Insurance vs Banking: Understand The Differences With New BPC Report by Bipartisan Policy Center
Introduction
Immediately after the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), conventional wisdom held that insurers mostly escaped the legislation. Five years later, it is clear that is not the case. The Federal Reserve now plays a significant role in regulating and supervising roughly one-third of the life insurance industry and one-quarter of the property and casualty insurance (P&C) industry. In addition, the Federal Deposit Insurance Corporation (FDIC) now has resolution authority over many insurance companies, and the U.S. Treasury Department has a new Federal Insurance Office (FIO) that may soon activate its authority to negotiate international insurance agreements.
The business of insurance is fundamentally different from the business of banking. Each has its own specific models and practices, risk profiles, risk-management strategies, and regulatory regimes. Each has a different balance sheet, revenue stream, and customer value proposition. Insurers and banks run into financial trouble for very different reasons and the regulatory approaches to managing troubled insurers and banks are markedly different.
This paper describes the differences between insurance and banking. It examines and compares key aspects of both industries: size, business models, distribution channels, regulatory oversight, safety and soundness, consumer protection, reasons for failure, resolution, and systemic risk.
Among the Financial Regulatory Reform Initiative’s core observations are:
- The differences between banks and insurance companies are greater than their similarities;
- Policymakers and regulators need to fully recognize and understand these differences and act accordingly; and
- As federal regulators take on roles in overseeing a significant part of the insurance industry, they should be careful to tailor their regulation and supervision of insurance companies to the ways these companies differ from banks.
If these three propositions sound simple, that’s the point.
Insurance vs Banking: Size Of The Industry
The size of insurance companies are generally measured by the premiums they receive from policyholders, while banks and thrifts often are measured by total assets.
Banks
As of mid-2015, the United States was home to over 6,300 banks and thrifts (or savings and loans), which held more than $15.8 trillion in assets. In addition, there were just under 6,200 credit unions with total assets of over $1.1 trillion.
Insurance
There were approximately 850 life insurance companies doing business in the United States in 2014, and another roughly 2,600 P&C insurers in 2013. In 2013, life insurers collected about $740 billion in premiums (without adjusting for reinsurance premiums), while P&C companies collected approximately $570 billion. Together, life and P&C insurers held about $7.3 trillion in assets, just less than half of the value of assets held by banks and thrifts.
Business Models
Both banks and insurers encourage savings and promote economic growth, but they do so in different ways-and make fundamentally different promises to their customers. Insurers manage risk by aggregating it and by matching the duration of their assets and liabilities. Banks manage risk through diversification to avoid too much exposure to any one set of risk factors.
Banks
Banks play a valuable economic and social role as financial intermediaries, connecting savers looking to safeguard their money with borrowers looking to invest or spend. Banks help depositors easily access funds, build wealth, save for retirement, and more. Banks provide credit to borrowers to buy homes, automobiles, or to build and expand businesses. Banks do this primarily through maturity transformation, the process by which banks take relatively short-term funds from depositors and creditors and transform them into assets by lending on a relatively long-term basis. The deposits received by banks are accounted for as liabilities and, generally, can be immediately accessed by the depositors. When a bank makes a loan, that is an asset to the bank-it is a promise by the borrower to pay the bank money in the future (including interest on the loan and repayment of the principal).
Insurance
Insurance provides social and economic value by helping individuals and businesses reduce their exposure to risks. A policyholder pays premiums to an insurance company in exchange for a promise by the insurer to pay for a future loss covered by the policy. Policyholders get nothing tangible for their premium payments, only a contract setting forth the insurer’s promise to pay in the future if a covered loss occurs during the policy period. Insurers count these policy obligations as liabilities on their balance sheets.
Policyholders reduce their own risk by shifting it to insurers. Paradoxically, insurers better manage their own risk by taking on more policyholders, so long as the risks of those policies are diversified and properly underwritten. This win-win situation is made possible by the law of large numbers, which allows insurers to pool risks from their policyholders, spreading their liability for losses over a diverse group of customers.
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