In spite of the federal takeover of AIG in September 2008, most people are surprised by the fact that the role of consumer protection against insurance company failures actually falls into the hands of state governments. State insurance regulators are responsible for monitoring the financial health of the insurance companies that are licensed to do business in their respective states. After regulators step in and everything blows up, it's the job of the state's guarantee fund to step in and protect the policyholders.
- The federal government protects consumers in the event that a bank or brokerage fails, but does not protect consumers in the event that a life insurance company declares bankruptcy.
- If a life insurance company implodes, policyholders are protected by state governments, specifically state insurance regulators, who monitor the financial wellbeing of life insurance companies.
- If an insurance fund fails, the state regulators will first try to transfer the policy to a stable insurance fund, and if that's not possible, will instead keep the policy active through the state's central guarantee fund.
Insurance Company Failure 101
When an insurance company fails and goes into liquidation, the state's insurance guarantee fund will kick in to protect the state's policyholders. If possible, the guarantee fund will try to transfer policies to other stable insurance companies; if that fails, the policy will continue to be administered by the central guarantee fund. When a state guarantee fund takes over an insurance or annuity policy, it will be subject to the coverage limitations set by each state.
In Florida, for example, the limits for life insurance and annuity benefits are as follows:
- Death Benefit: $300,000 per insured life
- Cash Surrender: $100,000 per insured life
- Cash Surrender: $250,000 for deferred annuity per contract owner
- Annuity in Benefit: $300,000 per contract owner
Variable Annuities May Not Apply
When it comes to life insurance, determining whether you have coverage and how much coverage is provided by your state is pretty straightforward. On the other hand, if you have a variable annuity, you will need to review your annuity contract and read the fine print set forth by your state to know if you are protected. In the case of Florida, a variable annuity policy isn't covered unless some aspect of the policy is guaranteed by the insurer. That means the insurance company is being paid to cover some kind of liability associated with the policy. No liability to the insurer means no help for you.
If you want to get information about your state's coverage, you can go to the National Organization of Life and Health Insurance Guarantee Associations website. Once you are on that website, you can click on the link for your state's association. If you don't fully understand what's covered, call your state's association directly for help regarding your situation.
Not all variable annuities are covered by the state in the event that an insurance company fails; read the fine print on your annuity contract and the rules of your state to see if you qualify.
Maximizing Your Coverage
If you want to increase the size of your state guarantee fund security blanket, then you need to work within the limits of your state's law. In the majority of states, you can increase coverage by doing business with multiple insurers. In most states, the individual coverage limit is doled out on a per-company basis, so if you have two policies with two different companies, you will get double the coverage.
This technique of layering coverage through multiple insurance companies is similar to how people maximize their FDIC coverage by opening bank accounts through multiple banks. Given the large face amounts involved with life insurance and the underwriting hassles that would be involved in getting multiple life insurance policies through different insurance companies, it isn't practical in the real world and could end up costing you more money for the same amount of coverage.
On the flip side, doing business with multiple annuity companies to increase your state coverage limits can be a useful strategy. While it's not practical for life insurance, most states will give your spouse a duplicate level of coverage if they own an annuity. For example, if you are looking to invest $200,000 into an annuity and your state's guarantee is $100,000 per individual, both you and your spouse could invest with the same company to get the $200,000 of cash-value coverage. Guarantees on variable annuities during the 2008-2009 market downturn were a major source of financial pain for most insurance companies that deal in the variable annuity market, and it's no coincidence that major insurers with large variable annuity portfolios sought money from the government (Hartford $3.4 billion and Lincoln $950 million). As a result, anything to help shore up your exposure to any single annuity company is probably a good idea.
A Flaw in the System
The problem with the guarantee system in most states is that it lacks a pre-funded reserve, meaning there is no rainy day fund set aside if one of them fails. Instead of having insurance companies pay into a fund every year as banks do for the FDIC to cushion the blow, the state guarantee funds divvy up the losses and pass them on to the other state-licensed insurance companies in the same line of business according to their in-state market share. If you assess fees after a catastrophic failure of a major player, that is like asking Bank of America and Citigroup to cover Lehman's losses. If a large scale disaster were to occur, it is unclear whether the structure funding the current safety net system would be able to succeed without some type of taxpayer intervention.
The Bottom Line
While the state guarantee safety net has functioned successfully for many years, it does have potential flaws. In the end, people looking to purchase life insurance or an annuity should rely first on the insurer's ratings and their financial strength. However, spreading the risk and positioning yourself to be first in line if something goes wrong is always a good idea. This maxim holds especially true if you have a lot of money in variable annuities with guarantees on them.