Financial innovation and standards for the capital of life insurance companies

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

The nation's tangible assets are essentially financed by households' savings. Some of this financing is direct, such as the ownership of residences or [TABULAR DATA FOR TABLE 2 OMITTED] durable goods (Table 2). Most is indirect, taking the form of financial assets, which constitute about two-thirds of households' savings. In turn, about one-half of these financial assets are the liabilities of financial intermediaries, most of which are managed by depository institutions, life insurance companies, and pension plan advisors that frequently offer savers and investors contracts with guarantees of cash values or returns.

By design, many financial intermediaries bear risks in running mismatched books, risks arising from their writing liabilities with specific commitments that, in turn, are backed by their investments (directly or indirectly) in durable tangible assets. In order to fulfill their obligations to their customers, the return to and, therefore, the value of the investments behind intermediaries' assets must generally fulfill investors' expectations. In addition, savers may not attempt to withdraw a significant amount of their savings from these intermediaries when the earnings on their assets may be depressed too greatly or when new opportunities offer savers greater yields.

Financial intermediaries customarily diversify or hedge some of their risks. For example, life insurance companies purchase a variety of assets to achieve a stream of income that more closely matches the outlays required to meet their obligations. These companies also generally issue different types of insurance or investment contracts as well as maintaining other lines of business in order to manage better the volatility of their cash flows. Indeed, much of the financial innovation of the 1970s and 1980s reflected intermediaries' efforts to diversify their businesses and hedge their risks better through broader portfolios of assets and liabilities.

Other things equal, an intermediary's capacity for bearing risk diminishes as its capital diminishes or the difference between the yields on its assets and liabilities diminishes. Capital is the difference between the value of an intermediary's assets and that of its liabilities. The less capital per dollar of liabilities and hence per dollar of assets, the greater is the chance that relatively low returns on investments will prevent the intermediary from meeting its contractual obligations. Intermediaries also expect to earn a sufficiently great margin between the yields they earn on their assets and the yields they offer savers - a portion of which may be regarded as an insurance premium - to accommodate the risks they bear. Mutual fund advisors, for example, invest negligible capital in their funds, earn a comparatively small margin, and retain relatively few risks.(3) Except for fees and commissions to defray the costs of selling their shares and managing their assets, mutual funds essentially pass the returns on their assets and the risks inherent in those assets to their shareholders. Insurance companies, on the other hand, maintain considerably more capital, anticipate earning substantial margins, and retain more risk by offering savers and investors contracts with specific guarantees and options. The more savers value competitive yields and the more investors can avail themselves of competitive terms for funds in public capital markets, the more intermediaries' potential profit and capacity for bearing risk shrink.