For many advisors, the possibility that insurance companies will run into financial difficulties makes recommending annuities a nonstarter. But annuities are the best way to mitigate longevity risk, which may pose a greater danger, and advisors can take steps to help protect clients from insurers’ financial problems.
Many prominent individuals have raised concerns about insurer-solvency risk. In William Bernstein’s recently published e-book, "The Ages of the Investor," for example, he compares bond ladders to annuities and concludes that it's difficult to know which risk is greater: the longevity risk associated with bond ladders or the insurer-solvency risk associated with annuities. Wade Pfau's June 20 blog post mentioned Bernstein's concerns, elaborating with discussion from readers.
I’ll identify some steps advisors can take to insulate clients from the possibility than an insurer might fail, but first let’s look at the degree of risk in insurance companies and what it means for policy holders.
The role of guaranty associations and some history
The insurance industry is regulated by the various states, each of which has a Life and Health Guaranty Association, with annuities falling under the life category. The role of the guaranty associations is to back up the contract guarantees in life, health and annuity policies. For annuities, such guarantees include the payments for single-premium immediate annuity (SPIAs) and deferred-income annuities (DIAs), the minimum interest guarantees in other types of fixed annuities (including fixed-index annuities), and living benefit guaranties in variable annuities. States place caps on the amount they will guarantee and these vary by state, with $250,000 being a common limit applying to the present value of annuity benefits.
Funds to support the policyholders of failed insurers are collected from assessments drawn from all insurers operating in a given state. The National Organization of Life and Health Insurance Guaranty Associations (NOLHGA), the nationwide coordinating body for guaranty associations, provides a wealth of information about its constituent associations.
History shows that annuities have traditionally been an extremely safe investment. Insurance company insolvencies have been few, companies in trouble have often sold business to healthy insurers, and guaranty associations have provided an additional safety net. In my review of the historical record, I could only find a few cases where annuity owners ended up with less than their insurer promised. One resulted from the 1983 bankruptcy of Baldwin-United, which involved a takeover by MetLife and a court-ordered reduction in benefits. Another involved the 1991 failure of Executive Life, which continued to pay annuity benefits in state-managed rehabilitation mode until this year, when balance sheet deterioration led to liquidation. Going forward, owners of Executive Life annuities that exceed state guaranty caps will suffer losses.
The chart below plots the number of insurer failures each year that required NOHLGA to coordinate the rescue of policyholders—typically cases where the failed insurer operated in three or more states.
There were 70 failures in total over this period, and most of them were concentrated between 1991 and 1994, when some insurance companies became too enamored with junk bonds. There was a slight uptick in failures after the 2008 financial crisis, but that spike was hardly alarming given the stresses on the financial system. One company that did not fail, but got lots of publicity, was AIG, which deserves separate discussion.