What if an Insurance Company Goes Bankrupt?
Tons of people ask this question and those who don’t are probably thinking about it. Annuities are supposed to be safe so what happens if a company fails? Most people understand that every state has a guaranty fund for insurance contracts but there’s a lot that needs to happen before that even comes into play. Aside from any insurance that may be available in your state there are several layers of protection that annuities provide.
Insurance companies operate quite differently than banks in that they have a 1:1 asset to liability ratio. Banks are much more highly leveraged with the victims of the 2008 financial crisis being so thinly capitalized that some were in the neighborhood of 1:36. That means if a mere 3% of their liabilities were in default it would wipe out all of their assets. Foreclosures began to happen and it didn’t take long for the water to recede and several banks to be figuratively seen as swimming with no trunks.
On top of a very conservative leverage ratio, insurance companies are required to hold a certain amount of cash in reserves to prevent short-term funding issues related with the normal business cycle. Banks need the FDIC and I wouldn’t put any money in there if they didn’t have it. An insurance company’s first line of defense is that they insure themselves.
A little fun fact: New York Life has more in company reserves than does the FDIC. That’s right! One single mutual insurance company has more liquid cash available than the corporation built to protect the entire banking industry.
An insurance company has a general account and a separate account. When you buy an annuity, your money is used to purchase a block of conservative assets held in the general account. The separate account holds riskier investments. If the company fails it’s typically not because of problems with the general account. Most often it’s because of failed investment in the separate account.
When AIG ran into trouble with collateralized debt obligations (CDOs) in 2008, many aggressive agents urged annuity holders to surrender their contracts and go with a more stable insurer. That turned out to be a phony pitch. The company itself and state regulators sent letters to contract owners warning them of the scam and stating officially that annuities were not in danger. The general account had not been compromised but some separate investments had. AIG annuities were never affected.
Also, I think there’s some misunderstanding about what it takes for a company to actually fail. First, the company is put under state receivership if cash outflows exceed cash inflows or if the operating surplus turns negative. It doesn’t mean the company failed it just means that its financial strength has been compromised. In the same sense, you’re not bankrupt just because you only make the minimum payment on a credit card.
The insurance commissioner in the company’s state of domicile will take over control of a company when certain conditions of financial distress have been met. The first step would be for the state to sell off underperforming assets. Any losses incurred would be subsidized by company reserves. Stable parts of the business will remain on the books if the company is to be rehabilitated or sold to another company for profit that would further help to recoup losses from the bad investments. It’s a long process that obviously requires more detail but through it all, annuity payments and insurance claims are all paid.
When people ask what would happen if a company goes bankrupt my quick response is that they are likely to see another insurance company buy the block of business. Their annuity would then be backed by another carrier because annuity pools are usually a profitable part of the business. This happened in the mid-90s when Conseco was put in receivership. Don’t quote me but I think it was Metlife who purchased the annuity business so everyone with a Conseco annuity got a new cover page and correspondence sent from a different company.
The worst case I recall of insurance company failure was Executive Life of New York (ELNY) in 1990. The process of rehabilitation and liquidation took state regulators 23 years to complete. It wasn’t until 2013 that a final settlement was reached. Throughout that time, annuity payments were made, contracts were cashed out and claims were paid as the regulators managed investments, sold pieces of the business and slowly worked through company reserves. It might have been a pain in the butt for some but everyone got their money.
In 2013, regulators took all remaining reserves, funds from all the state guaranty associations and several large contributions from the insurance industry and formed the Guaranteed Annuity Benefits Association (GABC). GABC is a non-profit company that holds a series of zero-coupon treasuries for the purpose of making good on all remaining lifetime payments and liabilities for the former ELNY.
That’s a rare example but through it all you’ll be hard-pressed to find someone who has lost money in an annuity, unless you’re talking about a variable annuity. Those are risk-based funds held in the company’s separate account, but that’s beside the point.
To sum it all up, there are four components to the safety of an annuity. First, insurance companies back every liability, dollar for dollar, with an income producing asset. Second, additional reserves insulate the company from the ups and downs of the regular business cycle. Third, profitable asset classes, like annuities, can be sold to other carriers in times of financial distress. And finally, if all else fails and once everything has been liquidated the guaranty associations from several states steps in to soak up remaining liabilities.
It’s the kind of thing that happens so infrequently that I’m telling you about the one great example from nearly 30 years ago. How many banks have gone down since then? How many billions of dollars have been lost in mutual funds, real estate and bonds since then? And if you take my advice to go short-term with a solid company then you’ll never even get close enough to sniff this kind of trouble. It takes years to unwind an insurance company and an annuity gives you more collateral than you can get with any other asset.
I have no problem with anyone who wants to limit their investment to the maximum coverage offered by a state guaranty fund. But proper due diligence will show that annuities provide far more protection than even a money market fund. Have you ever read the fine print in that contract? You’d be surprised to learn just how much risk you’re taking by sitting in other assets that seem to hold value.
If you rely entirely on a state guaranty fund for safety then you haven’t done your homework. It’s fine for a backstop but there are plenty of lines of defense before it gets to that point.
There are several points in this paper where greater detail can be provided. My intention is to make it readable, provoke thought and provide a base of knowledge for understanding why annuities are truly the safest asset you can own.
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