economics_of_money_banking__financial_markets

Overall Evaluation

Market-Value Accounting for Capital Requirements. We have seen that the requirement that a bank have substantial equity capital makes the bank less likely to fail. The requirement is also advantageous, because a bank with high equity capital has more to lose if it takes on risky investments and so will have less incentive to hold risky assets. Unfortunately, capital requirements, including new risk-based measures, are calculated on a historical-cost (book value) basis in which the value of an asset is set at its initial purchase price. The problem with historical-cost accounting is that changes in the value of assets and liabilities because of changes in interest rates or default risk are not reflected in the calculation of the firmÕs equity capital. Yet changes in the market value of assets and liabilities and hence changes in the market value of equity capital are what indicate if a firm is truly insolvent. Furthermore, it is the market value of capital that determines the incentives for a bank to hold risky assets.

Market-value accounting when calculating capital requirements is another reform that receives substantial support. All assets and liabilities could be updated to market value periodicallyÑsay, every three monthsÑto determine if a bankÕs capital is sufficient to meet the minimum requirements. This market-value accounting information would let the deposit insurance agency know quickly when a bank was falling below its capital requirement. The bank could then be closed down before its net worth fell below zero, thus preventing a loss to the deposit insurance agency. The market-value- based capital requirement would also ensure that banks would not be operating with negative capital, thereby preventing the bet-the-bank strategy of taking on excessive risk.

Objections to market-value-based capital requirements center on the difficulty of making accurate and straightforward market-value estimates of capital. Historical-cost accounting has an important advantage in that accounting rules are easier to define and standardize when the value of an asset is simply set at its purchase price. Marketvalue accounting, by contrast, requires estimates and approximations that are harder to standardize. For example, it might be hard to assess the market value of your friend JoeÕs car loan, whereas it would be quite easy to value a government bond. In addition, conducting market-value accounting would prove costly to banks because estimation of market values requires the collection of more information about the characteristics of assets and liabilities. Nevertheless, proponents of market-value accounting for capital requirements point out that although market-value accounting involves some estimates and approximations, it would still provide regulators with more accurate assessment of bank equity capital than historical-cost accounting does.

FDICIA appears to be an important step in the right direction, because it increases the incentives for banks to hold capital and decreases their incentives to take on excessive risk. However, more could be done to improve the incentives for banks to limit their risk taking. Yet eliminating deposit insurance and the too-big-to-fail policy altogether may be going too far, because these proposals might make the banking system too prone to a banking panic.

PREVIEW

Banking is not the only type of financial intermediation you are likely to experience. 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 financial institutons. This chapter examines in more detail how institutions engaged in nonbank finance operate, how they are regulated, and recent trends in nonbank finance.

www.iii.org

The Insurance Information Institute publishes facts and statistics about the insurance industry.

Every day we face the possibility of the occurrence of certain catastrophic events that could lead to large financial losses. A spouseÕs 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.

Life Insurance

The first life insurance company in the United States (Presbyterian MinistersÕ Fund in Philadelphia) was established in 1759 and is still in existence. There are currently about 1,400 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 over 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

www.federalreserve.gov /releases/Z1/

The Flow of Funds Accounts of the United States reports details about the current state of the insurance industry. Scroll down through the table of contents to find the location of data on insurance companies.

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 liquidÑcorporate 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 1960s and 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 19.6% at the end of 1960 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.

Property and

Casualty

Insurance

There are on the order of 3,000 property and casualty insurance companies in the United States, the two largest of which are State Farm and Allstate. Property and casualty companies are organized as both stock and mutual companies and are regulated by the states in which they operate.

Although property and casualty insurance companies had a slight increase in their share of total financial intermediary assets from 1960 to 1990 (see Table 1), in recent years they have not fared well, and insurance premiums have skyrocketed. With the high interest rates in the 1970s and 1980s, insurance companies had high

The Competitive Threat from the Banking Industry

unnatural disasters such as the Los Angeles earthquake in 1994 and Hurricane Floyd in 1999, which devastated parts of the East Coast, and the September 11, 2001 destruction of the World Trade Center, exposed the property and casualty insurance companies to billions of dollars of losses. Therefore, property and casualty insurance companies hold more liquid assets than life insurance companies; municipal bonds and U.S. government securities amount to over half their assets, and most of the remainder is held in corporate bonds and corporate stock.

Property and casualty insurance companies will insure against losses from almost any type of event, including fire, theft, negligence, malpractice, earthquakes, and automobile accidents. If a possible loss being insured is too large for any one firm, several firms may join together to write a policy in order to share the risk. Insurance companies may also reduce their risk exposure by obtaining reinsurance. Reinsurance allocates a portion of the risk to another company in exchange for a portion of the premium and is particularly important for small insurance companies. You can think of reinsurance as insurance for the insurance company. The most famous risk-sharing operation is LloydÕs of London, an association in which different insurance companies can underwrite a fraction of an insurance policy. LloydÕs of London has claimed that it will insure against any contingencyÑfor a price.

Until recently, banks have been restricted in their ability to sell life insurance products. This has been changing rapidly, however. Over two-thirds of the states allow banks to sell life insurance in one form or another. In recent years, the bank regulatory authorities, particularly the Office of the Comptroller of the Currency (OCC), have also encouraged banks to enter the insurance field because getting into insurance would help diversify banksÕ business, thereby improving their economic health and making bank failures less likely. For example, in 1990, the OCC ruled that selling annuities was a form of investment that was incidental to the banking business and so was a permissible banking activity. As a result, the banksÕ share of the annuities market has surpassed 20%. Currently, more than 40% of banks sell insurance products, and the number is expected to grow in the future.

Insurance companies and their agents reacted to this competitive threat with both lawsuits and lobbying actions to block banks from entering the insurance business. Their efforts were set back by several Supreme Court rulings that favored the banks. Particularly important was a ruling in favor of Barnett Bank in March 1996, which held that state laws to prevent banks from selling insurance can be superseded by federal rulings from banking regulators that allow banks to sell insurance. The decision gave banks a green light to further their insurance activities, and with the passage of the Gramm-Leach-Bliley Act of 1999, banking institutions will further engage in the insurance business, thus blurring the distinction between insurance companies and banks.

Screening

Risk-Based

Premiums

C H A P T E R 1 2 Nonbank Finance 291

bonds, stocks, and loans into insurance policies that provide a set of services (for example, claim adjustments, savings plans, friendly insurance agents). If the insurerÕs production process of asset transformation efficiently provides its customers with adequate insurance services at low cost and if it can earn high returns on its investments, it will make profits; if not, it will suffer losses.

In Chapter 9 the economic concepts of adverse selection and moral hazard allowed us to understand principles of bank management related to managing credit risk; many of these same principles also apply to the lending activities of insurers. Here again we apply the adverse selection and moral hazard concepts to explain many management practices specific to insurance.

In the case of an insurance policy, moral hazard arises when the existence of insurance encourages the insured party to take risks that increase the likelihood of an insurance payoff. For example, a person covered by burglary insurance might not take as many precautions to prevent a burglary because the insurance company will reimburse most of the losses if a theft occurs. Adverse selection holds that the people most likely to receive large insurance payoffs are the ones who will want to purchase insurance the most. For example, a person suffering from a terminal disease would want to take out the biggest life and medical insurance policies possible, thereby exposing the insurance company to potentially large losses. Both adverse selection and moral hazard can result in large losses to insurance companies, because they lead to higher payouts on insurance claims. Lowering adverse selection and moral hazard to reduce these payouts is therefore an extremely important goal for insurance companies, and this goal explains the insurance practices we will discuss here.

To reduce adverse selection, insurance providers try to screen out good insurance risks from poor ones. Effective information collection procedures are therefore an important principle of insurance management.

When you apply for auto insurance, the first thing your insurance agent does is ask you questions about your driving record (number of speeding tickets and accidents), the type of car you are insuring, and certain personal matters (age, marital status). If you are applying for life insurance, you go through a similar grilling, but you are asked even more personal questions about such things as your health, smoking habits, and drug and alcohol use. The life insurer even orders a medical evaluation (usually done by an independent company) that involves taking blood and urine samples. Just as a bank calculates a credit score to evaluate a potential borrower, the insurers use the information you provide to allocate you to a risk classÑa statistical estimate of how likely you are to have an insurance claim. Based on this information, the insurer can decide whether to accept you for the insurance or to turn you down because you pose too high a risk and thus would be an unprofitable customer.

Charging insurance premiums on the basis of how much risk a policyholder poses for the insurance provider is a time-honored principle of insurance management. Adverse selection explains why this principle is so important to insurance company profitability.

Restrictive

Provisions

Prevention of Fraud

Cancellation of

Insurance

Deductibles

To understand why an insurance provider finds it necessary to have riskbased premiums, letÕs examine an example of risk-based insurance premiums that at first glance seems unfair. Harry and Sally, both college students with no accidents or speeding tickets, apply for auto insurance. Normally, Harry will be charged a much higher premium than Sally. Insurance providers do this because young males have a much higher accident rate than young females. Suppose, though, that one insurer did not base its premiums on a risk classification but rather just charged a premium based on the average combined risk for males and females. Then Sally would be charged too much and Harry too little. Sally could go to another insurer and get a lower rate, while Harry would sign up for the insurance. Because HarryÕs premium isnÕt high enough to cover the accidents he is likely to have, on average the insurer would lose money on Harry. Only with a premium based on a risk classification, so that Harry is charged more, can the insurance provider make a profit.1

Restrictive provisions in policies are an insurance management tool for reducing moral hazard. Such provisions discourage policyholders from engaging in risky activities that make an insurance claim more likely. For example, life insurers have provisions in their policies that eliminate death benefits if the insured person commits suicide within the first two years that the policy is in effect. Restrictive provisions may also require certain behavior on the part of the insured. A company renting motor scooters may be required to provide helmets for renters in order to be covered for any liability associated with the rental. The role of restrictive provisions is not unlike that of restrictive covenants on debt contracts described in Chapter 8: Both serve to reduce moral hazard by ruling out undesirable behavior.

Insurance providers also face moral hazard because an insured person has an incentive to lie to the insurer and seek a claim even if the claim is not valid. For example, a person who has not complied with the restrictive provisions of an insurance contract may still submit a claim. Even worse, a person may file claims for events that did not actually occur. Thus an important management principle for insurance providers is conducting investigations to prevent fraud so that only policyholders with valid claims receive compensation.

Being prepared to cancel policies is another insurance management tool. Insurers can discourage moral hazard by threatening to cancel a policy when the insured person engages in activities that make a claim more likely. If your auto insurance company makes it clear that coverage will be canceled if a driver gets too many speeding tickets, you will be less likely to speed.

The deductible is the fixed amount by which the insuredÕs loss is reduced when a claim is paid off. A $250 deductible on an auto policy, for example,

Coinsurance

Limits on the Amount of Insurance

Summary

C H A P T E R 1 2 Nonbank Finance 293

means that if you suffer a loss of $1,000 because of an accident, the insurer will pay you only $750. Deductibles are an additional management tool that helps insurance providers reduce moral hazard. With a deductible, you experience a loss along with the insurer when you make a claim. Because you also stand to lose when you have an accident, you have an incentive to drive more carefully. A deductible thus makes a policyholder act more in line with what is profitable for the insurer; moral hazard has been reduced. And because moral hazard has been reduced, the insurance provider can lower the premium by more than enough to compensate the policyholder for the existence of the deductible. Another function of the deductible is to eliminate the administrative costs of handling small claims by forcing the insured to bear these losses.

When a policyholder shares a percentage of the losses along with the insurer, their arrangement is called coinsurance. For example, some medical insurance plans provide coverage for 80% of medical bills, and the insured person pays 20% after a certain deductible has been met. Coinsurance works to reduce moral hazard in exactly the same way that a deductible does. A policyholder who suffers a loss along with the insurer has less incentive to take actions, such as going to the doctor unnecessarily, that involve higher claims. Coinsurance is thus another useful management tool for insurance providers.

Another important principle of insurance management is that there should be limits on the amount of insurance provided, even though a customer is willing to pay for more coverage. The higher the insurance coverage, the more the insured person can gain from risky activities that make an insurance payoff more likely and hence the greater the moral hazard. For example, if ZeldaÕs car were insured for more than its true value, she might not take proper precautions to prevent its theft, such as making sure that the key is always removed or putting in an alarm system. If it were stolen, she comes out ahead because the excessive insurance payment would allow her to buy an even better car. By contrast, when the insurance payments are lower than the value of her car, she will suffer a loss if it is stolen and will thus take precautions to prevent this from happening. Insurance providers must always make sure that their coverage is not so high that moral hazard leads to large losses.

Effective insurance management requires several practices: information collection and screening of potential policyholders, risk-based premiums, restrictive provisions, prevention of fraud, cancellation of insurance, deductibles, coinsurance, and limits on the amount of insurance. All of these practices reduce moral hazard and adverse selection by making it harder for policyholders to benefit from engaging in activities that increase the amount and likelihood of claims. With smaller benefits available, the poor insurance risks (those who are more likely to engage in the activities in the first place) see less benefit from the insurance and are thus less likely to seek it out.

Private Pension

Plans

www.pbgc.gov/

The web site for the Pension Benefit Guarantee Corporation contains information about pensions and the insurance that it provides.

pension plan pays her $1,753 or less after ten years, the plan is fully funded because her contributions and earnings will fully pay for this payment. But if the defined benefit is $2,000, the plan is underfunded, because her contributions and earnings do not cover this amount.

A second characteristic of pension plans is their vesting, the length of time that a person must be enrolled in the pension plan (by being a member of a union or an employee of a company) before being entitled to receive benefits. Typically, firms require that an employee work five years for the company before being vested and qualifying to receive pension benefits; if the employee leaves the firm before the five years are up, either by quitting or being fired, all rights to benefits are lost.

Private pension plans are administered by a bank, a life insurance company, or a pension fund manager. In employer-sponsored pension plans, contributions are usually shared between employer and employee. Many companiesÕ pension plans are underfunded because they plan to meet their pension obligations out of current earnings when the benefits come due. As long as companies have sufficient earnings, underfunding creates no problems, but if not, they may not be able to meet their pension obligations. Because of potential problems caused by corporate underfunding, mismanagement, fraudulent practices, and other abuses of private pension funds (Teamsters pension funds are notorious in this regard), Congress enacted the Employee Retirement Income Security Act (ERISA) in 1974. This act established minimum standards for the reporting and disclosure of information, set rules for vesting and the degree of underfunding, placed restrictions on investment practices, and assigned the responsibility of regulatory oversight to the Department of Labor.

ERISA also created the Pension Benefit Guarantee Corporation (called ÒPenny BennyÓ), which performs a role similar to that of the FDIC. It insures pension benefits up to a limit (currently over $40,000 per year per person) if a company with an underfunded pension plan goes bankrupt or is unable to meet its pension obligations for other reasons. Penny Benny charges pension plans premiums to pay for this insurance, and it can also borrow funds up to $100 million from the U.S. Treasury. Unfortunately, the problem of pension plan underfunding has been growing worse in recent years. In 1993, the secretary of labor indicated that underfunding had reached levels in excess of $45 billion, with one companyÕs pension plan alone, that of General Motors, underfunded to the tune of $11.8 billion. As a result, Penny Benny, which insures the pensions of one of every three workers, may have to foot the bill if companies with large underfunded pensions go broke.

Public Pension

Plans

www.ssa.gov/

The web site for the Social Security Administration contains information on your benefits available from social security.

The most important public pension plan is Social Security (Old Age and SurvivorsÕ Insurance Fund), which covers virtually all individuals employed in the private sector. Funds are obtained from workers through Federal Insurance Contribution Act (FICA) deductions from their paychecks and from employers through payroll taxes. Social Security benefits include retirement income, Medicare payments, and aid to the disabled.

When Social Security was established in 1935, the federal government intended to operate it like a private pension fund. However, unlike a private pension plan, benefits are typically paid out from current contributions, not tied closely to a participantÕs past contributions. This Òpay as you goÓ system at one point led to a massive underfunding, estimated at over $1 trillion.

The problems of the Social Security system could become worse in the future because of the growth in the number of retired people relative to the working