Are Guaranteed Insurance Contracts Really Guaranteed?

I recently had a question from a client with regard to evaluating a guaranteed insurance contract (GIC) as an investment strategy. I thought it was an interesting topic to share on my PMD blog.

A GIC is similar to a CD issued by a bank, except that GICs are sold by insurance companies. As with CDs, they’re relatively “safe” investments that pay a fixed interest rate over a certain period of time, say one to five years.

The one advantage GICs have over CDs and money market funds is that they generally offer a higher yield than those investment vehicles, typically 0.5% to 1% higher. But before you go out and replace all your CDs with GICs, consider some of the disadvantages.

The foremost disadvantage is counter-party risk, which means you could lose your investment if the insurance company becomes insolvent. GICs are not backed by the full faith and credit of the United States Government and they are not insured by FDIC; they are simply a promise to pay by the insurance company. If the insurance company becomes insolvent, your money could become worthless.

Some would argue that this is a highly unlikely scenario, but they also probably never envisioned the collapse of financial titans Bear Stearns and Lehman Brothers. If you still think the higher GICs yields are worth it, you should occasionally check the stability of the insurance company issuing the contract. I would also suggest that you diversify your GIC positions among multiple insurance companies to help control counter party risk.

Make sure you also take a close look at the fees associated with GICs. Do the math to make certain that the return of a GIC with high fees is still superior to the return of a similar-term CD with low or no fees. You should also inquire about whether there is flexibility to gain access to your money if you need liquidity and consider any possible tax ramifications on your portfolio.

Most important, you should consider the GIC investment relative to your financial planning goals and objectives. Like CDs and money markets, they are designed to preserve your wealth, not substantially grow it. Such short-term investments sometimes don’t even beat inflation.

If you are considering this type of investment, I suggest you limit your exposure to 5-10% of your investable net worth, and couple this strategy with other asset classes to ensure you have a diversified portfolio that can meet your long-term financial needs.