You have just received a letter from your state's insurance commissioner, and the news is not good. Your firm's auto insurer is insolvent! You find the letter particularly alarming because you filed a new claim only a week ago. What should you do? Don't panic! Your claim will likely be paid by your state's insurance guaranty fund.
What Is a Guaranty Fund?
A guaranty fund (or guaranty association) is an organization established by state law. Its purpose is to protect policyholders from insurer insolvencies. It pays claims an insurer would have paid had it not become financially impaired. The fund is typically governed by a board of directors elected by participating insurers. It is overseen by the state insurance commissioner.
Guaranty funds exist in all fifty states, as well as Puerto Rico and Washington D.C. Most states maintain separate funds for property/casualty insurance and life/health insurance. This article will focus on the former.
To deal with insolvent insurers, many states have passed a guaranty law based on a model act drafted by the National Association of Insurance Commissioners. Some states have enacted the model act "as is," but most have passed a modified version.
Insurers are required to participate in a state's guaranty fund if they are licensed to do business in that state. An insurer licensed in all 50 states must participate in a fund in each of those states. Only licensed insurers are subject to the guaranty law. Unlicensed insurers (such as surplus lines carriers) are not. Thus, if your business is insured by a non-admitted insurer that is declared insolvent, you cannot seek coverage for unpaid claims from your state guaranty fund.
Some states require employers that self-insure their worker's compensation obligations to participate in a guaranty fund for self-insured employers. The fund pays benefits to workers if their employers are unable to pay due to bankruptcy or insolvency.
How Funds Have Evolved
A few guaranty funds were created in the 1940s, but most emerged in the 1960s and 1970s when insurer insolvencies began to rise. Initially, states maintained a single fund to cover one line of business, such as workers compensation or personal auto insurance. Insurance companies were relatively small. Many wrote one line of business in a single state. If an insurer went bankrupt, only a limited number of policyholders and one state fund were affected.
Nowadays, many states maintain several guaranty funds. For instance, a state might operate separate funds for auto insurance, workers compensation, and other lines (including general liability and commercial property coverages). Insurers are much more complex than they were 40 or 50 years ago. Most offer a variety of coverages in multiple states. Some insurers write policies in virtually all states. Thus, insolvency that occurs today may affect numerous policyholders and involve guaranty funds in many different states.
When an Insurer Fails
The Insurance Information Institute cites a number of reasons why an insurance company might fail. These include insufficient claim reserves, too-rapid growth, inadequate rates, insurance fraud, and poor management. Many insurer insolvencies result from a combination of factors.
State insurance departments oversee insurance companies to ensure they are financially sound. To that end, they require insurers to submit periodic financial statements. If a regulator believes an insurer has become financially unstable, he or she may take control of it by obtaining a court order. If the insurer's financial situation can be improved, the regulator might attempt rehabilitation. If the insurer cannot be rehabilitated, or if the attempt to rehabilitate it fails, the regulator may ask the court to issue an order of liquidation.
Once the order has been issued, the regulator may administer the liquidation himself or delegate this task to another party (called the receiver). The receiver distributes the insurer's remaining assets to creditors under a plan approved by a court. The receiver notifies policyholders that the insurer is being liquidated and that claims will be paid by the state's guaranty fund. The receiver also notifies policyholders of the date on which their policies will be canceled.
How Funds Are Financed
Most states operate guaranty funds with money obtained from assessments on insurance companies. The assessments are typically made after an insurer has been declared insolvent. This means that insurers might be assessed in 2017 for insolvency that occurred in 2016. Insurers are subject to assessments only if they write the same line of business as the defunct company. That is, insurers that write workers compensation insurance are assessed if a workers compensation insurer has become insolvent. Likewise, auto insurers are assessed following the demise of an auto insurer.
Once an insurer has been declared insolvent, the insurance department determines the value of the company's remaining assets. It then calculates the amount of money the guaranty association will need to pay claims. This amount is assessed by insurers. State laws typically specify a maximum amount that insurers may be assessed. This is typically one or two percent of an insurer's net written premium.
Most states permit insurers to recoup the money they've been assessed via one of the following methods:
- Increased premiums
- Surcharges on policies
- Offsets on premium taxes
New York is the only state that does not make post-insolvency assessments. Instead, the state maintains a fund using the money it collects from insurers. If an insurer becomes insolvent, the fund is used to pay claims on that insurer's behalf. If the fund drops below a certain amount, more money is collected from insurers.
Claims Covered By Guaranty Funds
Guaranty funds pay some, but not all, types of claims. Most exclude claims filed by self-insured employers. Some also exclude certain lines of business, like surety and credit insurance. Some guaranty funds exclude punitive damages.
An insured business is generally covered by the guaranty fund operated by the state in which the business is located. However, workers compensation claims are administered by the guaranty fund of the state where the claimant (employee) resides. This means that a claim filed by a worker who lives in Missouri will be handled by Missouri's guaranty fund, even if the employer is based in another state.
Guaranty funds pay both first-party and third-party claims. If a liability claim has been filed against your firm and defense is needed, the fund will pay your defense costs. Most guaranty funds specify a maximum amount they will pay for any claim. The most common limit is $300,000. The fund will not pay any portion of a claim that exceeds the specified limit. Thus, some policyholders may collect only a portion of the claim payments they are owed. However, no limit applies to workers compensation claims. Such claims are typically paid in full.
To be covered, claims must generally occur on or before (or within 30 days after) the date of the order of liquidation. If your policy expires before the 30-day period has passed, your coverage will end on your policy expiration date. You must obtain replacement coverage from another insurer promptly to avoid uninsured losses. Guaranty funds do not write new policies.
Claims may be paid 30 to 90 days after the liquidation has been declared. Some claim payments may take longer. Liability claims generally take longer to settle than property claims.
Many states prohibit businesses from seeking coverage from the guaranty fund if their net worth exceeds a specified floor, such as $25 million or $50 million. These caps are based on the concept that well-capitalized businesses have the financial wherewithal to absorb unpaid claims. They don't require the same amount of protection as smaller businesses.
Some guaranty funds provide reimbursement of unearned premium. Unearned premium means premium you have paid for coverage you have not received because your insurer is insolvent. For instance, suppose that your firm pays a $5,000 premium for a policy that runs from January 1, 2017, through January 1, 2018. Your insurer is declared insolvent on July 1, 2017, and your policy is canceled effective that date. You paid for twelve months of coverage but have received only half that amount. You may be able to recoup $2,500 in unearned premium from your state's guaranty fund. Many guaranty funds impose a limit (such as $10,000) on the amount of unearned premium you may collect.