In order to understand the AIG debacle or any other possible seizure or bailout of an insurance company, it is important to understand the inner-workings of the insurance industry.  The insurance business, whether property/casualty or life, is a spread business.  A spread business in one in which you borrow at an interest rate that is lower than the interest rate that you earn.  In the insurance world the insurance companies borrow from policy holders.  When you pay the insurance premium on your automobile, house or life insurance policy the insurance company is effectively borrowing from you.  The insurance company takes that money, invests in bonds, stocks, and private equity but promises to pay you when something tragic happens.  The investment return that the insurance company earns on the money that it borrowed from its policy holders minus the payments made to policy holders is the spread or revenue for the insurance company. The profit comes when deducting all taxes and business expenses.

This idea can be seen most directly in an annuity policy in which the life insurance company agrees to pay you 4% per year until you die.  They make an actuarial assumption on your mortality, or how long on average they expect you to live.  Let us assume that on average they believe your will live for 20 more years.  If you, and a group very much like you will live for 20 more years, then they can take all of the money you gave them for the annuity and invest it in 20 year corporate bonds.  If they can earn a yield of 5% on their investment, then the insurance company is earning a spread of 1% on your money.  That is the heart of the insurance business in a nutshell.

The difficult aspects in running insurance companies come in the  the possible lumpiness of insurance claims, complexity of the products they sell, and the difficulty in effectively managing assets against liabilities.

The lumpiness of insurance claims is self-evident.  If you are a property/casualty insurer with a lot of exposure in Florida, a large and destructive hurricane in Florida can create devastating losses for you as an insurer.  Likewise, if you are a life insurer and there is a pandemic (more effective swine flu) killer, then you can lose substantial amounts of money off of life insurance claims.  These claims can be very lumpy and it can be tricky to correctly diversify your exposures and provide adequate capital for catastrophic events.

The complexity of the insurance products comes with “financial innovation”.  In the old days, insurance companies paid out if you crashed your car, found your house on fire, were robbed, or someone died.  Now insurance companies sell some of the most exotic financial options invented.  Variable annuities with embedded options with rate resets, floored guarantees, and numerous investment options.  The insurance contracts are flooded with characteristics that are determined by market conditions and policy holder behavior.  These complex products have gotten numerous companies in trouble (Hartford).  The complexity of property/casualty insurance contracts is much more sane, but have you ever tried to forecast the probability and number of hurricanes in the gulf region?

Lastly comes the asset/liability management.  This is the all-encompassing catchall for where most companies screw up.  The screw-up usually comes in the form of greed.  The insurance companies want to borrow as much money from policy holders as they can while earning as much return on that borrowed money as possible.  How do you do that?  By offering high crediting rates to the policy holders while taking more risk on the assets.  More risk can stem from investments in low credit quality bonds (high yield) but even there the return is limited.  When insurance companies run out of high yield cash products, they turn to the great people of wall-street for “financial innovation”.  That is basically how CDO’s, CDO^2, CPDO’s, CLO’s and synthetic bonds were created, as a need to satisfy spread-based businesses with higher return investments.  Why would an insurance company invest in a AAA rated 4% yielding bond when they could put the cash in a AAA rated tranche of a CDO that yielded 6%?  That extra 2% went straight to the bottom line….until the whole deck of cards collapses because that 2% difference truly represented a risk not captured by the AAA rating.

Up next:  AIG and its quick collapse…