How Safe Are Annuities?

Historians are still debating whether the bank failures of the 1930s caused the Great Depression, or whether the Great Depression caused the bank failures.  What is certain is that by 1933, 11,000 of the nation’s 25,000 banks failed and closed their doors, leaving many depositors high and dry.

When the public began to learn of the stock market crash of 1929, they began lining up at the teller window to withdraw their money.  With no money to lend, and outstanding loans going into default, the banks just couldn’t survive.

When Franklin D. Roosevelt became president in 1933, one of his first priorities was to fix the banks.  He declared a three-day bank holiday to stop the run on the banks.  That stopped the bleeding and probably saved around 1,000 banks.  Then, in 1933, the Federal Deposit Insurance Corporation (FDIC) came into being.  Even though banks have failed since then, the insurance program worked and depositors were protected.  After the stock market crash of 2008, FDIC insured bank accounts upped the limit of insurance from $100,000 per account to $250,000.

But that’s banks.  What about annuities.  Are they FDIC insured?  No. Yet, proponents of annuities endorse them as “safe-money” investments in which you cannot lose your principal once you deposit your money unless you withdraw your money prematurely. How is that the case?

Actually, there are more layers of protection for money in an annuity than there are in banks.  First of all, you have the assets of the insurance company itself backing up your investment.

Insurance companies are some of the most highly regulated companies in America.  They are subject to strict capital reserve requirements that are much higher than the capital reserve requirements for banks.  Insurance companies (the only entities through which you can purchase an annuity) are required by law to keep at least a dollar in an untouchable reserve account for every dollar of depositors’ money they have at risk.

Also, insurance companies own corporate bonds that are considered “same as cash” when it comes to safety.  The corporations whose bonds they hold are some of the largest and safest corporations in the world.  These bonds make regular interest payments to the insurance companies who hold them.  Insurance companies also purchase some of the most highly-rated conservative investments available.  A large percentage of the capital of these carriers is placed in U.S. government bonds, which are, of course, backed by the full faith and credit of the United States government.

A much smaller portion of the assets of insurance companies is placed in conservative A-rated investment real estate, such as large office buildings which are occupied by Fortune 500 companies.  Have you ever noticed that when you drive through a major U.S. city the skyscrapers and glass towers are insurance buildings?  In many cases, these properties are fully paid for, which serves to add to an insurance company’s financial security.

Strong Reserves: Which would you say have the strongest reserves, banks or insurance companies?  Insurance companies!  This is one of the reasons why insurance companies are actually safer than banks and why there have been many more bank failures in America than there have been failures of insurance companies.

Example:  If a bank takes in $10 million in deposits, it might make $90 million in loans.  If only $10 millionof those loans default, the bank could exhaust its reserves.   When real estate bubbles burst, banks suffer losses on their loans backed up by property values, forcing them to rely on government bailouts where tax-payers’ money has to be used to keep them solvent.

Remember when mega-banks like Bear Stearns and Lehman Brothers were in the news because their financial foundations were threatened and they called for government bailouts?  That’s because multi-billion dollar investment banks like that use what is called “leverage ratios” of 30 – 1, and even 40 – 1.  In other words, they will speculate with $300 million when they only have $10 million in reserves.  All it takes is a pronounced market reversal to put a large institution such as that on its ear, which is exactly what happened in the market melt-down of 2008.   Insurance companies aren’t able to speculate like that.

Wait a minute!  What about AIG?  Wasn’t it part of that melt-down too?  Yes.  AIG stands for American International Group, not American Insurance Group as many surmised.  While AIG, the giant insurance conglomerate, overinvested in real estate and mortgages in the years prior to 2008, AIG the insurance company that was a very small part of its parent, AIG the conglomerate, was never in trouble.  Even though AIG, the giant insurance conglomerate, had to be bailed out by the federal government after the crash of 2008, the insurance operations were always solvent and stood on their own.

 Can an Insurance Company Fail?

 Can an insurance company fail? Yes. It rarely happens, but insurance companies, if they make bad investments with the profits held outside their reserves, can fail.  The bankruptcy of Conseco in 2002 is a good example.  So what happens then?   If an insurance company does fail then state guaranty associations guarantee your investment up to a maximum amount.  The existence of state guaranty associations should not be a factor in selecting an annuity, but you need to know about them.  Each state has rules administered by the state department of insurance that requires insurance companies to belong to the guaranty association.  If an insurance company fails, policy holders are unharmed because another company steps in and buys that block of business.  It’s just another layer of protection.

In October, 2008, shortly after the market crash, and at a time when the nation was jittery over what financial tower would next collapse, Time magazine’s business and money section ran an article entitled “How Safe Is Your Insurance Company.”  Here’s an excerpt:

 “Unlike the banks that have collapsed or merged under pressure, insurance companies are tightly regulated, mostly by the states. The companies are required to keep vast sums of cash and short term investments to be able to pay off policies, and they are required to pay into state funds to protect policyholders in case one of the companies should ever fail.”