What Happens To Your Insurance Policy When the Insurer Fails?

American International Group, one of the largest insurance companies in the world, has been struggling to stay afloat this week. Moody’s Investors Service and Standard & Poor’s lowered their ratings on AIG; these downgrades, in turn, trigger clauses in AIG’s contracts with its trading partners that could require the company to raise billions for collateral or penalty payments. It looks as though the federal government has decided to keep AIG from going under. Still, today insurance policyholders may have been wondering: what happens to my insurance policy if the insurer goes bankrupt?

The financial health of an insurer is an important consideration whenever you are shopping for insurance.  Ironically, AIG’s life and property insurance businesses are believed to be healthy financially; the part of its business that has been losing massive amounts of money is the segment that provides insurance against mortgage defaults.  Its insurance assets are segregated according to state insurance regulations.  Right now, it appears that AIG’s policies are still safe, but what might have happened if it had become insolvent?

Insurance companies are regulated by the states rather than on the federal level.  When an insurance company does business in a state, that state typically requires it to participate in a state guaranty fund or guaranty association.  Each insurer pays a fee proportional to its business into a fund that’s maintained to back up the policy obligations of any insurance company that fails.

The coverage provided in the event of a failure depends on the state.  For life insurance policies, state guaranty funds typically provide coverage for at least $300,000 in death benefits and $100,000 in policy cash value (for policies such as whole life).  For homeowner’s and auto insurance policies, guaranty association coverage is also typically around $300,000, but it does vary.  It’s unlikely that an insurer would not be able to cover some of its claims even in insolvency, so the guaranty association typically acts to cover shortfalls.  A guaranty fund would also cover prepaid premiums lost due to an insolvency.

If an insurance company becomes insolvent, the state insurance commissioner typically takes control of the company’s regulated assets.  The state guarantee association then provides the prescribed coverage to policyholders while the receiver determines whether the company has enough assets to return to operation.  Often the business of the failed company is transferred to other more stable insurers.

If your insurance company failed and you did not have any claims in need of payment, your best strategy would probably be to seek new coverage if you can get it.  If you remain with the old company and the guaranty fund is not sufficient to cover your policy, in order to maintain full coverage you would have to pay additional premiums to the insurer that assumes the old company’s policies.  Alternatively, you could accept coverage at a lower level.

If you had a claim, it would be covered up to the extent permitted by the old company’s assets plus the guaranty fund coverage.  It’s possible that the full amount of your claim might not be covered in such a situation.  This is why it’s wise, especially if you’re purchasing a large amount of coverage, to try confirm that your insurance company is financially sound when you are shopping for coverage.  There are several online sources of rating information, including A.M. Best and a guide at insure.com.

Further information on insurance regulation in Massachusetts is available at the state’s insurance information portal.

Postscript- Sept. 22, 2008: Diedre Fulton, one of my colleagues in the Garrett Planning Network, was kind enough to draw our attention to a very helpful resource link at the National Organization of Life & Health Insurance Guaranty Funds. The NOLHGA site provides information on how insurance guaranty systems work and links to the web sites for each state guaranty association.

About the author

Thomas Fisher, CFP®

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