AIG Was Brought Down by a Unit Most of the Company Barely Knew
A large insurer required an extraordinary rescue in 2008 because one relatively small division had written enormous quantities of credit protection without holding reserves against it.
The Structure
AIG was one of the largest insurance companies in the world, with a conventional and generally well run insurance business across many countries.
Within it sat AIG Financial Products, a comparatively small unit that operated as a derivatives dealer. Among its activities, it sold credit default swaps, providing protection against default on debt securities including mortgage related instruments.
Why It Wrote So Much
The economics appeared extremely attractive. The unit collected premiums for insuring securities that carried the highest ratings and were considered very unlikely to default. Models indicated the probability of loss was remote.
Critically, this business was not conducted through a regulated insurance subsidiary and was not subject to the reserving requirements that govern insurance. A regulated insurer selling a policy must hold reserves against expected claims. A derivatives dealer selling protection was not obliged to reserve in the same way.
It was insurance in economic substance and a derivative in legal form, and the reserves that insurance would have required were not held.
What Actually Triggered the Crisis
The common assumption is that AIG failed because the insured securities defaulted. The immediate cause was different and more instructive.
The contracts contained collateral posting provisions. If the value of the insured securities declined, or if AIG's own credit rating was downgraded, it was required to post cash collateral to counterparties.
As mortgage security prices fell during 2007 and 2008 and AIG was downgraded, collateral demands arrived in enormous size and had to be met in cash immediately. The company had written protection generating modest ongoing premiums against an obligation to produce billions of dollars on short notice.
Why It Was Rescued
The authorities' concern was the counterparties. Major financial institutions globally had purchased protection from AIG and had treated that protection as reducing their own risk exposure for regulatory capital purposes.
If AIG failed, the protection became worthless, and every institution that had relied on it would simultaneously discover it held more risk than reported, at a moment when confidence was already collapsing.
The rescue was therefore substantially about the counterparties rather than about AIG. Public controversy followed when it emerged that those counterparties were paid in full.
The Structural Lesson
The transferable point is about regulatory arbitrage. Identical economic activity was treated differently depending on the legal form used, and capital flowed to the form requiring the least capital.
The insurance business inside AIG was solvent and largely unaffected. Regulated entities within the group were ring fenced. It was the unregulated unit that created the exposure, and the group structure meant the whole company bore it.
The Bottom Line
AIG sold insurance without calling it insurance and therefore without reserving for it, and collateral calls rather than defaults created the emergency. When the same economic risk is regulated differently by form, it migrates to the least regulated form.