During the greatest economic crisis the country has ever known, in response to wave after wave of failed banks, in 1933 Congress and Franklin D. Roosevelt created the Federal Deposit Insurance Corp. (FDIC), a government entity that guaranteed deposits of every American.
The point, of course, was not simply to protect consumers whose banks failed, but to rebuild confidence in the banking system as a whole — to prevent runs on fully safe institutions.
In a speech remarkable for its down-to-earth clarity, FDR explained: “It needs no prophet to tell you that when the people find that they can get their money — that they can get it when they want it for all legitimate purposes — the phantom of fear will soon be laid. People will again be glad to have their money where it will be safely taken care of and where they can use it conveniently at any time. I can assure you that it is safer to keep your money in a reopened bank than under the mattress. The success of our whole great national program depends, of course, upon the cooperation of the public — on its intelligent support and use of a reliable system.”
Today, the FDIC is one of the nation’s most recognized regulatory programs and bank runs are a thing of the past.
Although less heralded, a state-by-state system to similarly protect insurance companies also exists. As the country emerges from its second-greatest financial crisis ever, and as concern about financial institutions occasionally causes glances at insurance companies, it is worth a look at that system and the strong safety net it provides.
Because insurance is regulated on a state basis, the safety net is similarly run by each state. Although there are some technical differences, most states have very similar systems.
To start, unlike other financial institutions, insurance companies cannot go bankrupt. Instead, when a state regulator believes the company lacks sufficient assets to make good on all of its potential claims, he or she will petition the courts to have the company placed into receivership. Assuming the court agrees (and it will), the regulator then takes custody of the company, its operations, and assets.
At this point, a separate state agency — in my hometown, the New York Liquidation Bureau, which I ran for several years — then takes charge of the company. The agency is referred to as a “receiver” and the company, thereafter, known as an “estate.” The receiver will audit the estate to marshal its assets and determine what claims need to be paid.
In a large state such as New York, the receiver will have a team of claims adjusters to review both claims already made to the company and new claims that come in, going forward. The receiver will have a separate group to collect reinsurance, essentially contracts the insurer made with other insurers to cover part of its obligations; insurance on insurance. Because these reinsurance contracts are often an insolvent insurer’s biggest asset, considerable attention is paid to collecting the maximum amount of such assets.
The question you should be asking is what if the various assets — reinsurance, cash on hand, etc. — are not enough to cover all of the claims incurred? Indeed, the fact that the company is in receivership suggests that they are not. This is where the FDIC part of the equation comes into play.
Every state has a security fund (sometimes called a guarantee fund or guarantee association). It is funded by assessments on solvent insurers that pay into the fund for the privilege of doing business in that state. Once the receiver determines that a claim should be paid (remember the team of claims adjusters noted above), the security fund pays the claim, in full, 100 cents on the dollar, up to certain specified limits. In New York, the limit is $1,000,000 on most property-casualty claims and $500,000 on life insurance; it’s lower in many other states. In this way, individual insureds are protected.
The security fund may then, in turn, have a claim against the estate if there are assets available, but that is a fight between the fund and the estate. The insured has been paid and is well out of it.
Like the FDIC for banks, these security funds mean that the average individual with policies will be taken care of, even if his or her insurance company becomes insolvent. Thus, even during the second-worst financial crisis in this country’s history, insurance companies can continue, in FDR’s words, to be part of a “reliable system.” Businesses can count on their policies being covered.
Mark Peters is a partner at the international law firm Edwards Wildman. He previously served as head of the New York Liquidation Bureau, the agency that manages insolvent insurance companies on behalf of the state.