A Look Back at the AIG Meltdown

Copyright 2008 Gale Group, Inc.All Rights ReservedASAPCopyright 2008 Risk Management Society Publishing, Inc. Risk Management

November 1, 2008

Pg. 14(3) Vol. 55 No. 11 ISSN: 0035-5593

188583403

1798 words

The AIG meltdown: in mid-September, AIG was on the brink of bankruptcy before an $85 billion federal loan saved the company. AIG is hardly out of the woods, but assuming its customers do not flee in droves,the long-term affect on the insurance pricing cycle should be minimal; Fore front

Bradford, David K.

The AIG meltdown was driven in large part by losses in a nontraditional insurance product, a type of financial instrument called a credit default swap (CDS) issued by AIG Financial Services, a unit separate from the insurance businesses. A CDS operates like an unregulated insurance contract and provides protection against a default on assets tied to corporate debt and mortgage securities. AIG is one of the largest players in the CDS market with almost $600 billion of gross notional exposure in "super senior" credit derivatives, including $80 billion tied to subprime mortgages, and losses under these instruments--which at this point are accrued losses rather than paid losses--were triggered by the collapse of the subprime mortgage market.

The crisis at AIG is a "question of liquidity, not of capital," according to Rob Schimek, executive vice president and CFO of AIG Property Casualty Group. Although there have been few losses paid under the CDSs, contract provisions require AIG to post collateral in cash ifthe value of the assets underlying a CDS deteriorates. At the parentlevel, AIG has nearly $80 billion in shareholder equity, but most ofthat is locked in the company's insurance operations and cannot be liquidated to meet the collateral calls of the financial products unit. Schimek cites $26.7 billion in statutory policyholders' surplus forU.S. commercial lines with international commercial lines and personal lines having additional surplus. U.S. regulations prevent the parent from taking dividends from insurance subsidiaries of more than 10%of policyholders' surplus in a given year. That is good news for AIGpolicyholders--the assets of the insurance companies are all but untouchable--but it means that as the demand for collater al grew, AIG found itself in a bind with few alternatives available to quickly raise the necessary cash.

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AIG's need for cash reached crisis proportions just as a tidal wave of defaults under subprime mortgages was causing chaos throughout the world's financial markets. As a precursor to the AIG situation, onSeptember 6, government regulators seized mortgage giants Fannie Maeand Freddie Mac. On September 14, the 150 year-old Wall Street institution, Lehman Brothers, declared bankruptcy and rival investment bank, Merrill Lynch, agreed to be acquired by Bank of America.

On September 11, S&P placed AIG Holding's credit ratings on negative watch forcing AIG to raise yet more cash. Over the weekend AIG wasunable to raise enough cash to deal with these increasing obligations, and on September 15, the major credit rating agencies cut its ratings, triggering contract provisions that required the company to $14post.5 billion in collateral and providing the proverbial deathblow. By morning, the company faced bankruptcy protection and Chapter 11 reorganization.

The Fed Steps In

Initially, federal officials, other regulators and AIG tried to access the capital markets to alleviate the liquidity crisis. When thatfailed, the government announced it would provide AIG an $85 billionloan. The Federal Reserve said in a statement that it determined that a failure of MG could hurt the U.S. economy and financial markets already reeling from subprime losses. In return for the loan, the government will receive rights to a 79.9% equity stake in AIG. Warrant triggers and other loan terms are still being finalized.

AIG will pay interest at 8.5 percentage points above the three-month London Interbank Offered Rate (LIBOR), or about 11.4%. The steep interest rate gives AIG incentive to quickly sell off assets to pay back the loan. According to Schimek, AIG had intended to hold an investor meeting on September 25th to discuss the process of selling assets. The list of likely assets, according to Schimek, does not include core insurance assets. Speculation is that the first properties on theblock will be the company's profitable aircraft leasing arm, its stake in reinsurer Transatlantic Holdings, and its consumer lending and variable annuities businesses.

While the company has made no comments about which assets will be sold, the magnitude of its liabilities suggests AIG may sell at leastsome insurance subsidiaries. The most likely U.S. candidates are those companies that are comparatively autonomous and which serve well-defined sectors such as Hartford Steam Boiler Inspection & Insurance Company (boiler and machinery specialist), 21st Century Insurance Company (personal automobile business in 14 states) and Audubon InsuranceCompany (personal and small commercial lines in 12 states). Other AIG insurance units are deeply entwined through interlocking business models and inter-company pooling arrangements that would have to be disentangled before selling the companies as discreet entities. The National Union Inter-Company Pool, for example, has nine companies including flagship commercial lines carriers National Union and American Home. These companies represent the core of MG's presence in the property and casualty market and are unlikely to be sold except under extremely dire circumstances.

There are several likely buyers. C.V. Starr, a company led by former AIG CEO Maurice "Hank" Greenberg, stated in a SEC filing that it was pursuing options to acquire some or all of AIG. Munich Re chief executive Nikolaus von Bomhard said in a newspaper interview that the German reinsurer was interested in a number of AIG's assets. Japanese and Australian insurance groups are also likely bidders for pieces ofthe insurance business.

Insurance industry impact

According to an informal poll of insurance brokers, of those AIG insureds that contacted their brokers on September 15 and 16, about one-third requested their brokers get quotes from AIG's competitors. There was little reason for panic, however, as AIG's insurance operations are insulated from the losses in other segments of the company by insurance regulations that essentially wall off insurance company assets. The parent company was in trouble, but the insurance entities were profitable, and their balance sheets were unaffected.

Though their statutory financial statements were unchanged, A.M. Best downgraded the financial strength ratings of the domestic property & casualty subsidiaries to A (Excellent) from A+ (Superior). EdwardM. Liddy, AIG's new CEO, and other top management met with ratings agencies, some of which moved AIG from negative out look to developingas a result of the loan from the Fed. A.M. Best, however, announced that it was not ready to revise its outlook. "A.M. Best believes it is premature to declare financial stability to such an extent that a change in outlook or ratings is warranted," the rating agency stated.

Presumably the loan from the Fed will assuage the concerns of nervous policyholders and avert a wholesale exodus of AIG insurance customers. The downgrade in Best's rating may encourage some insureds to diversify their programs, but it now is less likely that the company will lose a significant number of customers over the long term. If there is a massive market dislocation caused by a stampede of AIG policyholders, it will likely lead to a sudden, short-term up-tick in commercial insurance rates. But if the market responds calmly, prevailing soft market conditions are unlikely to be affected. AIG's losses under credit default swaps have no impact on statutory policyholders' surplus, which equates to "supply" in the insurance supply-and-demand equation. The insurance industry remains overcapitalized, which barringa massive natural catastrophe should continue to exert downward pressure on rates at least through 2009.

The most significant impact of the AIG crisis would result from a sale of AIG insurance entities to companies with different business models and risk appetites. AIG has been an engine for product innovation and was sometimes seemingly fearless in its willingness to assume risk. If AIG's insurance operations were acquired by more conservative companies, insurance buyers would stand to lose the far-reaching benefits of the company's innovations in the management and financing of risk, as well as the integrated delivery of global insurance solutions.

This article was originally published in the September 19 edition of Advisen Risk News.

The Harder They Fall

After a credit rating downgrade on September 16, AIG faced new collateral obligations of up to $40 billion. With no liquidity in the market and no other options, the insurance giant was facing imminent bankruptcy. The Fed stepped in before the inevitable occurred, preventing what could have been the largest bankruptcy in history. Below are the companies big enough to make history, but not so lucky to be deemed "too big to fail."

1. Lehman Brothers Holdings Inc. Sept. 15, 2008-$639 billion

2. WorldCom Inc. July 21, 2002-$103.9 billion

3. Enron Corp. Dec. 2, 2001-$63.4 billion

4. Conseco Inc. Dec. 18, 2002-$61.4 billion

5. Texaco Inc. April 12, 1987-$35.9 billion

6. Financial Corp. of America Sept. 9, 1988-$33.9 billion

7. Refco Inc. Oct, 17, 2005-$33.3 billion

8. Global Crossing Ltd. Jan. 28, 2002-$30.2 billion

9. Pacific Gas and Electric Co. April 6, 2001-$29.8 billion

10. UAL Corp. Dec. 9, 2002-$25.2 billion

All Along the Watchtower

The fall of Lehman and nationalization of AIG kicked off the most tumultuous week on Wall Street since 1929 and left the whole financial world in shock. Here is what just a few key insiders had to say.

"There are no atheists in foxholes and no ideologues in financial crises." --Federal Reserve Chairman Ben Bernanke

"Nothing is more important right now than the stability of our capital markets. We're very vigilant, but we do not take, and I don't take, lightly ever putting the taxpayer on the line to support an institution."--U.S. Treasury Secretary Henry Paulson

"The mood changes on a daily basis from euphoria to despair and back again."--Michael Lewis, head of commodities research, Deutsche Bank

"Are you enjoying this? You think this is funny?"--A Lehman Brothers employee to observers taking pictures outside of Lehman's New Yorkheadquarters after the company declared bankruptcy

"The opportunity to have taken bold action would obviously have been better had they done it months ago. But better late than never."--R. Glenn Hubbard, former chairman of President Bush's Council of Economic Advisers

"There's a silver lining to this crisis on Wall Street, if we're smart enough to recognize it. The markets are sending an unequivocal signal that we need to change the way we do business ... To clean up the mess yet ignore this deeper signal would be fatal to our financialmarkets and our hopes for an ultimate recovery."--Jared Bernstein, senior economist, EPI

January 7, 2009