How do insurance companies protect themselves legally and financially?

Insurance companies are not exempt from bankruptcy. However, within the insurance industry, there are safety measures in place to deter the negative impacts of bankruptcy. Insurance companies rely on reinsurance, guaranty associations, and a financial reserve to combat bankruptcy.

Reinsurance is liability insurance for an insurance company. Reinsurance is when an insurance company sells some of the death benefit payout liability of each insurance policy to another insurance company. This spreads default risk across the entire insurance industry rather than remaining within one company.

A guaranty association is essential during bankruptcy. If an insurance company goes bankrupt, another insurance company within the guaranty association will take possession of their issued insurance policies and continue to ensure those policies are enforced as normal.

A financial reserve is excess cash-on-hand to handle financial obligations. A financial reserve is a legal requirement of insurance companies in which there must be a sufficient working capital ratio, or current asset to current liability ratio, of cash-on-hand versus the total current amount of death benefit payout liability. A sufficient current asset to current liability ratio means there must be more than enough cash available to pay liabilities due in the current year.

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