• AIG'S Financial Troubles: What Do They Mean for Me?
  • November 10, 2008 | Author: Damian J. Arguello
  • Law Firm: Davis Graham & Stubbs LLP - Denver Office
  • Who is AIG?

    American International Group (“AIG”) is an insurance and financial services conglomerate that was once the largest insurer in the world.  The AIG member companies include individual insurance companies within its Commercial Insurance Group (the “CIG”), as well as subsidiaries in such diverse businesses as personal insurance, aviation, and financial services.  The CIG includes business insurers AIG Environmental, Lexington Insurance Company, and National Union Fire Insurance Company of Pittsburgh. 

    What happened to AIG?

    AIG has faced a spate of problems since 2005.  Since February 2005, AIG shares have plunged from $73.46 to close at $3.51 on October 7, 2008. 

    On September 16, 2008, the Federal Reserve announced an unprecedented $85 billion emergency “bridge loan” credit line to AIG.  In turn, the U.S. government took a 79.9% equity stake in AIG.  The Fed also replaced AIG’s chairman and CEO with Edward Liddy, the former Chairman and CEO of Allstate Corporation.

    What caused this crisis?

    The predominant cause is that certain AIG member companies oversold a form of unregulated quasi-insurance called credit default swaps (“CDSs”) to banks, hedge funds, and other financial institutions. 

    How insurance works.

    To understand AIG’s problems, it is helpful to understand generally how insurance works.  Insurance is a risk transfer mechanism whereby policyholders transfer their risk of loss to an insurance company.  For example, an insurance company sells fire insurance to numerous homeowners around the country, betting that only a few of those homes will actually burn down.  If the insurer prices the policies correctly, the premiums will exceed the paid losses, resulting in a profit.  The insurer relies on the fact that a house fire in one part of the country is extremely unlikely to result in a fire elsewhere.

    What is a CDS?

    A CDS is a form of private, quasi-insurance for credit-related losses.  For example, banks that issued subprime mortgages turned to other banks, hedge funds, and other institutions to insulate themselves against the possibility that homeowners would default on those mortgages.  They paid a little money –quasi-premiums – in exchange for promises that the CDS seller would pay some agreed-upon portion of the default.  Similar CDSs are exchanged for other types of debt as well.  These arrangements are private because banks and hedge funds buy and sell CDSs amongst themselves, not through an exchange.  By some estimates, the CDS market grew to over $62 trillion by year-end 2007.

    AIG’s role in the CDS market.

    Certain AIG member companies sold CDSs to banks, hedge funds, and other institutional investors.  Unlike the more mainstream insurance products sold by the CIG and other subsidiary insurers, these quasi-insurance products are not regulated by state insurance departments or the federal government. 

    AIG did not sell CDSs through its state-regulated, domestic insurance subsidiaries.  However, AIG treated CDSs like other forms of insurance, relying on the theory that one credit default is unlikely to result in another.  Unfortunately, unlike house fires, financial markets are interconnected, and one credit default tends to cause other defaults.  Thus, AIG was the last link in the CDS chain, the ultimate guarantor for large numbers of credit defaults.

    When the housing and mortgage markets collapsed, holders of mortgage-backed securities incurred huge losses and called upon AIG to pay up.  As AIG’s losses mounted, its credit ratings fell and it was required to post additional collateral for its outstanding bonds.  AIG could cover neither its CDS obligations nor its collateral requirements.  Consequently, AIG’s failure was imminent, necessitating the Fed’s bailout. 

    Why does this matter to me?

    If you are an AIG policyholder:

    If an AIG insurance company insures you, there appears to be no immediate danger of unpaid claims.  The $85 billion Fed bridge loan appears to have stabilized AIG for now.  Additionally, AIG subsidiary insurers, including the members of the CIG, are regulated by the insurance departments of the states in which they are domiciled.  These insurance departments require them to maintain reserves and surplus to cover their estimated claims.  Thus, these companies are well capitalized and generally performing well.

    On October 3, AIG announced that it intended to retain its core U.S. insurance businesses (including the CIG), and retain an interest in its foreign insurance operations.  AIG is exploring divestiture of all other businesses, including its personal insurance operations, in order to repay the $85 billion credit line, which AIG has drawn down by $61 billion. 

    However, ratings agencies A.M. Best and Standard and Poor’s have questioned AIG’s ability to divest itself of various assets.  This leaves open the possibility that AIG could eventually sell off its core insurance units at some point to repay the bridge loan.  This could mean that the CIG members and other subsidiary insurers would be acquired by AIG’s competitors.  In turn, this could affect the subsidiary insurers’ financial stability and ratings. 

    Moreover, potential suitors for AIG subsidiary insurance companies are facing their own credit-related crises.  For example, on October 3, The Hartford Insurance Group announced that it accepted a $2.5 billion cash infusion from competitor Allianz AG in exchange for a stake in the company, spurred in part by The Hartford’s troubled mortgage-backed securities portfolio.  Thus, while there appears to be no immediate danger, you should continue to monitor the situation to see how AIG fares in its disposal of non-insurance assets.

    If you are not an AIG policyholder:

    Even if you are not an AIG policyholder, your insurance could be affected by virtue of reinsurance arrangements.  Insurance companies “cede” portions of their claim liabilities to other insurers under reinsurance “treaties.”  This dilutes the effect of major claims by broadly spreading the risk through the insurance market.  AIG subsidiary insurers reinsure portions of their claims with other insurers, and those other insurers in turn cede portions of their claims to AIG subsidiary insurers.  Thus, to some extent, these recent events may affect your insurance policies even if they were not issued by AIG subsidiary insurers. 

    More broadly, because AIG is a dominant force in the insurance and financial services industries, if it failed, the effect could cascade through the global economy.  For example, the institutional investors to whom AIG provided security for credit derivative losses would be forced to bear the full brunt of those losses, causing further losses and bank failures.  Many analysts noted that the Fed’s swift action immediately after announcing that no further bailouts would occur is a strong signal of AIG’s importance to the American and global economies. 

    What is the outlook for AIG now?

    As noted above, the Fed’s emergency bridge loan is expected to stabilize AIG in the short run and allow it to orderly divest certain assets.  However, there are no guaranties that the strategy will work, and a possible AIG bankruptcy remains a concern. 

    However, even if the AIG parent company declares bankruptcy, the subsidiary insurance companies may continue to do business as usual.  While the bankruptcy trustee would be able to liquidate AIG’s stock in those companies, the companies themselves remain beyond the bankruptcy trustee’s reach.  Congress exempted domestic insurers from the Bankruptcy Code, intending that they be rehabilitated or liquidated under state insurance regulations.  Thus, if AIG sought bankruptcy protection, state insurance departments would likely seize the subsidiary insurers and either rehabilitate or liquidate them outside the bankruptcy. 


    In summary, AIG’s financial outlook remains uncertain.  The individual subsidiary insurers remain stable at this point, and policy obligations do not appear to be in imminent danger.  However, the subsidiary insurers’ ultimate fate is uncertain, and we advise clients to continue to monitor this situation closely.