Since the early 1970s, life, annuity, and health insurance consumers have received protection against the financial risk of the insolvency of their insurer from guaranty associations (GAs) in their states of residence. This article discusses the mission and development of the guaranty system in the context of U.S. insurer insolvency resolutions, the operations of that system when insurers fail, and the financial capacity of the system.
How the system operates. In the banking system, the Federal Deposit Insurance Corporation (FDIC) has three roles: (1) provide a safety net for banking consumers; (2) serve as a receiver of failed depository institutions; and (3) regulate depository institutions, indirectly and sometimes directly. In contrast, the insurance guaranty system’s consumer safety net is separate and apart from both the regulation of active insurers and the receivership of failed insurers. Nonetheless, the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA) and its member GAs coordinate their activities with insurance regulators and receivers.
Insurance companies are expressly excluded from the definition of a debtor under the federal Bankruptcy Code. As a consequence, a failed insurance company does not enter bankruptcy but rather is placed in receivership by the insurance regulator of the state that granted the insurer’s charter. The receivership proceeding is conducted according to the state’s insurance receivership statute, which bears some resemblance to bankruptcy law. The proceeding is conducted before a state judge, and the insurance commissioner of the domiciliary state serves as the statutory receiver of the company.
Insurance receivership laws vary somewhat from state to state, but all have provisions for three basic levels of receivership. The first, and least severe, is described as conservation. The next most severe form is rehabilitation, in which the commissioner, as rehabilitator, is vested with title to company assets and control of company operations. Rehabilitation is in some ways analogous to a Chapter 11 bankruptcy reorganization. The most severe form of receivership is liquidation, which is analogous to a Chapter 7 liquidating bankruptcy. Under the Model Act as adopted in the states, NOLHGA’s member GAs become actively involved in an insurer insolvency resolution when their obligations to consumers are triggered by an order of the receivership court placing the insurance company into liquidation and finding it to be insolvent.
Once triggered, a GA becomes responsible for protecting contracts covered under its enabling statute, at least to the lower of the contract’s limit of coverage or the limit of coverage or cap set forth in the GA’s enabling statute. The associations’ core obligations are to make payments due on covered contracts and to continue coverage on these contracts on substantially the same terms as those extended to consumers by the failed insurer.
The core responsibility of GAs is to protect consumers whose insurers have failed—not the insurers. GAs were not created to bail out financially troubled insurance companies but rather to ensure that individual consumers receive a base level of financial protection during their insurer’s insolvency resolution process.
Financing and capacity considerations. The guaranty system relies on a combination of financing sources and resolution techniques to deliver protection for consumers. Life insurer resolution plans employ the insolvent insurer’s remaining assets as the first level of financing used to protect all insurance consumers pro rata—both for consumer benefits covered by GAs and for insurance benefits that GAs do not cover. Additionally, insurance receivership laws give policy-level claims priority over all other claims against an insolvent insurer’s assets, aside from receivership administrative costs.
Even with the funding from estate assets, additional funds from the guaranty system are critical to the success of a resolution plan. The guaranty system’s funds bridge the gap between the total GA-covered obligations and the estate assets allocable to meet those obligations. Simply stated, GAs must cover that gap for the consumers they are charged to protect.
The most significant source of GA funding is through assessments that GAs collect from the insurance industry. Each GA is authorized by its enabling statute to assess and collect, from insurance companies writing covered lines of business in the state, the amount needed to satisfy the GA’s obligations to policyholders. Member insurers are obliged to pay these assessments as a condition to maintaining their authority to write business in the state. Another source of GA funding is dividend distributions to GAs from insurance receiverships in which GAs previously have advanced funds to protect consumers.
Unlike the FDIC, the insurance guaranty mechanism does not involve a prefunded war chest available in advance of a particular insolvency. This “post-funded” system is well suited to insurance receiverships because insurance and annuity products are in essence commitments to deliver funding upon specified events or pursuant to a scheduled need. Unlike a bank demand account, many insurance obligations do not become due and payable to consumers until years after an insurer’s failure.
To provide an effective banking safety net, it is necessary for the FDIC to replace the cash of the failed bank with cash from the FDIC at the moment the bank fails. By contrast, the insurance guaranty system, by protecting not only against liquidity and credit risks but also against insurance replacement risks, meets its obligations to consumers in a different way that is appropriate to the nature of an insurance contract: by replacing insurance with insurance.
The recent financial crisis caused various media outlets to publish stories about the potential failures of life insurance companies. Some stories briefly addressed the guaranty system and its financial capacity, but few did so in detail, and none did so accurately. The stories typically compared the cited amounts to the total liabilities of life insurers and concluded or implied that the capacity of the guaranty system was inadequate to protect consumers. Such assertions are incomplete and unsound for two important reasons.
The first is that such assertions fail to account for the significant extent to which the costs of protecting life insurance consumers are almost always paid from assets that remain with the insurer after it has entered liquidation proceedings. The second reason is that such assertions fail to recognize that, in major insolvencies, the guaranty system is likely to employ an enhancement plan to spread the cost of protecting consumers across the period of years over which the insolvent insurer’s obligations to consumers mature.
The question really being asked, though, by those who have written about the potential effects of the economic crisis on the insurance industry and the guaranty system is whether the system is capable of protecting consumers if the economic crisis were to grow markedly worse. Could the guaranty system meet its obligations if the economy resulted in the simultaneous failure of several nationally significant insurers?
The answer, from historical experience, is “yes.” During the last major wave of life insurer insolvencies in the early 1990s, the guaranty system protected all consumers to whom it had responsibilities when confronted with the simultaneous resolutions of three nationally significant insurer failures plus a number of failures involving middle-tier and smaller companies. At no time—not even in the most expensive years—did the cost of protecting consumers even remotely approach the assessment capacity of the guaranty system.
In the current environment, NOLHGA expects the guaranty system will be able to meet obligations to all consumers under any reasonably foreseeable developments.
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