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With an insurance company, AIG (STOCK QUOTE: AIG), 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.

If the company is in dire financial shape, the regulator will take it over and immediately begin liquidating its assets. The condition of the company and the reason for the regulatory takeover determine how the failed company and its policyholders will be handled.

In the case of a major company failure in which subsidiaries are located in multiple state jurisdictions, one of the states would take the lead in handling the rehabilitation in cooperation with the other state regulators.

What happens to policyholders is a case-by-case situation, but typically, insurance claims continue to be paid. If you hold a life insurance policy and you pass away, the death claim on the policy would usually be paid. If the policy has a cash value, as would be the case with a whole life or universal life policy, the outcome is less clear.

The receiver could, in that case, freeze the cash values and not release them until such time as the assets of the company are valued. At resolution, you could be made whole or receive only a portion of your cash value.

If you own a fixed annuity and you are in the payout phase, the payments would typically continue. What could potentially change is the interest rate that is credited to your initial investment. If the receiver, or a potential buyer, determines that the interest rate is too high, a court order could be issued to lower the crediting rate on that block of annuities.

If you own a variable annuity, it would be slightly different. The assets underlying your contract are separated out from the general assets of the insurance company, so there should be no question of the value of the contracts. Your payout would typically continue, and the value of your annuity would remain tied to the underlying assets.

That all said, being the policyholder of a failed insurance company can be unsettling. One can't know with certainty what will happen, although in most cases, claims continue to be paid. There are nightmare scenarios, such as the Executive Life failures in the early '90s, when policyholders' cash values were frozen for months.

In AIG's case, if the parent company files for bankruptcy, it does not mean that the subsidiary insurance companies are part of that bankruptcy. Conseco (CNO) - Get Free Report is a prime example.

Conseco, a holding company, filed for bankruptcy in 2002, yet the subsidiary insurers were never taken over by state regulators and continued to operate throughout the company's reorganization. The same could happen with AIG because its problems are not within the insurance companies.'s Financial Strength Ratings of AIG's 16 life insurance and annuity subsidiaries in the table below show that the individual insurers are fairly strong, well capitalized and able to pay claims.

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Source: Ratings

The bottom line is that policyholders need to be educated about the strength of the insurance companies they do business with. A company failure could be relatively seamless to a policyholder or it could be disastrous. In the case of AIG, however, the problems do not lie in the insurance companies themselves so there's no need for policyholders to panic. Ratings issues financial strength ratings on each of the nation's 8,600 banks and savings and loans which are available at no charge on the Banks & Thrifts Screener. In addition, the Financial Strength Ratings for 4,000 life, health, annuity, and property/casualty insurers are available on the Insurers & HMOs Screener.