Education of Risk Manager: AIG CDO Like Products in 1980s

Education of Risk Manager: AIG CDO Like Products in 1980s

When I worked for Pacific Standard, which had the dubious distinction of being the largest life insurance insolvency of the 1980s, I had few investment-related tasks.  Investments were handled by the overly aggressive parent company Southmark, which gave little attention to risk.

But I knew things weren’t going well, and so I interviewed widely, finally landing two job offers with Midland National and AIG.   I chose the spot with AIG, because they led me to believe I would work on the international side.  When I arrived, lo, I had a job on the domestic side.  As far as the job went, had I known I would be placed on the domestic side, I would have rather gone to Midland National.  They thought I had real leadership potential — whether true or not, that’s what I was told, and I would not have minded living in South Dakota, or nearby.  As it was, there were many good things that happen to me as a result of living in-between Wilmington, Delaware, and Philadelphia, living on the PA side of the line for reasons of adoption and homeschooling.

When I got to AIG, there was one main thing that involved my risk management skills.  AIG parent wanted growth in GAAP earnings.  They wanted to see a 15% ROE, which few in the life industry were attaining.  In order to do that, they entered into reinsurance treaties (before I arrived).  These would lever up the balance sheets of the subsidiary companies, without incurring debt.  Most of them passed risk to the reinsurers, one did not.

So, when I was called into an examination by the Delaware State Insurance Department auditor over the one treaty that did not pass risk, he said to me, “You know this treaty does not pass risk.”  I replied, “Under ordinary circumstances, I would agree, but the reinsurer has taken a significant loss from this treaty.”  He said, “What do you mean?”  I replied that when Congress passed the DAC tax, the reinsurer suffered the loss — they paid up front, and we pay over time, with zero interest.

He looked at me and said that reinsurance treaties did not exist to cover tax policy, and that the treaty was a sham.  I just shrugged.  I was not the creator of the treaty, and would not have done it if I had been at American International Group Inc (NYSE:AIG) two years earlier.

But the there were the two larger treaties that passed risk with a vengeance to a large reinsurer [LR] who is no longer a reinsurer (if anyone wrote treaties like these, he might not be a reinsurer anymore either).  In one sense, the treaties were structured like the trading requirements in CDOs.  If you must trade:

  • Get more income
  • Don’t give up rating
  • Don’t extend maturity
  • And a few more smaller things.

I was not there when the treaties were created.  Had I been there, I would have paid a lot more attention to them, and instructed the investment department to set up segregated portfolios, which was not done.  As it was, bonds that underlay the treaty were casually sold as if free to do so.

Now I arrive on the scene.  After reading the treaties, and looking at the data, I conclude that the treaties have been abused on our side.  I suggested to LR that I go through the history, and reallocate bonds that would have fulfilled the treaties strictures, an re-work the accounting so that the terms of the treaty would be fulfilled.  Initially LR agreed to this.

The treaty passed all investment risk to the reinsurer, so defaults would hit them.  What was worse, the liabilities underlying the treaty were structured settlements.  (Structured settlements result from a court case where someone is injured.  The plaintiff offers to buy from a reputable life insurer an annuity that will make the requisite payments.  Low bid wins, and if the defendant is badly injured, the cost goes down for payments that terminate at death.  That’s where most of the bad estimates com in.)  In those days, structured settlements were a “winner’s curse.”  If you won, it was because you mis-bid.  American International Group (NYSE:AIG) Domestic Life Companies regularly overbid for their business (as did most of the industry).  LR did not do enough due diligence to see the underwriting errors.

I did a mortality study to estimate how badly we needed to increase reserves, and lo, it was more than $100 million, all of which would flow to LR.  LR decided to sue.  After I had gone on to Provident Mutual, AIG settled with LR.  Our missteps with the assets made the case tough, and the reinsurance treaty was rescinded.  That should have been enough to jolt AIG’s earnings for a quarter, but it did not.  Funny that, and it always left me a little suspicious of AIG.  (And LR.)

Before I left AIG, I had clipped the wings of the underwriters of the structured settlements so that they could not write on cases for the most severely disabled.  I also shut down a tiny line of variable annuities that was losing money left and right to an outsourcer who had a sweet contract from a prior management team, but upon leaving AIG I did not feel that great, because I had not built anything — most of my time had been spent trying to limit losses from prior bad underwriting and planning.  It wasn’t fun, and I loved my next company more because I got to build.

PS – a prior note on AIG.

By David Merkel, CFA of Aleph Blog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.