. The "insurance" approach is appropriate for small random failures in normal economic times, but not for widespread losses. This is because as losses increase into the systemic range they are no longer linear – they do not scale up in an even, predictable manner. They can indeed rise exponentially!

The solution for an insurance event is to make payment and move on. You might be tempted to think that the solution of a systemic failure is make similar payment and close out the problem, but it isn't. The solution is to recapitalize institutions, not cash them out via merger or liquidation at the low point in their value. Such a "selling at the bottom" means the institution can never recover the inherent value that every credit union possesses. Credit unions, like all other financial institutions, must earn their way out of problems. Capital assistance gives them the chance to do this.

Such was the insight that led to a completely new financial model and regulatory approach to the NCUSIF in 1983-1984. Too big to fail means too big to insure. The actuarial approach is appropriate when failures are few and far between. But system financial risk is an uncertain event that is more like an earthquake than it is traditional insurance accidents. The bottom line is that share and deposit funds are about public assurance, not actuarial insurance.

Slipping In and Out of the Insurance Model

Managing systemic risk is not the responsibility of the NCUSIF alone. More than capital is needed to retain confidence in troubled institutions; so is liquidity. That is the purpose of the CLF, also owned and capitalized by credit unions. The CLF was closely integrated with the corporate network as its distribution channel. Throughout the crisis of last fall, when the world’s largest banks were threatened with financial cardiac arrest, the credit union system continued to lend, take in funds, and serve members. That in large part owed to the corporate network's providing liquidity wherever needed.

Credit unions' ability to continue business as usual during the height of the financial crisis was the result of a better system solution, not a government bailout. Even though NCUA did not respond to multiple requests for CLF assistance by both the corporates and natural person credit unions, the collective approach nonetheless prevailed.

But then the old mindset took over. Instead of using collective resources to restore solvency, NCUA began to estimate losses far into the future. Using models whose assumptions and calculations it would not share with those outside the agency, NCUA projected losses from securities with cash flows five, seven, or more years in the future and required credit unions to expense those losses today. The underlying assumption is that losses are somehow fixed and knowable and that institutional value cannot be restored through future operations. While the "insurance" model might apply when a car is totaled in an accident, it is not the reality of a credit union that continues serving members, creating more value every day.

If the insurance model were somehow determinative of the future, then WesCorp with a $4.0+ billion negative net worth should have been closed months ago. All an insurance-like approach encourages is the belief that problems can be expensed away. Anyone who has worked in a credit union knows that is the path to failure.

What Needs to Be Done

Three immediate changes need to be implemented by the Board and management of the NCUSIF:

  1. Change the financial model at the NCUSIF and the consequent approach when looking at the industry's problems;
  2. Inject capital from the NCUSIF to help restore viability to institutions caught up in systemic problems;
  3. Support the value creation efforts of these institutions, which in the case of natural person credit unions, means making loans.

Why does capital assistance make economic sense? Take a simple example of a credit union with 4% net worth. The core earnings ratio of all credit unions at September 30, 2009, was 1.5% (though in some troubled cases the core was over 3%!).

This means the return on equity (with core earnings of 1.5%) of 4% is 37.5%! The $10 billion dollars in the NCUSIF earns less than 25 basis points at the margin and just over 2% on the entire portfolio.

Why not invest in an institution that has this earnings potential by using the collective capital assembled for just this purpose? Sure, there is risk that problems could worsen, but considering the incredible return there is the probability that any capital contributed could be paid back, not expensed. That outcome would be a win for the NCUSIF, for the credit union's members, and for the cooperative system.