Insurers do fail, and, as a matter of fact, they do fail with a certain frequency. If AIG can fail, then smaller insurers will fail for sure. Partially, this is true, especially because during financial turmoil, credit ratings do not reflect accurately the stability of a company. For instance, AIG held a high credit rating in August 2008 despite the reported losses. However, two weeks later, the company filed for bankruptcy and its credit level was heavily downgraded.

After a prominent insurer’s failure, policyholders worry about what would happen if their insurance company went bankrupt. Because insurers do fail, each state has a regulatory system to regulate the financial deals of the insurers and protect the insured. All state regulatory bodies are ruled by The National Association of Insurance Commissioners (NAIC). Although some states have stricter protections for policyholders than others, insolvencies do occur as a result of multiple operations of insurers in more than one state.

Primarily, state regulators and NAIC require insurers to participate in state guaranty funds so that policy obligations are backed up if any insurance policy fails. In that way, insurers remain solvent and have enough cash for claims coverage.

If an insurer goes bankrupt, claims may be delayed or limited, but, by no means abandoned, until solvency is restored. If, however, after state management the insurer is still insolvent, then guaranty funds are provided by the state so that claims are covered.

Normally, the business of the failed insurer is transferred to other solvent insurers. In the meantime, priority is given to hardship cases, while there are also mechanisms for short-term insurance coverage. If the guaranty funds are not sufficient to fully cover the claim, then the insured would have to pay additional premium in order to get full coverage or accepting coverage at a lower level. If there are no claims outstanding, then the insured seeks immediately for new coverage.

Guaranty funds generally cover auto and home insurance, but they also have exclusions that include life, disability, accident, health, annuities, and mortgage. In the majority of states, the Guaranty Fund System reimburses insured whose net worth tops $25 million.

The policies owned by the bankrupted insurer are honored until the renewal date, unless state regulators suggest alternative options. In any case, there is always a risk involved in finding a new insurer that relates to high risk market realities. Therefore, it is wise, particularly for large amounts of coverage, to thoroughly review the financial solvency of the insurer. A financially sound insurer will rarely fail, unless it gets involved in segments that provide insurance against defaults as it has happened with AIG. However, looking for good information will reveal all factors that determine a firm’s financial condition.

On the other hand, there is the possibility that the transition gap functions in favor of the insured until a new credible and reliable insurer is found and can guarantee claims coverage as a part of the market correction policies.

Without a doubt, insurance insolvency is one of the biggest challenges in the current credit crisis. Going over the current insurance coverage and be aware of how a potential bankruptcy would affect the business is a good tool so that the insured continues having the current insurance coverage.