The one financial industry that seems to be dodging the subprime bullet is insurance. Only a handful of companies have had their safety ratings knocked down because of an excessive exposure to Wall Street's toxic waste. The vast majority has enough capital to withstand the known problems on their balance sheets, the rating companies all say.
Nevertheless, you should pay attention to the downgrades when you're shopping for a new insurance policy or annuity. You buy insurance to transfer risk, not to take it on yourself, says David Schiff, editor of Schiff's Insurance Observer, an industry newsletter. You want super safety, from a highly rated firm. With 30 to 50 insurers rated A+ or higher from A.M. Best and AA or higher from the other rating companies, there's no point settling for anything less, he says.
So far, Standard & Poor's has downgraded four life-insurance companies and their subsidiaries, at least partly because of their risky subprime holdings -- American International Group Inc., Beneficial Life Insurance Co., Scottish Re Group Ltd. and Security Benefit Life Insurance Co. Fitch Ratings Ltd. downgraded them, too. Another dozen insurers have been clipped for various other reasons.
Security Benefit specializes in variable tax-deferred annuities. It currently carries ratings in the A-minus to BBB- minus range, with a chance of further downgrades to come.
Those are still investment-level grades (although the BBB- minus barely hangs in there). No alarm bells are ringing for people who already hold insurance and annuities from downgraded players. New buyers, however, have other choices.
Security Benefit President Thomas Swank says that his company is primarily an asset manager and should be judged on performance rather than insurance ratings. Its subprime debt is still performing, he says, and the company has enough assets to back its annuity guarantees.
AIG's problems stem from the insurance against defaults that it sold on investments linked to subprime mortgages. S&P said that if its earnings don't stabilize by the third quarter, it will probably be cut another level, to A+ from its current AA- minus. AIG thinks its capital position is strong enough for an AA-range rating but will consider raising additional capital.
None of the ratings companies say that the insurers are teetering toward insolvency, although more of them will face downgrades if the economy stays weak. The industry is better capitalized than it was a few years ago, says Robert Swanton, managing director of life and health insurance in North America for S&P. Historically, life insurers rarely fail.
That attitude worries Karen Shaw Petrou, managing partner of consulting firm Federal Financial Analytics Inc. in Washington. She thinks that solvency is an outdated yardstick for measuring the health of large, diversified insurance companies, operating internationally and trading in the global derivatives markets. Liquidity has become a risk, too, she says. Like investment banks, insurers could suffer a crisis of confidence that cuts off their short-term funds and interrupts their ability to pay.
At present, failing insurers are managed by the states where they're licensed to do business. But the states aren't equipped to handle too-big-to-fail insurers that present a global investment risk. Petrou thinks that companies like these should come under the purview of federal regulators, who ought to be developing contingency plans.
"We keep learning hard lessons," Petrou says. "Fannie Mae and Freddie Mac were supposed to be bulletproof, too."
If your life-insurance company fails, your state's guaranty fund will step in and transfer the policy to a new insurer. In most states, you're protected for as much as $300,000 in death benefits, and more if the failed insurer has enough assets. If you have, say, a $1 million policy, however, you may be at risk. The policy might be transferred with a reduced cash value, which could lower the benefit if you died. (A few states protect as much as $500,000 in death benefits. Cash values are usually protected up to $100,000.)
Tax-deferred annuities and annuities yielding monthly payments are usually covered for their current value, or as much as $100,000. On larger contracts, monthly payments are likely to be reduced.
Health-insurance guarantees depend on the state. Claims in the pipeline will be paid. Any policy not guaranteed renewable will be canceled.
The guaranty associations don't cover pure variable products such as annuities, whose value is linked to investments. They're held in a legally segregated account, says Joel Levine, senior vice president of Moody's Life Insurance Team in New York. In theory, that should protect an account value from a general failure of the firm.
Pick the best
Hybrid products are another matter -- for example, variable annuities with guaranteed minimum death or income benefits. So far, there has never been a failure involving hybrids, says Peter Gallanis, president of the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA). If the guaranteed portion is backed by the insurance company's assets, the guaranty funds would step in. "It all depends on how the contract is written," Gallanis says.
A separate guaranty fund covers auto and homeowners insurance, usually for $300,000. You're protected only for claims in the pipeline. If your insurer fails, your policies will be canceled immediately. You will have to race for coverage somewhere else.
These risks are remote but why chance them at all? Go for top-rated coverage, every time.
Quinn, a leading personal finance writer, is a Bloomberg News columnist. She is a director of Bloomberg LP, parent of Bloomberg News.