Banking is not the only type of financial intermediation you are likely to encounter. You might decide to purchase insurance, take out an installment loan from a finance company, or buy a share of stock. In each of these transactions you will be engaged in nonbank finance and will deal with nonbank financial institutions. In our economy, nonbank finance also plays an important role in channeling funds from lender-savers to borrower-spenders. Furthermore, the process of financial innovation we discussed in Chapter 10 has increased the importance of nonbank finance and is blurring the distinction between different kinds of financial institutions. This chapter examines in more detail how institutions engaged in nonbank finance operate, how they are regulated, and what trends in nonbank finance have occurred recently
Every day we face the possibility of the occurrence of certain catastrophic events that could lead to large financial losses. A spouse's earnings might disappear due to death or illness; a car accident might result in costly repair bills or payments to an injured party. Because financial losses from crises could be large relative to our financial resources, we protect ourselves against them by purchasing insurance coverage that will pay a sum of money if catastrophic events occur. Life insurance companies sell policies that provide income if a person dies, is incapacitated by illness, or retires. Property and casualty companies specialize in policies that pay for losses incurred as a result of accidents, fire, or theft.
The first life insurance company in the United States (Presbyterian Ministers' Fund in Philadelphia) was established in 1759 and is still in existence. There are currently about 1,700 life insurance companies, which are organized in two forms: as stock companies or as mutuals. Stock companies are owned by stockholders; mutuals are technically owned by the policyholders. Although more than 90% of life insurance companies are organized as stock companies, some of the largest ones are organized as mutuals.
Unlike commercial banks and other depository institutions, life insurance companies have never experienced widespread failures, so the federal government has not seen the need to regulate the industry. Instead, regulation is left to the states in which a company operates. State regulation is directed at sales practices, the provision of adequate liquid assets to cover losses, and restrictions on the amount of risky assets (such as common stock) that the companies can hold. The regulatory authority is typically a state insurance commissioner.
Because death rates for the population as a whole are predictable with a high degree of certainty, life insurance companies can accurately predict what their payouts to policyholders will be in the future. Consequently, they hold long-term assets that are not particularly liquid—corporate bonds and commercial mortgages as well as some corporate stock.
There are two principal forms of life insurance policies: permanent life insurance (such as whole, universal, and variable life) and temporary insurance (such as term). Permanent life insurance policies have a constant premium throughout the life of the policy. In the early years of the policy, the size of this premium exceeds the amount needed to insure against death because the probability of death is low. Thus the policy builds up a cash value in its early years, but in later years the cash value declines because the constant premium falls below the amount needed to insure against death, the probability of which is now higher. The policyholder can borrow against the cash value of the permanent life policy or can claim it by canceling the policy.
Term insurance, by contrast, has a premium that is matched every year to the amount needed to insure against death during the period of the term (such as one year or five years). As a result, term policies have premiums that rise over time as the probability of death rises (or level premiums with a decline in the amount of death benefits). Term policies have no cash value and thus, in contrast to permanent life policies, provide insurance only, with no savings aspect.
Weak investment returns on permanent life insurance in the 1970s led to slow growth of demand for life insurance products. The result was a shrinkage in the size of the life insurance industry relative to other financial intermediaries, with their share of total financial intermediary assets falling from 15.3% at the end of 1970 to 11.5% at the end of 1980. (See Table 1, which shows the relative shares of financial intermediary assets for each of the financial intermediaries discussed in this chapter.)
Beginning in the mid-1970s, life insurance companies began to restructure their business to become managers of assets for pension funds. An important factor behind this restructuring was 1974 legislation that encouraged pension funds to turn fund management over to life insurance companies. Now more than half of the assets managed by life insurance companies are for pension funds and not for life insurance. Insurance companies have also begun to sell investment vehicles for retirement such as annuities, arrangements whereby the customer pays an annual premium in exchange for a future stream of annual payments beginning at a set age, say 65, and continuing until death. The result of this new business has been that the market share of life insurance companies as a percentage of total financial intermediary assets has held steady since 1980.