The Magazine

The Meltdown Next Time

The financial danger nobody knows about.

Sep 21, 2009, Vol. 15, No. 01 • By ELI LEHRER
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First, guarantee associations could be pre-funded in a manner similar to the FDIC. New York State has, since the mid-1980s, pre-funded its guarantee associations. The existence of an already-in-place fund greatly decreases the possibility of cascading insolvencies by reducing the need for, and amounts of, sudden assessments. Pre-funding, though, has drawbacks. First, states might raid the funds. In 2006-as several times before-the New York state legislature tried to use the guarantee funds to bail out an ailing workers' compensation fund. Second, the greater costs of pre-funding will almost certainly end up in consumers' insurance bills. And consumers don't want to pay higher rates.

A national guarantee fund with essentially the same structure as the existing state funds is another option. Legislation now pending before Congress proposes one as part of the creation of a federal insurance regulator. The current version of this legislation, the National Insurance Consumer Protection Act, would start a national guarantee fund while still requiring national insurance companies to continue to participate in every state's guarantee fund. Although this would reduce the ability of one company's collapse to have a massive negative impact on large companies or the overall economy, a system of dual guarantee funds could well prove even more destabilizing to small and medium-sized companies than the current system in that it would essentially double their exposure to other companies' insolvencies.

Although no perfect solution exists, the best way to reduce the risks of the guarantee fund system probably lies with trying both ideas: a pre-funded agency for annuity insurance as part of a broader reform of retirement savings and a national fund for everything else.

Pre-funded annuity insurance will almost certainly become a political necessity if the country becomes serious about replacing Social Security. Given the amount of money involved in the collapse of any sizeable annuity provider, the assessments would prove just too much a shock to the insurance system. Such a system would probably have to figure out a way to distinguish between the "insurance" and "investment" components of these annuities and work to provide a partial safety net rather than an absolute "your money is safe" guarantee.

For the automobile, homeowners, and other insurance policies, the national guarantee fund option before Congress would significantly reduce risk. Although the collapse of any enormous insurer would still rattle the system, cascading insolvencies would be very unlikely. The system wouldn't be totally safe, particularly if insurers still had to participate in state guarantee funds, but its enormous assessment base would make it more stable and mitigate a lurking threat to the health of the economy.

Eli Lehrer is a senior fellow at the Competitive Enterprise Institute and director of its Center for Risk, Regulation, and Markets.