Insurance Companies vs. Banks: An Overview
Financial institutions like banks and insurance companies may seem similar at first glance, but they operate on distinct models, resulting in significant differences between them.
Banks face federal and state oversight, especially post the 2007 financial crisis leading to the Dodd-Frank Act. Conversely, insurance companies are primarily regulated at the state level. Calls for increased federal oversight of insurance companies have arisen, particularly following the pivotal role played by American International Group, Inc. (AIG) in the crisis.
The Dodd-Frank Act, enacted in 2010 under the Obama Administration, introduced new governmental bodies to supervise the banking sector. However, there have been efforts to roll back aspects of this Act, with the House of Representatives voting for repeal in May 2018 during President Trump’s tenure.
Image: Investopedia / Sabrina Jiang.
Insurance Companies
In contrast to banks, insurance companies serve as financial intermediaries offering protection against specific risks, such as accidents or property damage. Customers pay premiums to insurance companies in exchange for this coverage.
These companies invest premiums in diverse assets like real estate and bonds, acting as intermediaries between clients and investment channels.
Unlike banks, insurance firms do not create money but strategically manage client funds for long-term stability.
Banks
Banks accept deposits, pay interest on them, and subsequently lend these funds at higher rates. This process positions banks as intermediaries between depositors and borrowers, generating revenue from interest rate differentials.
By leveraging deposited funds to extend loans, banks contribute to money creation within the financial system.
Some banks collaborate with insurance companies to provide insurance products, a practice prevalent in Europe and also gaining traction in the United States.
Key Differences
One contrasting aspect is that banks deal with short-term deposits and long-term lending, potentially facing liquidity challenges during mass withdrawal scenarios.
Insurance companies operate based on insured events and long-term investments, enabling better risk management compared to banks susceptible to rapid fund withdrawals.
Insurance companies strategically invest premiums for future obligations, mitigating immediate financial risks.
Unlike banks, insurance firms are not interlinked in a centralized payment system, reducing systemic contagion risks but lacking a lender of last resort akin to the Federal Reserve for banks.
Special Considerations
Both banks and insurance companies face challenges related to interest rate fluctuations and regulatory compliance.
Interest Rate Risk
Interest rate fluctuations impact banks and insurance companies, influencing their profitability and asset valuations. Mitigation strategies include adjusting rates for deposits and loans.
Insurers investing in bonds and real estate also contend with interest rate risks affecting investment returns and policyholder payouts.
Regulatory Authority
U.S. banks are overseen by various regulatory bodies, including the Office of the Comptroller of the Currency (OCC) and Federal Reserve entities, whereas insurance companies fall under state guaranty associations’ jurisdiction.
In cases of insurance company insolvency, state guaranty associations collaborate to compensate policyholders, highlighting the decentralized regulatory framework of the insurance sector.