Help! My Life Insurance Company Went Belly up

What if your life insurance company kicks the bucket before you do?

The odds of that occurring are historically very slim, and the chances of a policyholder "losing it all" in such a scenario even slimmer, given the numerous and robust regulatory backstops to insurer insolvency.

"It's very, very rare for a life insurer to become insolvent," says Michael Barry, spokesman for the Insurance Information Institute, an industry trade group. "Life insurers are among the best capitalized insurance companies out there."

Indeed, just 80 multistate life and health insurers and 326 single-state or regional insurers have failed over the past four decades. Life insurers performed particularly well during the recent recession, with just eight insolvencies between 2008 and 2012. Not only did those companies' combined liability of $900 million pale in comparison to the $639 billion Lehman Brothers bankruptcy, but also most policyholders recovered all or nearly all benefits under contract.

That said, understanding the safeguards against life insurer insolvencies and the steps you can take before and after purchase to protect your policy could help you avoid accidentally endangering your investment.

Guaranty: The insolvency 'safety net'

Under the federal bankruptcy code, failing insurance companies cannot declare bankruptcy. Instead, they enter into a three-tiered, highly structured resolution program run by their home state's guaranty association, or GA. This office, which operates within each state's insurance department, serves as an insolvency "safety net" for life, annuity and health insurance consumers. (Separate GAs also protect homeowners insurance and auto insurance customers.)

Because state insurance laws vary and life and health insurers often operate in multiple states, the National Organization of Life and Health Insurance Guaranty Associations, or NOLHGA, was created in 1983 to coordinate insurance failures that cross state lines.

Insurers pay into guaranty funds that protect consumers against insolvency in much the same way the Federal Deposit Insurance Corp. has your back in a bank failure. Under models established by the National Association of Insurance Commissioners, individual life policies are guaranteed to $300,000 (cash values to $100,000) and annuities to $250,000, although state amounts may vary.

And, because life benefits are not payable upon demand in the same way as bank deposits, policyholders need not worry about a run on their troubled insurance company.

"One of the best friends of a resolution plan is using the value of time to achieve an orderly disposition of the assets of the company, as opposed to a fire sale," says Peter Gallanis, president of NOLHGA. "The liabilities come due over a long period of time. Because life insurance companies tend to invest conservatively to honor those liabilities, their holdings tend to be long-term and conservative."

When an insurer runs into financial trouble, it faces three possible levels of receivership by the state.

Conservation: Under this least severe option, the state works with the troubled insurer to maintain business as usual, identify problems and explore solutions. If the solutions work, the company may be released. If not, it proceeds to one of the two remaining options.
Rehabilitation: Similar to Chapter 11 bankruptcy, the state takes over control of the company, including its assets, and attempts to steer it back to solvency.
Liquidation: Analogous to Chapter 7 bankruptcy, the state either finds a healthy insurer to assume the insolvent company's policies, or failing that, develops a plan to distribute the remaining assets, with guaranty funds if necessary, to honor policyholder claims.

Even in the rare case of liquidation, Gallanis says the financial loss to policyholders is usually minimal. "Going back to the Great Depression, folks have realized in excess of 96 cents on the dollar on their life contract claims and 94 cents on annuity claims," he says.

Keep calm and -- well, you know the rest

Rule No. 1 if your insurer enters receivership is: Don't freak out. Barry says you stand a far greater chance of damaging or even terminating your own policy if you overreact to a notice of receivership and cease to pay your premiums.

"If you stop premium payments, it's very hard because then have to get your agent back involved to reach into the company to get you back on track. And if you have a whole life policy, now you're impacting the cash value," he says.

Barry also cautions against the urge to cash out a whole life policy. "You may get a quick $6,000 to $10,000 by surrendering it, but you may be giving up a $50,000 or $100,000 benefit to your beneficiaries," he says. "Plus, you may not be able to afford or qualify for another policy."

Richard O'Boyle Jr., an independent life insurance agent and senior account associate with New York City-based Schaefer Enterprises Inc., says your agent can be a valuable ally should you need cash from an insurer in receivership.

"An agent can help draft a letter to the company requesting a 'hardship disbursement,'" he says. "A lot of times, the client doesn't even have the policy number anymore or know whether it was policy version A or B. The agent also knows the keywords to drop in there to make sure you'll be heard."

To minimize your exposure to insolvency before you insure, O'Boyle suggests these tips.

Know your ratings. Research the financial strength of your short list of prospective insurance companies at A.M. Best, Fitch Ratings, Moody's, and Standard and Poor's. In general, the better the rating, the lower your risk.
Insure with an "admitted" company. Companies that are approved, or "admitted," to write life insurance in your state pay into the state guaranty fund; those that aren't, don't. If you insure with a "nonadmitted" insurer and it goes broke, you could lose out completely.
Diversify your insurers. "A lot of people place all their eggs in one basket," O'Boyle says. "When you invest too much in one company, it's easy to get too concentrated."