The audacity of AIG, Part 1

The key to understanding AIG's role in the financial crisis is this:

1. AIG sold a special kind of unregulated financial insurance - much more insurance than it could have ever paid out in the event of a downturn.


2. AIG never set aside any money to cover insurance claims.


3. A financial downturn occurs and AIG does not have the money to pay out its claims.

The scale at which AIG sold this insurance is almost unbelieveable. There is a reason for this.

In most circumstances, a person buys insurance as a method of protecting their assets (for example, their house) against a loss (ie, a hurricane). Here in SF, we know that there is a hurricane season that lasts about half of the year (Rick used to have a pool going). As a result, the possibility of needing that insurance, to cover some (or all) of your loss, is real. Now, imagine that someone with money to spend (say from New York) convinces insurance companies to let him/her also buy insurance on houses in South Florida.

In fact, let's say that our investor has deep pockets and buys 30 policies for every house in the region. And let's say that the insurance company doesn't have to reserve any money for this new type of insurance. And lets say Wilma II blows through. In this case, Mr. NY Investor made a great deal of money, except the insurance company can't pay because it can't cover the policies. Oh no!

to be continued...