by Joan Tupponce
For Virginia Business
Some businesses that rely on American International Group Inc. (AIG) to insure their risks began to wonder in recent months if doing business with AIG was a risky proposition itself.
Their concern stemmed from the unnerving news that the insurance and financial-services giant was in a crisis that could be turned around only by a lifesaving intervention by the federal government. An $85 billion loan now has grown to $150 billion bailout package that gives the government a $40 billion equity stake in the company. The restructured deal was announced the same day that AIG reported a third-quarter loss of $24.47 billion largely from write-downs on investments.
The bailout calmed the initial fears of some AIG customers in Virginia. “People became more comfortable after that,” says Tom Brown, CEO of Roanoke-based insurance broker Rutherfoord Cos.
Virginia brokers say the crisis didn’t prompt customers to leave AIG en masse, but it did raise anxiety as well as a lot of questions. Mainly people wanted to know: How did this happen? What caused the insurance giant to stumble? “When the news hit we fielded dozens of calls from agents,” says Robert Bradshaw, president and CEO of the Richmond-based Independent Insurance Agents of Virginia Inc. “Those were lessened after the bailout. What the bailout allowed the commercial insurance industry to do is to take a breather and not react and overreact.”
The bailout of AIG was one of the more remarkable milestones in a global financial crisis that has prompted massive government intervention on many fronts. In addition to providing money to AIG, the federal government has seized mortgage-finance companies Fannie Mae and Freddie Mac and initiated a $700 billion financial rescue plan known as the Troubled Asset Relief Program (TARP). TARP originally called for the government to buy up toxic mortgage-backed securities. Treasury Secretary Henry Paulson now has broadened TARP to include investing in banks and purchasing auto loans and credit-card debt.
AIG’s tumble made substantial waves in the economy because the company is a dominant force in the insurance industry. The National Association of Insurance Commissioners says AIG owns 71 U.S.-based insurance companies and 176 other financial-services firms around the world. AIG’s worldwide property and casualty businesses generated approximately $40 billion in revenue last year. The company now is considering selling some of its companies to pay back the government loan.
“They were the 800-pound gorilla in virtually every specialty sector,” says Anthony Markel, vice chairman of Richmond-based Markel Corp., which provides a variety of specialty insurance products. “Everything is yet to play out, but it’s clear that AIG is going to be a different organization. They will be less of a powerhouse. We’re going to have to see what their future holds.”
Company retaining clients
News of a $440,000 sales conference at a California resort in late September — less than two weeks after the initial loan was announced — didn’t help AIG’s battered public image. The weeklong event, held for independent life insurance agents, had been scheduled for many months.
Despite the turmoil, AIG continues to get new domestic commercial property and casualty business and is keeping much of its existing business on the books, says company spokesman Peter Tulupman. “Our client retention remains strong. However, it does vary from line to line.”
AIG’s troubles caused many Virginia businesses to take a wait-and-see attitude in deciding whether to renew their policies, says R.C. Moore, principal at Richmond-based broker TB&R Insurance. He believes the industry is in the “middle chapters” of this saga. TB&R has taken steps to identify all of its customers with AIG products to see whether they wanted to make a move or stay with AIG. “Those customers were looking to us to give them assurance that this would not be a problem,” Moore says.
There are no assurances, however. Therefore, brokers are providing customers with alternatives if they decide against renewal. “To this point nobody has asked us specifically to replace their coverage,” says Moore. “However, AIG is a very small percentage of our agency.”
Swaps caused trouble
Ironically, AIG’s problems stem not from its insurance business but largely from its involvement in speculative financial instruments known as credit-default swaps. Swaps originally were contracts that insured bond-like securities, collateralized debt obligations or CDOs, against default. Eventually hedge funds and other investors began trading swaps, creating an unregulated $55 trillion market. In the past 10 years, AIG issued $440 billion in swaps. But the once-profitable swaps turned toxic last year because of increasing defaults on subprime mortgages included in CDOs. The AIG unit issuing swaps had losses of $25 billion in the second quarter. The company nearly went under when it had to raise $15 billion in additional collateral because of a downgrade in its debt rating.
John “Mac” L. McElroy III, senior vice president and managing director for the Virginia operations of Baltimore-based broker RCM&D, says it’s important for customers to separate the AIG commercial insurance division from the AIG financial-services division. “The commercial insurance division is regulated by state insurance commissioners, and investment portfolios are managed quite conservatively in accordance with state requirements,” he says.
McElroy also notes that AIG came to the rescue of many companies during a “hard market” in the mid-1980s when commercial insurance wasn’t easy to get. “They did so at a stiff price, but they continued to do business when many of their competitors pulled away all together,” McElroy says. “Unfortunately, like some other big companies, they diversified into other financial services areas which proved to be a disaster. They had very poor oversight of their investments and transactions on the financial services side of the house.”
Other issues affect industry
AIG’s trouble isn’t the only issue that will impact the insurance industry in coming months. The economic downturn, rising inflation and failing financial institutions are all factors that will affect the insurance market but to what extent isn’t yet clear. “The situation is very fluid,” says Chris Schutt, managing director for Marsh of Virginia. “All of these factors are already having an impact on the availability and pricing of certain coverages such as directors-and-officers liability,” he says.
Publicly traded companies purchasing directors-and-officers liability coverage already are seeing higher premiums because of the expected increase in shareholder lawsuits as a result of the downturn in the financial market. “Public companies and financial institutions are also seeing more restrictive terms on D&O, as well as higher deductibles and lower limits from individual insurers,” Schutt says.
Insurance companies make much of their profit by investing the money they receive from premiums. Insurers, in fact, are among the nation’s largest investors in mutual funds. But like other investors, insurance companies have been buffeted by the recent wild swings in the stock market. “The investment side of the insurance industry is suffering,” says McElroy. “That puts more pressure on underwriting to generate higher returns.”
That pressure eventually could result in slight increases in insurance premiums. Currently, the insurance industry is still experiencing a soft market, which allows customers to shop for the best insurance rates. That climate will help keep insurance premiums from spiking. “I think there will probably be a little increase in premiums, but right now we are not looking at massive increases,” Bradshaw says.
However, the soft market, which has led to rate reductions, is beginning to deteriorate. McElroy believes “we are close to the bottom of that soft market.”
Capacity expected to be steady
Even if premiums do increase, the supply of insurance, known as capacity, should remain steady. “I don’t think any of this will harden the market or reduce capacity for 2009,” says Moore.
While AIG has been the attention-getter for a couple of months, it’s not the only element factored into the commercial insurance outlook for 2009. Natural disasters, such as fires in the West, tornadoes in the Midwest and Hurricane Ike which hit Texas, play a role as well.
Modelers at the Insurance Information Institute in New York estimate insured losses from Hurricane Ike at $9.8 billion, making it the fourth most expensive hurricane in U.S. history. But those numbers don’t compare to the $40.6 billion in losses that resulted from Hurricane Katrina in 2005. “The recent hurricanes haven’t had a dramatic impact on the marketplace,” McElroy says.
That’s good because AIG’s problems already have done enough to rattle the industry. Markel says no other insurance company could have such an effect on the insurance market because of its size and broad range of coverage. “It really is a defining moment,” he says.