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Futures Organizations Release Economic Feasibility Study on Industry Insurance Regime

Date Posted: November 27, 2013

Chicago, IL—CME Group, Futures Industry Association, the Institute for Financial Markets and National Futures Association announced Nov. 15 the release of a study on the economic feasibility of adopting an insurance regime for the U.S. futures industry.

The study was commissioned by the four sponsoring organizations in November 2012 and was conducted by Compass Lexecon, a consulting firm that specializes in the application of economics to legal, regulatory, and policy issues.

Christopher L. Culp, an expert on risk management with extensive consulting experience in both insurance and derivatives, led the team that conducted the study.

“The objective of the study was to analyze and quantify the potential costs of various scenarios, including a government-mandated solution similar to what exists today in the securities industry as well as voluntary market-based solutions provided by private insurance companies,” Culp said.

“The study does not provide any policy recommendations, but the hope is that it will assist policy makers by clarifying the amount of insurance coverage that could be obtained through these solutions and the potential costs for each.”

The study examined four models for providing customer asset protection insurance (CAPI) for losses arising from the failure of futures commission merchants (FCMs) and developed quantitative estimates for the potential costs of two models in particular.

The analysis was based on customer account data provided by six FCMs ranging in size from large to small as well as risk exposure data provided by CME and NFA.

The four models were:

• CAPI provided to individual futures customers by primary insurance carriers;

• CAPI provided to customers of individual FCMs that purchase insurance on behalf of all of their customers;

• CAPI provided to customers of FCMs opting to participate in a captive insurance company backed partially by reinsurance; and

• CAPI provided to all customers of all FCMs under a government mandate.

To assess the potential commercial viability of the first three models, all of which would be provided by insurance or reinsurance companies on a voluntary basis, Compass Lexecon contacted a number of insurance companies to discuss the potential design and solicit realistic indications of the potential costs.

The insurance companies commented that the first two models would be too cost-intensive relative to the number of customers and assets at risk, and identified several structural impediments related to the provision of CAPI to customers or specific FCMs directly.

The study therefore concentrated on developing detailed indications of the economic feasibility of the third and fourth models.

With respect to the third model, the study found that there was an interest among insurance companies in offering CAPI on a voluntary basis to U.S. futures customers.

In particular, a syndicate of eight insurance companies submitted an indicative term sheet for a captive insurance company called the Futures Industry Customer Asset Protection Insurance Company (FICAP).

While not a formal proposal, such a term sheet may be indicative of the potential terms that such a consortium would be interested in offering.

As proposed, FICAP would initially cover up to $300 million in claims by customers of participating FCMs.

The first $50 million in losses would be covered by a first-loss deductible funded in part by the participating FCMs.

The additional $250 million in coverage would be provided by the consortium of insurance companies, subject to a proposed maximum payout of $50 million per FCM.

The total cost of such a program, including reinsurance and annual fees, was estimated at $18 million to $27 million per year, although the final cost would depend on actual underwriting analyses, the number of participating FCMs, and negotiations between FCMs and the insurance companies.

Based on the indicative term sheet provided by the syndicate, Compass Lexecon assessed the potential cost for FCMs that opted to participate in FICAP as well as the potential cost for their customers.

The study found that the indicative terms were restrictive, but noted that negotiations on an actual deal might lead to terms more favorable to FCMs and their customers.

With respect to the fourth model, the study assessed the viability of offering the same kind of protection that is afforded to securities investors by the Securities Investor Protection Corporation.

Under this model, a Futures Insurance and Customer Protection Corporation (FICPC) would provide up to $250,000 to all customers of every U.S. FCM to cover losses arising from the failure of under-segregated FCMs.

FICPC would be funded by mandatory payments from FCMs of up to 0.5% of each FCM’s annual gross revenues from futures up to a stated target funding level of $2.5 billion.

The study estimated the annual funding amounts for such a program and the amount of time it would take to reach the target funding level of $2.5 billion.

The study determined that it would take approximately 55 years to reach the target funding level, assuming no interim losses, and concluded that under these assumptions a government backstop would likely be necessary to close the gap between actual funds available and potential customer liabilities in order to lend credibility to the program in the short run.

The insurance study is the latest in a series of initiatives taken by the futures industry to enhance customer protections and address the concerns raised by the collapse of MF Global and Peregrine Financial Group.

New rules and systems have been put in place to provide customers with more information about the status of their funds and the financial condition of their FCMs.

In addition, the industry’s self-regulatory organizations have put in place systems to receive daily confirmations from all depositories holding customer segregated funds as well as new rules that will strengthen internal controls and hold senior executives accountable for authorizing the movement of customer funds and preventing any misuse.

The executive summary of the study and the full text of the study can be found on each of the sponsors’ websites.

For more information, call 312-781-1335.

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