Wednesday, March 11, 2009

Insurance “Guarantee Funds,” Another Mirage?

By Option ARMageddon's Rolfe Winkler:

I’ve written about the insurance industry’s troubles lately and was wondering……if a bank goes bust, its depositors are protected (at least theoretically) by FDIC…….is there a safety net for insurance policy-holders? Well, kind of. Each state has its own insurance “guarantee fund,” a private consortium of insurers operating in the state who agree to fund certain policy-holder’s losses should one of their brethren turn up insolvent. Here is a list of all the guarantee funds, including their insurance limits and contact information.

But here’s the kicker: None of these guarantee funds actually have any funds. There’s no pot of money for a rainy day. No, state insurance guarantee schemes are “post-funded.” Bailout cash is raised AFTER an insurer fails.

A useful report from Congressional Research Service has more:

Each guaranty fund is a mandatory association of all licensed insurers doing business in that state. Each fund has a board of those insurers, and the board governs the fund. An accumulation of money does not actually exist until after the insolvent [insurer]’s liabilities and assets are evaluated, each participating insurer is billed for its proportionate share of the shortfall, and each insurer remits its allocated share for that particular insolvency. The “fund” is the sum of those remittances. The term “guaranty fund” can also refer to insurers’ statutory obligation to participate in this protection system. In general, each state’s guaranty fund is responsible for the policyholders residing in that state, and the protection extends only to policyholders of licensed insurers within the limits of statutory coverage in that state of residence.

FDIC’s Deposit Insurance Fund is small, yes. But at least there are funds and at least these are set aside from the balance sheets they are meant to protect.

In the past, the insurance guarantee fund scheme has worked fine. It’s easy for insurers to fund the failure of smaller competitors one at a time. But what happens if the whole system is at risk of failure? That’s a very real risk, of course. It’s the reason we’ve shoveled $173 billion to AIG.

With that in mind, I wanted to highlights a few passages from the document mentioned at the top.

A significant rise in surrender rates [on insurance policies] inspired by consumers needs for cash or because of rumored or real failure of insurance companies could be disastrous. Because of widespread loss of liquidity, the industry would struggle to raise adequate cash to meet surrender requests. A “run on the bank” in the life and retirement business would have sweeping impacts across the economy in the U.S. In countries around the world with higher savings rates than the U.S., the failure of insurance companies like AIG would be a catastrophe.

If AIG were to fail notwithstanding the previous substantial government support, it is likely to have a cascading impact on a number of U.S. life insurers already weakened by credit losses. State insurance guarantee funds would be quickly dissipated, leading to even greater runs on the insurance industry.

——–

Failure would produce an immediate “run on the bank,” which would likely lead to state seizures of local operations, causing a lock-up in customers’ retirement accounts and payment of monthly/quarterly annuity checks.

Seizure by state regulators would have an adverse impact on state guarantee funds, which are unfunded, resulting in assessments against other insurance companies.

Such assessments in an already weak market could lead affected industry players to sell assets, resulting in downward pressure on fixed income markets.

———

Insurance is the oxygen of the free enterprise system. Without the promise of protection against life’s adversities, the fundamentals of capitalism are undermined.

That last line is the conclusion of the report. Oppose the AIG bailout and you put capitalism itself at risk, which makes you a communist. McCarthy would be proud.

But I digress. Attentive readers will have noticed that the theme of this post runs parallel to my criticism of FDIC insurance. Society has decided its prudent to protect itself from the failure of certain vital industries, but has utterly failed to fund the protection schemes. Unfunded liabilities. It’s our middle name.

I have argued that it’s prudent to keep some money in your mattress to protect yourself from the systemic failure of the banking system. They’re not paying you any interest anyway. To be very clear, I am NOT advocating that everyone rush to cash in their insurance policies. What I am saying is that people should not be afraid to look into their insurer’s solvency. If your insurance rep/salesman/whoever dismisses insurer solvency questions as crazy talk, or hands you the latest report from AM Best, they aren’t doing their job.

If insurers were healthy, they wouldn’t be taking TARP money, they wouldn’t be availing themselves of the Fed’s lending facilities and they wouldn’t be asking regulators to go easy with respect to capital requirements. The industry is in serious trouble and there’s little to protect policy-holders in the event of widespread failures.

Again, I am NOT predicting the imminent demise of the insurance industry. I am saying that the risk is high enough that insurance customers need to be asking tough questions. Those who do will be glad they did…

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