Buying an Annuity? Kick the Tires.

Immediate annuities promise that your money will be there when you need it. But many investors are questioning how good those guarantees really are.

The reality is that insurance companies offering annuities can, and have, failed. But policyholders can take comfort from a well-established, industry-financed safety net. Although investments aren't always covered in full, history suggests these annuities are about as safe an investment as you can get without the full backing of the U.S. government.

That said, there's no reason to court trouble. The current environment shows why -- even in good times -- investors should seek out the strongest companies in the marketplace.

A recent Encore column discussed the ins and outs of immediate annuities. These insurance products convert your cash into income that can be guaranteed to last the rest of your life.

Many readers wondered, however, about the safety of insurance companies. And it's no wonder. The near collapse of AIG -- American International Group -- and concerns about other big-name insurers such as Hartford Financial Services and Lincoln National have made headlines.

Is Your Annuity Safe?

"How do you know that the insurance company issuing your immediate annuity will remain solvent?" one reader wrote. "The current economic crisis...gives one pause when considering handing over great amounts of money to any company."

To answer the question, it helps to step back and look at how annuities work.

Annuities are basically IOUs. You hand your money to an insurer, and it promises to pay you back a certain amount at a later date. Your money is pooled with others' and invested. States require life insurers to hold reserves against their obligations and limit the kinds of investments made with the money.

Still, problems arise. This year, Virginia-based Shenandoah Life Insurance was hit by significant losses on investments including mortgage-guaranty companies Fannie Mae and Freddie Mac. The state stepped in, and while the company can't sell new policies, existing holders are being paid.

Others have different troubles. At AIG, the problem was the company's unregulated insurance of complicated financial transactions between big Wall Street firms. The firm's life-insurance operations, while tarnished, aren't seen as in danger of collapse.

At Hartford and Lincoln Financial, the firms were hit with losses from guarantees they sold to variable-annuity holders to protect against drops in the stock market.

When an insurer runs into trouble, state regulators assess if there will be enough assets to pay policyholders. If there is a shortfall -- as is often the case in insolvencies -- there's a safety net in the form of state guaranty associations.

The idea is that between a troubled insurer's own assets and money the guaranty associations can tap policyholders will be made whole. That's usually -- but not always -- the case. In recent insolvencies, about 90% of policyholders have received full benefits, according to the National Organization of Life and Health Insurance Guaranty Associations, or NOLHGA.

As with the Federal Deposit Insurance Corp. protection for bank deposits, insurance associations cap the benefits for policyholders. It varies by state, but the limit on annuities is often $100,000. States have varying rules on the amounts an individual can collect should he or she hold multiple policies from a collapsed insurer.

"We have got plenty of financial capacity backing up this system," says Peter Gallanis, president of NOLHGA. "We're very well positioned to protect consumers under any situations that are likely to develop."

Rely on the Ratings

In the search for the strongest insurers, the primary tools are financial-strength ratings. The reputations of ratings agencies have taken a hit thanks to wrong calls on complicated debt transactions.

But Joseph Belth, publisher of the Insurance Forum newsletter and a long-time professor of insurance at Indiana University, says when it comes to the agencies' assessments of insurers' ability to pay policyholders, "they've done a pretty darn good job."

There are four major ratings companies: A.M. Best, Fitch, Moody's and Standard & Poor's.

Making life confusing for an annuity shopper is that there are often multiple sets of ratings for an insurer, such as one for the debt issued by the holding company and one for the financial strength of the insurer's ability to pay claims.

Worse, each ratings company uses its own scale. The highest mark at A.M. Best is A++, but at S&P, a company with that same rating is several notches down from the top.

And don't rely on one set of ratings, says Mr. Belth. Check the opinions given by each rating company and read the actual reports -- as dense as they may be, he adds. Don't look just at the current ratings; check to see if they have changed in the past six months. If the rating has been lowered it may be best to look elsewhere.

Source: online.wsj.com - 04-26-2009