NEW YORK—American International Group Inc. Chief Executive Officer Robert H. Benmosche's reported threat to quit last week—and subsequent pledge to continue his work at AIG—set the stage for a battle over pay curbs, while underscoring the enormous challenges AIG still faces, observers say.

Concerns that Mr. Benmosche might step down came after a Wall Street Journal report Wednesday that said he was considering resigning because of executive compensation constraints imposed by the U.S. government, and particularly the most recent review by Kenneth Feinberg, the Treasury Department's special master for Troubled Asset Relief Program executive compensation.

According to the report, which cited anonymous sources, Mr. Benmosche told directors he was “done” with the job he took in August—becoming AIG's third CEO since its 2008 bailout—because the pay policies hurt his ability to retain top executives.

The report touched off a wave of speculation, and hours later, Mr. Benmosche sought to calm concerns with a memorandum signaling he planned to stay at AIG.

The chief executive told employees he was “totally committed to leading AIG through its challenges,” while acknowledging that he has been frustrated by negotiations to devise an executive compensation plan that is “fair.” He called the pay issue a “barrier that stands in the way of restoring AIG's value” and repaying its government debt.

Mr. Benmosche told employees he would continue “to fight on your behalf” and said the company is involved in ongoing discussions with Mr. Feinberg.

Last week's development “raises the stakes,” said Bill Bergman, an analyst with Morningstar Inc. in Chicago. “AIG has made their case public, and it's clear they intend to fight this issue.”

Mr. Benmosche's reported threat to step down might have “simply been the result of emotions boiling over,” but it could signal that the former MetLife Inc. CEO is “under even more pressure than he anticipated when he took the job,” said Mark Lane, a research analyst with William Blair & Co. in Chicago.

Last month, Mr. Feinberg ordered pay cuts averaging 50% for the top 25 executives at seven companies that had received Treasury funding, including AIG, among other changes (BI, Oct. 25). The rules applied for the rest of 2009, but were expected to be used as the basis for a compensation program for 2010, Mr. Feinberg said. In addition, he is expected to rule on pay structures for the next 75 highest-paid employees by year-end.

“There is likely a lot of push and pull going on, and it's possible that the solutions being offered by the government are even more severe than anticipated,” said John A. Challenger, CEO of executive recruiter Challenger, Gray & Christmas Inc. in Chicago.

Observers said there are strong pay arguments on both sides.

“On one hand, there is a lot of political pressure; but on the other hand, the restrictions mean AIG is at a serious competitive disadvantage,” Mr. Lane said.

The issue of executive compensation has become even more acute as the economy begins to recover and other opportunities emerge for staff, observers say.

“I think there will continue to be an exodus of talent,” Mr. Lane said.

“I don't think you will see a hundred employees walk out the door, but there will be some departures, and it will likely be the key players who decide to leave,” said Richard V. Smith, senior vp at Sibson Consulting in New York. “These are the exact people you need on your team to rebuild the company,” he said.

Beyond any short-term financial incentives, “employees are going to have to believe they have a future in the company,” said Morningstar's Mr. Bergman. And AIG still faces the massive challenge of rebuilding its franchise and “inspiring confidence” in its future, he added.

AIG is working to sell assets, streamline its operations and improve profitability in an effort to repay the government after it received a 2008 bailout package of up to about $180 billion, in which the government took a roughly 80% stake in the company.

Mr. Benmosche, who came out of retirement to take the top job at AIG, is a “very driven CEO, and he does want to succeed,” said John Wicher of John Wicher & Associates Inc. in San Francisco. But from the beginning, the new CEO “made it pretty clear he was going to do things his way,” Mr. Wicher said.

For example, Mr. Benmosche disagreed with previous CEO Edward Liddy's approach to asset sales and, instead, implemented a slower approach to restructuring, believing it would generate more money.

In addition, AIG has rebranded its property/casualty business, formerly AIU Holdings, as Chartis Inc., in an attempt to separate and ultimately spin off the unit.

While observers say it's too soon to judge Mr. Benmosche's performance, they note that the company is showing signs of stability.

AIG earlier this month posted its second straight quarterly profit. A recovery in the value of its investments helped, although its underlying insurance operations reported lower revenues. Following the results, New York-based Moody's Investors Service said in a statement that the insurer has made progress on its restructuring plan and “will likely be able to repay the government loan.”

Had Mr. Benmosche quit, the move likely would have had a destabilizing effect on the organization, observers say.

“It is in the board's best interest to keep him in there. They do not want to go through this process all over again,” Mr. Lane said.

At the same time, “his willingness to fight demonstrates he is not just going to roll over, and that might actually boost morale,” Mr. Wicher said.

Meanwhile, AIG Vice Chairman Jacob A. Frenkel retired last week.

In a Nov. 10 memo, Mr. Benmosche wrote that although Mr. Frenkel, who joined AIG in 2004, “had been contemplating this change for some time, Jacob had agreed to stay on to help AIG through its challenges. Now that AIG has stabilized, Jacob has decided to move ahead with his retirement.”

Senior Editor Mark A. Hofmann contributed to this report.