Insurance Guaranty Funds
Released: 2008-02-27T00:00:00

Revising Insurance Regulation: The Debate1

Proponents of federal regulation of insurers make analogies to banks and their regulation. They argue that insurers, like banks, should be allowed to elect whether to hold a state or a federal charter and to reap the perceived benefits of choosing their regulator. The analogy of insurers to banks is useful—insurers and banks are both financial intermediaries performing similar important functions in the U.S. economy. They are also both so important that our society has constructed protection for consumers holding contracts with insolvent financial intermediaries of both types. The federal insurance funds of the Federal Deposit Insurance Corporation (FDIC), the Pension Benefit Guaranty Corporation (PBGC), and the National Credit Union Share Insurance Fund (NCUSIF) provide similar protections. They operate differently, however, than the state-based system of insurance guaranty funds. These differences may gain significance if Congress considers federal regulation of insurers.

How Insurance Guaranty Funds Work

Provision for policyholders of insolvent insurers began slowly in the late 1930s. By the 1950s, some states had security funds for disabled workers covered by insolvent workmen's compensation insurers, and a few had similar provision for policyholders of insolvent automobile insurers. Then, in the late 1960s, Congress considered creating a federal fund, similar to the FDIC, to protect all property-liability policyholders. State regulators and insurers objected to federal regulation, and they cooperated to create a model law that at least 47 states had enacted in some form by 1974. Most states did not enact life and health insurance guaranty fund laws until after the Baldwin-United insolvency in 1983 and the Executive Life insolvency in 1990. All states had enacted life and health insurance guaranty fund laws by late 1992.

Three principles guided the drafters of both model laws: policyholders should not lose their risk protection upon insolvency; losses due to insolvency should be shared; and claim payments should not be unduly delayed by an insolvency. These principles operate differently in property-liability insurer insolvencies than they do in life and annuity insolvencies, as discussed below. Property and liability coverages are short-term contracts, usually no longer than one year, while life and annuity contracts are long-term contracts, often for the life of the insured.

Under both model laws, once the home state insurance commissioner determines that the insurer—whether property-liability or life—is financially troubled, the commissioner is required to take steps to protect policyholders and claimants. The commissioner can order the insurer to take corrective steps and to suspend business. The commissioner can petition a state court either for an order of rehabilitation, if it is determined that the insurer's problems can be corrected, or for an order of liquidation, if it is not. The court's order of liquidation appoints the commissioner as liquidator, and the commissioner appoints a receiver. The receiver takes possession of the insurer's offices, records, and assets. Assuming the records are adequate, the receiver advises policyholders and claimants of the insurer's liquidation and of the process for filing a claim against the insurer's estate.

Cooperation among the states where the insolvent insurer operated is essential. Usually the insurance commissioner in the insurer's state of incorporation—known as its "domicile" or "domiciliary state"—petitions first for an order of liquidation from a state court in that domicile, and that court retains principal jurisdiction over the insurer's liquidation. The domiciliary insurance commissioner also appoints the lead receiver. Insurance regulators in the other states where the insurer operated will appoint ancillary receivers, after entries of orders of liquidation in those states. The lead and ancillary receivers cooperate, with the assistance of the guaranty funds and the national associations of guaranty funds.

The order of liquidation in each state generally triggers the operation of that state's guaranty fund, though the trigger varies by state. Each guaranty fund is a mandatory association of all licensed insurers doing business in that state. Each fund has a board of those insurers, and the board governs the fund. An accumulation of money does not actually exist until after the insolvent's liabilities and assets are evaluated, each participating insurer is billed for its proportionate share of the shortfall, and each insurer remits its allocated share for that particular insolvency. The "fund" is the sum of those remittances. The term "guaranty fund" can also refer to insurers' statutory obligation to participate in this protection system. In general, each state's guaranty fund is responsible for the policyholders residing in that state, and the protection extends only to policyholders of licensed insurers within the limits of statutory coverage in that state of residence.

Property-Liability Insurers

The entry of an order of liquidation of a property-liability insurer typically terminates all existing property-liability policies within 30 days, though the insurer remains liable for any claims that arose before the order. The order usually prohibits the insurer from issuing any new policies, and it suspends all claims payments to allow an orderly and equitable evaluation of the insurer's liabilities and assets. State laws give policyholders' claims on the assets precedence over general creditors, but not over the expenses incurred by the liquidator, receiver, and guaranty associations.

The entry of the order of liquidation obligates that state's property-liability guaranty association to begin processing claims from residents, though it is not obligated to cover all claims. For example, most states' laws usually cap coverage at $300,000 and exclude claims for punitive damages. The property-liability insurers that are members of the guaranty association assess themselves proportionate to their premium volume in that state to fund the difference between the insolvent's assets and the residents' claims. The assessments are imposed first on the particular type of property-liability insurance that occasioned the insolvency and are limited to 1% to 2% annually of each insurer's premium volume in that line in that state. If that assessment proves insufficient, then other types of property-liability insurance—known as "accounts"—may be assessed as well. Most states allow assessed insurers to include the assessments in their rates, though some states allow insurers to surcharge policyholders or offset the assessment against their premium taxes.

Life Insurers

The entry of an order of liquidation of a life insurer, in contrast, does not cancel life or health insurance policies or annuity contracts. The rationale is that, unlike property-liability coverage, which an insured may replace easily, life and health insurance and annuity contracts may be difficult to replace. The model law's drafters decided that, to preserve the policyholder's risk protection through an insolvency, coverage issued by a life insurer should be continued through an insolvency. In practice, life insurance guaranty associations often meet this obligation collectively by selling or transferring the covered policies to another life insurer.

As with property-liability insurance, there are limits on life insurance guaranty fund protection. Generally, $300,000 is the limit on life insurance death benefits, $100,000 is the limit on cash values in life insurance and annuity contracts, and $100,000 is the limit on health insurance policy benefits. Most states' laws cap coverage for any one life at $300,000, though some states have higher limits. Guaranty association coverage usually extends neither to any policy or portion of a policy in which the policyholder bears the investment risk, nor to HMOs.

Also as with property-liability insurance, licensed life insurers in each state assess themselves for the shortfall. Typically, assessments up to 2% of each life insurer's premium volume, by type or "account," are imposed annually. If that assessment proves insufficient, then other types or accounts may be assessed. Most states allow life insurers to recoup those assessments by offsetting up to 20% of the assessment against their premium taxes for five years.

Other Financial Intermediaries' Protection Systems

The FDIC protects deposits in banks and savings associations. The Pension Benefit Guaranty Corporation (PBGC) protects participants in defined benefit pension plans. The National Credit Union Share Insurance Fund (NCUSIF) protects "share" accounts in credit unions. Each represents legislative interest in maintaining confidence in financial intermediaries and legislative choices about how to spread potential losses should a financial intermediary fail, as does the insurance guaranty fund system.

Unlike the insurance protection system, however, the FDIC, PBGC, and NCUSIF are all congressionally created protection plans and are administered federally. There are other differences among the protection systems, too, including whether the protection fund exists before the insolvency, whether the contributors to the fund pay based on the risk each presents to the system's solvency, and whether those contributors can recoup the costs of their payments to the system.

The similarities and differences among the various protection systems are summarized in a chart in the Appendix .

Policy Issues

Opinions differ markedly over whether the current insurance guaranty fund system functions well or poorly. Supporters say that the current system has been very effective. The President of the National Conference of Insurance Guaranty Funds (NCIGF) notes that funds have paid out about $21 billion in claims that would have gone unpaid in the last four decades. The National Organization of Life and Health Guaranty Associations (NOLHGA) indicates that, since 1983, guaranty funds have protected 2.2 million policyholders by guaranteeing more than $21.2 billion in benefits and contributed $4.4 billion to ensure that policyholders received their benefits. Some critics of the current state insurance guaranty fund system say it is inefficient, slow, parochial, and fragmented, and they urge that it be replaced with a federal system or significantly reformed. Other critics say the existence of guaranty funds distorts incentives by allowing some insurers to increase risk-taking behavior and by imposing the costs of that behavior on more conservative insurers. The critics say that the current system "provide[s] a powerful risk subsidy incentive that [solvency] monitoring does not entirely offset." That effect is exacerbated by flat-rate assessments, they say. These critics argue for risk-based assessments similar to that required by the FDIC. One critic has observed that incentives are further distorted by "the existence of tax offsets and by the insurers' ability to pass some of these costs to policyholders."

Whether to change the current system of policyholder protection would be a significant policy issue in any legislation to authorize or require federal regulation of insurers. In the 110 th Congress, Senators John Sununu and Tim Johnson introduced the Senate version of the National Insurance Act of 2007 ( S. 40 ), and Representatives Melissa Bean and Ed Royce introduced a House version ( H.R. 3200 ). Both bills would require all federally licensed insurers to participate in state guaranty funds, with the possibility of a federal guaranty fund if the state guaranty funds do not treat national insurers in the same manner as state insurers. Versions of the National Insurance Act ( S. 2509 and H.R. 6225 ) were also introduced in the 109 th Congress, by Senators Sununu and Johnson and Representative Royce.

In the 108 th Congress, Senator Ernest Hollings introduced legislation ( S. 1373 ) to require all interstate insurers to be federally licensed and regulated. It would have established a pre-funded national insurance guaranty association and required all interstate insurers to pay into the fund. In the 107 th Congress, Representative LaFalce introduced legislation ( H.R. 3766 ) to allow insurers to elect federal licensing and regulation. It would have required all insurers electing federal regulation to participate in state guaranty associations. Senator Chuck Schumer proposed similar legislation in the 107 th Congress to create an optional federal charter for insurers. It also would have required federally regulated insurers to participate in a state-based system of policyholder protection operating generally as it does now.

Some of the policy issues that Congress might confront should it consider federal chartering for insurers are as follows:

Should federal legislation create a federally based protection system for federally chartered insurers, or instead require them to participate in the state-based guaranty fund system?

Creating a federally based protection system would entail direct federal costs at least for establishing and maintaining its administrative infrastructure, even if the system were administered by the FDIC. Requiring federally regulated insurers to participate in a state-based protection system would entail significant, though unquantifiable, indirect costs to policyholders, insurers, and taxpayers. This is because incentives would be misaligned: that is, the costs of insolvencies would fall on the states, not on the federal regulator, and the states, though bearing the financial burden, would have no control over the effectiveness of federal regulation for solvency. These conflicting objectives could create the potential for significant economic inefficiencies.

If Congress considers federal regulation of insurers, should it also consider creating a federal system of policyholder protection?

Creating a federal policyholder protection system for federally regulated insurers might stress the federal budget and arguably undermine market discipline. On the other hand, it might more directly align behavioral incentives, because a federal regulator would have both the responsibility for regulating for solvency and the responsibility for all or some portion of the unfunded claims of an insolvent insurer, as well as for administering the liquidation.

Should any federal system of policyholder protection include or exclude state-regulated insurers?

Including state-regulated insurers in any federal policyholder protection system could distort incentives, because it would bifurcate the responsibility for solvency regulation of state-charted insurers from the consequences of any failure of that regulation. On the other hand, excluding state-chartered insurers from any federal system might destabilize either or both of the federal and state protection systems. This is because fewer insurers would be members of either system, which would mean that any assessments would be imposed on a reduced premium base.

If Congress were to create a federal protection system, what limits should apply?

The principal issues would be deciding what types of policyholders would be protected in the event of an insurer's insolvency and what the limits on their recovery should be. This would be challenging, especially for property coverages for regional disasters, such as earthquakes and hurricanes, and for business liability coverages. Also, if Congress wished to protect only policyholders of federally regulated insurers, then constituents might have different levels of protection depending on whether their insurers were state-regulated or federally regulated. Alternatively, Congress might require states to adopt levels of protection identical to the federal levels.

If Congress were to create a federal policyholder protection system, should it be pre-funded or post-funded?

Insurers would likely argue strongly for post-funding, as they have been historically averse to paying for any government-held fund. Their competitors in the financial intermediation marketplace, such as banks and savings institutions, might argue that insurers should be subject to pre-funding like themselves. There would be technical issues, too, such as whether to maintain separate funds for life insurers and property-liability insurers and how to calculate an appropriate fund balance.

If Congress were to create a federal policyholder protection system, should an insurer ' s assessments be based on its risk profile?

Though some argue that flat assessment rates dilute market discipline, determining how to profile insurers' risks could become technically complicated and politically contentious. Insurers are required currently to hold additional capital based on their risks. Very generally speaking, life insurers calculate that additional required capital based on a categorization of the riskiness of their investments, and property-liability insurers calculate it based on the types of insurance they underwrite and their past experience in each line of insurance. Whether analogous calculations would be feasible for guaranty fund assessments has not been studied.

Other issues would include whether insurers should have access to the Federal Reserve Board's discount window and the relationship of any federal system of policyholder protection to the FDIC.

Conclusion

Whether to maintain some level of policyholder protection against insolvency may be a significant issue in any congressional consideration of federal regulation of insurers. How to offer that protection will likely entail more difficult decisions. Policy considerations could include whether to offer federal protection or to require federally regulated insurers to participate in the existing state system. Should Congress decide to offer federal protection, technical issues could include how to fund the protection, its scope, the location of the administering agency in the executive branch, and how to enforce market discipline fairly.

Appendix. Comparing Features of Various Protection Systems