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Compare insurers with banks in respect of the guaranty system and the regulatory requirements each faces.

FRM® Part I · Financial Markets and Products · Insurance Companies and Pension Plans · FRM1.FM.2.i

The idea

Banks and insurers are both regulated for solvency, but the systems differ. In the United States banks face federal regulation and deposit insurance funded by premiums paid by banks in advance. Insurers are regulated mainly state by state. Policyholders are protected by state guaranty associations that in most states levy the surviving insurers after a failure. Bank capital under Basel covers credit, market and operational risk, with liquidity standards added. The credit risk internal ratings approach uses a one-year 99.9 percent confidence level. Insurance regimes such as Solvency II use 99.5 percent and add underwriting risk, which banks do not have. Insurers face less run risk because life policies and claims cannot be withdrawn on demand like deposits. Remember: premium-funded and federal for banks, post-failure levy and state-based for US insurers.

A practice question

From the question bank, with the reason each wrong option is wrong.

In the United States, how are insurance companies primarily regulated compared with banks?

  1. Insurers mainly by the states, while banks face federal regulation - correct
  2. Insurers are regulated mainly by a single federal agency, like banks, with no role for individual statesWhy not: In the United States, insurance regulation is mainly at state level.
  3. Insurers face no regulation of solvency, unlike banksWhy not: Insurers are subject to solvency regulation, including risk-based capital.
  4. Both are regulated mainly by individual states with no federal roleWhy not: Banks are subject to federal regulation, including federal deposit insurance.

US insurers are regulated state by state, with the NAIC coordinating standards, while banks face federal oversight. This contrasts with the EU, where Solvency II applies across the union.

A harder one

Why is a life insurer generally less exposed to a sudden run on liabilities than a bank?

  1. Policy values cannot normally be withdrawn on demand without penalty, unlike deposits - correct
  2. Life insurers hold far more liquid assets than banks, so they can meet any withdrawal requestWhy not: Life insurers hold long-dated assets; their protection from a run comes from the nature of their liabilities.
  3. Life insurers have no liquidity risk at all, since their claims are always predictableWhy not: Insurers do have liquidity risk, for example from surrender or catastrophe claims, but it is much less than a bank's.
  4. Life insurers are covered by federal deposit insurance, so policyholders never withdrawWhy not: Federal deposit insurance applies to banks, not to insurers.

Deposits are demandable, so a loss of confidence can cause a run. Life policies cannot normally be cashed in without surrender charges, and claims are tied to insured events.

The hardest tier

Compared with bank deposit insurance funded by advance premiums, what is a weakness of a guaranty system that is funded by levies on surviving insurers after a failure?

  1. There is no mechanism to protect policyholders at all after a failure, because no fund is ever createdWhy not: Guaranty associations do pay claims up to limits; the weakness is how the cost is funded.
  2. The levy lands on survivors just after a failure, when they may be weak, and is not risk-based - correct
  3. Taxpayers must absorb all the losses of the failed insurer, because the industry cannot be leviedWhy not: The system is financed by the industry, not by taxpayers.
  4. Surviving insurers are overcharged in advance, so the fund is always larger than any failure needsWhy not: The levy is imposed after the failure, not in advance.

Funding after the event means the cost comes when conditions are poor and the levy is not linked to the risk each insurer posed, reducing incentives for the industry to control risk in advance.

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