When I was a young actuary, I worked for the now defunct Pacific Standard Life.  In 1984, PSL discovered Universal Life Insurance, and sold so much of it that it went insolvent, and was bought out of bankruptcy by Southmark.  I came to the company in 1986, but by 1988 I had my concerns.  Aside from the aggressive investment policy (junk bonds), Southmark had interlaced the capital of their subsidiaries, with one subsidiary owning the preferred stock of another, and vice-versa.  They even did a deal with ICH, exchanging preferred stock.  So long as neither defaulted, both looked more solvent, like two drunks holding each other upright.

My point for the evening is that there are clever ways to make an insurance company look more solvent than it should appear to be.  I mentioned the preferred stock manuever.  There are also deals regarding reinsurance.  A common traansaction is to sell of future profits in exchange for capital today.

Why do I write about this?  AIG again.  While I worked for the domestic life companies 1989-1992, I served as the actuary for the annuity line of business.  That involved the reinsurance treaties on annuities, which were designed to reduce the capital needs of the business, and thus increase leverage.  As I have sometimes said, “reinsurance is the ultimate derivative.”  If derivatives are opaque, reinsurance doubly so.  Tearing apart a reinsurance treaty is tough, and it takes significant skills that most auditors and regulators don’t have.

During my tenure at AIG, the reinsurance treaties were designed to decrease the capital needed to support the business.  Given the need for a 15% after-tax return on average equity (which was sometimes described as the “religion” of AIG), the easiest way to do it was to compromise the capital needed to support the business through reinsurance.  Equity goes down, ROE goes up.  That was the nature of AIG, and I could never be a lifer there because of the ethical problems I faced.

Now one of the assumptions that I have made about AIG is that the subsidiaries of AIG are well-regulated and solvent.  But why should I assume that things have gotten better since when I served in AIG?

If I had the Statutory data (regulatory accounting), I would look at all of the statutory statements of domestic insurers that AIG owns, and look for reinsurance and cross-shareholdings.  I would discount external reinsurance credits, and internal reinsurance I would check to make sure that reserves reinsured equal reserves insured.

If things are today like tkey were in the early 90s, I would expect to find the amount of capital needed to support the business compromised through reinsurance treaties.  Within a year, we will know if that is true.  There are some alleging large fraud here.

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Now, ther are other problems with the bailout of AIG, notably that it harms their competitors.  Government support may lead AIG to discount premiums because they don’t have to turn a profit in their current state.  This harms the rest of the industry.  Why should insurers with no government support have to battle an insurer with govenment support?

Also, as I have said before, there is no reason to bail out AIG the holding company, which is what our dear government has done.  We only care about the operating insurers, not the company that owns them.  For the nonregulated entities inside AIG, the only one that has a material impact on the rest of the world if AIGFP.  Guarantee this if the US government must, but stay out of the rest of AIG.  Let that go into insolvency, there is no compelling reason tfor the US to protect it with tax monies.