AIG, insurance reserves, and the “fool-me-once” principle

Bailing out AIG with its policyholders’ money looks like bad morals and bad policy.

Maybe I’m wrong about this, and I invite correction from those who know more than I do, but at first blush the decision by New York State to allow AIG to use insurance reserves as working capital seems to me grossly unethical.

Right now, no one wants to lend AIG any money, because there seems to be no assurance that AIG would be able to pay it back. If you want to buy insurance against default on a dollar’s worth of AIG debt, today’s price is 54 cents up front plus 5 cents a year. (Can you say “junk”?) And fear of default could be self-fulfilling; if no one lends AIG money, then it will go out of business, maybe before the end of the week.

So there’s a scramble on to get AIG some cash, in hopes that the firm will be able to sell some assets if given time. So far, the Fed has said no, the banks have said no, and Warren Buffet has said no. Doesn’t sound to me as if those folks think that AIG’s problem is just a liquidity squeeze.

So the insurance regulators of New York State have told AIG that its insurance subsidiaries can lend the parent company up to $20 billion worth of reserves. That money is supposed to be there to guarantee that AIG’s policyholders will be able to collect on claims. In effect, the state is re-writing the all those insurance contracts retroactively, picking the pockets of the policyholders.

If AIG is too big to be allowed to fail &#8212 if an AIG collapse would be the final trigger for an old-fashioned panic, with big effects on the real economy &#8212 then maybe it needs a dose of the same medicine that Fannie and Freddie got: a bailout from the taxpayers combined with nationalization of the enterprise so that the taxpayers and not the shareholders will benefit if the firm turns out to be solvent after all. Or we could do a bailout without nationalization, though I for one don’t see the case for socializing risk while privatizing reward.

But either would be better than bailing out AIG with its policyholders’ money, unless some government is at the same time prepared to protect the policyholders against an AIG default. People buy insurance to avoid gambling. For New York State to force them to gamble anyway is wrong, and may have bad long-term effects on the willingness of individuals and firms to buy insurance from firms registered to do business in New York. Fool me once …


A reader writes:

My understanding was that NY state is unlike all other states in that it requires insurers to pay into a catastrophic failure fund in real time. Other states have this fund, but it is only funded after the fact by all the surviving insurers. So NY state might feel safe in deciding to allow those assets to flow upstream because they already have an insurance fund in hand to cover it, should AIG fail in the long run?

If that’s right, it certainly changes the conclusion. If this is in effect a tax on all the other insurers in New York State, the benefit they get from not having AIG fail might easily justify the move. But then insurance regulators need to start looking at the parent companies of the insurers for signs of excess risk, in addition to their usual business of keeping the reserves up to strength.

Second update

Another reader, this one professionally involved in insurance law and regulation, supplies more light:

Your correspondent was right, but it really doesn’t matter. Keep in mind that an insurance company pays claims over a very long tail. Life insurance claims normally take years to develop (until the insureds die, or the term expires); P&C claims even longer; CGL claims longer still (keep in mind that some insurers are still getting asbestos and pollution claims from policies issued in the 1950s and 1960s!). So the fact that the guaranty fund is not prefunded really doesn’t matter much. By the time the bulk of the claims have been rolling in, it will have (or at least have the opportunity to get) adequate money.

That said, there are three big problems.

1.) AIG is the biggest US insurer by far. This is especially true in certain states (e.g., NY) where regulatory costs are really prohibitive for all but the biggest insurers — and yes, AIG played a big role in making sure that the regulatory costs were so high. So you’ve got fewer insurers, with AIG making up an enormous market share. I’m not entirely clear how the other insurers are going to be able to meet their guaranty fund assessments as AIG claims develop and mature. You very well may see a ton of companies flee the market to avoid these costs.

2.) Not all lines are covered by the guaranty fund, and many that are have caps. Workers’ comp (a line that AIG has a HUGE concentration in) comes to mind — I believe there is a pretty rigid cap. I’m not sure what subs are sending capital up the holding company system, but if they are in these lines, you’ve got a problem. You also have the problem that AIG often uses (at least it used to when I was working with/for it) a pooling system where all of its subs essentially combine their premiums, claims and assets into a big pool, and then they take a pro rata share of that single pool. I know that they use(d) this arrangement for workers’ comp and auto; I’m not so sure on other lines.

3.) The biggest problem is that this really limits the endgame. There is very little chance that the AIG companies will go into insolvency &#8212 no one with any power will let that happen. The much more likely result is an organized run-off (either through a statutory rehabilitation or a de facto one), where AIG stops writing new business, and it manages the existing business until it has all matured/terminated/expired. The biggest tool that regulators have in such a situation is the ability to sell off individual companies. But the big draw in buying individual insurers is not the policies themselves &#8212 those are liabilities! It’s the assets in the reserves that generate income. The buyer usually thinks that it can manage the claims and invest the assets better than the seller has been doing. If you deplete the assets, the problem becomes pretty stark pretty quickly. No one will by the AIG companies, so a traditional run-off (as happened with Kemper in the late 90s) is impossible.

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: