“If a man does away with his traditional way of living and throws away his good customs, he had better first make certain that he has something of value to replace them.“
With this African Basuto proverb, Robert Ruark began his acclaimed 1955 novel, Something of Value. Although this quote may be appropriate for any aspect of human endeavor, for the purpose of this article, we will consider its application to the existing state-based insurance guaranty system which serves to protect policyholders and beneficiaries of life insurance products in cases of insurance company insolvencies.
Since the onset of the financial crisis in 2008, there has been public discussion of whether the current state-based system is adequate to provide such financial protection to insurance consumers. This was raised during the deliberation of the Dodd-Frank Act, by policy makers, business and consumer organizations at hearings before the Federal Insurance Office, at Congressional hearings, and in other public arenas. This article will make the case that the existing state-based system of providing financial guarantees to consumers of life insurance products works very well. It is a “good custom” that should not be replaced!
This argument is based upon key fundamental differences between life insurance products and bank products. Likewise, I hope to demonstrate that the needs and systems for providing such financial guarantees to bank and life insurance consumers are totally different. The current state-based system for guaranteeing life insurance products should not be replaced with the FDIC system for insuring bank products, any more than the FDIC system should be replaced by a state-based system. The two systems are simply not interchangeable.
Here is an important fact to keep in mind. From the onset in 2008 of the greatest financial crisis since the Great Depression until the end of 2011, approximately 419 banks have been declared insolvent and taken over by the FDIC. During that same time period, only 8 life insurance companies were deemed insolvent and placed in liquidation by the state-based system, The National Organization of Life and Health Insurance Guaranty Associations.1 I would encourage readers, as well as public policy makers, to keep this important fact in mind going forward.
In its January 2, 2012 edition, The Wall Street Journal reported that,"Ninety-two banks failed in 2011, well below the previous two years totals. The list of what regulators call 'problem banks' is shrinking. And the latest two bank failures were the first in nearly a month—the longest failure-free period in almost three years. So is the era of troubled banks over? Don’t bet on it."
The business of banking is strikingly different from the business of life insurance. The fact that almost 40 times the number of banks than life insurance companies have failed since 2008 is a meaningful indicator of these differences.
At the simplest level, a bank is “any organization engaged in any or all of the various functions of banking, i.e., receiving, collecting, transferring, paying, lending, investing, dealing, exchanging, and servicing (safe deposit, custodianship, agency, trusteeship) money and claims to money both domestically and internationally.”2 By contrast, a life insurance company is a financial institution that provides life insurance, which is “a contract, under which the insurer agrees, in return for a stipulated consideration, to pay a certain sum of money upon the occurrence of a given contingency which, under the ordinary life insurance policy is the death of the insured.”3
The fact that the business of banking involves accepting of deposits and making loans, and the business of life insurance does not involve those functions, helps to explain why the banking sector experienced tremendous financial losses and insolvencies during the latest financial crisis, and why the life insurance sector did not.
It is important to understand these fundamental differences between these functions of banking and insurance. Bank “checking account deposits (individual, partnership, and corporation accounts) as demand deposits are subject to withdrawal by the depositor at any time, without notice, by check or in cash.”4 There are generally no restrictions on the withdrawal of deposits. Consequently, a major difference between the business of banking and the business of insurance is that banks can and do experience “bank runs.” A “run on the bank” is “a concerted movement of depositors to withdraw deposits from a bank, out of fear of its insolvency, especially in times of panic or money or credit disturbance.”5 As a bank run progresses, it generates its own momentum, in a kind of self-fulfilling prophecy as everyone rushes in to withdraw their deposits before the bank gives out all of its assets. As more people withdraw their deposits, the likelihood of default increases, and this encourages further withdrawals, which “can force the bank to liquidate many of its assets at a loss and to fail.”6 This can destabilize the bank to the point where it faces bankruptcy. By contrast, with respect to life insurance products, there is no such thing as a run on a life insurance company! This distinction is critical to understanding the differences between the state-based system for guarantying life insurance products, versus the FDIC-based system for guarantying bank products.
Essentially, life insurance products are long term contractual arrangements that are intended to pay benefits upon a future contingency. Typically, insurance consumers pay premiums over long periods of time, in exchange for the payment of a benefit or benefits upon the occurrence of the future contingency. Life insurance policies with cash accumulation policies “usually provide the insured the right to borrow from the insurer on the policy” as an “advance on the insurance proceeds,” but doing so will result in some loss of future financial benefits since “the proceeds that the insurer must ultimately pay under the policy is reduced by the amount of the policy loan.”7
Moreover, the payment of benefits to life insurance consumers occur at different times in the future, and not all at one time. Typically, life insurance policyholders die at different times; thus, death benefits are not all payable at the same time. This difference further helps to illustrate why there is no such thing as a run on an insurance company.
These fundamental differences between the business functions of life insurance versus banking make all the difference in the world in providing the rationale for the financial regulatory systems for guarantying insurance and banking products in the event of insolvency.
For example, in the case of a bank failure, the FDIC typically sweeps in as the “receiver” and takes over an insolvent bank and allocates the assets to other solvent banks. As the receiver, it is the “duty” of the FDIC to “realize upon the assets of the closed bank, having due regard to the condition of credit in the locality; to enforce the individual liability of directors thereof; and to wind up the affairs of such closed bank in conformity with the provisions of the law relating to the liquidation of national banks.”8 This system protects the bank's consumers and the remaining bank business.
The mechanism for unwinding an insurance company, by contrast, is different. As noted, all benefits due to consumers upon the insolvency of a life insurance company are not due and payable at the time of the insolvency, and they cannot be withdrawn like bank deposits. In fact, the state-based system actually allows for the infusion of capital through the assessment process which can enable an insolvent insurance company to continue to operate for “a decade or more”9 after it has been deemed insolvent.
Banks and insurance companies do fail. Just as the FDIC system seems to have worked well for providing financial protection for bank consumers in the event of bank failures, the state-based insurance guaranty system has worked well, and continues to work well, in providing financial protection to life insurance consumers in the event of life insurance company failures.
Hence, as the public debate moves forward, all interested parties should remember the old Basuto proverb quoted above. The “good custom” of the state-based insurance guaranty system should not be replaced with something that is not of value! Endnotes
- 1. Insurance Oversight and Legislative Proposals, Testimony for the Record of The National Organization of Life and Health Insurance Guaranty Associations Before the House Financial Services Subcommittee on Insurance, Housing and Community Opportunity (November 16, 2011)
- 2. Bank, Encyclopedia of Banking & Finance, 10th; Woelfel, Charles J.
- 3. Couch on Insurance, 3rd, § 1:39; Plitt, Steven; Maldanado, Daniel; Rogers, Joshua D.
- 4. Withdrawal, Encyclopedia of Banking & Finance, 10th; Woelfel, Charles J.
- 5. Run on a Bank, Encyclopedia of Banking & Finance, 10th; Woelfel, Charles J.
- 6. Bank Runs, Deposit Insurance, and Liquidity, Journal of Political Economy (June 1983, vol. 91, no. 3, pp. 401-19); Diamond, Douglas W.; Dybvig, Philip H.
- 7. Couch on Insurance, 3rd, § 80:1; Plitt, Steven; Maldanado, Daniel; Rogers, Joshua D.
- 8. Receivership, Encyclopedia of Banking & Finance, 10th; Woelfel, Charles J.
- 9. Insolvency and Default: An Overview of the State Insurance Receivership System, 27 THE BRIEF 12; Semaya, Francine L.; Marema, Lenore S.