How Safe Is Your Life Insurance Policy?

Question: I've been shopping around for life insurance and want to make sure I buy a policy from a company that will be able to pay if and when the time comes. How do I use a company's financial strength rating to gauge this, and how is it determined?

Answer: The financial health of your life insurance provider is important to consider, but first come bigger questions, such as do you need life insurance, how big a policy do you need, and what type makes the most sense in your case--term, whole, universal, or variable? Once you've answered these questions, it's time to find a policy and a company that fits your profile. This may be done via the many insurance marketing websites or through an agent. In either case, at some point you're likely to be presented with a list of companies and financial strength ratings for each.

Measuring a Company's Financial Strength
Prominent ratings agencies for insurers include Standard & Poor's, Moody's, Fitch, and A.M. Best. These agencies look at an insurance company's balance sheet, business model, and even management in assigning a financial strength rating. So what does a company's financial strength have to do with life insurance? Well, you wouldn't want to buy a policy only to find out the company that sold it to you has run into financial trouble. If in a worst-case scenario your insurer went out of business, not only would you be uninsured but you would also have to reapply for a policy at an older--and potentially more expensive--rate than your previous policy, and your whole life policy could lose cash value. "The financial strength rating in a sense reflects the opinion of the rating firm about the likelihood that the company will financially survive," says Joseph Belth, editor of The Insurance Forum, a monthly newsletter that publishes an annual report on the financial strength ratings of insurance companies.

The agencies use different rating scales, so it's not always easy to compare among them. For example, the top Standard & Poor's rating is AAA whereas the top A.M. Best rating is A++. Also, subtle differences exist at various breakpoints in these scales. For example, in Moody's scale a rating of Baa represents a moderate credit risk, whereas A.M. Best lumps its B++ and B+ ratings in with higher ratings under a grouping labeled "secure." You can check an agency's financial-strength ratings for various insurance companies by visiting the agency's website (registration might be required).

Because ratings can vary from agency to agency, Belth recommends looking at ratings from as many sources as possible before settling on an insurance provider. However, many, if not most, insurance companies aren't rated by any of the large ratings firms, he says. In that case, Belth notes "you're on your own" in trying to determine what the company's financial strength might be. Consumers looking for complete information on the financial health of small, unrated insurers might have difficulty conducting adequate due diligence.

Policies Guaranteed Against Insolvency--Up to a Limit
Although insurance companies do fail from time to time, there is a system in place to ensure that their policies remain in force even after they become insolvent. All 50 states, plus the District of Columbia and Puerto Rico, have life and health insurance guaranty associations that step in to make sure that policyholders aren't left holding the bag if their insurance company becomes insolvent. In that event, the state insurance regulator may oversee a liquidation, at which time the state guaranty association may pay covered claims or transfer policies to a financially sound insurance company, or the association may continue the policies or issue replacements itself. Nearly all life and health insurance companies operating in a state are required to participate in its guaranty association, which means they help fund continued coverage and claims payments when a member company offering the same type of insurance becomes insolvent. In nearly all states, the limits of coverage are $300,000 for life insurance death benefits and $100,000 for the net cash value of the policy; a handful of states have limits as high as $500,000 for each of these. Coverage is provided by the guaranty association in the state in which the policyholder resides, even if he or she purchased the policy elsewhere.

For customers who hold policies worth more than their state guaranty limits, one option is to buy multiple policies within those limits from different companies to reach the desired total amount. So instead of buying a $1 million policy from a single company, you could buy $250,000 policies from four different companies. The downside is that not only is this somewhat inconvenient, but it also might result in paying more than you would for a single policy because of the additional fees involved, not to mention different premium rates.

Large-scale life insurance company insolvencies have become relatively rare. From 1988-2010, state guaranty association members spent about $2.4 billion covering the policies of troubled life insurance companies, the vast majority of that coming in the 1990s following a string of insurance company failures blamed partly on the companies' heavy investments in risky fare such as junk bonds. Although many insurance companies weathered the 2008-09 financial crisis in decent shape, there were exceptions, most notably American International Group (AIG), which had to take $182 billion in government bailouts as a result of bad bets on mortgage-backed securities.

Criticism of Agencies
The ratings agencies are by no means perfect. Many of the same agencies that assign financial strength ratings also assign credit ratings to companies and governments based on their ability to pay back their debts. The collective reputation of these agencies took a hit during the financial crisis when many of the mortgage-backed securities they rated as safe turned out to be junk. Critics also point to the fact that many companies--including insurance providers--pay the agencies to rate them as evidence of conflicts of interest.

The good news is that, despite their problems, the agencies on the whole do provide a good indication of an insurance company's long-term viability. You don't want to be one of the unlucky few who discovers that the policy you bought for you or your family is causing more problems than it was meant to solve. Buying from an insurer with a good financial strength rating is one way to stack the odds in your favor.

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