Banks vs Insurance Companies: How Are They Different?

Banks and insurance companies are two main types of financial institutions. But they both have key differences, including how they guarantee your money. That can be of importance for retirement savers as they strive to make confident, well-informed decisions about where they park their hard-earned savings.

Indeed, it’s not uncommon for this question of “banks vs. insurance companies” to come up when someone is exploring whether to buy a certificate of deposit or fixed annuity. For the reason, this article will focus on life insurance companies for the insurer side of the discussion.

Here’s a look at some of the core differences between banks and insurance companies, including how they back customer dollars with financial reserves of their own.

Both Institutions Have Different Roles

While both are financial institutions, insurance companies and banks have very different business models. They also have highly different roles in the economy.

Life Insurance Companies

Life insurance companies are in the business of risk management and pooling. They sell life insurance and annuity policies to customers to protect them against different kinds of risk. Some of the risks that these policies guard against include premature death, loss of income or possessions, depletion of assets, and costly healthcare bills.  

Policyholders pay premiums, either as a lump sum or regular payments over time, to life insurance companies. In turn, life insurers put this money into long-term investments such as Treasury securities, investment-grade bonds, and commercial real estate holdings.

The insurance companies use these monies to uphold their insured promises to their customers. Since they are investing and overseeing these dollars for their own benefit, life insurance carriers don’t create money in the financial system.

Banks

On the other hand, banks are largely in the business of making money through lending. They collect deposits from customers and pay interest for use of the money. From there, banks lend the money to borrowers who need capital for business reasons. In return, these borrowers pay a higher rate for their loans than the interest rate paid to bank depositors.

In this way, banks use money from customer deposits to build a larger base of loans and make money on the payments they collect from borrowers. Bank customers want only so much access to their deposits each day. As a result, banks are able to keep a certain amount of deposits in reserves and then use the remaining deposits for their lending.

Since banks use deposit monies to make multiples on their money via lending, they do create money in the financial system, unlike insurance companies.

Banks and FDIC Insurance

Another distinction for banks is that they enjoy the backing of the U.S. government.

Banks have been backed by FDIC insurance ever since the Great Depression. The failure of many banks in the wake of the market crash led to the establishment of the Federal Deposit Insurance Corporation.

Known more commonly as the FDIC, it guaranteed that it would insure banks that became financially insolvent up to a certain amount for each customer. When the FDIC was first created, that amount was $100,000. Since then, it has been raised to $250,000 per account in order to keep up with inflation.

Since the FDIC is ultimately backed by the federal government, FDIC insurance makes bank savings and checking accounts as safe as Treasury securities in the eyes of most consumers. This backing from the federal government comes from the “full faith and credit” clause of the U.S. Constitution.

What About Money in Excess of the Coverage Limits?

Those who want to maintain savings in excess of the FDIC coverage limits must spread their money around to different banks so that they can keep all of their cash safe.

For example, a bank customer who wants to put $1,000,000 into CDs would have to deposit $200,000 at five different banks to ensure that all of their money remains insured. Not only that, this money would have to be deposited at different banks.

This insurance wouldn’t apply if the money sat in deposits at several different branches of one bank. FDIC insurance limits apply to each bank, not each location.

More on FDIC Coverage

But there is something that most bank customers are unaware of. The actual insurance fund that the FDIC uses to help insolvent banks is only backed by a few cents on the dollar.

If all of the banks everywhere became insolvent at once, the FDIC would be unable to meet its obligations to everyone. Of course, the federal government would most likely step in at that time. The government might inject a large amount of cash into the insurance fund, and it may even raise taxes or print more money in order to cover the shortfall.

But the fact remains that banks only have to carry a few cents for every dollar that they take in.

Life Insurance Companies and Reserve Requirements

Life insurance companies, on the other hand, have much stricter requirements regarding the cash reserves that they maintain. By law, life insurers in all 50 states must have at least one dollar in cash reserves for every dollar of premium that is issued in the form of annuities or life insurance.

In other words, life insurers must keep at least 100% of their ‘deposits’ as minimum reserves. Many insurance companies actually go beyond this, maintaining a reserve surplus above 100% so they can make good on their guarantees to policyholders.

Of course, the life insurance industry can’t raise taxes or print more money. But for all practical purposes, it doesn’t matter because life insurance companies already have the money. Furthermore, there is no limit on the amount of money that is backed by cash reserves.

Another Key Difference

The investor mentioned above would need to spread their money out among several banks in order to make sure that it’s all insured. Alternatively, they could put the entire $1,000,000 with a life insurance company and enjoy the guarantee of dollar-for-dollar cash reserves backing the entire amount.

Many life insurance companies can accept purchases for even millions of dollars. However, they must be able to track the source of money to ensure that it came from a legal venture.

Life Insurance Company Failures

What if a life insurance company was to become insolvent? Then reinsurance companies would step in and cover policyholder losses up to a certain amount.

Although the exact amount can vary by company, state, and situation, the limit is usually quite high, such as $300,000. Check with your financial advisor or insurance professional for details about limit amounts for your state.

What to Expect When a Bank or Insurer Goes Under

While most bank and life insurance customers enjoy the peace of mind that comes with these guarantees, there is something to note if a bank or insurer fails. The actual process of getting their money back from their bank or life insurance company can take quite a while.

If a bank or life insurance company goes belly up, then the bureaucratic process for refunding customers’ and policyholders’ money can take several weeks at the very least. It may even take quite a while longer in many cases.

Life Insurance Companies Have a Strong Record

That being said, retirement savers should know that very few life insurance companies have ever failed. State regulators closely monitor the cash reserve status of insurance companies.

They take action to ensure that possible financial problems will be prevented from happening in most cases. Because of this, strict state insurance regulations, and other safeguards at the state level, the number of people who have ever lost money with a life insurance company failure is arguably quite small.

Back in 2005, A.M. Best published a 27-year study of health and life insurance company insolvencies. The study showed how the failures of insurance companies tend to be significantly lower than those of banks.

Overall, insurance company failures were relatively few during the 27-year period. Insurer impairments ranged from 1 to 250 companies in a stable economy to 1 in 35 companies in an unstable economy. The average of impairments was 1 to 109 companies throughout the 27 years of study.   

Not only that, another study of Canadian and U.S. financial institution failures from the 1980s to 2010 had similar insights. According to the researchers, there were 1,681 commercial bank failures in the United States from 1982 to 2010. In contrast, 291 life and health insurance company failures took place during that same period.

What Is the Better Option?

This isn’t to say that insurance companies are “better” than banks – or even vice-versa.

Rather, the point is that life insurance companies have a very strong record of keeping their promises to policyholders. As a whole, the life insurance industry has held this record with success for hundreds of years.

So, if the bottom falls out of the economy or our economic system otherwise fails, which institution would fare better? The answer to that would probably depend heavily on the specific factors involved in the fallout and how the public reacts to it.

But most serious financial experts today know that in the end, your money is pretty darn secure with a life insurance company just as it is in your local bank.

Making Confident Choices for Your Future

If you are looking for a dependable place to put your money, and you think that banks or Treasury securities are the only place to put them, think again. It would realistically take the end of the world as we know it for the insurance industry to fail, with its trillions of dollars in collective cash reserves.

Consult your financial advisor for more information on the guarantees for your money by these two institutions and how this can affect you.

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Use our “Find a Financial Professional” section to connect with someone directly. You can request an appointment to discuss your questions and your overall situation. Should you need a referral, please call us at 877.476.9723.