NEW YORK (Money Magazine) - Ironic, isn't it, how investments we considered fail-safe can suddenly lose their air of invincibility? It happened to stocks in the '90s and to bonds late last year as investors began to realize that the long decline in interest rates was likely coming to an end.

Now some people are suggesting that annuities -- investments issued by life insurers and renowned for their security -- should be added to the list. Is nothing sacred?

In the first nine months of last year alone, some $171 billion flowed into annuities. But with insurance companies reeling from the three-year bear market in stocks and nursing losses in bonds, there's a growing concern about insurers' ability to stand behind their annuities.

Given the popularity of annuities, it's time to see whether the apprehension surrounding them is justified or overblown (or, as is often the case, a bit of both). I'll begin with an assessment of the financial health of insurers, then describe what happens to annuity owners if an insurer actually fails and finish up by suggesting ways that you can protect yourself if you own or plan to buy an annuity.

There's no doubt that life insurers have been going through a difficult stretch. In the first 10 months of last year, downgrades of insurer financial strength ratings by A.M. Best outpaced upgrades by three to one, the highest margin in 10 years.

But that hardly means we're about to see a wave of meltdowns like those of the early 1990s. A.M. Best vice president Michael Cohen points out that the insurance industry today has more capital and more liquid assets than it did a decade ago. Despite recent downgrades, he says, the overwhelming majority of companies still have high ratings and are financially sound.

That said, in December, Conseco Inc., a financial services firm with several annuity issuers, filed for bankruptcy; it was unclear what impact that move might have on Conseco's insurance and annuity subsidiaries.

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A relatively small number of other annuity issuers have also fallen to what rating companies consider "vulnerable." While that's certainly cause for concern, such a rating doesn't necessarily mean imminent failure. Cohen estimates that insurers in vulnerable territory have roughly a 3 percent chance of becoming insolvent within three years.

If you happen to own an annuity from a troubled insurer, your exposure varies greatly depending on what type of annuity it is. If you have a fixed annuity -- an investment much like a certificate of deposit -- then your money has become part of the insurer's general account, essentially its main asset base, and is thus linked directly to the insurer's financial health. If general account assets, which are mostly bonds, deteriorate and the insurer goes belly up, you could lose access to your money and possibly suffer a loss.

The story is different for variable annuities. In that case, you've invested mutual-fund-like portfolios that are held separate from the insurer's general account. You can lose money when stocks or bonds tank, but for the most part your annuity remains immune to the insurer's financial woes.

I say "for the most part" because there are ways that variable-annuity holders can get hurt. Most variables offer a "fixed account" option, basically a fixed annuity within a variable annuity. (I'm not making this up.)

Money in a variable's fixed option is treated the same as a fixed annuity. Most variables also come with a death benefit that guarantees that when you die your beneficiary will receive the higher of the market value of your account or your original investment. Payments under that guarantee could be jeopardized.

When an insurer goes under, the insurance commissioner in the state where the company has its headquarters seizes control and, on the strength of an order from a state court, typically places it in rehabilitation.

No, that doesn't mean a trip to the Betty Ford clinic. It's a process of sorting through the assets and liabilities with an eye toward salvaging as much value as possible to repay policyholders. Usually, the first thing officials do is place a total or partial moratorium on withdrawals. The idea is to prevent mass redemptions that would force officials to sell assets at fire-sale prices, leaving less money available for policyholders.

After the North Carolina commissioner placed London Pacific Life & Annuity in rehab last August, for example, holders of fixed annuities were allowed to take out only 10 to 20 percent of the value of their accounts, although they could apply for hardship withdrawals to meet "basic life support needs" or college tuition. North Carolina officials estimate that the moratorium will last two to three years, although the process can drag out much longer.

At Mutual Benefit Life, which failed in the early 1990s, hundreds of thousands of annuity holders had only limited access to their money for some eight years.

During rehab, officials can also lower an annuity's interest payments below the rate the insurer quoted. Similarly, if you have already annuitized -- that is, turned your account value into monthly payments -- officials can cut those payments, as they did at least initially by some 30 percent in the case of Executive Life back in the early '90s. Still, the hope in a rehab is that asset values will eventually rebound enough to cover policyholders.

If a company's problems are so severe that it can't be rehabbed, the insurance commissioner liquidates it. That can leave fixed-annuity holders vulnerable to substantial losses, since the value of the assets that are sold typically falls short of account values.

Once the company is in liquidation, however, a safety net of sorts kicks in. Each state has a guaranty association that steps in to cover policyholders. The coverage varies by state, but generally it's limited to $100,000 in cash value for annuities and life insurance policies and $300,000 for life insurance death benefits.

The coverage for variable-annuity death benefits is murkier, but the $300,000 limit would likely apply. One caveat: If your annuity's rate is deemed unreasonable, some guaranty associations have the right to lower the interest credited to your account retroactively as far back as three years.

Clearly, getting involved with a failing insurer is something you want to avoid. That's why it pays to take some prudent steps to reduce the chances of getting caught up in such a mess.

Stick to highly rated insurers. If you're buying an annuity, limit yourself to highly rated insurers. (For insurer ratings, see the box below.) "There's no such thing as no chance of a company failing," says Joseph Belth, editor of the Insurance Forum newsletter. "But the higher the rating, the smaller the likelihood of failure."

Annuity Check Moody's Investors Service Insurance Forum Ratings Issue Fitch Ratings A.M. Best Standard & Poor's Nat'l Org. of Life and Health Insurance Guaranty Assoc.

If you already own an annuity from a company with a low or vulnerable rating, consider switching to one issued by an insurer with higher grades. That decision can get complicated if you face a surrender charge, or penalty for early withdrawal, which can start as high as 12 percent and take up to a dozen years to disappear. You'll have to weigh the peace of mind of moving your money now against taking a hit on the surrender charge.

Diversify. Just as spreading your money among several stocks protects you from a meltdown in one firm, splitting your stash among annuities from two or more highly rated insurers reduces the odds that all your money will get dragged into a rehab or liquidation.

Resist the impulse to just yank your money. Why? Because if you're under age 59 1/2, you will owe taxes on any gains, plus a 10 percent federal penalty. Consider doing a tax-free rollover, called a 1035 exchange, to a more secure annuity. You may still owe surrender charges, but at least you won't also be shelling out money to Uncle Sam.