Insurance Companies vs. Banks: What’s the Difference?

Insurance companies vs banks: an overview

Banks and insurance companies are financial institutions, but they don’t have as much in common as one might think. Although they have some similarities, their operations are based on different models which lead to notable contrasts between them.

While banks have come under federal and state oversight and come under greater scrutiny since the 2007 financial crisis which led to the Dodd–Frank Act, insurance companies are only subject to state-level regulation. Various parties have called for greater federal regulation of insurance companies, especially given that American International Group, Inc., (IGA) an insurance company, played a major role in the crisis.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed by the Obama administration in 2010, established new government agencies to regulate the banking system. President Trump has pledged to repeal Dodd-Frank, and in May 2018 the House of Representatives voted to repeal aspects of the law.

Key points to remember

  • Banks and insurance companies are both financial institutions, but they have different business models and face different risks.
  • Although both are exposed to interest rate risk, banks are more systemically linked and more susceptible to depositor panics.
  • While insurance companies’ liabilities are longer-term and don’t tend to face the risk of a run on their funds, they have taken on more risk in recent years, leading to calls to greater industry regulation.

Investopedia / Sabrina Jiang


Insurance companies

Banks and insurance companies are financial intermediaries. However, their functions are different. An insurance company insures its customers against certain risks, such as the risk of having a car accident or the risk of a house catching fire. In return for this insurance, their clients pay them regular insurance premiums.

Insurance companies manage these premiums by making appropriate investments, thus also functioning as financial intermediaries between customers and the channels that receive their money. For example, insurance companies can funnel money into investments such as commercial real estate and bonds.

Insurance companies invest and manage the monies they receive from their customers for their own benefit. Their business does not create money in the financial system.

Banks

Working differently, a bank takes deposits and pays interest for their use, then turns around and lends the money to borrowers who usually pay it at a higher interest rate. So the bank makes money on the difference between the interest rate it pays you and the interest rate it charges those who borrow money from it. It acts effectively as a financial intermediary between savers who deposit their money in the bank and investors who need that money.

Banks use the money their customers deposit to build a larger loan base and thus create money. Since their depositors only request a portion of their deposits each day, banks only hold a portion of these deposits in reserve and lend the rest of their deposits to others.

Main differences

Banks accept short-term deposits and grant long-term loans. This means that there is a gap between their liabilities and their assets. In case a large number of their depositors want their money back, for example in a bank rush scenario, they may need to find the money quickly.

For an insurance company, however, its liabilities are based on certain insured events occurring. Their clients can get a payout if the event against which they are insured, such as a house fire, occurs. Otherwise, they have no claim with the insurance company.

Insurance companies tend to invest the premiums they receive for the long term in order to be able to meet their liabilities as they arise.

While it is possible to cash out some insurance policies prematurely, this is done based on the needs of the individual. It is unlikely that a very large number of people want their money at the same time, as happens in the case of a bank run. This means that insurance companies are in a better position to manage their risks.

Another difference between banks and insurance companies is the nature of their systemic links. Banks operate as part of a larger banking system and have access to a centralized payment and clearing organization that connects them. This means that it is possible for systemic contagion to spread from bank to bank due to this type of interconnection. US banks also have access to a central banking system, through the Federal Reserve, and its facilities and support.

However, insurance companies are not part of a centralized clearing and payment system. This means that they are not as susceptible to systemic contagion as banks. However, they don’t have a lender of last resort, the kind of role the Federal Reserve plays for the banking system.

Special Considerations

There are both interest rate and regulatory oversight risks that affect both insurance companies and banks, albeit in different ways.

Interest rate risk

Changes in interest rates affect all kinds of financial institutions. Banks and insurance companies are no exception. Considering that a bank pays its depositors a competitive interest rate, it could be led to increase its rates if the economic conditions justify it. Generally, this risk is mitigated since the bank can also charge a higher interest rate on its loans. Changes in interest rates could also have a negative impact on the value of a bank’s investments.

Insurance companies are also exposed to interest rate risk. Since they invest their premiums in various investments, such as bonds and real estate, they might see a decline in the value of their investments when interest rates rise. And during periods of low interest rates, they run the risk of not getting enough return on their investments to pay their policyholders when claims come due.

Regulatory authority

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 (OCC).

In the case of state chartered banks, they are regulated by the Federal Reserve Board for member banks of the Federal Reserve System. As for the other state-chartered banks, they fall under the jurisdiction of the Federal Deposit Insurance Corporation, which insures them. Various state banking regulators also oversee state banks.

Insurance companies, however, are not subject to federal regulatory authority. Instead, they fall under the jurisdiction of various state guarantee associations in all 50 states. If an insurance company goes bankrupt, the state guarantee company collects money from other state insurance companies to pay the bankrupt company’s policyholders.

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