AIG’s Sinking Fortunes

It was perhaps the most remarkable sinking since the Titanic. In the span of 48 hours, the stock of the American International Group (AIG) in the United States, commonly branded in the media as the “largest insurance company in the world,” sank to the bottom of the financial markets in mid-September 2008.The only thing saving AIG from bankruptcy proceedings was a last-minute, US$85-billion life raft thrown out by the U. S. Federal Reserve. “I think it’s hard to believe that a [broker’s] market [such as AIG], which has historically been so strong financially and is as well-respected as it has been, went south so quickly,” said Peter Blodgett, president-elect of the Insurance Brokers Association of Ontario (IBAO), summarizing much of the water-cooler discussion about AIG transpiring in any number of Canadian broker offices. “I think it caught a lot of people off-guard.”

The U. S. Federal Reserve’s rescue effort comes with a significant catch: AIG is all but required to sell off a portion of its assets. Publicly, AIG says it wants to keep its property and casualty units. But privately everyone is waiting for the other shoe to drop, knowing Canadian (re)insurers have the financial means to acquire AIG’s Canadian property and casualty insurance subsidiaries should they be put up for private auction. Whether they will have the opportunity to buy is anyone’s guess.

AIG’s financial shipwreck in the United States confounded many observers because it flew in the face of how well-capitalized AIG’s insurance units remain. But the iceberg AIG hit had more to do with the wheeling and dealing of AIG’s Financial Products unit in the murky world of credit derivatives and associated subprime mortgage exposures.

One might expect public confidence in the solvency of insurers to be a topic for conversation in light of AIG’s now-legendary liquidity problem. On the contrary, the Canadian property and casualty industry expresses complete confidence that what happened in the United States can’t happen here. Canada’s federal system of financial solvency regulation simply wouldn’t allow its insurance industry giants to navigate in such shallow capital waters, Canadian industry analysts observe.

AIG HITS THE ICEBERG

Although media headlines typically refer to AIG as an insurance company, most insurance industry representatives don’t view what happened to AIG as an insurance-related crisis. A recent briefing by the consulting group Advisen observes that, in addition to the capital locked up in its property and casualty operations, AIG also derives income from businesses unrelated to traditional unlicensed insurance products. “The crisis at AIG is driven in large part by losses on a type of investment instrument called a credit default swap (CDS) issued by AIG Financial Services, a unit separate from the insurance businesses,”Advisen notes. “A CDS operates something like an unregulated insurance contract. It provides protection against a default on assets tied to mortgage debt and securities.”

In a credit default swap, one party makes periodic payments to another in exchange for a payout if a third party defaults on a loan. A very simplified version of how a CDS works is as follows1:

The Sunny Days Pension Fund owns Cdn$20-million worth of a five-year bond issued by Troubled Corporation. Fretting that Troubled Corporation might live up to its name, Sunny Days tries to protect itself in the event of a default. Sunny Days therefore buys a CDS for a notional amount of Cdn$20 million from Security Bank. In return for Security Bank’s credit protection, Sunny Days pays Security Bank 2% of Cdn$20 million ($400,000) in quarterly installments of Cdn$100,000 over five years.

If Troubled Corporation does indeed fold sometime before the five-year payment schedule is up, Sunny Days stops paying the quarterly premium to Security Bank and Security Bank refunds the pension fund’s Cdn$20-million loss. If there’s no default, Security Bank gives Sunny Days its Cdn$20 million back after five years and keeps the quarterly payments. Either way, Sunny Days is protected in the event of Troubled Corporation filing for bankruptcy.

A CDS isn’t an insurance product, in the sense that it doesn’t require a loss to a tangible, physical asset in order to trigger the protection.

Advisen notes AIG “is one of the largest players in the CDS market, with almost [US]$600 billion of gross notional exposure in ‘super senior’ credit derivatives, including [US]$80 billion tied to subprime mortgages.”

The media’s conflation of the derivatives activities of AIG’s Financial Products unit with the activities of AIG’s well-capitalized insurance units is partly a byproduct of AIG’s status as a somewhat peculiar financial animal. “I don’t know what AIG is,” Dan Danyluk, the CEO of the Insurance Brokers Association of Canada (IBAC), said in an interview. “I don’t think anybody’s known for a long time. It’s an incredibly densely complex organization. The fact of the matter is, [AIG held] securities deemed by rating agencies to be secure because nobody believed that that many people would default on their mortgages. And in fact, that many people did default on their mortgages.”

And when they did, ratings agencies in the United States responded with downgrades. Over the period of five years, AIG saw its credit rating go from a ‘AAA’ rating in 2001 to an ‘AA-‘ rating in late 2007. But AIG’s ship really started to take on water on Sept. 14, 2008, when large U. S. investment banks such as Lehman Brothers and Merrill Lynch — banks that, like AIG, were exposed to losses arising out of defaulted subprime mort- gages — either declared bankruptcy or arranged mergers in order to forestall bankruptcy.

AIG ran into a serious cash-flow problem. Ratings agencies such as Fitch, Standard & Poor’s (S&P’s) and Moody’s had all downgraded AIG’s credit rating. In downgrading AIG from an ‘A’ to an ‘A-,’ S&P’s stated on Sept. 14: “The main reason for the rating actions is the combination of reduced flexibility in meeting additional collateral needs and concerns over increasing residential mortgagerelated losses. Mark-to-market losses from mortgage-related investments and swap exposures have placed significant pressure on AIG’s ability to access capital and liquidity.”

The credit downgrades “trigger[ed] contract provisions that required the company to post US$14.5 billion in collateral,”Advisen says. Exacerbating this state of affairs, if AIG failed to post the collateral, it would be considered to have defaulted on its subprime mortgagerelated CDSs, as Steven D. Levitt writes in his blog on the New York Times Web site. “Were AIG to default on CDSs, some other AIG contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims.”At the parent company level, AIG had nearly US$80 billion in shareholder equity, but most of it was locked up in the group’s life and property and casualty insurance operations and could not be liquidated to meet the collateral costs.

Upon observing the company’s serious cash-flow problems, shareholders showed no mercy. AIG’s stock prices fell 60% in one day following the announcement of the rating downgrades. As AIG tried to rally support from private investors, its stock price plummeted to less than $2 per share in a span of 48 hours, having traded at $75 per share only a year before. Negotiations with private investors collapsed and AIG faced filing for Chapter 11 bankruptcy protection. At this point, AIG started discussions with the U. S. Federal Reserve bank, which announced an extraordinary US$85-billion loan to AIG on Sept. 18.

The terms of the loan were stringent. They left the U. S. federal government owning 79.9% of the company; interest and other payments connected to the debt amount to a total of 11.3%.Analysts saw the strict terms as a means to force AIG to act quickly to resolve the crisis. “The purpose of this liquidity facility is to assist
AIG in meeting its obligations as they come due,” the Federal Reserve announced in a statement announcing the loan. “This loan will facilitate a process under which AIG will sell certain units of its businesses in an orderly manner, with the least possible disruption to the overall economy.”²

Brian Wilcox, the president of the Toronto Insurance Conference (TIC), a Canadian commercial brokers association, says the U. S. Federal Reserve’s loan to AIG was necessary, even if in the long-term it may not prove to be sufficient. “What happened in the United States with the government coming in and providing the federal band-aid was necessary,” he says. “AIG is just one part of what’s happening in the United States, which affects us all. Had they not done that, I wouldn’t want to predict what would have happened. Personally, I think it’s only a band-aid. I think that AIG is still in a scenario in which they’ve got to shake things up.”

A. M. Best noted in a recent Web seminar that AIG’s property and casualty operations remain well-capitalized, allowing such a shake-up to be possible. “It’s very important to note, from our perspective, that the operating companies remain strong,” said Tony Diodato, who heads A. M. Best’s property and casualty ratings for the U. S. market. “Although AIG’s business profile and franchise value has been tarnished by the recent events, A. M. Best believes AIG remains a formidable player in the property casualty marketplace. However, A. M. Best has short-term concerns, including potential policyholder departures, erosion of confidence from key constituents such as brokers, banks and credit facilities.”

Risk managers were certainly having a second look at AIG policies. Asked for their first impressions of the crisis, many risk managers in the United States — the people who buy AIG’s insurance products on behalf of the companies they represent — reported looking for other options, even though they recognized the strong financial position of AIG’s property and casualty units.

Advisen, which does consulting work for the Risk and Insurance Management Society (RIMS), an association of risk managers in North America, conducted a survey to measure confidence in AIG after the US$85-billion bailout. Its survey of 1,000 risk managers found that 68% of respondents said they were “very confident” or “somewhat confident” in AIG’s financial strength. At the same time, 71% of AIG commercial lines policyholders said they planned to get quotes from AIG competitors when their policies were up for renewal.

“Many insurance buyers recognize the crisis at the AIG ultimate parent level didn’t affect the solvency of the insurance subsidiaries, but nonetheless there was immediate reaction among brokers and buyers to look at all options,” said David K. Bradford, the executive vice president and chief knowledge officer of Advisen. “After the federal loan was secured, it’s clear that the marketplace responded with support for AIG. Still AIG will have to fight to keep its book of business and this fight will likely drive further reductions in premium pricing.”

SPILLOVER EFFECT

In Canada, brokers reported receiving calls from AIG’s commercial policyholders, asking about the status of their insurance.And what would be the broker’s advice in these unusual circumstances?

“Certainly AIG Canada is different than the U. S.,” IBAO president Rod Hancock cautioned. “All of the safeguards of OSFI [Canada’s financial solvency regulator, the Office of the Superintendent of Financial Institutions] and the government regulations have not changed, so AIG has to follow those rules. So from that perspective, I wouldn’t be saying we have to move [the policyholder over to another insurer]. I think you are going to get clients that will want to look and see what there is. But I wouldn’t worry about saying, ‘We have to get out of here,’ because [AIG Canada] will pay a claim tomorrow in Canada.

“The larger issue seems to me to be what is the AIG U. S. going to do? They obviously have control [over AIG Canada’s destiny] somehow. Are they going to sell it? Are they going to keep it? That part we have no control over, so my client isn’t going to be able to make a choice over that.”

Certainly there is a lot of speculation among Canadian brokers and risk managers alike about whether AIG Canada is destined to be unloaded as part of the forthcoming sale of the company’s assets. AIG’s general insurance division accounts for about US$72 billion of the company’s overall US$1.7 trillion in operating income. In Canada, AIG has five main non-life insurance operations3 that collectively reported a 2007 net income of more than Cdn$209 million.

Speculation about a potential sale of AIG’s Canadian subsidiaries persisted even after AIG announced on Oct. 3, 2008 that it planned to keep the core of its property and casualty operations.

“American International Group, Inc. (AIG) today indicated its intent to refocus the company on its core property and casualty insurance businesses, generate sufficient liquidity to repay the outstanding balance of its loan from the Federal Reserve Bank of New York and address its capital structure,” the company announced in a press release. “AIG had drawn $61 billion on the Fed credit facility as of Sept. 30, 2008.AIG plans to retain its U. S. property and casualty and foreign general insurance businesses, and to retain a continuing ownership interest in its foreign life insurance operations. AIG’s worldwide property and casualty businesses generated approximately [US]$40 billion in revenues in 2007. The company is exploring divestiture opportunities for its remaining high-quality businesses and assets.”

Brokers at the National Insurance Conference of Canada (NICC) in Ottawa-Gatineau at the time of AIG’s announcement believed AIG was not giving away names largely because it wanted to tease potential offers from buyers. Had AIG listed the companies it wanted to sell, it ran the risk of having to sell them at “firesale” prices, brokers and reinsurers noted.

Certainly AIG’s Canadian assets would be an excellent pick-up for any number of well-capitalized companies in Canada, Canadian brokers note. “Every major market in Canada is looking to buy,” says Peter Burns, second vice president of the IBAO.

As of press time, merger rumours abounded. Canadian holding companies and insurers Fairfax Financial, Manulife Financial and Sun Life were all reported to have been in the running to buy AIG’s Canadian subsidiaries or portions thereof. Other names coming up in brokers’ gossip circles include Lloyd’s of London, ING Canada, AXA Canada, Munich Re and even Dominion of Canada General Insurance Company. Transatlantic Re board members announced they were already looking over offers for sale of the reinsurance company.

Whatever happens to AIG and/or its Candian holdings, consumers in Canada are protected because of AIG’s reliance on the independent broker channel to distribute their insurance products, says Justin MacGregor, past president of TIC and currently president-elect at IBAC. “The thing about the AIG situation is that they are a broker-oriented company,” says MacGregor. “Certainly I know from our shop, the moment we became aware that things could be going awry, we were looking for alternatives [for AIG policyholders] should the worst happen. We didn’t know whether the sky was going to be falling in, whether this was a knee-jerk reaction or whether there might be a reality that would be dealt with in a sensible manner and put back onto a sensible footing. The second there was an indication something was wrong, we were acting in the client’s best interests to identify alternatives should the worst-case scenario break.”

PUBLIC CONFIDENCE IN INSURANCE

Post-bailout, it appears the worst-case scenario is no longer a concern. Members of Canada’s property and casualty insurance industry are working hard to make sure the Canadian public understands the insurance industry is an innocent bystander in all of this. B
rokers, insurers and regulators alike are concerned that AIG’s poor fortune in the United States, triggered by its Financial Products unit — a unit that has nothing to do with insurance — has potentially and unfairly dragged the good name of the insurance industry through the mud. “Until just recently, there has been a prolonged, a several-months-long debate about confidence in the banking industry, the confidence in the investment industry and only in the last very short period of time, in the last week or so, did this become a discussion about public confidence in banking, investment and insurance,” observes Paul Kovacs, the president and CEO of the Property and Casualty Insurance Compensation Corporation (PACICC). The fund pays claims to policyholders in the event of a Canadian insurer bankruptcy. “I think that’s an important message for our colleagues in the insurance industry,” Kovacs continues. “For the very first time, this global dialogue, which is also a Canadian dialogue, has expanded to include a discussion saying, ‘I am also concerned about insurance.’The implications of that are unclear, because this is very new for us.”

Almost invariably, sources interviewed for this story did not believe AIG’s meltdown in the United States would ultimately lead to a crisis of confidence in the Canadian insurance industry. In fact, Canadian industry sources show manifest and absolute confidence in the solvency of Canadian insurers. When asked about the source of their confidence, they point to the fact that Canada’s regulatory environment around solvency is much different here than in the United States.

SOLVENCY REGULATION IN CANADA

“We’re regulated for solvency purposes by OSFI and they set out the capital requirements for the property and casualty industry,” says Barbara Sulzenko-Laurie, the vice president of policy for the insurers’ trade organization, the Insurance Bureau of Canada (IBC). “They set very high capital requirements. In fact, next to Australia, they’re probably the highest capital requirements in the world. They add to the cost of carrying out business in Canada, and that’s been a source of concern for us for a number of years. Having said that, in these times, people can look to that solvency regulation as being a protection.”

OSFI makes no apologies for setting its capital targets high. At the NICC, OSFI superintendent Julie Dickson told hundreds of Canadian insurance industry delegates that OSFI’s capital requirements meant no Canadian property and casualty insurer had to take a writedown on the basis of similar credit derivatives activities that ultimately sank AIG’s fortunes.

“OSFI has faced criticism in the past for our stance against financial leverage in P&C companies, and we have been criticized by those who say we artificially add to the cost of capital, but despite the criticism we stand by our decisions,” Dickson said. “Regulated P&C companies in Canada do not have debt on their balance sheet, nor are they generally selling products that require collateralization in the event of credit downgrades. Debt — and OSFI has been adamant about this — does not belong on the balance sheets of operating P&C companies.”

In a separate statement, OSFI said it is satisfied with the capital requirements for Canadian insurers following on the heels of the financial services meltdown in the United States. “In general, we can say that federally regulated financial institutions (banks and insurers) are well capitalized, which is helping them deal with the current market events,” said OSFI manager of communications and public affairs Rod Giles. Would OSFI be tempted to raise its capital requirements as a result of the dampening effect the United States credit crisis might ultimately have on Canadian insurance companies’ investment portfolios? “Regarding capital requirements, there are no changes envisioned at this time,” Giles responded. “We believe the current regulatory requirements are appropriate.”

Kovacs observed OSFI’s role as a dedicated solvency regulator distinguishes Canada’s regulatory environment from that of the United States. In the United States, for-profit ratings agencies play a much stronger role in the determination of an insurer’s solvency, Kovacs said. More than a few Canadian insurance industry representatives have suggested the U. S. regulatory environment, including the role of ratings agencies, might be in line for some changes after the AIG bailout.

“Certainly if you compare between Canada and the United States, there is a role played by the rating agencies in the United States,” Kovacs says. “The rating agencies are evaluating, judging, pontificating on the solvency of the insurance companies in the United States. In Canada, the solvency supervisors are doing that.”

The stronger role for ratings agencies in the United States is derived in part from U. S. regulators not having solvency as the only item in their job description, Kovacs suggests. In addition to solvency, U. S. regulators must also oversee rate adequacy and market conduct. “There is a more complicated responsibility of American insurance regulators when compared to OSFI’s clear focus on solvency and confidence in the system,” Kovacs says. Seeing what ratings agencies do, U. S. regulators have developed a certain confidence in letting ratings agencies handle solvency determinations while the regulators focus on other aspects of their role. What happens to that confidence going forward may soon be up for discussion.

There is a fly in the ointment of Canadian insurance regulation, however, and that is in that nebulous area of provincial versus federal jurisdiction. Although OSFI has an admirable track record overseeing federally regulated and licensed insurers, Kovacs notes, not all insurers in Canada are federally regulated. Some insurers operate in only one or a few provinces and hence choose to be licensed exclusively with provincially regulators. And with many — but not all — provincial regulators, it’s a whole new ball game, Kovacs notes. “PACICC has great confidence in OSFI and…feels very positive about the current OSFI system and approach that they have in place,” he says. “We have more questions about some — and perhaps I’ll be a little bolder and say most — provincial solvency supervisory systems. In the experience that PACICC has been through, the companies that have failed recently have been disproportionately provincially supervised.”

Kovacs said PACICC has recently undertaken and published research identifying which provincial regulators have met the standards for insurance industry regulators, as outlined in a 2005 report by the International Association of Insurance Supervisors (IAIS). Meeting these minimum standards is crucial for preventing spectacular insurer insolvencies of the type that AIG has temporarily averted, the IAIS notes in a Sept. 22 press release. “The Federal Reserve’s rescue offer would likely not have been made if it were not for the core value of AIG’s insurance subsidiaries, which exists due to sound solvency regulation and oversight provided by IAIS members worldwide,” the international regulatory association noted.

How AIG will look coming out of this financial crisis is anyone’s guess. Much is still to be determined. But clearly strong solvency regulation plays a critical component in making sure insurance company ships have the proper capital base to avoid icebergs in the future, the Canadian P&C industry notes.

1 This example is an offshoot of a scenario outlined in the Wikepedia definition of a CDS, with apologies to Wikepedia (and the online encyclopedia’s critics).

2 The U. S. federal government just recently passed a US$700-billion financial aid package that would allow the government to buy toxic, subprime mortgage- related assets and thereby remove them from the U. S. financial markets.

3 American Home Assurance Company (Canadian Branch), Transatlantic Re (Canadian Branch), Commerce & Industry Insurance Company of Canada, The Boi
ler Inspection and Insurance Company of Canada, AIG United Guaranty Mortgage Insurance Company of Canada.

———

“I think it’s hard to believe that a [broker’s] market [such as AIG], which has historically been so strong financially and is as well-respected as it has been, went south so quickly. I think it caught a lot of people off-guard.”

———

“I don’t know what AIG is. I don’t think anybody’s known for a long time. It’s an incredibly densely complex organization.”

———

“We’re regulated for solvency purposes by OSFI and they set out the capital requirements for the property and casualty industry. They set very high capital requirements. In fact, next to Australia, they’re probably the highest capital requirements in the world.”