When an Insurance Company Fails

With an insurance company, AIG(AIG Quote), now at the top of the list of major U.S. firms on the verge of financial ruin, it's important to understand what happens when such a company fails.

American International Group is a holding company that owns 71 domestic insurance companies that sell virtually every type of coverage, including life, health, annuities, property, auto, aircraft and product liability.

Insurance companies are regulated at the state level by the insurance department in which the individual subsidiary is based. When an insurance company gets into trouble, the state regulator steps in and takes control of it.

"The state insurance commissioner effectively becomes the CEO of the company," explained Joseph Belth, professor emeritus of insurance at Indiana University and editor of The Insurance Forum.

If the regulator believes that the company has good assets and a strong book of business, the regulator will direct it to be rehabilitated. During rehabilitation, the company is restructured. The company builds capital and cleans up its operations, with the ultimate goal of being released from rehabilitation to operate on its own.

"The commissioner seeks to rehabilitate the company and minimize losses to policyholders, which could include selling all or parts of the company or modifying policy structures," Belth said.

In the case of policy modifications, i.e., lowering of guaranteed interest rates or increasing premiums, Belth said that a court order would be required, and affected parties would have input.

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