Continuing profitability / Is this strictly an investment problem?

	2007 Net Income	2008 Net Income	2007 Net Operating? Income	2008 Net Operating? Income	Surplus Increase net of Capital Contributions and divs	Yellow Column less Realized Capital Gains
Total P&C	5,563	733	7,210	654	(353)
Total Life	3,404	(23,218)	7,206	2,819	(29,539)	(1,840)
Total	8,967	(22,485)	14,416	3,473	(29,892)

	Net Underwriting Gain 2007	Net Underwriting Gain 2008	Net Investment Gain 2007	Net Investment Gain 2008
Total P&C	2,189	(1,939)	3,783	2,485

Take a look at the above two tables.? For the P&C OISs, investment results were worse in 2008, but the really big swing was in underwriting, where profits were around $4 billion lower than 2007.? My summary figure for core P&C statutory earnings in 2008 is the -$353 million highlighted in green.? That is the surplus increase net of capital contributions and dividends.? I.e., how much did the value of the companies fall as a result of the year operations — $353 million.

For the life companies, I did the same calculation, but netted out realized capital losses, which should not recur, for a core statutory loss of $1.84 billion.? I can’t split that entirely into underwriting and investments, as with P&C, but taking out the realized capital gains approximates it.

My main point here is that 2008 was a bad year for AIG’s OISs even without the investment losses.? Not enough to take any of the main OISs into insolvency by itself, but bad still.

Articles and other issues

More holding company liquidity out of thin air: receiving a $800 million loan from American General Finance, a wholly owned subsidiary, in exchange for giving the subsidiary $600 million in capital to satisfy a debt covenant.? Wonderful, American General Finance is somewhat less creditworthy to bondholders of the firm, and the AIG holding company gets cash.

AIG attempts to raise cash and reduce leverage through the sale of subsidiaries that are in relatively good shape:

• Investment Management Businesses
• 21^st Century Insurance (Personal Auto, mainly)
• Reorganizing AIU Holdings to make it more saleable.

The price talk doesn’t look that great.? Counting in Hartford Steam Boiler, premium prices are certainly not being realized.

In general, the simplest units to sell are the simplest ones to value.? They have the easiest models for analyzing likely future free cash flows, or distributable earnings.? I have said before that when a company is in a crisis, and has to sell off assets, that it makes a great deal of difference what kinds of assets they sell off.? If they reach for the dirtier assets, and wish to keep the clean ones, it is usually a sign of confidence in the future.? If they sell the good assets, because that is all they can do, they are just stalling for time, and hoping that a better day arrives.? Hope is not a strategy, but that is what seems to be going on here.

Now, as for Maurice Raymond Greenberg’s claim that he had nothing to do with the wreck of AIG, let me simply say that he should shoulder a lot of the blame.? Most of the increase in leverage occurred under his watch.? AIG was a decidedly more risky investment when he left than in the late 80s, when the balance sheet had virtually no debt.? He encouraged a fear-based culture that was very bottom-line oriented for the quarterly earnings estimate, even to the point of buying finite reinsurance to manipulate the results.? He pushed for an aggressive culture at AIG Financial products, and he got one.? He may not have been there for the worst of it, but he certainly sowed the seeds of future trouble.

Summary

To what degree were AIG’s operating subsidiaries sound? Answer: aside from the mortgage insurers, the P&C subsidiaries were basically sound, though with some issues such as capital stacking, affiliated assets, etc., as mentioned above.? The non-mortgage P&C subsidiaries didn’t have a great 2008, but they would have survived as standalone entities.

The life and mortgage subsidiaries are another matter.? Without the help of the US Government, many of them would have failed.? Even now, given the levels of affiliated assets, capital stacking, deferred tax assets, etc., they are not in great shape now should there be another surprise.? Profitability is likely to be lower in the future than in the banner years of the middle of the 2000s decade.

The US government acted for multiple reasons on AIG.? Among them was to protect the other life insurers of the US from getting surcharged in order to pay for the costs going to the guarantee funds, along with systemic risk issues at AIG Financial Products (which was much bigger).

If AIG did not have AIGFP, and no bailout from the US Government, the company as a whole would have come under severe stress, and some of the life and mortgage subsidiaries would have gone into insolvency, but the company as a whole would probably have survived.

Investment implications

My view of AIG is this: the common stock will go out worthless, or nearly so.? Preferred stakes will be compromised at best.? Beyond that, I am less certain.? I look at two types of debt securities and wonder, though.? I am planning on doing a review of the funding agreement-backed notes, and perhaps a closer look at American General Finance notes after the first quarter is reported.

The tough part is we don’t know what the government will do.? If their main goal was stabilizing AIGFP, and that job is nearly complete, then if the value of AIG as subsidiaries get sold appears to not support the preferred stock, the government might walk, and not throw good money after bad.? At that point, bonds of the holding company would suffer further, because the insurance commissioners will carefully watch any dividending up to the AIG holding company.? They got bailed out once.? They will be watching more closely from now on, because lightning doesn’t often strike twice in the same place.

My basic view is take a conservative posture on AIG securities.? There are many competing interests, some political, some economic, fighting over the corpse of this once great company.? Be wary of investing in the capital structure of AIG.

Deferred Tax Assets

Here is a table of deferred tax assets by OIS, for those having more than 10% of surplus in DTAs. Deferred tax assets are only valuable to the degree that you can earn income adequate to use them. The column ?DTA payback? indicates the number of years of 2007 earnings (a relatively good year) that it would take to fully use the DTAs.

Now, it may no longer matter whether AIG ever pays taxes or not. It is largely ?in one pocket, out of the other? with the government. But it does have some solvency and profit implications for the subsidiaries.

Subsidiary	DTAs/ Surplus	2008YE Surplus	DTA payback
American General L&A IC	152%	488	6.24
Am Int LIC of NY	133%	371	13.22
AIG LIC	131%	360	11.91
AIG Annuity IC	117%	3,045	15.53
First SunAmerica LIC	85%	544	17.37
The Variable Annuity LIC	70%	2,841	7.08
UG Residential IC of NC	61%	200	NA
American General LIC	50%	5,185	6.66
American Life IC	43%	3,900	2.93
AIG Premier IC	37%	144	151.43
SunAmerica LIC	35%	4,653	4.94
Hartford Steam Boiler IAIC	29%	443	1.65
AIG Centennial IC	24%	305	NA
AIG Hawaii IC	23%	64	NA
AIG SunAmerica LAC	20%	1,271	4.26
United Guaranty IC	19%	52	2.60
American Home Assurance Co	19%	5,702	1.81
AIU IC	18%	726	3.66
AIG National IC	12%	17	NA
Merit LIC	12%	406	2.00

DTAs as assets earn no income, and there is nothing that can be tapped for cash in a crisis. In insolvency, they are not very useful, because acquirers can only use them in very limited ways. Therefore, having a long DTA payback period, or a high amount of DTAs as a fraction of surplus is a negative for profitability and solvency.

This will prove to be more of a difficulty if prior profitability levels are not regained, which could be particularly difficult for the equity-sensitive OISs, where fees from variable products will likely be down for a while. Also, consider that the OISs as a whole may find that 2007 was an exceptionally good year for investments and underwriting, and may not be achievable any time soon.

Reinsurance

Before I start this section, a small word of warning.? I am a life actuary, not a P&C actuary, so I may not get all of the nuances on reserve credits for P&C companies.? I have worked on life reinsurance issues at all of the life companies that I have worked with, or consulted for, but it is not my specialty.

Reinsurance involves a transfer of risk to another insurance carrier.? To the degree that risk is transferred, a reserve credit can be set up to reflect the discounted expected value of future claim payments.

Reinsurance does carry a risk, though, if the reinsurer can’t or won’t pay.? AIG’s rather sharp handling of reinsurers in the past carries with it the risk that reinsurers will be less than sympathetic to their problems.? Because of AIG’s difficulties, reinsurers will be more likely to try to deny claims while AIG is weak.? And like the parable of the unjust steward, some AIG employees might be inclined to compromise at levels fairer to the reinsurer.? After all, opportunities at AIG are ebbing, but having friends in the industry is always an aid when looking for work.

Here’s a table listing the size of the net reinsurance reserve credits by subsidiary relative to the size of the surplus.

Subsidiary	2008YE Surplus	Reinsurance Reserve Credit / Surplus
AIG National IC	17	1300%
Am Int IC	374	1006%
Am Int Specialty Lines IC	726	742%
AIU IC	726	407%
Am Int IC of Delaware	48	319%
UG Mortgage Indemnity Co of NC	128	260%
AIG Excess Liability Co.	1,438	179%
Lexington IC	4,263	162%
AIG Hawaii IC	64	144%
Landmark IC	155	143%
American General LIC	5,185	101%
New Hampshire Indemnity Co	140	100%
United Guaranty Residential IC	1,106	97%
21st Century IC	747	96%
American Life IC “Alico”	3,900	93%
AIG Premier IC	144	92%
AIG Centennial IC	305	83%
AIG LIC	360	70%
Audubon IC	39	69%
UG Residential IC of NC	200	45%
Hartford Steam Boiler IAIC	443	41%
F book	23,314	22%
American General L&A IC	488	18%
Delaware American LIC	25	16%
SunAmerica LIC	4,653	13%
Am Int LIC of NY	371	12%
First SunAmerica LIC	544	6%
AIG SunAmerica LAC	1,271	5%
AIG Auto IC of NJ	21	2%

A few notes: 1) The higher the reinsurance reserve credit is relative to surplus, the greater the risk if the reinsurers can’t or won’t pay.? 2) AIG reinsures many of their risks internally through intercompany P&C pools, but the reinsurance credits from those agreements should net out of the net reinsurance credit figure. The reinsurance pools spread out risk within AIG, but do not reduce the risk within AIG.? Plus, say an insurance commissioner trying to keep an OIS afloat in his state might take actions that keep that OIS safer, but that would push risks to other OISs in other states.? 3) There is one odd entry called “F book.” Five OISs share one statutory book for all of their reinsurance – National Union Fire IC, American Home Assurance Co, Commerce and Industry IC, New Hampshire IC, and AIG Casualty Co.? Those OISs are 5 of the 6 largest, ranked by 2008 year-end surplus.?? Though large, there is not much reinsurance credit exposure there.

Whether internally or externally reinsured, the size of reinsurance credits relative to surplus raise solvency risk issues if reinsurers can’t or won’t pay.

Unrealized Capital Losses

Subsidiary	C UR CG / Surplus	2008YE Surplus
Pacific Union Assurance Co	-385%	20
AGC LIC	-360%	5887
American Life IC “Alico”	-118%	3900
American General LIC	-89%	5185
SunAmerica LIC	-74%	4653
AIG Casualty Co	-46%	1457
AIG Annuity IC	-29%	3045
American Home Assurance Co	-21%	5702
The Variable Annuity LIC	-20%	2841
Hartford Steam Boiler IAIC	-16%	443
Commerce and Industry IC	-16%	2678
Audubon IC	-15%	39
AIG LIC	-15%	360
Lexington IC	-10%	4263
Am Int Specialty Lines IC	11%	726
AIU IC	32%	726
UG Residential IC of NC	34%	200
AIG SunAmerica LAC	50%	1271

The table to the left indicates current unrealized capital gains as a fraction of surplus.? When I first looked at this, I though most of these must have been from unrealized losses on bonds, but to my surprise, they are mostly losses from affiliated company stocks, which must be valued at market price or net worth.

But as I began to dig into the losses, I found something unusual at Alico. At the end of 2007, almost the entirety of their surplus assets were composed of AIG common stock.

Delaware regulators, please tell me, why would you allow this?? It is one thing to allow this for a pup subsidiary like Pacific Union, and quite another thing for a big dog like Alico.

For those less aware, holding affiliated stock of subsidiaries is capital stacking, which raises leverage, but owning holding company stock is creating capital out of thin air.? When things are going good capital rises disproportionately.? When things are bad, the opposite happens.? We are experiencing that negative part of the cycle now.

Now there were other areas of loss for AIG OISs, many are detailed in this article here.? I’m not generally a fan of insurance companies investing in anything more dangerous than investment grade bonds.? My main reason for this view is the outlier types of events, like that which we are seeing now.? Insurance companies should never want to be in a situation where they are suffer underwriting losses at? a time where they are taking losses on the investment side as well.? Most of these losses from limited partnerships (private equity and hedge funds), though unrealized, have already hit capital levels.? Some will make part of the losses back, but many will not.? In this environment, high risk investments are not being rewarded.

Capital Stacking, Cross-guarantees, and Surplus Notes

After the difficulties with securities lending, the next issue reminded me a lot of the first company I worked for: Southmark.? A two-time loser in chapter 11, in their second trip of insolvency, they interlaced the capital of their subsidiaries, forcing them to do business on a thin capital base.? Subsidiary A would own stock of subsidiary B, and B would own stock of A.?? They would both look more solvent, but would not be any more solvent.? Neither “asset” could be tapped for liquidity purposes.? In AIG’s case, most of the capital stacking was not so crude.? Most of it was operating subsidiaries owning shares in other subsidiaries, without another transaction going the other way.

Capital stacking increases leverage in a hidden way.? Say Subsidiary A owns Subsidiary B.? The surplus of B not only supports B’s business, but also A’s business.? A downturn in the business of B affects not only the affairs of B, but also A, particularly so if the surplus of B is a large fraction of A’s surplus.

With AIG, many of the operating insurance subsidiaries [OISs] held stakes (usually common stock) in other OISs.? Here’s a table of those subsidiaries with the exposure to the issue:

Subsidiary	2008YE Surplus	Affiliated Assets / Surplus
Am Gen Property IC	18	628%
AGC LIC	5,887	171%
UG Residential IC of NC	200	138%
SunAmerica LIC	4,653	107%
National Union Fire IC	11,825	90%
American Life IC “Alico”	3,900	79%
Audubon IC	39	77%
American General LIC	5,185	74%
New Hampshire IC	1,652	72%
AIG Centennial IC	305	63%
Hartford Steam Boiler IAIC	443	47%
AIG Casualty Co	1,457	35%
AIU IC	726	34%
AIG Hawaii IC	64	27%
AIG Excess Liability Co.	1,438	24%
American Home Assurance Co	5,702	23%
AIG Annuity IC	3,045	22%
American General L&A IC	488	22%
Commerce and Industry IC	2,678	20%
The Variable Annuity LIC	2,841	20%
Am Int IC	374	19%
Am Int LIC of NY	371	19%
AIG Premier IC	144	18%
United Guaranty Residential IC	1,106	16%
New Hampshire Indemnity Co	140	13%
Hartford Steam Boiler IAIC of CT	46	11%
Lexington IC	4,263	11%
Pacific Union Assurance Co	20	10%
AIG LIC	360	9%
AIG SunAmerica LAC	1,271	8%

Some of AIG’s larger OISs have significant exposures to other subsidiaries.? One minor subsidiary, Pacific Union, invested directly in AIG’s common stock.? That subsidiary doesn’t have much business in it, and is in little danger of insolvency, but is the most egregious example of creating capital out of thin air.? (I feel the same way when companies contribute common stock to Defined Benefit plans.)

Other OISs of note: 1) AGC LIC seems to be an intermediate level holding company, with little business of its own.? 2) National Union is the biggest P&C company.? 3) Alico is the intermediate holding company for most of the International Life business.? 4) SunAmerica and American General are holding companies for the companies when they were acquired by AIG.? They have significant business in themselves as well.

There are guarantees as well.? Some of the larger subsidiaries, like National Union, together with AIG, guarantee a number of other domestic and international OISs.

Finally, there are surplus notes, concentrated in the mortgage guarantee subsidiaries.? This is another way of creating capital out of this air.? Surplus notes are considered as surplus, not debt, to the issuer, because any payment of principal or interest must be approved by the state Insurance Commissioner.? Subsidiary A offers surplus notes to Subsidiary B, which sends cash back to subsidiary A.? Subsidiary B gets to admit the surplus note as an asset.? New surplus created, with no transfer of risk to an external party.? Three of the four mortgage guarantee subsidiaries issued surplus notes to other AIG mortgage insurance-related subsidiaries totaling a little less than $900 million.

Now, given all of the complexity and leverage from all of these arrangements, it is all the more stunning that the normally intelligent New York Insurance Department allowed for the OISs of AIG to contemplate lending $20 billion to AIG.? At the time, I thought the idea was dubious.? This article from Enforce (pages 17-20) gives the definitive treatment of the issue, though I disagree with one of their main conclusions.? I don’t think the Federal Government would do a better job regulating insurance than the states currently do.? They have certainly not distinguished themselves in their regulation of depositary institutions.