Updated: May 2
At Energetic, we mainly see our insurance policy applied to enhance credit and help optimize terms of financing. There is an implicit benefit to lenders as well – who can treat the insured offtaker cash flows as investment grade. We are inclined to ask whether there is a more explicit impact might be available to banks and corporates alike. Credit insurance is routinely applied as an instrument to substitute credit rating and reduce risk-weighted assets or improve Tier 1 capital ratios. New Current Expected Credit Losses (“CECL”) rules have been in place for ~2 years, and we are inclined to ask: Why aren’t Insured’s considering Insurance to reduce CECL?
What are Current Expected Credit Losses or CECL?
The Current Expected Credit Losses (“CECL”) accounting standard was designed to change how financial institutions account for expected credit losses. This standard, ASC-326: Financial Instruments – Credit Losses, significantly impacted two previous standards: FAS-5: Allowance for Loan and Lease Losses (“ALLL”), and FAS-114: Accounting for Creditors for Impairment of a Loan. CECL applies to any institution that issues credit (such as banks, savings institutions, and credit unions) and files regulatory reports in accordance with US GAAP. Public business entities have already adopted CECL, while calendar year-end private companies were required to adopt CECL on January 1, 2023.
CECL requires financial institutions and other covered entities to recognize lifetime expected credit losses for a range of financial assets based not only on past events and current conditions, but also reasonable and supportable forecasts. Under CECL, provisions for expected losses over the entire life of the loan are reserved when the loan is originated or purchased. The previous accounting standard utilized an incurred loss methodology (“ILM”), whereby a loss allowance was recognized once it was probable that a credit loss had occurred and the amount of such loss could be reasonably estimated.
What is the Impact of CECL?
CECL was issued to replace ILM as policymakers determined that the increase in allowances occurred too late in the business cycle. This was particularly evident in the wake of the 2008 financial crisis. As such, CECL generally increases the responsiveness of provisioning for credit losses to changes in economic outlook. However, lifetime loss allowances applied at loan origination or purchase potentially result in higher provisions in each reporting period and possible reduction and/or volatility in capital ratios and profitability metrics (particularly during periods of outsized loan growth). This may also directly impact:
How loans are priced.
How much capital is allocated to a portfolio lending strategy.
Which products are offered to customers.
The degree of reserve movement and related impacts are naturally influenced by economic conditions, as well as the nature of an institution’s portfolio and process for recoveries, among other factors.
The Value of Credit Insurance for CECL
The use of credit insurance, when properly structured and attached to a loan, is an appropriate means to offset expected credit losses and achieve capital relief under CECL.
As it relates to credit insurance, guidance under ASC 326 states that a freestanding insurance contract may not offset an institution’s estimate of expected credit losses. In other words, an entity would estimate its allowance for credit losses under ASC 326 without contemplating recoveries from credit insurance.
Freestanding Insurance Contract is defined as being entered into:
Separate and apart from an institution’s other financial instruments or equity transactions.
In conjunction with some other transaction and is legally detachable and separately exercisable.
Examples of freestanding contracts:
Insurance acquired separate and apart from the original transaction, such as credit enhancement after the origination or acquisition of the underlying financial asset.
Purchase of credit default swaps.
Determination of how credit insurance can be used to offset CECL reserves is based on the nature of the credit insurance contracts and its attachment to individual, or set of, credit transactions. Requirements for an insurance contract to be deemed Non-Freestanding include the following:
Named insured or the named loss payee is the institution extending the credit transaction.
Exercise of the contract is explicitly tied to the status of the credit transaction.
Term of the insurance is equal to or less than the term of the credit transaction.
By meeting these requirements, a correctly drafted insurance policy can be seen and non-freestanding in nature and should therefore qualify to directly offset the expected credit loss calculation.
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This article does not constitute and is not intended by Energetic Insurance to constitute financial advice or a solicitation for any insurance business.