To What Degree Were AIG’s Operating Insurance Subsidiaries Sound? (2)

The Securities Lending Fiasco

Most, if not all life insurance companies engage in securities lending to some degree.  AIG did it in a big way, involving almost all of their life subsidiaries.  When a life insurer lends out its bonds, they receive back safe liquid collateral equal to 100-102% of the par value of what they lent out.  Most companies leave well enough alone at that point.  After all, you still receive the income on the bonds you lent out, plus securities lending fees.  The borrower receives the income on his collateral, less securities lending fees.  The borrower sells the bonds he borrowed, hoping to buy them back cheaper.

So far, so good, but AIG added a wrinkle to the game.  The safe liquid collateral was a slack asset to them.  Why not replace it with equally safe and liquid assets that offered considerably more yield, like bonds backed by AAA-rated subprime or Alt-A mortgage collateral?  After all, AIG was already writing financial reinsurance through default swaps on such mortgages, why not add to a winning bet?

They did so in a big way:

Subsidiary

Realized sec lending losses

2007YE Surplus

RSLL / 2007YE Surplus

American General L&A IC

(977)

471

-207%

AIG LIC

(871)

440

-198%

AIG Annuity IC

(7,110)

3,729

-191%

Am Int LIC of NY

(771)

553

-139%

First SunAmerica LIC

(653)

501

-130%

The Variable Annuity LIC

(3,562)

2,838

-126%

American General LIC

(3,790)

5,704

-66%

SunAmerica LIC

(2,281)

4,716

-48%

AIG SunAmerica LAC

(424)

1,151

-37%

Merit LIC

(50)

705

-7%

American Life IC (Alico)

(470)

6,718

-7%

Delaware American LIC

(1)

24

-4%

Life Companies Total

(20,960)

27,550

-76%

It took an amazing amount of skill to lose 76% of the surplus of the affected life companies.  One company, American General L&A IC, lost more than double its surplus.  Wow.  Why did this turn out so wrong?  The assets were mismatched to the liabilities in two ways:  1) The mortgages had longer lives than the securities lending transactions.  Even if there were no credit issues, there was no way to assure that the mortgage bonds would be worth the same at the beginning and end of the transaction.

2) Though AAA-rated, they were not credit risk-free.  Non-prime mortgages were made to borrowers of lower quality.  Of their own, they wouldn’t be investment grade, much less AAA, without credit support.  That credit support came through subordination.  Other investors would take the first X% of losses before the AAA bondholders would take any losses.  That X-factor was set too low.  In order to maintain a AAA rating, the X-factor not only has to be high enough that losses don’t harm the AAA investors, it has to be high enough that other investors would think that it would be almost impossible for losses to harm the AAA investors.

Subsidiary

Net capital contributed / 2007 Surplus

(neg = divs)

2007YE Surplus

Net capital contributed

(neg  =  divs)

American General LIC

123%

5,704

7,004

AIG Annuity IC

167%

3,729

6,223

The Variable Annuity LIC

113%

2,838

3,213

SunAmerica LIC

57%

4,716

2,696

AGC LIC

12%

7,729

895

American General L&A IC

185%

471

872

First SunAmerica LIC

153%

501

768

AIG LIC

167%

440

736

Am Int LIC of NY

101%

553

557

AIG SunAmerica LAC

25%

1,151

284

New Hampshire IC

19%

1,369

265

American Life IC

3%

6,718

211

Commerce and Industry IC

7%

2,688

180

UG Mortgage Indemnity Co of NC

55%

55

30

21st Century IC

0%

663

2

AIG Auto IC of NJ

0%

18

AIG Centennial IC

0%

335

AIG Excess Liability Co.

0%

1,248

AIG Hawaii IC

0%

65

AIG National IC

0%

18

AIG Premier IC

0%

162

Am Gen Property IC

0%

18

Am Int IC

0%

367

Am Int IC of Delaware

0%

45

Am Int Specialty Lines IC

0%

638

Audubon IC

0%

42

Delaware American LIC

0%

24

F book

0%

Landmark IC

0%

146

New Hampshire Indemnity Co

0%

102

Pacific Union Assurance Co

0%

67

UG Residential IC of NC

0%

194

United Guaranty IC

0%

24

United Guaranty Residential IC

-2%

496

(10)

Hartford Steam Boiler IAIC of CT

-26%

43

(11)

AIG Casualty Co

-5%

1,884

(103)

Hartford Steam Boiler IAIC

-22%

720

(158)

Lexington IC

-5%

4,551

(250)

Merit LIC

-38%

705

(270)

AIU IC

-33%

1,398

(463)

American Home Assurance Co

-8%

7,297

(571)

National Union Fire IC

-6%

12,157

(787)

Totals

30%

72,089

21,313

As a result of the securities lending losses, and the troubles at AIGFP, the Fed and Treasury began the bailout of AIG.  (Look at the above table to see the amount pumped in and taken out of each subsidiary on net.)  Why did they indirectly bail out life insurance companies that they do not regulate including one that mainly serves foreigners (Alico), by bailing out the AIG holding company?

I can’t be totally certain here, but I suggest that all major state insurance regulators should send Ben Bernanke, Tim Geithner, and Hank Paulson some really nice gifts, because had AIG’s life companies failed, the state guaranty funds would have been hard pressed to come up with something north of $10 billion by surcharging the other insurance companies doing business in each state.  At a time like this, where many life insurers, particularly ones facing credit risks, and those having variable policies, where profitability has declined along with the stock market, the surcharges could have kicked additional life insurers over the edge, and who knows how big the cascade would have been.

(Note to corporate bond managers managing insurance money: this is why you don’t own insurance bonds in your neck of the industry.  The company you manage money for already has contingent credit exposure to all of their peers through the guaranty funds.)

AIGFP was the bigger issue, but the domestic life companies of AIG posed a separate, distinct issue that the US Government addressed, right or wrong.