[This was the inaugural post to my Ohio co-op law blog from a few years ago. A blog I almost immediately failed to maintain. Republishing it as the first post of my reinvigorated blog efforts. It remains relevant]
In case reading the full post and the associated links raises the risk of causing an aneurysm, here is the takeaway: Beware “moral hazard” and incorporate governance protections. I recommend an 8th co-operative principle in addition to the traditional 7 co-operative principals. The 8th principle: Its ok to trust your management, but verify the truth of what they are advocating. And keep in mind that the task grows more difficult with size.
Here we go…
According to Modern Money Theory economist L. Randall Wray, the FIRE sector of the economy extracts 40% of the corporate profits from the economy but provides only 20% of the value.
F – Finance; I – Insurance; and RE – Real Estate
As professor Wray points out in the linked article, the profits vs value relationship in the FIRE sector is simply crazy.
This post will focus on a FIRE component that historically has had a co-operative bent: insurance (as in mutual insurance companies).
So what is moral hazard and what can we learn about moral hazard and its impact on mutual insurance operations, and as a proxy to co-ops in general? For a general description, click here for the Wikipedia post on moral hazard.
One particularly repugnant form of moral hazard is where the agent (co-op management) knows where the bodies are buried and uses that knowledge to enrich themselves at the expense of the co-op membership. The case of Allied Mutual is one that some have said was looted by its management. See here for the wrap up several years later. For purposes of this post, the money quote was as follows:
In 1996, David Schiff decided to spend some time traveling the back roads of Iowa and visiting insurance companies. At that time, Schiff was disheartened by the avarice and amorality he had observed in New York, and believed that in the American heartland he would find old-fashioned virtues and corn-fed honesty. Instead, he stumbled into the biggest racket the insurance industry has ever seen: the mutual-insurance industry’s attempt to separate policyholders from hundreds of billions of dollars.
But lets be clear, its not the mutual insurance industry that was the problem. Management out of control was the problem.
Less offensive (maybe) but still detrimental is the classic case of moral hazard where co-op management takes unwarranted risks since they have an upside (because of compensation incentives) with little downside. State Farm (a mutual insurance company) in relationship to the State Farm Bank might be an acceptable example.
Now, before I am flamed for criticizing a mutual that seems to compare favorably to its shareholder owned rival, Allstate, I would point out that the focus here is on management relative to the deal the true owners receive. Click here for a brief story that discusses State Farm’s 2011 executive compensation. Click here for a reference to State Farm’s 2012 compensation for its CEO. And click here for a story about Allstate’s 2012 CEO compensation.
As was noted in the 2011 State Farm compensation story, the hit to executive compensation may have stemmed from the need to pump $700 Million into State Farm Bank as a result of losses incurred there from 2007 to 2010.
So, somebody thought it was a good idea to have a bank. Perhaps hindsight is 20-20, but some prominent commentators have pointed out that banking might be not much more than a sophisticated compensation scheme for management. A compensation scheme where management leaves with wheelbarrows full of cash during the temporary good times, but largely passes the tab on to others when the buried risks blow up.
Clearly, State Farm’s CEO and the other executives received less compensation due to performance and are also receiving less for running a bigger and more profitable company (in the aggregate) than their shareholder owned rival. So perhaps there is an argument that management is “paying for the mistake” and also generally makes less than shareholder owned rivals. But $10 Million of comp is still a huge pile. And has anyone calculated the year in and year out loss to the policy owners of State Farm stemming from the unintended and undesirable diversion of $700 Million from its insurance operations to rebuild the capital of State Farm Bank?
And finally, why maintain a virtual bank at all? State Farm had the option to adhere to one of the seven co-operative principles to cooperate with other co-operatives. Credit unions are co-ops and they are physically everywhere!