Buying life insurance typically happens at two distinct life stages:
Parents with young children wisely buy a term life policy that will provide financial security for a growing family until the youngest kid is an adult.
Households nearing retirement can buy a straightforward income annuity to cover basic living costs, beyond what Social Security will provide.
In both instances, the purchase involves entering into a long-term relationship with a life insurance company. Your term life policy might be for 20 years or more. If you buy an income annuity in your 60s with a lifetime benefit, payments could extend well into your 90s.
Focus on insurers' financial strength, not just price
Before you purchase any life insurance policy or annuity product from a life insurer, check the firm's financial strength rating. This is a grade given out by credit rating agencies that sizes up a company's ability to make good on all its promised payments.
There are four main rating agencies: A.M. Best, Fitch Ratings, Moody's Investor Service and Standard & Poor's. It's a smart move to check at least two ratings.
If you are working with an agent, they can provide the info for you. Get a rating agency document showing the actual grade; it is not good enough to take an agent's word that it's "highly rated" or "A-rated." You want to see the actual ratings.
Even better, get the info yourself with a quick web search of the name of an insurance company with the added term "financial strength rating." That should lead to the company's website page that clearly displays multiple ratings. If you can't easily find the info on an insurer's website, that's a worthy yellow flag in itself. This is important and basic information that every insurer should be eager to display.
Clear as mud
Because nothing ever seems to be easy in the world of consumer finance, each rating agency uses its own grading system. A.M Best has 15 possible ratings, S&P has 24. The highest financial strength rating given by A.M. Best is A++. From Moody's, Aaa.
You might want to consider sticking with a company with ratings that fall into one of the top three slots from a given rating agency:
A.M. Best: A++, A+, A
Fitch: AAA, AA+, AA
Moody's: Aaa, Aa1 Aa2
S&P: AAA, AA+, AA
That's a conservative guideline. Just keep reminding yourself that you are making a decades-long commitment.
Your state's backup plan
Of course, a company on solid financial footing today may run into trouble years down the line and may be at risk of not being able to pay out claims to existing policyholders. That's not at all common, but it can happen.
In the rare event a life insurer becomes insolvent, state guaranty funds kick into action.
Each state and the District of Columbia has a guaranty association run by the state's (or D.C.'s) insurance department and funded by insurers doing business there. The insurance department for that state typically will try to broker a deal for another insurer to take over the business. But the guaranty association also promises to step in and continue payouts - up to certain limits - to life insurance policyholders if there's ever a problem. These guaranty funds also provide similar protection for health insurance policyholders.
The National Association of Life & Health Insurance Guaranty Associations reports that state guaranty associations have stepped in with nearly $9 billion since 1983 to help continue promised payouts.
Each state's guaranty fund has its own payout limits, and the payouts vary based on the type of policy. You can find out the limits for your state by searching for the name of your state and the term "insurance guaranty association." You can also find links to state info from the NOLHGA website. (Search for "NOLHGA policyholder information.")
If you bought a $1 million term policy and your insurer becomes insolvent, and your family files a claim following your death, they could face a huge disappointment. Typically, for life insurance death benefits, every state association guarantees it will cover death benefits up to $300,000. In Connecticut, Maine, New Jersey, New York and Washington state the death benefit coverage is $500,000. Utah residents may also be covered up to $500,000 in certain circumstances.
And switching insurers can be costly. You paid premiums all through your 30s, say, to one insurer. If you decide to switch, you're now a more-expensive-to-insure 40-something.
You can purchase separate policies from different insurers where no death benefit exceeds your state's maximum guaranty fund payout. Be careful: Buying multiple policies from the same insurer will not help you; the general rule is that the guaranty fund will pay up to the maximum for all policies held by an individual with a single insurer.
If you have a permanent life insurance policy that has an investment component, your state guaranty association will cover cash-surrender values too. The general limit is $100,000, but some states provide up to $300,000 in cash surrender values, and a few provide coverage up to $500,000.
For annuities, the general guaranty association coverage limit is $250,000 in present value of a policy. Want more annuity income? The same strategy works here too: Buy annuities from a few different insurance companies.
Again, insolvency is a rare occurrence. But insurance is not something you want to gamble on. Choosing a life insurer that is on the strongest financial footing right now is a smart safety-first strategy for all life insurance products.