What happens if your insurance company fails?

What happens when an insurance company fails? This is one question it's important to know the answer to if you're considering the purchase of an immediate annuity to generate retirement income. As I've advocated in prior posts, unless you have significant lifetime income from your employer's defined benefit retirement plan, you should consider purchasing an immediate annuity for your retirement income portfolio. An immediate annuity pays you a lifetime retirement income, no matter how long you live and no matter what happens in the economy.

One objection people give to purchasing an annuity is the possibility that your insurance company might fail. The well-publicized failure of many banks during the recent downturn has only exacerbated people's fear of insurance company bankruptcy. Is this fear something that should prevent you from buying an annuity? Probably not, but you'll want to pay attention to the details. Let's take a look.

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State guaranty associations protect your policy

There's no federal program in place that protects consumers from insurance company bankruptcies like the Federal Deposit Insurance Corporation (FDIC), which protects against bank failures. However, each state has an insurance guaranty association (GA) that backs up insurance company policies in the event of the insurance company's bankruptcy. Your state's GA is funded by making assessments on every insurance company that currently does business in your state. These collections pay for the obligations of failed insurance companies that your state's GA has accepted.

If your insurance company should fail, your policy is usually protected by the GA in your state of residence, even if you bought the policy while living in another state. In some cases, the protection may be provided by the state where the insurance company had its headquarters.

As with FDIC insurance, there's a limit to the amount of insurance protection offered by a GA. This limit varies by state and depends on the type of insurance you have. For example, common insurance limits are $300,000 for life insurance death benefits, $100,000 for cash surrender values of life insurance policies, and $100,000 or $250,000 for annuity contracts. You can learn more about the terms that apply in your state of residence at the website of the National Organization of Life & Health Insurance Guaranty Associations (NOLHGA). This website also contains a link to each state's guaranty association.

Insurance company failures are different from bank failures

Although bank failures have caused a lot of concern about the stability of all financial institutions, it's important to recognize there are critical differences between failures of banks and insurance companies. Here are some key differences:

-- It's hard to start a "run on an insurance company" like a "run on a bank." While you can always withdraw the money from your bank accounts, you would have to die for life insurance benefits to be paid, and with immediate annuities, you'd have to wait each month to receive your check. Unlike with a bank, there's generally a longer timeframe in which to address financial problems at insurance companies.

-- Insurance companies usually aren't as leveraged as banks, so when they fail, their liabilities might be only 10 to 20 percent higher than their assets. A bank's liabilities, on the other hand, can be far higher than its assets.

As a result of these differences, there have been far fewer insurance company failures compared to bank failures. According to the most recent report from the NOLHGA, there were 74 failures of multi-state insurance companies from 1987 to 2009 that the NOLHGA was involved with. By contrast, there were 157 bank failures in 2010 alone, and another 92 in 2011.

What should you do?

There are two steps you can take to protect yourself from insurance company failures. First, learn about the limits of your state's guaranty association, and then keep your annuity purchases below this limit. To do this, you may need to buy annuities from more than one insurance company.

Second, only buy annuities from the top-rated insurance companies. You can view an insurance company's rating if you use an online annuity bidding service, such as Vanguard's Annuity Access program or ImmediateAnnuities.com

There can be other objections to buying an annuity -- primarily the fact that with many immediate annuities, your purchases is irrevocable and you can't ever access your original investment. This objection can be minimized by annuitizing just a part of your retirement savings, so you have other assets that you can access.

The bottom line is, if you do some homework, you can minimize your exposure to the potential bankruptcy of your insurance company. Don't let the fear of insurance company failure hold you back from generating a secure, lifetime retirement income.