Financial innovation and standards for the capital of life insurance companies

New England Economic Review, Jan-Feb, 1995 by Richard W. Kopcke

I. Capital Markets and the Role of Financial Intermediaries

Economic development depends on the efficient transfer of resources from savers to investors. Although savers may finance investments by making loans directly to investors or by purchasing investors' offerings of stocks and bonds,(2) much of this financing passes through financial intermediaries. Insurance companies, banks, thrift institutions, pension funds, finance companies, and other intermediaries issue their own liabilities to savers, using the proceeds to acquire the debt and equity issued by investors.

Financial intermediaries create derivative securities, essentially transforming the obligations of investors into financial assets that appeal to savers. In doing so, intermediaries encourage capital formation by fostering saving on terms that entail a lower cost of capital for investors. Without intermediation, each financial contract between savers and investors must [TABULAR DATA FOR TABLE 1 OMITTED] reconcile their frequently disparate motives. Savers, who seek more than an attractive yield from their financial assets, also value attributes such as liquidity, assurance of their family's well-being in the event of sickness or death, or an annuity for the remainder of their lives after they retire. Investors, on the other hand, ordinarily seek obligations that conform more closely to the life spans of their assets or the patterns of their earnings and cash flows. While households have had limited interest in accumulating savings in 30-year debentures, steel manufacturers have had less interest in financing furnaces by issuing demand debt or options tied to the lender's life span. Intermediaries also serve savers and investors by evaluating investors' prospects, monitoring their performance, and providing both savers and investors a dependable access to funds on terms commensurate with their risks and returns.

Mismatched Books and the Role of Capital for Financial Intermediaries

The nation's tangible assets generally have a long life span (Table 1). During the past four decades, real estate - residential structures, nonresidential structures, and land - has represented about three-fifths of tangible assets. Business equipment and consumer durable goods represent about one-fifth of this wealth. Except for inventories, which now represent about one-twentieth of total assets, the stock of tangible assets is inherently illiquid. The nation as a whole cannot sell a substantial share of these assets very quickly, except perhaps at greatly depressed prices.

Although the nation essentially is committing itself to its fixed investments in real estate and durable goods, individual investors nonetheless may "liquidate" their investments by selling them to others at "fair" prices when a market exists and when buyers and sellers are equally well informed. These transfers are most facile, and investments appear to be most liquid, when incentives for installing new assets are most inviting. This apparent liquidity often diminishes greatly for many assets, especially those lacking dependable public markets, when business activity slumps.