Your Life Insurance Policy May Not Be Protected

An earlier version of this story included a subhead that gave the impression that MetLife is in imminent trouble. This is not the case. As of the end of its 2008 third quarter, MetLife had unrealized losses of $17 billion out of a total investment portfolio of $324 billion. On Nov. 5, Moody's Investor Services affirmed MetLife's Aa2 financial-strength rating, its second-highest rating.

With the financial system in crisis, investors increasingly rely on government guarantees to protect their money. Bank accounts are backed by the Federal Deposit Insurance Corp. and its $53 billion war chest. After decades on their own, money market funds now are backed by the U.S. Treasury. And life insurance policies and annuities? They're backed by state guaranty associations. There's only one hitch: The states have virtually no cash on hand and must rely on promises to pay made by healthy life insurers.

In today's climate, that could be a major problem. Stocks of life insurers, formerly immune to the fear and panic hitting other sectors, recently became the market's target of choice. Shares have declined nearly 50% in the past two months as investors have learned the extent of losses in insurers' investment portfolios. Metropolitan Life (MET), for one, said its debt investments declined $17 billion in the third quarter of 2008. Adding to the pressure, many insurers sold variable annuities with guaranteed-income features, which could cost them an additional $15 billion to support, according to a recent Fitch Ratings report.

So far the system has held up. Insurers are not banks—which can tumble in an instant if worried depositors pull money simultaneously. Insurance companies fail in slow motion, if only because policyholders pay expensive penalties to cancel policies. When insurers do fail, state regulators sell off what they can and bill the remaining life insurers operating in that state to make policyholders whole. "The funds have been pretty good at providing a basic level of consumer protection," says Peter G. Gallanis, president of the National Organization of Life & Health Insurance Guaranty Assns.

But the system runs on the assumption that only small insurers are likely to fail, and then only one at a time. Few noticed in 2007, when Benicorp Insurance in Indiana and Texas-based Lincoln Memorial Life Insurance both flopped.

Sometimes, though, failures are far more substantial. When Executive Life went belly-up in 1991, states couldn't raise enough to cover its obligations. Annuity and life insurance policyholders in California recovered as little as 70 cents on the dollar or were forced to accept modified terms with alternative providers. "I wouldn't put a tremendous amount of credence in guaranty funds," says Adam Sherman, president of advisory firm Firstrust Financial Resources in Philadelphia.

It remains to be seen if the insurance market will further weaken or keep muddling through. But if a large company does fail, certain guaranty funds may not live up to their name. In a handful of states, a single insurer dominates the business, writing nearly one-fifth of the total dollar value of premiums. Even in others, guaranty funds are typically permitted to assess surviving companies only a small amount—about 1% to 2% of premiums per year. "The funds could become exhausted," says Donald Light, an insurance analyst at consultancy Celent.

Insurance customers need to be more vigilant. Stop focusing only on cost and service and start worrying about solvency. Check such agencies as Standard & Poor's (MHP), Fitch Ratings, Moody's (MCO), and A.M. Best to find the highest-rated companies, and be alert for downgrades. Then dig deeper. Find out about an insurer's exposure to real estate and mortgages and make sure its debt holdings are investment-grade. "Everyone's under the false assumption that it doesn't matter what company you buy from," says Thomas Archer, chairman of financial-services firm Archer Financial Group in New York. "It does."