Convenient Fictions About AIG

On the same day Ed Liddy resigned as CEO of AIG, the NYT editorialized against a bill that would allow insurance companies to choose between being regulated at the state or federal level. Putting aside the merits of their argument and the sheer surprise value of the NYT arguing against federal regulation of..well, anything, the editorial made certain claims about AIG and its collapse which have become conventional wisdom. But that doesn't mean they're true.

The insurance businesses of A.I.G. did not falter during the financial crisis, and remain solvent and functional to this day. There are many problems with state regulation of insurance -- it is inefficient for insurers and inconsistently applied by the states -- but it has done a good job ensuring the safety and solvency of insurance operations, something that can't be said about federal bank regulation.

What failed at A.I.G. was its non-insurance business -- specifically, the financial products unit, overseen by the federal Office of Thrift Supervision, arguably the weakest of all the federal bank regulators. A.I.G. was permitted to choose the thrift office as its non-insurance overseer in 1999, after it bought a small savings and loan.

Thus, A.I.G.'s bailout is not an indictment of state regulation of insurance. It is a vindication of it, because the insurance businesses weathered the crisis relatively unscathed.

(Emphases added.)

This is the story which has been told numerous times since AIG collapsed in September 2008: a normal, functional insurance business was brought down by a hedge fund-like division at AIG Financial Products.  President Obama and Ben Bernanke have popularized this viewpoint.

The problem is that this story doesn't fully match up with AIG's numbers.  Based on the information provided by AIG in March as to the payments made to its counterparties from September through December 2008 , the infamous financial products division required about $66 billion in aid (about $54B of which was related to the infamous credit derivatives). But the staid, state-regulated insurance businesses pulled their weight: they ran up about $43.7 billion in losses on securities lending transactions! (A $20 billion capital contribution to the insurance subsidiaries was accordingly required.) If that qualifies as "weather[ing] the crisis relatively unscathed," I'd hate to see what a real business failure would have looked like.

State insurance commissioners have proffered various excuses as to why their regulatees were able to run up such losses.  But even if AIG's holding company improperly used its insurance businesses to run up these losses, how does it reflect well on the state regulatory regimes if the improper activities went undetected for so long?

Tom Maguire has been doing yeoman's blogging on this topic for some time (from which I have pulled most of the links), but it has otherwise attracted surprisingly little attention. Recently, however, David Merkel published an eight-part series on AIG and its insurance businesses at Seeking Alpha.  Merkel's summary is as follows:

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 below. 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.

(Emphasis added.)

I think Maguire has a good explanation of how, in the words of Thomas Gilovich, "we know what isn't so" with respect to AIG:

[B]laming everything on unregulated credit derivatives is a better story for politicians who reflexively favor more regulation when the current crop of regulators mysteriously fail.

As the disclosures came out around the time that everyone wasraging against the $165 million in bonuses paid out to AIG FP employees, not many people noticed the extent of the losses at the regulated insurance businesses - and the regulators are happy to keep it that way.  In fairness, as Maguire points out, Obama and Bernanke had good systemic reasons to push the "hedge fund" story, so as to avoid a collapse of confidence in the insurance industry. But as we look for another CEO for AIG and debate how to regulate insurance companies generally, it would be nice to take the facts into account.