I have been interested in this topic for some time and done a bit of research. Although I am sure that Brewer has forgotten more than I know on the subject. I also should note I never worked for an insurance company so there is lots I don’t understand about the business.
First it is rare that that people loss money on annuities. Executive Life is by far the largest failure in the last 30 years. While the bankruptcy of insurance companies isn’t uncommon, generally state regulators
find other insurance companies to take the over or transfer policies. . In addition to Exec Life, in doing research I found a handful of other insurance companies bankruptcies which resulted in loses to policy but couldn’t find details. In the case of Exec Life, it was one of the largest insurance companies in CA. It failed in 1991, and lawsuit continue for more than decade. From what I can tell policy holders got between $.40 to $.70 on the dollar, with those over the State Guaranty Fund getting less. What I am unsure from Googling the subject in the past is when did people get paid, getting your money 10 years after the company went may not be very valuable.
As Brewer said policy holders have first claim on companies assets, and much like banks, they have regulators and policy and procedures to make sure they don’t take excessive risks. Still since we have catastrophic failures in the savings loan back in the 1990s and most recently with investment banks in 2008, and the near collapse of bank system and hundreds of individual banks failures since 2008, so some caution is order. After the AIG bailout, I think it is wise to at least question the overall safety of annuities and the life insurance business. Overall I’d be significantly more worried about the safety of an annuity than I would my money in a bank under the FDIC limit.
A few of the things that bother about the insurance business. First that it is regulated at the state level and the competence and professionalism of the regulators varies widely. In most case state insurance commissioner are either an elected official or a political appointee, it is relatively rare that the commissioner has any experience in the insurance business. Like the banking business, insurance business involves a lot of math and finance and in general I worry about the ability of a state to attract the best and the brightest to become insurance regulators. This is especially true for regulating a multinational like AIG, in theory money is suppose to stay in the entity that is licensed to sell insurance in your state. In practice as the Exec Life case proves money is fungible and can be relatively easily moved. Next industry profit margin are pretty small, most companies suffered large losses in 2008 and 2009 and there is a lot of competition.
I also question the value of insurance company rating. The good news is that insurance companies are rated by the major agencies and for the most part the agency ratings are within two notches of each other (a company rated AA by one agency is very likely to be rated between AAA- and A+ by the others). While an agency credit rating is certainly more valuable than assurances from the insurance agent that a company is “rock solid”, forecasting the financial strength of a company 30 years seems virtually impossible for anybody. After the recent scandal where Moody’s S&P, Fitch etc rated securities like CDO as AAA only to seem them turn in toxic waste less than two years later it is hard have a great deal faith in the rating agencies competence. As practical matter it is also very difficult to judge the value of a higher rated insurance company. Imagine a 65 year old couple who sole income is from social security $2K/month and 250K annuity, AAA company insurance says they’ll give them $1200/month AA $1250 and single A company $1300 for joint SPIA. I have no idea if the higher rated insurance company is worth giving up $100 month in income. As people get more comfortable buying stuff over the internet I expect to see less involvement by insurance agents, and more price competition between insurance companies and hence more pressure by lower rated companies to offer better rates.
State guaranty associations are ill equipped to handle failures of large insurance companies and I think a multiple failures would cripple the system. Unlike FDIC insurance where banks pay ~$.25 per $100 worth of deposits into a fund, state guaranty associations are purely reactive. Only after an insurance company starts to go bankrupt does the SGA assess its member for the cost of bailing out the bankrupt company. This works fine for a small insurance company, in the case of Executive Life not so well. Imagine a future financial crisis involving insurance companies, your firm already losing money gets hit with large assessment to pay for other failing firms. Rather than pay the assessment, you elect to stop doing business in the state and leave the SGA. (Sure there is a lawsuit involved) By pulling out you increase the assessment on other insurance companies doing business in the state, potentially leading to a chain reaction of companies leaving the state (much like happened in Florida after a bad hurricane season). Unlike the FDIC insurance fund which is backstopped by Uncle Sam, SGA are not backstopped by states.. Finally as practical matter annuity coverage is pretty low $100K typically with a few states providing $300K this just doesn’t buy you a lot of income. A few years ago I spent 3 weeks trying to contact Hawaii’s guaranty association, I sent 6 emails and made more than a dozen phones calls before giving up and getting my questions answered by a lawyer in Hawaii insurance commissioners office. Given this level of responsiveness for simple questions, I sure would hate to try and get money from them.
In conclusion, in theory I really like the idea of using annuities to provide a base income for somebody in retirement. In practice, I think it is a lot more difficult to do it. It seems me that it most prudent to treat an annuity as bond with the insurance company. Now to be fair, to the inherent protections of insurance contracts make a annuity safer than the equivalent 30 year corporate bond. So from a safety prospective maybe treat an annuity as the equivalent of a muni bond of a similar investment grade?? In today’s interest rates if you limit yourself to $100k per company for a 55 year old couple that is a bit above $4300 income per contract and at ~5K at 65. In some states it maybe hard to find 1/2 dozen insurance companies you want to do business with.
Finally and perhaps most important annuitizing enough to get a decent base income (say 30 to 50K) results in you having a very significant exposure to a single sector; the insurance business. As people heavily invested in tech in the late 90s or those of us in the financial or home builders sector in 2008 found out the hard way, over concentration in a sector is very dangerous. When a sector gets hit, bad companies go out of business, but good companies also get devastated. Often the damage just extends to stockholders, but sometimes bond holders (and I include annuity contracts in this group) also can get hurt. One things that bothers me most about the insurance business is the very high correlation with a retiree’s investment and worries. Worried about an extended period of low bond and equities returns? bad for you and just as bad for insurance companies. What if medical breakthrough find a cure for cancer, heart disease and obesity? It increase your likelihood for outliving your money, but also is horrible news for insurance companies. Worried about cost of nursing homes continuing to rise rapidly? guess what the same insurance company that sold you an annuity probably sold lots of long term care contracts also. In short virtually any financial concern (except for SS payments being cut/taxed) you have in retirement is equally bad news for insurance companies. When people advocate using annuities to minimize investments risk, I fear they are trading one set of risk for another. There will be a future crisis in the insurance business, just like there has been in agriculture, autos, airlines, banks, oil, real estate, technology, textiles..... If we will see it in my lifetime I have no clue