by L. Carlos Lara
[Reprinted from the November 2014 edition of the Lara-Murphy-Report, LMR]
The financial strength of the life insurance industry is impressive. Compared to commercial banks and investment firms, their solvency record has been nearly faultless even during hard economic times. While Americans witnessed Standard & Poor’s Rating Services actually downgrade the long term credit rating of the United States in 2011 with a negative outlook1, the life insurance industry not only survived the 2008 financial crisis, it emerged from the Great Recession financially sound and continuing to issue policies, paying policyholder claims and servicing in-force business. This is not to say that life companies are totally immune to failure. Quite the contrary, in any competitive marketplace you will find financial impairments, including failures— they are inevitable. More to say that the number of failures in the life insurance industry spanning a period of nearly 200 years is small contrasted to other financial intermediaries in the U.S. economy. Even so, with the few companies that have actually failed, recovery to policyholders has been substantial. “In the more recent insolvencies more than 90 percent of policyholder benefits have been recovered in full.”2 Many of these insurer’s financial problems were solved without public knowledge and often a friendly merger or acquisition resulted.
The secret to this impeccable record stems from the industry’s long history of conservative financial management in addition to the layers of solvency surveillance methods employed by the industry, third-party analysts, and state regulatorsthat work to ensure a financially healthy insurance industry. In this LMR article we will cover some of the more relevant tools used by state insurance regulators to monitor these secure financial enterprises. In the paragraphs that follow I hope to be able to answer the question that most policyholders, including myself, really want to know: “What happens to my insurance cash values and benefits in a worst case scenario?”
Policyholders Come First
As stated previously in other LMR articles related to this subject (see the LMR Archives at www.lara-murphy.com), the life insurance industry, like most financial intermediaries in the U.S., is highly regulated. However, unlike the commercial banking industry’s solvency monitoring tools that aim to prevent risks to the entire banking system, insurance solvency monitoring is focused primarily on protecting the policyholders. As the owner of several insurance policies that objective is comforting.
Additionally, we have often stated that unlike most other financial institutions in our economy, the insurance industry is regulated at the state level rather than at the federal level. This form of decentralization may seem odd to many readers since most of us are aware that state laws differ from one another. However, this is how it has worked in the insurance industry dating back to the early 1900s. An insurance commissioner,3 either elected or appointed by the Governor, enforces each state’s body of insurance laws. Insurers wishing to conduct business in all 50 states must be licensed in each state and must comply with 50 different state’s requirements. Regulatory uniformity among the 50 states is achieved by and through the National Association of Insurance Commissioners (NAIC),4 a trade organization composed exclusively of insurance commissioners from each state.
The objective of insurance commissioners, in addition to bringing about nationwide regulatory consistency and protecting the public’s interest, is to “strive to detect financially troubled companies early, take corrective action to restore them to financial health when possible, and minimize the negative repercussions to policyholders of the financial failures that do occur.”5 Please note that, once again, the emphasis is in protecting the policyholders. Financial professionals typically know this important information, but often neglect sharing this with clients and prospects, forgetting that for the average American these regulatory differences many times represent completely new revelations to their understanding of the life insurance industry. These distinctions can be immensely helpful in properly understanding the mechanisms that safeguard the public’s money, which in many cases is their life’s savings. If advisors are to give clients a full range of essential advice then providing this level of information to the public should not be overlooked.
Risk-Based Capital Requirements
There are several important solvency monitoring tools used by insurance commissioners and their staff, but the one solvency regulation that should be singled out as the most important is a life insurance company’s net worth (the excess of assets over liabilities). This topic too has unique distinctions not commonly found with other financial institutions. To be precise, it is imperative to understand that the principle liabilities on life insurance balance sheets are actually policy reserves. In last month’s LMR article [Why Evaluating Life Insurer Financial Strength is Important] we learned that insurance companies follow a very conservative strategy of matching assets to their long-term liability commitments known as “asset liability matching.” But here we mean specifically that state regulators require additional capital cushions for all present and future liabilities by mandating an overstatement of future expected claim costs.
“For example: the mortality rates required to be used in reserve calculations are much greater than those actually experienced by insurers. This fact results in reserves being higher than they would be were realistic mortality assumptions used. In effect, this requirement means that insurers ordinarily have some surplus or cushion embedded within their liabilities.”6
Still yet another layer of conservatism is found in the limitations regulators place on the quality and quantity of assets to be purchased by insurers. This summons special focus on their valuation. A 2012 study of the Life Insurance industry conducted by the Federal Reserve Bank of Chicago revealed that 74% of assets were in investment-grade bonds with 44% being corporate bonds.7 The study was an impressive indicator of a financially solid insurance sector. In fact, riskier investments, especially for market sensitive insurance products, are required by law to have an additional increase of policy reserves. This emphasis on a stockpile of capital reinforcements with regards to the management of insurance companies is hard to ignore.
In addition to these mandates, state regulators also require life insurers to use a completely different method of accounting standards known as Statutory Accounting Principles (SAP). What makes this form of accounting so important is that the assessment emphasis is placed squarely on an enterprise’s solvency rather than on the value of a company as an ongoing concern. It allows regulators to analyze more stringently these extra reserve requirements. Needless to say SAP financial statements are more conservative than Generally Accepted Accounting Principles (GAAP) commonly used by all other U.S. corporations.
Finally, these regulatory methods all come together in the implementation of the NAIC’s Risk-Based Capital (RBC) model law that evaluates the adequacy of each insurer’s surplus (with surplus being synonymous with capital). The riskier an issuer’s operations are the larger the amount of capital it is made to hold. An insurer that invests in low-grade bonds exposes itself to greater default risk and therefore it is required to hold more surplus than one that invests in high-grade bonds as mandated. This very important law spells out several contingency risks of life insurers and then makes use of a complex formula with several risk-based capital ratios that have certain thresholds. A ratio below the required threshold triggers progressively more intrusive actions by regulators that help identify inadequately capitalized insurers. In other words, above the ratio threshold there is “no-action,” but as an insurer moves below the threshold there is first the “company action level,” followed by the “regulatory action level,” then the “authorized control level,” and finally the “mandatory control level,” which is the regulatory seizure of the company. Through this process regulators are able to detect financially troubled companies much earlier and move quickly to rehabilitate them.
Before we discuss what regulators actually do to a financially impaired insurer once they find one, there are two other important tests or regulatory restrictions placed on life insurance companies that should be mentioned in the interest of assuring the reader of the insurance sector’s financial solidity.
Cash-Flow Testing and Dividend Restrictions
Life insurance companies are required, as part of their statutory filings, to model thousands of economic scenarios to ensure that their assets and future cash-flows provide enough liquidity to provide policyholder obligations. These modeling scenarios also have mandatory cash-flow thresholds. Consequently, additional reserves will be required if they do not meet these points of entry. When we hear and read that the insurance companies had far fewer failures than commercial banks and other investment firms even during the Great Depression of the 1930s, these cash flow management efforts within the insurance industry explain why they were able to survive these major economic downturns.
More importantly, the states impose restrictions on any money transfers, such as dividends, to their parent holding companies or other affiliates. Additionally, all the assets, reserves, and capital/surplus must be maintained by the life insurance subsidiary and be completely separated from the group’s other funds and obligations. That’s another way of saying that there is effectively a wall between a life insurance subsidiary and its parent company and affiliates, which mostly operate in the federally regulated markets. Although money transfers are permitted, state regulators must approve any money transfers that exceed certain limits that may potentially damage the financial strength of the life company. It is because of this regulation that we can now understand why the assets within AIG’s life insurance subsidiaries remained separated and did not require taxpayer bailout money. Even if the AIG holding company and conglomerate had been allowed to fail, the life insurance subsidiaries would have been financially insulated and safe. As policyholders we could not have a better example of the financial fortitude and conservatism of the life insurance industry than AIG, whose temporary misfortune occurred in our own day and time.
The NAIC has several other important solvency surveillance tools which we cannot cover in detail here, but they include annual Audited Financial Statements, Financial Analysis Solvency Tools (FAST), Insurance Regulatory Information System (IRIS), Onsite Financial Examinations, Professional Third Party Oversight (including rating agencies), and several forms of Informal and Formal Actions by regulators, all of which serve to establish proper incentives and safeguards to keep the number of insurer insolvencies to a bare minimum.
Of course, long before the regulators have to step in, managers running insurance companies know if their business is heading into financial trouble and take voluntary action to reverse their course. These steps may include such measures as expense cutting, selling pieces of their business, purchasing relief reinsurance, exploring merger possibilities or trying to sell their company to another more financially sound enterprise. Fortunately many of these options do in fact work with minimal disruption to policyholders. However, occasionally there is that one company that slips beyond the rehabilitation stage. In the past some of these insurers have been household names, but generally they are small companies. The course of action taken by regulators against these insolvent entities represents for policyholders the worst-case scenario or what we may describe as the bottom line to a life insurance company that must be seized and dismantled.
Liquidation— The Last Straw
Before assessing the outcome of this final phase, the reader should realize that although the insurance industry is highly regulated, it must pass the “market test” on its own merits, in contrast to commercial or investment banks that can look to the “lender of last resort,” (the Fed), when they make poor decisions. The FDIC which protects bank deposits states on its website that it is backed by the full faith and credit of the U.S. Government. However, in light of the recent Dodd-Frank Act this guaranty has been called into question. The point is that life insurance companies make no such claims to the public. State governments do not provide insolvent life insurers taxpayer money to solve their financial difficulties. Life companies, like all other corporations on the open market, operate in a competitive profit and loss environment. They have to provide their own safety nets to protect their customers. But from what we have learned already on how life insurance companies are conservatively managed, even a failed insurer probably has more assets to distribute or sell than your typical financially insolvent company. This may ultimately explain why the recovery to policyholders is historically high and the failure rate is so low.
The authors of the American Bar Association reference book used in the writing of this paper felt comfortable enough to state that “the average policyholder is highly unlikely ever to be required to deal with the insolvency of a life insurer.”8 It is true that there are several options and plenty of lead time to exit or transfer out of an insurance carrier if absolutely necessary. But though they may be minimal, unfortunately failures do occur. When it is found inadvisable that an insurer should be rehabilitated a “conservation order,”9 or liquidation order, is granted to the insurance commissioner to move the company toward the final closing of operations. The insurance commissioner, acting in a similar role to a receiver in bankruptcy, is given full title to the company’s assets and makes final settlement of all obligations. The following distribution priority is mandatory by law and it is executed accordingly.
- Cost of Administration— first
- Employee Salaries— second
- Policyholder Claims
- All Other Creditors
- Shareholders —last (in the case of Stock Companies)
What is important to recognize in this final stage is that once the insurance commissioner becomes involved as a receiver he will be focused intensely on conserving assets on behalf of the policyholders. However, triggered simultaneously with the granting of the commissioner’s conservation order are the Guaranty Associations. This is an indemnity organization that functions in the same way the FDIC works with commercial banks, but without federal government support. Financed with the assets of the failed insurer and the proceeds from an assessment system funded by other solvent life insurers, the guaranty association begins immediately to provide coverage and benefits to the policyholders of the failed company. They will also actively transfer policies to other insurers and generally assume the role of an ongoing insurer or they will honor cash benefits to those that want out. Although the guaranty association has statutory indemnification limits, policyholders can also make a priority claim against the assets of the liquidated insurer for any claims not paid by the guaranty associations.
“While these laws vary somewhat from state to state, most states provide for guaranty association payment amounts up to these limits:”10
The reader should check for the actual limits in their own state because some are actually higher.
- $300,000 in life insurance death benefits;
- $100,000 in cash surrender or withdrawal value for life insurance;
- $100,000 in withdrawal and cash values for annuities;
- $100,000 in health insurance policy benefits
All 52 insurance guaranty associations are members of the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA)11 and work together to provide continued protection and support for policyholders.
The near invincibility and fortitude of the life insurance industry has been underscored repeatedly in this article because of the impressive solvency record it possesses. Commercial banks and investment firms have not been able to match this performance. The secret to the life insurance industry’s financial strength lies in their conservative management style that places such great emphasis on policy reserves. It’s as though they are made to operate with a built-in capital cushion. For this reason few insurers ever fail and even in the rare cases when they do, recovery to policyholders is substantial. That’s the good news of this article and why my personal assets are concentrated in the insurance sector.
However, putting a positive spin on an article that ultimately discusses what happens to policyholders when an insurer actually fails is admittedly difficult. The truth is that when a policyholder’s insurance company actually fails, it makes no difference to him or her how impressive all these statistics are. A failed life insurance company that has one’s insurance coverage and benefits is going to be a problem no matter how you look at it. Even though one may not actually suffer a complete financial loss in the end, there will be uncertainty, delays, and just plain aggravations. None of these makes for a pleasant experience.
Since failures in any competitive marketplace are inevitable we should simply stress that buyers should be vigilant in their initial selection of carriers. Study carefully the rating agency reports provided by the company and contract with only the best rated. It can also be wise to place needed insurance coverage with several insurers instead of putting all your eggs in one basket. Finally, be just as vigilant in the selection of your agent. Choose qualified financial professionals who will provide you with the full range of financial advice including any early warnings and escape routes if financial problems with a carrier are imminent. This will add an additional layer of safety to your insurance purchase and relieve you of unnecessary stress. The Authorized IBC Practitioners listed at www.infinitebanking.org/finder is an excellent place to start.
1. Downgrading the U.S. Credit Rating, Wikipedia, The Free Encyclopedia, November 22, 2014 http://en.wikipedia.org/wiki/United_States_federal_government_credit-rating_downgrades
2. “Who’s Watching Your Back?” An Assessment of Life Insurance Policyholder Protections Following the passage of the Budget Control Act of 2011, Article, by Atlas Advisory Group, Who’s Watching Your Back? – Carlson Hammond
3. Insurance Commissioner, Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Insurance_commissioner
4. National Association of Insurance Commissioners, Wikipedia, the Free Encyclopedia, http://en.wikipedia.org/wiki/National_Association_of_Insurance_Commissioners
5. The Advisor’s Guide To Life Insurance, Harold D. Skipper, PhD and Wayne Tonning, Copyright 2011, M Financial Group, American Bar Association, Chapter 4. Page 70.
6. The Advisor’s Guide To Life Insurance, Chapter 4 Page 70
7. The Sensitivity of Life Insurance Firms To Interest Rate Changes, Berends, McMenami, Plestis and Rosen, Federal Reserve Bank of Chicago https://www.chicagofed.org/webpages/publications/economic_perspectives/2013/2q_berends_mcmenamin_plestis_rosen.cfm
8. The Advisor’s Guide To Life Insurance, Chapter 4, Page 78
9. Life Insurance, Kenneth Black Jr., Harold D. Skipper, Kenneth Black III, Copyright 2014 by Lucretian, LLC, Chapter 13, page 309
10. Life Insurance, Chapter 13, page 309
11. National Organization of Life and Health Insurance Guaranty Associations (NOLHGA), Wikipedia, The Free Encyclopedia http://en.wikipedia.org/wiki/National_Organization_of_Life_and_Health_Insurance_Guaranty_Associations