WASHINGTON Imagine a scenario: The banking industry is in crisis, with a wave of costly failures nationwide. Would it make sense for the Federal Deposit Insurance Corp. to have a reinsurance policy for such catastrophic losses?
That is the question the FDIC paid a Marsh & McLennan Cos. risk management unit $300,000 to answer.
As part of its broad effort to reform the deposit insurance system, the FDIC hired MMC Enterprise Risk in November 2000 to study the possibility of using reinsurance to cover some of the agencys potential losses. The unit delivered its report last month, and FDIC officials are mulling their options.
At least initially, reinsuring a small portion of total losses say, $2 billion only after the FDIC absorbed some huge amount say, $30 billion may not appear to be of much use for the agency.
But it is not interested in merely using reinsurers in a traditional way. Rather, a senior FDIC official said in an interview last week, reinsurance may yield a valuable free-market perspective on the risk of loss banks and thrifts pose.
Eventually reinsurers could help the FDIC set the rates that banks and thrifts pay for deposit insurance, said Art Murton, who runs the agencys insurance division.
The report and its recommendations are important because, even though the debate over deposit insurance reform was sidelined in Congress by the Sept. 11 terror attacks, lawmakers are expected to return to it this year. If reform is enacted, the FDIC would probably get considerably more leeway in setting bank and thrift premiums.
Mr. Murton said the price the agency would be charged for reinsurance could help determine the premiums it charges banks and thrifts.
When I think about what this study does, there are a couple of possibilities, he said. One is the pricing of the risk-based premiums at different segments. The other is fund adequacy. The prices we would be charged give a reading on if the reserves would be adequate to handle the risks they are facing.
The reports authors agreed that reinsurers could provide a check on the FDICs evaluations.
It provides some external review of the FDICs own assessment of risk, said Christopher M. McGhee, a managing director of MMC Enterprise Risk. You have people who have money on the table that stand to lose if they just take the FDICs word for it. They will work with the FDIC, asking did you consider this or that. It is another set of eyes that help assess the FDICs policies.
Mr. Murton said that, if the worst-case scenario does happen, a reinsurance policy would provide yet another backstop to protect the industry from steeper premiums or taxpayers if the fund is exhausted and Congress steps in.
The unexpected does happen I dont think anyone can argue with that, he said. This reinsurance, if in place, would provide funds at a time when we are suffering big losses. Instead of having to raise premiums at that time, these funds are kicking in. The deposit insurance fund gets money that way, instead of trying to assess the industry, or drawing down the fund and exposing taxpayers. This would help deposit insurance serve as a stabilizer, as opposed to making the economic cycle worse.
Mr. Murton stressed that the report was in no way a plan to privatize the FDIC, and he did not indicate whether it would adopt any of the recommendations.
MMC Enterprise Risk based its report on a survey of the countrys 28 top reinsurers, which were asked to review a profile of the FDICs bank-failure risk and other data. It found substantial interest within the industry for reinsurance arrangements with the FDIC but only for catastrophe insurance.
The agency could get more than $5 billion of coverage, the report estimated.
However, the reinsurers had several caveats to any future deals with the FDIC.
First, the report said, they did not want to be exposed to losses from a single large institution or a small group of big banks. It recommended that any reinsurance relationship either exclude the largest 100 institutions or limit the amount a single failure could contribute to a claim.
The report suggested that the FDIC might use capital-market instruments to hedge its losses from larger institutions, but it provided no details on how such an arrangement would work.
The reinsurers also said they preferred that any transaction be explicitly rated by ratings agencies and earn either an AA or AAA.
The report offered few clues to how much a reinsurance deal would cost the FDIC. It said reinsurers needed a better idea of what the agency would ask them to insure and what their risk would be.
But the report did offer some examples: $2 billion of reinsurance at a relatively low risk level would cost $4 million a year, but $500 million of reinsurance on a portfolio of institutions more likely to fail might cost $10 million a year.
Such costs would not make a dent in the mandated ratio of reserves to insured deposits, and they would represent a very small portion of the $2 billion the deposit insurance funds bring in each year.
MMC Enterprise Risk said that an initial program could be set up in about a year if the FDIC decides to pursue it.
The reinsurance market has been dramatically affected by the Sept. 11 attacks, but the changes would not affect the possibility of any FDIC deal, according to the 48-page report.
Even though deposit insurance reform would not have to be enacted for the FDIC to implement a reinsurance agreement, any arrangements value would be undercut if the agency does not have more freedom to charge premiums or adjust the reserve ratio.
Congress allowed the FDIC to share up to 10% of its total risk with the private sector in the FDIC Improvement Act of 1991 and required it to investigate the possibilities of reinsurance. But an early 1993 study, coming on the heels of tremendous losses in the savings and loan crisis, said that reinsurers considered any such deal too risky, and the subject was largely dropped.
FDIC officials had said that they anticipated a better response from the reinsurers this time, because of the current strength of the banking industry.
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