What Would Happen if a Big Insurer Failed?

Analysis September 04, 2024 at 03:51 PM
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What You Need To Know

  • A guaranty fund can impose assessments to come up with the cash needed to make good on guarantees.
  • A fund can also issue bonds.
  • In extreme situations, a fund can get court approval to reduce the amount of protection it provides.
Federal Reserve building

The effect of the failure of a large U.S. life, health or annuity issuer on state life and health guaranty funds is not clear, according to Daniel Hartley, a senior economist at the Federal Reserve Bank of Chicago.

A state guaranty fund usually imposes assessments on surviving member insurers to cover the cost of an insurer failure, rather than building large reserves.

"The failure of a large life insurer could leave some states in the position of having to levy assessments on the remaining insurers for many years," Hartley writes in a recent Fed paper on how state insurance guaranty funds protect policyholders.

Insurers usually pay life and annuity benefits long after the products are purchased, and issuers pay annuity benefits over many years. That long time horizon could limit how quickly a guaranty fund would need to come up with large amounts of cash to make good on guaranty obligations, Hartley says.

He notes that guaranty funds can cope with gaps in cash flow by issuing state revenue bonds.

But the life and health guaranty fund system is run by the states and is less transparent than the FDIC insurance system for banks, and the fact that insurance company failures have been less common than bank failures means that observers have less information about how a big failure might work, he warns.

"The few examples of insurer failures raise important questions regarding the combination of legal uncertainty and timing, as well as the equitable treatment of similarly situated policyholders," Hartley concludes.

What it means: Hartley's paper could now be what federal regulators have in mind when they're thinking about the possibilities of life and annuity issuers failing.

The guaranty funds: Hartley points out that the insurance guaranty system is different than the FDIC system partly because insurers are regulated by the states, rather than the federal government, and because few insurance companies have failed in recent decades.

Banks, for example, must mention that they are insured by the FDIC in their ads. They apply the same insurance limits to all types of insured deposits.

In contrast, state laws based on the Life and Health Insurance Guaranty Association Model Act forbid insurers from mentioning guaranty funds when they are selling insurance. Insurance regulators want life and annuity buyers and their advisors to watch insurers carefully for signs of any problems, not depend on the funds to protect them against failures.

The guaranty fund rules differ from state to state, some state regulator efforts to help struggling insurers are confidential, and guaranty fund exposure limits vary by product type.

In a typical state, Hartley writes, the exposure limit might be $250,000 for the present value of individual annuity benefits, $300,000 for life insurance benefits and just $100,000 for life insurance net cash surrender value.

Protection haircuts: In extreme cases, a guaranty fund can also get court approval to reduce the guaranty fund protection below the usual payout cap, Hartley says.

The Federal Reserve Building. Credit: Shutterstock

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