The insurance industry was rocked by the government bailout of AIG last week, to date the leading specialty lines insurer in the world.  According to the U.S. Surplus Lines – Market Review by A.M. Best Research for 2008 (sponsored by NAPSLO, see here & here), AIG wrote 22.2% of surplus lines business segment in 2007.

It appears the problems leading to the government action are not contained in AIG’s insurance company subsidiaries.  The NAIC issued the following statement (see here):

The insurance subsidiaries are solvent and able to pay their obligations.

The NAIC statement went on to say:

Non-insurance entities are not subject to the strict solvency framework applied to insurers. This allowed various non-insurers to engage in risky credit transactions (huge positions in credit derivative swaps on mortgage-backed securities) without the appropriate limits and minimum capital/surplus to protect the company from a downswing in the mortgage-backed security markets.

Credit default swaps written through a London-based subsidiary called AIG Financial Products were the culprit, according to a recent story by the Mail from London (see here).  AIG Financial Products sold credit default swaps (CDS) with a range of investment organizations.

A CDS is linked to a specific type of asset, typically a company bond or other loan or package of loans. The buyer of the CDS pays a regular sum to the issuer. In return, if there is a default on the asset the issuer pays out a predetermined amount of money.

By 2007 [the AIG FP] division was providing guarantees mainly through credit default swaps on about $500billion of assets… On February 29, AIG announced it was writing off $11.1billion (£5.5billion) on its CDS business.

A more detailed summary of CDS and AIGs participation in this market are available on the web.  One article, found here, provides an excellent summary of CDS, the CDS market, and AIGs role, and notes that CDS do not exhibit the independence of exposure units found in most insurance products.  A second article (see here) provides some background on accounting issues and asset valuation.  Other articles may also be helpful: here & here.

While the future of AIG’s core insurance subsidiaries appear to be favorable, including their role as a leading writer of specialty lines insurance business, the current situation with our financial markets is of significant concern.

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