What’s CECL, and How Will it Affect Insurance?

The Financial Accounting Standards Board (FASB) has implemented current expected credit loss (CECL) as a standard. CECL affects banks, credit unions, and other financial institutions, such as companies that are registered with the Securities and Exchange Commission.

What is CECL?

According to Visible Equity, “the basis of the CECL requirement is to review loans that share similar risk characteristics on a collective basis.” While your certified public accountant (CPA) can help you with the new forecasts, you do need to have a basic understanding of CECL and how it affects managing credit. Current expected credit loss models the contractual cash flows the financial institution does not expect to collect from a recognized financial asset or a commitment to extend credit. Its key principles include:

  • The single model which applies to, “all financial instruments measured at amortized cost.”
  • The expected loss model which removes the concepts of the incurred and probable threshold.
  • The life of instrument reserve which requires a future forecast that is reasonable and supportable.
  • The risk-weighted model which reflects an actual model of potential risk of loss, as opposed to an estimate.
  • The time value of money concept if the potential risk model was based on a discounted cash flow model. The risk model must use the effective interest rate as the discount rate.

Its affects the Allowance for Loan and Lease Losses (ALLL) for lenders holding loans in a portfolio. According to DistressedPro, “Allowance for Loan and Lease Losses (ALLL) is a special bucket where the bank puts cash in order to make up the difference when they are taking losses on non-performing assets.” The major calculations change CECL brings is that lenders must post a reserve from the loans’ inception against the lifetime expected credit loss rather than reserving for losses on an incurred basis. Impacts from this change include:

  • The pricing of loans
  • The amount of capital allocated to a portfolio lending strategy
  • The products offered or extended to consumers
  • Net income because the updated ALLL impacts pre-tax operating income

The costs for compliance will also increase for financial institutions in relation to loss forecasting and reporting. This may adversely affect credit unions, especially smaller institutions with limited reserves.

How to Mitigate CECL Impacts

The reserve against the lifetime expected credit loss from a loans’ inception produces a costly problem for lenders and their customers. According to ABA Banking Journal, “banks already possess much of the data covered under CECL. But whether it’s housed in the right system or saved in the right form—or whether it’s available at all—needs to evaluated.” Lenders can mitigate this impact using mortgage insurance. Financial institutions using traditional primary loan-level mortgage insurance (MI) may leverage that insurance coverage to offset the reserve requirement. The mortgage insurance can be paid by the borrower or the lender to qualify. Using this method also offsets pricing impacts and financial statements.

Although other forms of credit enhancement exist, CECL does not recognize them because they can be independently excised and exercised from the loan. Forms of credit enhancement CECL does not recognize include pool insurance, credit default swaps, and other “freestanding” contracts.

Your institution can use numerous options for traditional mortgage insurance. A financial institution could use borrower-paid mortgage insurance (BPMI) or lender-paid mortgage insurance (LPMI). Choose from paying a single premium at the purchase of the policy, paying a monthly premium, or using a split premium that charges you a portion of the premium at purchase and then monthly payments to cover the remainder. Before choosing between a single payment or monthly ones, study the cancelability of the insurance policy, prepayment options, and insurance rates.

Preparing for CECL

According to MGIC Connects, “to take advantage of this option, if you do not already have mortgage insurance, insure your current production. Regardless of the impending CECL changes, mortgage insurance provides a helpful tool to financial institutions for risk mitigation.”

The changes CECL will bring are numerous. Preparing for them requires pre-planning far in advance of the implementation date of the fiscal year beginning December 15, 2019.