How Insurance Companies Work

Insurance companies provide financial protection against a variety of potential risks. In exchange for a premium, insurance companies agree to provide specific benefits, such as guaranteed income in the form of an annuity, or legal coverage for liability claims.

Policyholders must continue to pay their premiums to keep their insurance contract in force. Otherwise, the insurance company can cancel the contract. If you stop paying into an annuity, the insurer may charge a surrender fee, which can be up to 7% of the total annuity amount.

Collecting premiums is the main way that insurance companies make money. Premiums are invested in different assets, like stocks or corporate bonds, to generate revenue. The revenue is used to cover operating expenses and pay claims. Investing premiums also enables insurance companies to offer products, like annuities, that provide guaranteed income.

When you purchase an annuity, the insurance company guarantees consistent income payments for the rest of your life. Annuity guarantees are supported through a few different sources, like the insurer’s general account, capital reserves and corporate investments.

All of these financial sources are monitored and regulated by state insurance departments to ensure the company remains financially stable and can meet policyholder obligations. If an insurer becomes insolvent, each state provides some level of financial protection for consumers that are affected.

Keep in mind that annuity guarantees are only as strong as the insurance company that issues the contract. The financial stability of the annuity provider should be top of mind when choosing a company. If something happens to the insurance company, you might not receive the full amount of your annuity benefits.

If an insurance company issuing an annuity is performing poorly or goes bankrupt, a few things can happen. Oftentimes, the contracts are transferred to a different insurance company, which takes over the payouts. If that doesn’t happen, the state guaranty association will step in.

All 50 states and Washington D.C. have a state guaranty association, which covers insurance products that are guaranteed. Guaranty associations collect payments from insurance companies in the state, and distribute the funds to consumers when an insurer is unable to meet its financial obligations.

While state guaranty associations can provide some peace of mind, they don’t provide unlimited protection. Each state association issues guaranteed coverage up to a certain limit, which varies by state. Most state associations guarantee annuities up to $250,000.

When you’re shopping for an annuity, remember that the insurer’s financial health matters just as much as the product features. It’s a good idea to check third-party financial stability ratings from organizations like AM Best, Fitch, Moody’s and Standard and Poor’s (S&P) Global.

Additionally, you should learn about the insurer’s financial reserves and annuity regulations in your state. For example, if you want to purchase an annuity that exceeds your state guaranty association’s coverage limits, you might consider getting several smaller annuities from different companies for more protection.

Annuities are often mistaken for investment products, but they’re insurance products issued by insurance companies. Annuities operate differently than bank deposits or investment accounts.

The main difference between insurance companies and banks is that insurers focus on risk pooling and long-term guarantees, which is why annuities offer benefits like guaranteed lifetime income. Banks and investment firms accept short-term deposits, pay interest on the funds and lend the money to borrowers and investors.

Unlike insurance companies, banks and investment firms don’t collect premiums. Banks make most of their money by charging borrowers higher interest rates than the bank pays on deposits. Banks also generate income by charging customers monthly account maintenance fees, late payment fees, ATM fees and investment fees.

If you’re thinking about purchasing an annuity for retirement income, you might be wondering if your money is safe with an insurance company instead of a bank. The answer is yes, insurers have multiple protections in place to safeguard your money, including regulatory oversight, reinsurance and state guaranty associations.

Banks have similar regulatory requirements and security measures to keep your money safe. But the primary way that banks protect your money is through the Federal Deposit Insurance Corporation (FDIC), which insures deposits up to $250,000 per depositor, per bank. Money that gets deposited into an annuity is not FDIC-insured.

Annuities are generally very trustworthy products. But if you’re considering an annuity for retirement, it’s important to choose the right annuity provider. Not all insurance companies are created equal. When choosing an annuity provider, here are some things to look for:

Editor Norah Layne contributed to this article.