Author: root

Life insurance and the banking sector are the two core sectors where customers keep money with the trust that their money is safe. Both the sectors protect the customer’s money. This article looks at both the assets and liabilities of the banking and insurance sector to find out the similarities and differences. The article also looks at the risks of both sectors to find whether there are opportunities for cross-pollination of people working from both sides.

In both sectors, customers place their money with the respective institutions such as banks and insurance companies. In the banking sector, deposited money creates liability to be returned upon withdrawal. Similarly, in the insurance sector, the premium received creates liability which is paid when a claim arises (death, maturity, and surrender). So, money placed by customers in both sectors creates liability.

Safer asset creation accords secured returns

On the other hand, the money collected by both institutions is invested to back the liabilities which create assets. Under the insurance sector, the money received in the form of a premium is used to purchase the assets like government securities, corporate bonds, equities, and other assets. These assets so purchased to match the amount and tenure of liabilities.

In the banking sector, the money deposited by customers is used to create assets in the form of Government securities, corporate bonds, and equities while other assets are created by giving loans. The bank charges a higher rate of interest from the loanee compared to the depositor to meet expenses and profit margin.

Both the institutions take credit risk by investing to back their liabilities. In the insurance sector, investments are highly regulated with a high percentage of investment in Government bonds and a relatively lower percentage in corporate bonds, and even lesser in equities, thereby having relatively lower credit risk from the point of the probability of default. On the other hand, in banks, most of the assets are created by giving loans to individuals and institutions subject to higher default risk, thereby they have high credit risk. The mechanism of the creation of credit risk under both institutions is similar.

Managing the risk of liquidity

Liquidity risk in the banking sector is a key risk from the customer’s deposit point of view, that is, customers to be paid on demand. Therefore, the banks in India are to maintain a certain Cash Reserve Ratio (CRR). The money kept under CRR may be used to pay when the demand arises from bank customers. The CRR is the ratio of cash required to keep as a reserve as a percentage of total deposits. This cash is either stored in the bank’s vault or deposited with the Reserve Bank of India (RBI) on which no interest payment is made. The current CRR is 4% of Net Demand and Time Liabilities (NDTL). This money cannot be used for investment and lending.

One of the applications of CRR is to control inflation as high CRR will reduce the amount available for lending in a form of loan thereby reducing banks’ liquidity leading to reduced circulation of money in the economy.

Similar to CRR, another tool used to manage the liquidity in the banking system is the Statutory Liquidity Ratio (SLR) is the minimum percentage of deposits (NDTL) that is to be invested in gold, cash, and other securities. These deposits are kept with banks and not with RBI. The current SLR is 18%.

Similar to CRR, SLR is also used to trap the circulation of money in the economy which can control inflation. Also, SLR is used to control the ability of the banks to lend; higher SLR would restrict bank’s ability to give loans.

The restrictions applied in the banking system in a form of CRR and SLR helps in managing the liquidity position of the banks to enable payment to depositors. Similarly, in the insurance sector, to enable the payment of claims, the regulator has prescribed a very strict investment norm with a high percentage of investment in government bonds for the security of money. Such investment in government bonds can be easily liquidated to help maintain liquidity in the insurance sector. Both the sectors use the same methodology of either cash flows or liquidity coverage ratio to assess the liquidity position along with stress tests to identify higher requirements of liquid cash.

In the banking sector, CRR and SLR act like a reserve to be used when required paying to customers on increase in withdrawals, similarly, in the insurance sector, insurance companies are to keep reserves to pay claims when arises. These reserves are calculated at prudential assumption based on guidelines given by the insurance regulator. Such reserves are to be invested based on the regulatory investment guidelines. The purpose of the reserve is to meet the customer’s claims when they arise. In both sectors, there are prudential norms to safeguard the money of the customers in meeting liabilities.

There is a similar inherent mechanism under both the banking and insurance sector to protect the customer’s money, managing the credit and liquidity risk. There can be opportunities for cross-pollination of skills between the two sectors. Actuaries are very strong on the liability side while banking folks are strong on the asset side, an amalgamation is possible.

The blog has been authored by Sonjai Kumar, Certified Risk Management Professional from IRM London

DISCLAIMER: The views expressed are solely of the author and ETBFSI.com does not necessarily subscribe to it. ETBFSI.com shall not be responsible for any damage caused to any person/organisation directly or indirectly.