Insurance companies have an exceptional record of protection. The states require that an insurer must keep enough money to cover the current and future obligations of the policies issued, plus a little bit extra. This money is referred to as policy reserves, statutory reserves or legal reserves. Insurers are restricted in the amount of stocks, real estate and junk bonds they may own and must invest mostly in investment-grade bonds. In addition, the surrender charges allow the carrier to maintain policy liquidity by regulating outflow to avoid runs on the bank. And as a last resort, every state has a guaranty fund and every annuity owner covered by a guaranty fund has been protected up to fund limits in the past.
On providing index-linked interest, insurers are protected because they limit their risk. The exposure in an index annuity for the typical insurance company is the cost for the option link a set and predetermined cost. If you had a dollar, made five cents interest and spent the five cents to buy an option on the index, and the index went down 50 percent or the index-link provider went bust, what is your maximum loss? Five cents. How much do you still have? One dollar.
AIG’s problems focused attention on the insurance industry, but it was not the insurance side that got AIG in trouble. As NAIC president Sandy Praeger said last year, “The federal bailout of the non-insurance portions of AIG does not negatively change the solvency strength of its insurance subsidiaries. The key distinction here is that AIG’s insurance subsidiaries did not cause this crisis, rather, they will play a critical role in the solution.”
There are a lot of urban myths being passed around. How do you debunk them? Here are three ideas. First, people have lost money in fixed annuities if they were exposed above the guaranty fund, but I could only find four carriers in the last 20 years where anyone lost money. Second, the state guaranty fund has zero dollars in it; the solvent insurers are assessed after a company fails. Third, there is no such thing as a legal reserve system; legal reserves are just an accounting term.