Reed Smith LLP on AIG’s Financial Distress: How Credit Default Swaps and the Lack of Regulation Brought down an Insurance Giant and Implications for the Insurance Industry
The recent financial collapse of American International Group, Inc. (“AIG”) came as a shock to many people. How, they wondered, could one of the largest insurance organizations in the world fall so far and so quickly, to the point of bankruptcy and eventual bailout by the federal government? Equally troubling are the implications of AIG’s collapse on the insurance industry, in terms of the possible future of AIG’s subsidiary insurance companies and the potential for changes in the way insurance is regulated going forward.
This article seeks to address these questions and concerns. First, it provides a brief summary of the causes of AIG’s financial distress, including a discussion of credit default swaps, the arcane financial instruments at the root of the collapse, how they caused AIG’s downfall, and what the federal government has done to rescue (or at least to ease the transition of) AIG. Next, this article discusses some of the implications for the insurance industry. It describes the relationship among AIG and its insurance subsidiaries and explains how that relationship, along with AIG’s announced plan for paying back the $150 billion federal loan (plus interest), may affect the ability of the insurance subsidiaries to operate in the future. This article also explores the effect on the broader insurance industry, including the real possibility of comprehensive federal regulation of insurance for the first time in the history of the United States. Credit default swaps raise interesting issues concerning the nature of insurance and whether it makes sense to regulate them and similar financial instruments as insurance products. This article concludes that some form of increased federal scrutiny of insurance and credit default swaps is quite likely.
The authors provide an analysis of the role of credit default swaps in the financial and insurance markets and explain how AIG became a major player in credit default swaps. They then examine the implications of AIG’s subsequent financial distress on the insurance industry.
“The deterioration in AIG’s financial situation raises several issues related to insurance. One set of issues concerns the possible future of AIG’s subsidiary insurance companies, and other issues are more broadly focused on potential changes in the insurance industry. Many risk managers and lawyers began confronting the first set of issues almost immediately after news of AIG’s brush with bankruptcy and subsequent government bailout became public: are the insurance subsidiaries at risk of bankruptcy or liquidation themselves, and what would happen to them, the insurance policies they issued, and their ability to pay claims if they are unable to operate? The other issues have to do with concerns over the adequacy of the scope and rigor of the current schemes to regulate insurance companies.”
The authors also analyze the future of AIG. They explain what steps AIG has proposed to take to survive and what the consequences might be if AIG is unsuccessful, noting that “one must be cognizant of the possibility that one or more of the AIG insurance subsidiaries could eventually be liquidated.” They state that “An order of liquidation is the end of the road for an insolvent insurance company. It is akin to a Chapter 7 proceeding, although insurance companies are exempt from the federal Bankruptcy Code.” The authors then explain what that liquidation process would entail.
The financial collapse of AIG may lead to federal regulation of the insurance industry. In addition, should credit default swaps be regulated as insurance products? The authors explore that question, beginning with the view that
“regulating credit default swaps as insurance could have an enormous impact on their use as a financial instrument that greatly restricts their utility and worth as vehicles to hedge investments. Resolving the questions of whether and how to regulate credit default swaps as insurance requires an analysis of what the concept of ‘insurance’ includes, how credit default swaps do and do not fit this concept, and the ramifications of regulation on the industry.”
This article concludes with this recommendation.
“In the modern financial services industry, a truly national voice of a federal regulator may be required as part of a comprehensive structure to regulate these worlds. Credit default swaps, half insurance and half something else, are reminiscent of a device from a much earlier time in the history of insurance, the wagering contract. One of the goals of any scheme to regulate credit default swaps, whether at the state or national level, should be to clarify the status of these financial instruments so that appropriate regulations can be enacted.”
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