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Recent events have called to mind the Great Depression and that era's run on bank deposits, which forced many financial institutions to close. Younger investors may remember the savings and loan crisis of the 1980s, in which savings institutions were too aggressive in obtaining deposits and making risky loans, forcing many of them to shut down. Numerous small life-insurance companies and other financial institutions have been forced to close due to insolvency.
Until recently, it was easy to think that events like these could never happen again. Yet in order to reassure investors that they can safely entrust their money and assets to financial institutions, regardless of their size, there are a number of different forms of insurance protection that cover various types of financial accounts. Whether you have a bank account, a brokerage account, or a life insurance policy, various organizations stand behind your financial institution in the event of unforeseen problems.
FDIC and bank deposits
As you likely know, the Federal Deposit Insurance Corporation insures bank depositors for amounts as much as $100,000 in the event that a bank fails. Although certain periods, such as the late 1980s and early 1990s, have been particularly bad in terms of the number of failed banks, at least one bank has failed in nearly every year since the FDIC's insurance fund was established in 1934. The FDIC has paid out tens of billions of dollars to depositors during its 70-year history.
For most depositors, $100,000 is more than enough protection for their bank deposits. However, if you wish to keep more money in FDIC-insured accounts, there are a number of things you can do. First, you can keep accounts at different banks. Each bank will have a separate $100,000 insurance limit, so opening accounts at 10 different banks would allow you to keep $1 million in FDIC-insured accounts. Second, by including different names on certain accounts, you can increase the available insurance on your deposits. For instance, you can have an account solely in your individual name with $100,000, a joint account with someone else with another $100,000, and yet another $100,000 account that includes a pay-on-death provision, which instructs the bank to pay the proceeds to the person you designate on your death. By using a series of different account registrations, you can multiply your $100,000 insurance protection many times over.
SIPC and brokerage accounts
With the advent of in-house brokers appearing inside traditional banks, there's a lot of confusion about different forms of financial insurance. According to federal regulations, banks have to be extremely clear that products sold by in-house brokers are not insured by the FDIC, and are therefore subject to market risks of loss. While the FDIC provides blanket protection to all bank depositors with accounts at a failed bank, it doesn't provide any protection to brokerage account owners, even if all of their transactions occurred at the bank. And no one protects investors from bad decisions about what investments they buy.
Brokerage accounts have a different form of protection. The Securities Investor Protection Corporation protects brokerage investors when their brokerage firm fails. However, the SIPC protects investors differently than the FDIC does. Since the FDIC deals only with money deposits, while the SIPC must address not only cash balances but also stocks, bonds, and other securities, this distinction is logical.
In general, when a brokerage firm fails, the SIPC asks a court to appoint a trustee to oversee the liquidation of the firm's assets. If the firm's assets cover the legitimate claims of brokerage customers, the SIPC doesn't need to do anything further. However, if the assets are insufficient to meet customer claims, the SIPC reserve fund will cover the deficiency up to $500,000 per customer, with a maximum of $100,000 in cash claims. In most cases, investors will receive any stocks and bonds they own in kind, rather than having to accept their cash value. Although some types of assets, including future contracts, currencies, and limited partnerships, may not be covered by SIPC, most typical investments are covered.
Guaranty funds and insurance companies
When an insurance company fails, policyholders suddenly bear the risk that promises made by the insurance company will not be fulfilled. After a lifetime of paying premiums, this poses a big problem for insurance owners, who may be unable to find replacement coverage with other insurers.
In order to protect consumers, most states have guaranty funds that cover policyholders in the event that their insurance company fails. While each state's laws are somewhat different, most states cover as much as $300,000 in death benefits for life insurance. In addition, if you own annuity contracts, guaranty funds typically cover up to $100,000 in value.
Although all of these organizations provide some protection for investors, it's still best to avoid having to go through the process of dealing with an insolvent financial institution in the first place. Because most institutions issue their own financial information to the public, you can look on your own to make sure your bank, brokerage firm, or insurance company has the stability and resources to stand behind its assurances to you.
Nevertheless, it's comforting to know that even if the worst happens, your assets will still be protected.
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