Both banks and insurance companies are financial institutions, but they don’t have as much in common as you might think. Although they do have some similarities, their operations are based on different models that lead to some notable contrasts between them.
While banks are subject to federal and state oversight and have come under greater scrutiny since the 2007 financial crisis that led to the Dodd-Frank Act, insurance companies are subject only to state-level regulation. Various parties have called for greater federal regulation of insurance companies, particularly considering that American International Group, Inc., (AIG) an insurance company, played a major role in the crisis.
Both Are Financial Intermediaries
One similarity between banks and insurance companies is that they are both financial intermediaries. A bank takes your deposits and pays you interest for their use, and then turns around and lends out the money to borrowers who typically pay for it a higher interest rate. Thus, the bank makes money on the difference between the interest rate it pays you and the interest rate that it charges those who borrow money from it. It effectively acts as a financial intermediary between savers who deposit their money with the bank and investors who need this money.
An insurance company, on the other hand, insures its customers against certain risks, such as the risk of having a car accident, or the risk that a house catches on fire. In return for this insurance, their customers pay them regular insurance premiums. Insurance companies manage these premiums by making suitable investments, thereby also functioning as financial intermediaries between customers and the channels that receive their money. For instance, insurance companies may channel the money into investments such as commercial real estate and bonds.
Subject to Interest Rate Risk
Changes in interest rates affect all sorts of financial institutions. Banks and insurance companies are no exceptions. Considering that a bank pays its depositors an interest rate that is competitive, it might have to hike up its rates if economic conditions warrant. Generally, this risk is mitigated since the bank can also charge a higher interest rate on its loans. And changes in interest rates could also adversely impact the value of a bank’s investments.
Insurance companies are also subject to interest rate risk. Since they invest their premium monies in various investments, such as bonds and real estate, they could see a decline in the value of their investments when interest rates go up. And during times of low interest rates, they face the risk of not getting a sufficient return from their investments to pay their policyholders when claims come due.
Banks Face an Asset-Liability Mismatch
Banks accept short-term deposits and make long-term loans. This means that there is a mismatch between their liabilities and their assets. In case a large number of their depositors want their money back, for example in a bank run scenario, they might have to come up with the money in a hurry.
For an insurance company, however, its liabilities are based on certain insured events happening. Their customers can get a payout if the event they are insured against, such as their house burning down, does happen. They don’t have a claim on the insurance company otherwise. Insurance companies tend to invest the premium money they receive for the long-term so that they are in a position to meet their liabilities as they arise.
While it is possible to cash in certain insurance policies prematurely, this is done based on an individual’s needs. It is unlikely that a very large number of people will want their money at the same time, as happens in the case of a run on the bank. This means that insurance companies are in a better position to manage their risk.
Another difference between banks and insurance companies is in the nature of their systemic ties. Banks operate as part of a wider banking system and have access to a centralized payment and clearing organization that ties them together. This means that it is possible for systemic contagion to spread from one bank to another because of this sort of interconnection. U.S. banks also have access to a central bank system, through the Federal Reserve, and its facilities and support.
Insurance companies, however, are not part of a centralized clearing and payment system. This means that they are not as susceptible to systemic contagion as banks are. However, they don’t have any lender of last resort, in the sort of role that the Federal Reserve serves for the banking system.
Banks Create Money
Banks use the monies that their customers deposit to make a larger base of loans and thereby create money. Since their depositors demand only a portion of their deposits every day, banks keep only a portion of these deposits in reserve and lend out the rest of their deposits to others.
Insurance companies invest and manage the monies they receive from their customers for their own benefit. Their enterprise does not create money in the financial system.
In the United States, banks and insurance companies are subject to different regulatory authorities. National banks and their subsidiaries are regulated by the Office of the Comptroller of the Currency, or the OCC. In the case of state-chartered banks, they are regulated by the Federal Reserve Board for banks that are members of the Federal Reserve system. As for other state-chartered banks, they fall under the purview of the Federal Deposit Insurance Corporation, which insures them. Various state banking regulators also supervise the state banks.
Insurance companies, however, are not subject to a federal regulatory authority. Instead, they fall under the purview of various state guaranty associations in the 50 states. In case an insurance company fails, the state guaranty company collects money from other insurance companies in the state to pay the failed company’s policyholders.
The Bottom Line
Banks and insurance companies are both financial institutions, but they have different business models and face different risks. While both are subject to interest rate risk, banks have more of a systemic linkage and are more susceptible to runs by depositors. While insurance companies’ liabilities are more long-term and don’t tend to face the risk of a run on their funds, they have been taking on more risk in recent years, for example by expanding into products such as annuities, leading to calls for greater regulation of insurance companies.