Risky Trading of Swaps in A.I.G. Insurance Unit?

A.I.G. Financial Products was not the only subsidiary of American International Group trading risky derivatives, according to an article in the New York Times yesterday.While the London subsidiary nearly brought down the entire financial system with credit derivatives tied to subprime and other complex mortgages, A.I.G.'s core insurance business based in Delaware was dabbling in credit default swaps, too, according to according to the article, "Risky Trading Wasn't Just on the Fringe at A.I.G."

The insurance unit, known as Alico or American Life Insurance Company does business overseas in 40 countries and the counterparties on the opposite side of the swaps are big U.S. banking companies, reported the article.

Although the portfolio of swaps was small as compared to the swaps in the London unit, the presence of swaps in a regulated insurance company points to flaws in insurance regulation, contends the article. For instance, A.I.G.'s insurance unit did not have to set aside capital reserves to guarantee its payments on the swaps it sold. The problem or status quo is that there is no federal regulation of insurance companies; federal regulation mainly focuses on banking, whereas the states regulate insurance, pointed out the article. Meanwhile, the Senate Banking Committee meets today to consider the financial regulatory overhaul. If the bill already passed by the House becomes law, then insurance units like Alico that use swaps to sell protection against bond defaults, would be designated as a "swap dealer" and be required to set aside capital reserves.

There is also disagreement on whether or not credit default swaps are insurance contracts. Insurance regulators in Delaware, quoted in the article, contend the swaps are a banking product. They are not an insurance product, because insurance products put together a pool and customers are charged a premium based on the riskiness of the pool. One insurance regulator said that credit default swaps do not involve a pool; there is one buyer and one seller for every contract.

Also, to be fair, Alico's portfolio was just a fraction of the size of the huge A.I.G. Financial Products exposure to credit default swaps. According to the article, if Alico's portfolio had blown up in 2007, the maximum loss would have been a little more than $1 billion, which would not have wiped out the company's $7 billion in surplus funds.

So is this a tempest in a teapot? The question is how many conventional insurance companies are placing bets on bond defaults, and do they have the reserves to meet the obligations of the swaps if the credit market were to sour

Alico's CFO explained in the article that the swaps were on bonds that are issued by a diversified group of companies, and these were high-grade corporate bonds. (The CFO claimed the strategy diversified the firm's holdings and increased yield.) This was very different than A.I.G. Financial Products' huge portfolio of credit default swaps which were heavily exposed to the housing industry, argued Alico's CFO in the article.

When the credit markets worsened in 2008, Alico realized a $52 million loss on the contracts it terminated, the article notes. The CFO said the company was always monitoring the markets and it saw the economics changing. Interestingly, the program was unwound and the company is not planning to start it again.A.I.G. Financial Products was not the only subsidiary of American International Group trading risky derivatives, according to an article in the New York Times yesterday. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio