When you’re going to make a decision about purchasing from an insurance company, whether it’s an annuity or a life insurance policy, it is important to make sure that the company is putting enough money in reserve, it is not taking too much risk on your money, and is a highly rated company with a rating of A or better. In this blog, Mel reviews the importance of working with a highly rated insurance company to protect your guaranteed death benefit and lifetime income.
The One Major Difference Between a Bank and an Insurance Company.
This one major difference is going to teach you a lot about why a bank is much riskier than an insurance company when you give them money.
I will share with you about the safety mechanisms that are in place, and why you should feel safe when giving money to an insurance company.
We all know that during the Great Depression that there was a run on the banks.
The banks didn’t have enough money to pay back to people that gave them money, and people lost an incredible amount of money.
So, the Federal Government came along and created the FDIC in order to restore consumer confidence and make sure that they knew that if they gave money to a bank, that that money would never be lost.
You see it on commercials, you see it on TV ads. I mean, everything that you see has FDIC anytime you talk about a bank.
The question that inevitably comes up when we’re talking about insurance products is about what type of protections are in place in order to make sure that the same type of thing doesn’t happen with insurance companies?
And that’s exactly what I’m going to be talking about today.
Leverage vs. Spread
The first thing I want to talk about is this one major difference between a bank and an insurance company, and that is simply how each of those companies make a profit.
This one thing determines why one is taking much more risk with a bank verses a life insurance company.
That is because a bank is making a profit through a mechanism of leverage.
When you give money to a bank, they’re only required to put 10% of that money on deposit.
The rest of that money, they can do whatever they want with. They can loan it out, they could do mortgage loans, when somebody swipes a credit card they’re going to pay it to a merchant and then charge that credit card holder an interest rate.
All these are ways that they can take that money you give them and make a profit on it.
The problem with this is, leverage is risky, and there’s an incentive for these banks to take more risk by having more leverage because they want more profits.
That is exactly why you have to have the FDIC, is to make sure that people have confidence to give banks money because they’re inherently risky.
Insurance companies are a completely different financial institution and they make a profit totally different than banks, which is why they are so much safer.
An insurance company makes money on something called a “spread.” Simple as that.
The way the spread works is that if an insurance company is going to guarantee a policyholder, let’s say a 1% interest rate. Well, that insurance company, let’s say, can earn 2% on the money that you give them.
The difference between those two numbers, which is called the spread of 1%, that’s the profit that the insurance company makes.
What this means is that the insurance company puts a lot more money into their reserve than the bank is required to keep on deposit when you give each institution your money.
These two numbers show you perfectly the risk and why banks are riskier than insurance companies.
Since 2007 which was the last financial crisis, per the FDIC website, 532 banks have gone into protection from the FDIC.
From that same period of time until today, only 19 insurance companies have gone into receivership. And all 19 of these companies are companies you’ve probably never heard of.
I’m going to talk about exactly what happens to those companies when they go out of business. Then explain why anybody who had money with these insurance companies were still made whole through the protections that are available through insurance.
How an insurance company works
The second thing, I want to give you a very simple example of how an insurance company works.
This is very simplified. But remember first that when thinking about this, that a bank is leveraged generally 10 to 1.
If you give a bank $100,000, they’re only putting $10,000 on deposit. An insurance company is much different.
Let’s say that you give an insurance company $100,000, they are guaranteeing you 1%. That 1% is not guaranteed for next year or the year after. It’s guaranteed usually farther out into the future.
In this example, I’m going to use 10 years. So, they are going to guarantee you 1% for 10 years, which means that they’re going to owe you $110,000, 10 years in the future.
So, how much money does that insurance company have to put in their company reserve to make sure that they have enough money for you in the future?
Well, in this example, it would be $74,624.
So, you can see they’re putting so much more money into reserve relative to a bank, which is why they’re safer.
But an insurance company is not going to simply just put $74,000.
They need to be prepared for any type of strains or stresses that happen in the economy or with their business, so they’re going to put more than $74,000.
They might put $80,000 or $81,000 into reserve.
This is one of the main things that determines the rating and the financial strength of an insurance company is how much money they choose to put into their company reserve.
If an insurance company is highly rated, like A + or A ++, it means that they’re choosing to put more money into reserve to make sure that no matter what, they’re going to be able to pay it to you in the future.
Now, what determines this number is based off the interest rate that an insurance company says that they can earn.
You give money to an insurance company, they’re going to take that money and put it into their general portfolio.
Within their general portfolio, they’re going to have a basket of investments. Those investments are going to be things like corporate debt, government debt, treasury bills, bonds, things like that.
They put those all into the basket or the general portfolio, and this insurance company says that they’re currently earning 4%.
That’s how you get to this number because 4% would yield $110,000. That’s why the insurance company puts more in reserve.
The second thing that determines the insurance company rating is their earnings growth projection.
If one insurance company comes along and they say, “Hey listen, we can offer you much more guaranteed income for the rest of your life, ” as an example.
However, the insurance company’s rated much lower. That insurance company might say, “Well it’s because we can earn 5% in our general portfolio.”
What that means is that insurance company is taking more risk with those investments, which means that they are less credit worthy, to get their higher yield they will have to put less money into reserve.
So, that’s how they’re able to do it. They take more risk, they put less into reserve and they pay you out more income. But their credit rating is lower for this risk.
You just have to keep that in mind when you’re looking at the rating of an insurance company. You definitely want to have a highly rated insurance company for anything that’s going to be providing you some sort of guarantee.
Now, the next question that you’re probably thinking is, “Okay, well, what happens if this money goes bad in the insurance company’s portfolio, or they’re not able to earn that 4% rate of return?”
Well, essentially that’s what happened to some of these 19 companies.
Maybe the money that they actually had to pay out in the future ended up being much more than they originally predicted.
That’s why these companies went into receivership. So, what happens to those companies that go into receivership?
First, I mentioned again that all these people were still paid the money that was owed to them, that they were always paid that money, which is a very important thing to know.
FDIC vs. State Guaranty Association
I want to first talk about the FDIC because that’s the thing that most of us are familiar with.
The FDIC, the I and the C in FDIC stands for Insurance Company. So, it’s an insurance company that insures against banks going insolvent.
I think that kind of gives you an example of why insurance companies are safer than banks. But insurance companies do have a safety mechanism as well.
They have something that is called a “State Guarantee Association.” And every single state, no matter where you live, is going to have their own individual State Guarantee Association.
They all have different protection limits. You can find out more information at this website, which is the national website, which is?NOLHGA.com
It’s a great website, has really good information on exactly what I’m talking about today.
Well, if one of these 19 companies wasn’t able to have enough money, then what happens is, all these insurance companies in the entire country, they come together and they pay money into the State Guarantee Fund proportional to the size of the company and how much premium they write in that state.
They make sure that they make these companies whole so that the policyholders receive all the money that they are guaranteed.
In a way, it’s a self-insurance. All the insurance companies insure each other. So, if one goes bad then all of the other ones will make sure that the claims are paid.
During the modern era of insurance, no policyholder’s ever lost any money that was promised to them through life insurance, or death benefits, or guarantees on annuity contracts.
And it’s this mechanism that has enabled that to be maintained for the last 100 years.
When you’re going to make a decision about purchasing something from an insurance company, whether it’s an annuity or a life insurance policy, it’s super-important that you look at the insurance company rating.
You might be told, “Oh, it doesn’t matter. It doesn’t matter if it’s a B-rated company.” It does matter, because that B-rated company is taking a little bit more risk.
If an insurance company is going to be providing you a death benefit that might not happen for 30 or 40 years, or if that insurance company is giving you a lifetime income for your entire life and your spouse’s life. I am sure you will agree with me, it does matter.
Any questions about this article, please call me at 888-839-3536