Insurance Companies vs. Banks: An Overview
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.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed by the Obama Administration in 2010, established new government agencies in charge of regulating the banking system. President Trump pledged to repeal Dodd-Frank and in May 2018, the House of Representatives voted to repeal aspects of the Act.Key Takeaways
- 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, leading to calls for greater regulation of the industry.
Insurance Companies
Both banks and insurance companies are financial intermediaries. However, their functions are different. An insurance company ensures 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. 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.Banks
Operating differently, a bank takes deposits and pays interest for their use, and then turns around and lends out the money to borrowers who typically pay for it at 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.
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.Some banks will arrange with insurance companies to offer insurance products to their customers. The bank will usually receive additional revenue from the sale of these products. This practice is most commonly found in Europe, but the United States also embraces the concept.
Key Differences
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.