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CONTRACTUAL SAVINGS INSTITUTIONS
Contractual savings institutions are financial intermediaries that acquire funds periodically on a contractual basis and invest them (lend them out) in such a way that they have financial instruments maturing when contractual obligations have to be met. In general, they can predict their liabilities fairly accurately, and thus they (unlike depository institutions) do not have to worry as much about losing funds. As a result, they mainly invest resources in longer term securities, such as, corporate stocks and bonds, and mortgages. Three major categories of contractual savings institutions—life insurance companies, fire and casualty insurance companies, and pension funds and government retirement funds—are briefly discussed below.
LIFE INSURANCE COMPANIES.
Life insurance companies sell life insurance policies that protect the beneficiaries of a policyholder against financial hazards that follow the death of the insured person. Life insurance companies also sell annuities in which an insurance company contracts to make annual income payments to the annuity buyer upon his or her retirement. These insurance companies acquire funds through payments of premiums by individuals who pay to keep their policies in force. Life insurance companies can calculate liabilities with a fair degree of accuracy using mortality tables. As a result, they use funds to buy longer term securities—primarily corporate bonds and mortgages. While corporate stocks are also long-term securities, life insurance companies are restricted in the amount of stocks they can hold. This government restriction is based on the perception that stocks are risky, and they may thus jeopardize the insurance companies' ability to meet liabilities. With about $2 trillion in assets, life insurance companies are the largest segment among contractual savings institutions.
FIRE AND CASUALTY INSURANCE COMPANIES
Fire and casualty insurance companies (also called property and casualty insurance companies) are in the insurance business like the life insurance companies. They insure policyholders against the risk of loss from a variety of contingencies, such as fire, flood, theft, or accidents. An individual buys car or home insurance, for example, from a property and casualty insurance company. Like life insurance companies, fire and casualty insurance companies acquire funds through payments of insurance premiums from policyholders. Unlike life insurance companies, however, the property and casualty insurance companies are subject to greater uncertainty with respect to their liabilities—there is no way to pinpoint as to when major disasters may happen. Two major hurricanes, Hugo in 1989 and Andrew in 1992, hit U.S. states, which multiplied the claim payments by the property and casualty insurance companies to policyholders manifold. Due to this kind of uncertainty, these insurance companies buy more liquid assets (shorter-term securities) than life insurance companies. Municipal bonds constitute the largest fraction of total assets. They also, however, invest in corporate stocks and bonds, and Treasury securities.
PRIVATE PENSION FUNDS ANDGOVERNMENT RETIREMENT FUNDS
Private pension funds and government retirement funds receive periodic payments of contributions from employers and/or employees that participate in the program. Employee contributions are either automatically deducted from pay or made voluntarily. The pension and retirement funds' liability is to provide retirement income, generally in the form of annuities, to individuals covered by these pension plans. As the liabilities of private pension and government retirement funds are fairly certain with respect to timing and are of a long-term nature, they invest resources in long-term financial instruments, such as corporate stocks and bonds.
The federal government has encouraged growth in pension funds through legislative actions that mandate establishment of pension plans, as well as through tax incentives to individuals that lower their costs of contributing to the pension plans. The federal 403(b) provision is an example of the federal tax incentive.
INVESTMENT INTERMEDIARIES
Most, though not all, investment intermediaries facilitate investments in financial assets by individuals and institutions by pooling resources and investing them according to stipulated objectives. The financial intermediaries included under this category are: mutual funds, money market mutual funds, and finance companies.
MUTUAL FUNDS.
Mutual funds are financial intermediaries that raise funds through sale of shares to many individuals and institutions, and pool these to buy a diversified portfolio of stocks, bonds, or a combination of stocks and bonds. The number of mutual funds in the United States has grown rapidly. Now, there are more mutual funds than the number of stocks on the New York Stock Exchange. With the growth in the mutual fund industry, characteristics of mutual funds have also undergone changes. At the present time, a specific mutual fund is organized around an investment philosophy. In selling shares to perspective participants, the mutual fund is expected to state its investment philosophy, and follow it (generally) in investing pooled resources. A mutual fund, for example, may be a broadly diversified stock fund that picks stocks from among all available domestic stocks. A stock fund may also, however, concentrate on a narrow range of stocks, such as small capitalization stocks, over-the-counter stocks, blue-chip stocks, depressed stocks, stocks that pay high dividends, or stocks of a particular sector of the economy. Thus, one must carefully interpret a mutual fund's investment into a diversified portfolio of, for instance, stocks—the diversified investment is subject to the investment philosophy of the relevant mutual fund. Also, different investment philosophies and levels of diversification carry different levels of investment risk. Even when a mutual fund specifies an investment philosophy, it may not be fully invested—it may keep, for example, some cash on hand for investment opportunities that may open in the future or to meet redemptions.
Similar to stock mutual funds, there are bond mutual funds. Once again, a bond mutual fund follows an investment philosophy—it may invest its funds in, for example, a diversified portfolio of bonds, in long-term Treasury bonds, higher-quality corporate bonds, lower-quality corporate bonds (the so-called junk bonds), or bonds of state and local governments (called municipal bonds or munis). Bond mutual funds are generally considered less risky than stock mutual funds. As mentioned earlier, some mutual funds also invest funds in a combination of stocks and bonds.
In general, mutual funds permit an individual to participate in a more diversified portfolio of financial instruments than would have been possible if the individual tried to make the investment on his or her own—the use of a mutual fund reduces the transaction costs for the individual. In addition, as mutual funds are expected to be managed by experts, the individual participating in a mutual fund can expect better returns. In addition to these benefits, mutual funds provide liquidity to individuals participating in these funds—they can redeem or sell their shares at any time. The value of their shares, however, will depend on the value of the mutual fund's portfolio (which, in turn, will depend on the conditions in the markets for the securities in which the mutual fund is invested). This obviously implies that an individual is not guaranteed to receive the principal amount back. Also, mutual fund shares, unlike deposits at a depository institution, are not insured by a federal agency.
MONEY MARKET MUTUAL FUNDS.
Money market mutual funds are like ordinary mutual funds with some added characteristics. The most important difference between mutual funds and money market mutual funds is that the latter invest in money market financial instruments (securities that have maturities of less than a year). Because of the kind of securities they invest in, assets of a money market fund are considered very liquid and are unlikely to generate losses to those that participate in these funds. Shareholders in a money market mutual fund receive investment income based on the earnings of the security holdings of the fund. A key characteristic of a money market mutual fund is that participants in these funds have limited check-writing privileges on their shareholdings—frequently, checks cannot be written for less than $500.
FINANCE COMPANIES.
Finance companies acquire funds by issuing commercial papers (short-term corporate debt instruments), stocks, and bonds. They use these funds to make loans to consumers to finance home improvements or to purchase a consumer durable (such as cars or furniture), and to small businesses for various purposes. Sometimes, a finance company helps to sell a particular product. GMAC or Ford Motor Credit company are examples of finance companies that perform such a function.
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