American International Group, Inc., or AIG is a company that provides insurance and financial services in the US and around the world. AIG had its origins in Shanghai in the 1920s and 1930s and its headquarters was shifted to New York by its founder Cornelius Vander Starr in 1939. It was the first American company that was founded overseas (Shelp and Ehrbar, 157). AIG deals with four types of services – General Insurance, Life Insurance and Retirement Services, Financial Services, and Asset Management (Yahoo.com, 2009). Maurice Raymond (Hank) Greenberg took over as CEO of AIG in 1967 and since then, helped transform the modest company into the world’s topmost insurance company.
Maurice Raymond Greenberg was CEO of AIG for 37 years since 1968 and during his tenure, he introduced new types of insurances that other insurance companies did not generally offer and this allowed the company to keep premiums very high. AIG offered the kidnapping and ransom insurance for First World executives posted to Second and Third World operations in places like Colombia, Mexico, and the former Eastern Bloc. It also became a leading seller of directors and officers liability coverage which insures corporate officers and directors against claims for personal malfeasance. While on one end, Greenberg tried to generate profit by charging high premiums, on the other side he tried to pay as few claims as possible (Shelp and Ehrbar, 7).
Greenberg also became famous for a new way of incentive compensation whereby he rewarded his salespeople with interests in two outside companies called C.V. Starr and Starr International (SICO) and this strategy was based on the fact that the success of the twocompaniesd depended on the success of AIG.
In February 2005, AIG was taken to court by Eliot Spitzer, New York State’s hyperactive attorney general, for documents relating to a phony transaction known as finite insurance, used by Greenberg to add $500 million to AIG’s reserve in 2000 (Shelp and Ehrbar, 2). Greenberg was forced out of AIG for inflating profits and making the balance sheet look stronger than the underlying reality. By this time, AIG had become one of the world’s biggest companies with sales of $113 billion in 2006 Saporitoo, 1). It had also written over 81 million life insurancee policies, with a face value of $1.9 trillion. It had covered many other small businesses, acted as an aircraft-leasing subsidiary with over 950 airline jets and provided insurances to public and private bodies in the US (Saparito, 1).
AIG was a very aggressive competitor and it was trying to make profit dealing in derivatives tied to the U.S. real estate market. It indulged in the CDS market. AIG sold large amounts of credit default swaps without properly offsetting or covering their positions. CDS were created as a way of providing insurance on bonds against default. By definition, a credit default swap (CDS) is an exchange contract in which the buyer of the CDS makes a series of payments to the seller in return for a payoff, in the event of a bond or a loan going into default. Since they are tradable instruments they became speculative instruments on deteriorating conditions in a company or country (Soros, 1).
Supposing an investor buys a CDS from CITI Bank where the reference is given as AIG Corp. The investor will make regular payments to CITI Bank and when AIG Corp defaults on its debt payment, the investor will receive one-timeme payment from CITI Bank and the CDS contract will be terminated. Sometimes, it is also possible for the investor delivers a defaulted asset to CITI Bank fo a payment of equal value. It is not necessary for an investor to own the AIG Corp Debt to buy CDS. He can buy it in a speculative manner, to bet against the solvency of AIG Corp in a gamble to make money if it fails. In reality, AIG, like other institutions, was dealing in CDS related to the U.S. real estate market. Companies that held CDOs (Collateralized debt obligations) offset their risk by buying CDSs from AIG FP Saporitoo, 1).
All worked well till the housing bubble burst due to overbuilding and overleveraging and this caused the value of the CDOs to plunge. Holders of CDSs on such securities pressurized AIG to make payment and this triggered the downfall of AIG. Later, the government had to intervene with tax payer’s money to bail AIG out. The recent problem at AIG is that the taxpayer money given to AIG by the government is being used to pay huge bonuses to its executives.
AIG wrote insurance on approximately $440 billion of credit default swaps. In so doing AIG was actually collecting premiums to guarantee against defaults by major companies around the world. AIG got into trouble when huge financial companies such as Lehman announced bankruptcy. Lehman was one of the companies that AIG was guaranteeing wouldn’t go bankrupt and when it failed, it had to pay up about $9 billion to its credit default swaps. The remaining companies followed and AIG had to suffer huge losses.
My personal opinion is that AIG played only one side of the transaction. The role of AIG was to spread risk like most other insurers. Rather it concentrated on too much risk without having a recognizable asset base. Moreover, it should have diversified its risk over a lot of names rather than sticking with a few big institutions. Their risk would also have been minimized further if, along with providing insurance, they had also purchased insurance from some other companies. However, the most important lesson is that use of toxic financial instruments such as CDS must be strictly regulated in such a way that they can be purchased only by those who own the underlying bond.
AIG seems to have entered the CDS unregulated market to continue its habit of falsifying balance sheets and income statements of banks and other financial institutions around the world. It can also be pointed out that AIG failed to realize that all of its CDS contracts were highly correlated. AIG had felt that they had minimized risk by providing insurance only for a few bonds they thought were safe. But they did not realize that these bonds were all of the same type and failure in one would most likely be followed by failures in others.
Moreover, their speculation that companies such as Lehman Brothers would never become bankrupt also failed. This shows that AIG was short-sighted in its approach of providing CDS. This mistake was the result of AIG being primarily insurers. Like insurance policies they had provided CDSs expecting to pay up one or two claims in the event of a bankruptcy. Moreover, they did not see that the few bonds they covered were likely to fail and that they were related to each other. Unlike in other insurance policy issues, in the case of CDS, failure in one will obviously lead to failure in another.
References
- Saparito, Bill (2008). How AIG bbecometoo big to fail? Time CNN.
- Shelp, Kent Ronald and Ehrbar, Al (2006). Fallen Giant: the Amazing Story of Hank Greenberg and the History of AIG. John Wiley and Sons.
- Soros, George (2009). One way to stop bear raids. The Wall Street Journal. Web.
- Yahoo. (2009). American International Group, Inc.