What Happens When an Insurer Fails? A Guide to Understanding Insurance Insolvency

Insurance company failures can be distressing events for policyholders. However, safeguards exist to protect consumers if their insurer becomes insolvent. This article provides an overview of what happens when an insurance company fails and how states regulate and support policyholders when insolvencies occur.

How Insurers Fall Into Financial Trouble

Insurance companies can fail for several reasons:

• Underpricing products – If premium rates are too low, claims may exceed revenues. This can quickly drain reserves.

• Catastrophic losses – A major disaster like a hurricane can generate huge claims that even well-capitalized insurers struggle to pay.

• Poor investment returns – Insurers invest premium dollars to generate income. If investments sour, insolvency risk rises.

• Loose underwriting – Writing too many high-risk policies without adequate pricing increases loss exposure.

• Fraud or mismanagement – Dishonest or incompetent leadership can undermine the financial health of insurers.

Well-run insurance companies take steps to minimize these risks. However, regulators occasionally must step in when problems arise.

The Role of State Insurance Departments

Insurance is regulated at the state level. State insurance departments monitor insurer finances to identify emerging problems. When an insurer shows signs of instability, the insurance commissioner can take action, such as:

• Placing the insurer under supervision, where operations are monitored closely

• Requiring the insurer to submit a financial recovery plan

• Restricting the insurer from writing new policies

If the insurer’s situation continues to deteriorate, the commissioner can petition the court to place the company into receivership. A “receiver” is appointed to take over operations.

Receivership and Insolvency

There are two types of receivership:

Rehabilitation – The focus is on correcting problems so the insurer can be restored to sound financial health. The company may be permitted to continue servicing existing policies during rehabilitation.

Liquidation – The insurer’s problems are deemed too severe for rehabilitation. Liquidation involves assessing the company’s assets and liabilities, selling off any assets, and using the proceeds to pay creditors based on priority class. Policyholders are generally the top priority class. If funds can’t cover all claims, lower priority creditors often get nothing.

If liquidation is ordered, the insurer is declared insolvent. Operations cease besides processing of claims. Ownership rights transfer to the liquidator.

Role of State Guaranty Funds

When insurers fail, state guaranty funds provide a safety net for policyholders. Here’s how they work:

• Insurers operating in a state pay assessments into the state’s guaranty fund.

• The fund is activated if a member insurer is liquidated.

• Guaranty associations are created to coordinate coverage for policyholders.

• Coverage limits are imposed based on policy type. For life insurance, most states cover $300,000 in death benefits. Health insurance limits are typically $500,000.

• Policyholders may file a claim against the estate of the failed insurer for amounts above guaranty fund limits.

• Guaranty funds pay amounts within coverage limits, recouping portions from the estate.

So while coverage limits exist, guaranty funds protect most policyholders from complete loss of benefits.

Assessing Your Insurer’s Financial Strength

Policyholders aren’t powerless against insurer insolvencies. You can check an insurer’s financial ratings from agencies like A.M. Best and Standard & Poor’s. Strong ratings indicate lower insolvency risk.

Watch for downgrades, which signal emerging problems. If your insurer’s rating drops significantly, consider replacing coverage. Switching while still healthy avoids gaps in coverage later.

Research your insurer’s history and management as well. Frequent leadership changes or past regulatory actions are red flags.

What To Do if Your Insurer Is Taken Over

If your insurer does end up in receivership, stay calm but take action:

• Keep paying premiums – Coverage may terminate if you stop paying.

• Contact the guaranty association – Learn how benefits will be paid going forward.

• Review policy details – Understand exact coverage limits under the guaranty system.

• File a claim with the receiver – For any benefits above guaranty fund limits.

• Consider replacing the policy – To avoid future uncertainty.

While inconvenient, insurer insolvencies need not result in financial catastrophe for policyholders. Oversight helps restore stability, and safety nets exist for protection. Staying informed, monitoring insurer health, and taking prompt action when issues arise can also help you navigate any company failures smoothly.

Frequently Asked Questions

What triggers receivership?

Insurers are placed into receivership when financial or operational issues become severe enough that the insurance commissioner believes the company can no longer operate independently. Exact thresholds vary by state. Receivership allows for greater regulatory oversight and control.

What happens to insurance agents when a company is liquidated?

Agents and brokers lose their appointments with the insurer once liquidation occurs. However, guaranty associations often establish processes to help assign existing policies to new companies. Agents assist in this transition. This helps minimize disruption for consumers.

Do policyholders need to reapply for coverage with a new insurer?

In most cases, no. Guaranty associations automatically transfer policies to a healthy insurer that assumes responsibility for providing coverage. Policyholders simply pay the new insurer going forward.

How are guaranty fund coverage limits applied?

Limits apply on a per-policy basis. For example, if you have three $200,000 term life policies with an insolvent insurer, each policy would be covered up to $300,000 by the guaranty fund. The limits are not aggregated across multiple policies.

What happens to cash value in a whole life policy when an insurer fails?

The cash value is protected by state guaranty funds like any other policy benefit. Typically the new insurer appointed by the guaranty association will maintain the cash value and allow ongoing accrual.

Do insurers purchase reinsurance to cover insolvency losses?

Yes, insurers often purchase reinsurance to help fill gaps if another insurer should fail. However, these policies may not cover all potential losses, so guaranty funds remain a vital backstop.

How long does the claims process take in liquidation?

Payouts from insolvent insurers can take 18 months on average, though some claims take several years to finalize. Policyholders need patience as receivers value assets, settle debts, and distribute funds. Filing a claim promptly is important.

What happens to independent agents’ commission payments if their insurer fails?

Commissions owed by a failed insurer become unsecured creditor claims. Unfortunately agents are often at the bottom of the priority list for repayment and have to absorb losses. Guaranty funds do not cover commissions.

Do state guaranty funds ever run out of money?

It is possible but rare. Assessments on member insurers can be increased to cover extraordinary insolvency losses. Most guaranty funds also have lines of credit and other mechanisms to access funds in a crisis.

The Bottom Line

Insurer insolvencies, while troubling, do not have to leave policyholders out in the cold. Oversight frameworks exist to restore or replace coverage. Monitoring insurer financial health remains important, but consumers have resources to get through company failures relatively unscathed. With preparation and knowledge, the protections in place can effectively mitigate risks.