American International Group Inc. is facing significant challenges amid the global financial crisis. In this

article,

let's explore how AIG got in trouble.

AIG has been known for three major business components:

• c Sell insurance. As an

  insurer, AIG reimburses organizations and individuals that suffer financial losses and defends them when they are sued.

• Park assets. AIG borrows money and buys assets for clients. It shows assets and debt on its balance sheet. It also leases

  assets to companies that do not want to show liabilities on their own balance sheets.

• c Smooth earnings. AIG has used its

  financial strength to reduce the volatility of net income for clients through alternative risk transfer mechanisms, such

  as

  credit derivatives.

For many years, the model worked splendidly. AIG would aggressively evaluate and accept risks that

others considered to be too risky. The company used its financial muscle to develop risk transfer products that were beyond

the capabilities of smaller or weaker insurers. AIG executives prided themselves on finding creative and profitable solutions

to policyholder problems. Under former Chairman and Chief Executive Maurice Greenberg, AIG built a culture that rewarded

success and punished failure.

For a long time, AIG expanded beyond regulated insurance. Statutory accounting limits profits

and growth rates by allowing insurers to show only admitted assets and forbidding the deferral of certain costs, among other

requirements. Capital markets are not so constrained. AIG and others created securities to bring the capital markets to

accept catastrophic and other risks.

How the problems started

To understand AIG and its bailout, which has now reached

$150 billion, let's start with conservative insurance accounting. Underwriters recommend products to offer in the market and

standards to evaluate risks. Insurers forecast the likely level of losses. Regulators allow only the most safe and liquid

assets to be shown on balance sheets. New business, profits and growth are restricted by understated capital.

The next

problem arises because insurers and reinsurers lack sufficient capital to handle large insured losses, such as: Hurricane

Katrina, $43.6 billion; Hurricane Andrew, $22.9 billion; the Sept. 11, 2001, terrorist attacks, $22 billion; and the

Northridge, Calif., earthquake, $17.5 billion. These figures, compiled by the Insurance Information Institute, reflect 2007

dollars.

Global insurance capacity is a small fraction of the values exposed. The solution to catastrophic risk is to bring

in the global capital markets, which recently had more than $50 trillion in capital. That's a large number even compared with

the $30 trillion of U.S. home values.

Thus, AIG added to its business model the sale and guarantee of

derivatives--securities whose value derives from another security or asset. Also called risk securitization and alternative

risk transfer, an insurance company transfers underwriting risks to the capital markets, through:

• c Tradable securities,

  which can be sold in pieces, or tranches, to many investors;

• Contingencies, in which investors agree to waive principal

  repayment if a contingent loss occurs;

• c Interest rates that offer relatively high returns to holders of the portions of

  the security;

• Principal repayment, either periodically or at maturity, to investors.

An example of ART is the

catastrophe bond. Say an insurer faces a $300 million loss if a hurricane damages insured property in Florida. The insurer

creates a two-year cat bond offering 15% annual interest and sells it to an investment banker that invests the cash received

in secure assets. Investors purchase tranches of the bond, collect interest for two years and hope a hurricane doesn't hit

Florida. With no loss, they get back $300 million at maturity. If a hurricane causes a $175 million loss, they receive only

$125 million.

Two things are true with catastrophe bonds and other insurance securities. First, profits are based on

payments to protect insurers against a natural or other disaster. Second, it actually is insurance. The invested money is

available to pay losses if they occur. AIG and others are not likely to get into trouble with cat bonds and similar

derivatives.

The situation changes dramatically when insurers move into noninsurance securitization. These securities are

attractive to investors because they offer above-market returns and have a low correlation to other investments that move in

tandem with interest rates, inflation and economic optimism. The combination of high return and low correlation diversify a

financial portfolio--at least in theory.

Three specific noninsurance securities handled by AIG and others can help us

understand what happened:

• Guaranteed investment contracts. A municipality approves a construction project and issues a

  bond sold to investors. The issuer deposits the proceeds in a low-rate interest account secured by a GIC from an

  investment

  bank that assures the return of principal when needed. The investment bank profits by investing the cash elsewhere at a

  higher rate of interest.

• Collateralized debt obligations. An investor wants to diversify a financial portfolio by

  purchasing home mortgages and buys from an investment bank a security with 1,000 mortgages as collateral. An investment

  bank

  can create CDOs from nonmortgage assets, but subprime mortgages were the genesis of the financial crisis. The investor

  collects monthly mortgage payments and receives the remaining principal when homeowners repay the loans.

• Credit default

  swaps. The investor who buys a CDO is concerned about the risk of default of the underlying loans, in this case

  homeowners

  defaulting on their mortgages. So the investment bank guarantees the monthly mortgage payments and eventual repayment of

  principal. The investor pays a fee for the guarantee.

Caught in the implosion

AIG got into the investment banking

business when it entered the realm of noninsurance securitization. The derivatives offered high returns, growth and no

government regulation. The company did not have to maintain reserves or otherwise comply with statutory restrictions.

As

the credit markets imploded, AIG was caught in a liquidity squeeze. Municipalities, concerned about home mortgages, demanded

funds early. Homeowners defaulted on monthly mortgage payments, banks foreclosed and holders of AIG credit default swaps

demanded their money. It was only after these events that AIG began to understand the full impact of its exposure, and that's

what prompted the massive federal bailout.

So what happens now? We will see. It appears that governments around the world

are moving to stop foreclosures, provide liquidity and offer guarantees to avoid collapse of the financial system. If

governments fail in this task, AIG will not be out of the woods.

John J. Hampton is the KPMG Professor of Business and Dean

of the School of Professional and Continuing Studies and Graduate Business Programs at St. Peter's College in New Jersey. To

read Mr. Hampton's columns and interviews, visit

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