Despite 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. If you have a life insurance policy, here's what to know about how you're protected.
- 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 goes out of business, policyholders are protected by state governments, specifically state insurance regulators, who monitor the financial wellbeing of life insurance companies.
- If an insurance fund fails, 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 guaranty fund.
- Reinsurance can reduce the risk of losing money when a life insurance company goes bankrupt.
What Happens When a Life Insurance Company Fails
Failures and bankruptcies are uncommon. According to the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA), no life insurance companies have filed bankruptcy since the 2008 financial crisis.
But if a failure or bankruptcy does occur, there are safeguards in place to protect consumers. These include:
- Statutory reserves
- Guaranty association membership
Life insurance companies are required by state law to maintain capital reserves to pay out policyholder death benefits in the event that the business fails. The amount that's required to be held back can vary from state to state but these reserves, along with other company assets, can be used to fulfill claims if the company goes bankrupt.
Reinsurance is another strategy that allows insurance companies to mitigate the risk of potential losses if a business failure occurs. Essentially, life insurance companies purchase insurance policies from other insurers which allows them spread out risk. So if one company goes under, for example, the other companies can take up the reins to ensure that any claims or death benefits are paid.
Guaranty associations, such as the NOLHGA, are another form of protection against losses. If a member life insurance company goes out of business, the membership association can step in and guarantee payment of benefits. The amount the association will pay may be capped at certain limits, depending on state law and membership is typically mandatory.
If your life insurance company fails, you may first need to pursue financial remedies through reserves or reinsurance before a guaranty association will pay any benefits.
Variable Annuities May Not Be Covered
When it comes to life insurance, determining whether you have coverage and how much coverage is provided by your state is pretty straightforward. Annuities, however, are different.
An annuity is a type of insurance contract in which you make payments to the annuity company, with the agreement that it will make payments back to you at a future date. A variable annuity delivers a rate of return that's based on the performance of underlying investments.
If you have a variable annuity, you'll 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, for example, 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.
Annuities can generate an additional income stream in retirement but if you want to earn a guaranteed rate of return, you might consider a fixed versus variable option.
Maximizing Your Protection 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, however, 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.
If you're considering annuities to expand coverage, pay close attention to the fees you might pay, including surrender charges, early withdrawal charges and administrative fees.
How Do You Find a Good Life Insurance Company?
Finding the right life insurance company can go a long way toward minimizing your need for these protections. That means finding a licensed insurer that's financially healthy and is able to pay out claims or death benefits for the foreseeable future.
There are some useful tools you can use to find the best life insurance companies. The first is AM Best, a company that issues ratings for life insurance, annuities and other financial products. AM Best ratings are assigned using a letter grade, similar to how a report card works. A rating of A+ or A++, for example, means the company's financial health is superior while a D rating indicates that an insurer may not be equipped to pay out claims if it comes under financial strain.
You can also review other industry ratings, such as those issued by S&P Global or Moody's to get a better sense of a life insurance company's financial strengths and weaknesses. Beyond that, you can take a closer look at the company's financials by viewing its annual report or quarterly earnings report if those are made public. These reports can tell you a company's assets and liabilities add up, how much it's earning and what it's turning in profits.
From there, you can also look at online reviews from established websites, consumer reviews and Better Business Bureau ratings. Together, these tools can help you narrow down the list of life insurance companies you're interested in doing business with.
Aside from financial health, consider the life insurance company's range of products and what you'll pay to get insured to find the right option for your needs and budget.
The Bottom Line
The thought of losing money on life insurance isn't very appealing, especially if you're counting on your policy to pay out a death benefit to your loved ones down the line. While there are safeguards in place they may not always be foolproof. If you're looking to purchase life insurance or an annuity it's important to thoroughly review the insurer's ratings and their financial strength when deciding where to buy a policy.