Posts Tagged ‘Insurance companies’

What Happens to Insurance Companies in a Financial Crisis?

Wednesday, September 17th, 2008
New York Stock Exchange, A Photo I Took Not Far From My Office

New York Stock Exchange, A Photo I Took Not Far From My Office

On Monday, I was in the Wall Street area where the mood was decidedly somber. I was standing at one of the street food vendors buying lunch when I saw CNBC anchor Dylan Ratigan leaving the New York Stock Exchange and entering the Wall Street subway station. CNBC interrupted its ordinary broadcast that evening to provide programs with experts discussing the concerns about the safety and soundness of our Wall Street institutions with specific reference to Lehman Brothers and AIG. Later that evening, one of the cable television networks (NOT CNBC) featured a guest commentator urging that the federal government “rescue” AIG because it is the world’s largest insurance company and policyholders must be paid. For people in the Gulf Coast and the Mid West recovering from Hurricanes Ike and Gustav and the associated flooding, the failure of an insurance company at this time is the last event they want to contemplate. Let’s try to separate the facts from the cable television theatrics to examine what the real issues are.

When insurance companies write business, they collect premiums and set aside required reserves to cover future losses. That is the first layer of protection for the policyholders: those reserves are set aside for their benefit. They are not available to retire other financial obligations of the company. Second, states have policyholder guarantee funds for life insurance companies to provide an additional level of security in the event of insolvency. Third, insurance companies pay premiums for reinsurance coverage, which provides an additional layer of capital available to pay claims. In the event that an insurance company becomes insolvent, the reinsurance company is not relieved of its obligation to pay the claims to the ultimate beneficiaries – the policyholders. What would happen in such an event is that the state insurance commissioner would establish a trust and appoint a trustee to oversee the orderly liquidation of the insurance company. The reinsurance company, or companies, as insurers often buy layers of capital protection from multiple sources, would pay their required claims into the trust in lieu of to the insurer and the trust would pay the policyholders. Finally, the insurance commissioner would likely to try arrange the sale of the insurance company’s operations to a financially sound insurance company which would then assume all of the liabilities for the policyholders it would acquire (along with the associated reserves).

With specific reference to AIG (American International Group), it has many subsidiaries operating in many different financial sectors, some of which are insurance companies. But the assets and the liabilities of these businesses are not fungible. The assets of its property-casualty insurance companies, for example, are held separately from certain of its other businesses that have exposures to the sub-prime mortgage market. More broadly, with respect to any corporate restructuring, there are different classes of constituents that have claims against a company should it go into bankruptcy: employees, creditors, suppliers and vendors, stockholders and, if the company is an insurance company, policyholders. In all cases, the policyholders’ claims are senior and superior to all others. They will be paid first. The cable television commentators I observed on television appeared to have confused the risks for the policyholders with those of the stockholders, bondholders and employees. They are certainly not the same. Nevertheless, the financial crisis underscores the importance of the advice we gave in the first (published in 2002) and second (published in 2008) editions of the book: consider the financial strength and claims paying ability when selecting an insurance company.