23 Dec Difference Between Banks & Insurance Companies
WHAT’S THE DIFFERENCE BETWEEN FINANCIAL SERVICE COMPANIES?
When I consider the FSOC’s SIFI Designation for non-banks, I’m reminded of two things – the difference between banks & insurance companies, and the joke:
“Do you know the difference between an elephant and a dozen eggs?”
“No, what’s the difference?”
“Well, if you don’t know, remind me never to send you to the store for a dozen eggs.”
Ergo…
“Do you know the differences between banks and insurance companies?”
“No, what’s the difference?”
“Well if you don’t know…”
You get the point.
SIFI GUIDELINES FOR NON-BANK COMPANIES
In the aftermath of the credit crisis and passage of the Dodd-Frank Act, the FSOC (Financial Stability Oversight Council) mandated which financial institutions were Systemically Important Financial Institutions (SIFI).
During the height of the crisis, AIG, Radian, and XL Insurance were in the headlines, so they became synonymous in the public’s mind of what an insurance company does. Compared to MetLife or Allstate, however, these companies couldn’t be more different than a Chanel suit and a tracksuit. But, the FSOC decided that they needed to explain their process for designating an insurance company a SIFI. You can read their process online: SIFI Designation for non-bank companies.
This blog takes a look at the FSOC’s SIFI Designation Process and explains the difference between banks and insurance companies. You may have to look elsewhere for the difference between a dozen eggs and an elephant.
The SIFI points of evaluation are:
- Size (measure is not further evaluated in this blog)
- Institutional Interconnectivity
- Leverage
- Substitutability
- Liquidity Risk & Maturity Mismatch
- Existing Regulatory Scrutiny
INSTITUTIONAL INTERCONNECTIVITY
Banks fund themselves in the interbank market. They borrow and lend funds from/to other banks creating direct interconnectivity between banking institutions. This interconnectivity can be taken one step further by pointing out that the Central Bank shows that banks operate within a system.
But insurance companies are stand-alone institutions. They receive a premium from clients in return for payment upon death in the case of life insurance. In the intervening time, the insurance company invests the clients’ premiums. While one might be tempted to compare the interbank market to the insurance-reinsurance relationship, the small size of this activity renders it unimportant and not truly systemic.
TRANSFORMATION OF MATURITY
Banks make long-term loans and tend to fund them short-term. On the funding side, insurers, as opposed to banks, are funded long-term (via premiums). Insurers don’t transform maturity. They run liability-driven investment policies and match their asset profiles with their liabilities.
LIQUIDITY RISK
Deposits are the largest item on a bank’s balance sheet. And deposits can be withdrawn at any time. Banks are by nature liquidity seeking businesses.
Insurers (annuity life, P&C, and health) policies are not called at will. Only non-annuity life policies are theoretically callable. However, the penalties for early withdrawal and possible elimination of tax benefits may make early withdrawal too costly.
CREDIT, MONEY & PAYMENT FUNCTION
Banks are an organization of settlement systems. Banks create credit, deal with the payment function and the liabilities are money.
Insurer liabilities do not constitute money, rather they are an illiquid future financial claim. Insurers do not provide essential market utilities – coupled with the fact that they’re less integrated to the financial markets, in that they are not an organizationally part of the settlement of payment systems.
SIMILARITIES BETWEEN BANKS & INSURANCE COMPANIES
Certainly, there are similarities between banks and insurance companies, with both being financial intermediaries and with their respective roles as investors. There are two other areas related to systemic risk worth mentioning: leverage and capital. While both are common to banks and insurers, each is used in very different ways.
LEVERAGE
Leverage in banking can be measured by dividing equity over debt. While this is valid for banks, insurance companies’ leverage is best measured as debt divided by assets. Rating agencies measure insurance companies’ leverage in the same way as well as debt over pre-tax earnings.
CAPITAL
Applying a capital surcharge to banks to rein in the creation of leverage via asset acquisition and credit growth is logical and makes sense. Insurers can reduce the debt leverage, but they can’t reduce their insurance assets because this would imply canceling insurance contracts with existing policyholders, a practice which is generally not allowed. So applying a capital surcharge to insurance companies won’t accomplish the brake on leverage that it accomplishes with a bank.
Banks’ and insurers’ funding needs are quite different. In the event of a crisis, a bank borrows money and uses that liquidity to pay back the depositors, while insurers borrow money and use that liquidity to pay off the last policyholder.
EXISTING REGULATORY SCRUTINY
US insurance companies are regulated on the federal level by the National Association of Insurance Commissioners (NAIC), which provides accreditation of national solvency standards and oversees centralized processes for company licensing, amongst other things. US insurance companies are regulated by the state in which they are registered to do business.
CRITICISMS OF SIFI DESIGNATION PROCESS OF NFC’S
- FSOC does not provide the information which led to SIFI designation
- The SIFI designation process itself is not transparent
- A lack of fundamental rigor in the SIFI evaluation process
- FSOC does not give the NFC’s the time or an opportunity to more comprehensive information to assist the process
- The consequences of SIFI designation and enhanced regulation are still uncertain
- FSOC has not shared how the implications of SIFI designation will intermingle with the international processes
SUMMARY
Capital surcharges aren’t the best solution to deal with systemic risk with regard to insurance companies. Size limits, changes in certain contracts, and maybe separate guidelines for complex contracts offer a more tempered approach and one which is more fitting given the insurance business model.
Greater regulatory supervision will increase the administrative costs of the life insurers as well. Add to this the unknown implications of SIFI designation and overseas regulators which make this issue all the more of a concern.