(a) Background of the corporation or institution

American International Groups earliest root is from Asia and then branched out in a
series of acquisitions, fusions, and consolidations, building it up to the giant pot.
AIG first started out in Shanghai by a young American entrepreneur who is
Cornelius Vander Starr in 1919. He founded the AAU, or American Asiatic
Underwriters, which is a low, two-way, two-clerk insurance agency that represented a
few American insurance companies established in Shanghai. They offered fire and
marine coverage. Seven years later, which is in 1926, Starr founded the American
International Underwriters (AIU) in New York, his first office is in America. The AIU
wrote insurance policies for Americans working outside the United States. He made for
the representation of Pittsburgh, Pennsylvania, and the Globe & Rutgers Company into
his close up.
In 1939, Starr decided to move his company's headquarters to New York
permanently after unrest spread in China and East Asia and the onset of the Second
World War. AIU experienced a rapid expansion during the 1950s, as they expanded
across 75 countries, most notably in Western Europe, North Africa, Australia, and the
Middle East. In 1952, the company merged with several other insurance, and they
collectively became known as American Home. Besides that, Starr already expanded his
companys operations to British and Chinese businessmen and established the
International Assurance Company (INTASCO), and also towards the Central American
and Caribbean businesses. When Starr joined the American Home board, he named
Maurice R. Greenberg as president, and the company formed the American International
Assurance Company of New York.
With Greenberg the company focused on broker sales, which permitted the
company to establish its own policies and maintain underwriting control. They focused
on industrial and commercial risks, which gave them negotiated rates instead of the usual
state-controlled rates. This permitted them to develop reinsurance facilities that would
cover large parts of major hazards and also control insurance ratings. American Home,
avoided medical insurance, but the new marketing strategies worked. Most large
corporations thought American Home for insurance.

The American International Group, Inc. as known today was formed in the late
1960s, when American Home began to be an important commercial and industrial
property and casualty insurer. In 1967, AIRCO formed American International Group,
which heralded the start of corporate re-constitution. Its many acquisitions and mergers
allowed it to become ace of the mammoth insurance groups ever.

(b) Chain of the case

AIGs result in 2007 was clearly unsatisfactory, said by the Chief Executive Martin
Sullivan. During years 2007, AIG reported a US $5.29 billion fourth-quarter net loss,
versus net income of $3.44 billion. To date, this case has been viewed through the
inaccurate conclusion of AIGs failure on its credit default swaps portfolio. Some more,
AIGs financial difficulties can be viewed from few difference businesses fields and this
is due to the shortcomings of the AIGs risk management.
In September 2009, the US government had bailout the American International
Group, Inc. (AIG) total $ 85 billion and the size of bailout increased to $ 180 billion over
next few month. This fall down of AIGs group can be traced back to March 2005, the
company rating was decreased from AAA credit rating to AA+ when the resignation of
AIGs current CEO, Hank Greenberg. However, this downgrade result not only leads by
the fail of derivative but also the mismanagement of AIGs group in internal control,
corporate governance and culture.
With the downgrade of credit rating, the company needs to post the margin on
those positions. The severe deterioration of the derivatives underlying AIGs credit
default swap portfolio forced AIG to post increasing the amount of collateral up the safe
limits. In November 5, AIG have agreed to post a total of $ 39.9 billion in collateral. This
problem of liquidity strains which caused by margin calls against the credit default swap
was making larger from AIGs securities lending unit.
During the time 2004 to 2009, AIGs insurances provide almost 90% of AIGs net
revenue and owned about 230 countries around the world. Prior to the Global Financial
Crisis, the American insurance regulators believed that the AIGs core operation in
insurances is generally sound. However, in years 2005, AIG decide to change in

investment strategy. The collateral in cash form would no long invest in low risk
securities, instead, AIG choose to invest in residential Mortgage Backed Securities. Many
people was disagree with the action and that was not the time to investing in the
Mortgage Backed Securities. Even the AIG rating these lines of businesses was too risky,
at the end of 2005, AIGs decide to stop underwriting subprime debt securities.
In next two years, AIGs Securities Lending Program aggressively expanded its
investment in subprime debt. By late of 2007, AIGs Securities Lending Programs held
amount up to $ 76 billion in liabilities and 60% is from the Residential Mortgage Backed
Securities (RMBS). The total asset of AIGs life insurances companies was about $ 400
million; about 11% of the assets were invested in RMBS and this lead to mismatch in
asset-liability management.
According to the Boyd (2011), the AIG manage in Securities Lending Programs
did not have a good management in perspective about the change in asset allocation. The
fund managers simply change in the prospectus which giving the freedom to invest in the
risky assets. When happen the subprime crisis, the answer of AIG is just the reassuring
mean buy misleading about the excellence of the portfolios risk management controls.
However, during late year 2007 and 2008, the RMBS was increase the difficulty to join
sell off and the size of RMBS portfolio is US pool was decrease from $ 76 billion to $ 58
billion by September 2008.
The subprime debt crisis began affecting AIG seriously in 2007, this decline in
market values was affected the AIG financial product and AIGs securities Lending
Programs. However, the fall in collateralized Debt Obligation (CDOs) make the AIGs
counterparties start to make the collateral calls. Initially AIG did not expect to suffer any
losses due to the subprime debt crisis, because based on the AIGs model, these collateral
calls was unnecessary. But the counterparties have their own models, which rating the
CDOs and some market participants began to report losses. Therefore, in 2008, AIGs
group forced to write down the value of the portfolios, which is unrealized loss of $ 11.25
billion. At the same time, S&P put AIG with the negative watch. The losses in securities
began affect the AIGs credit rating again. In mid of 2008, the rating based on the S&P
was reduced to AA-. Rating downgrade was created the situation become more serious;

this created the liquidity problems for AIG. The collateral calls increased by billions of
dollars every month.

(c) Lessons learnt from the case

Initially, AIGs securities lending activities such as reinvesting the cash collateral in
short-term U.S. were regulated and approved by state insurance regulators. Treasury
securities ensuring there was no maturity mismatch. However, AIG got greedy and
changed the nature of their securities lending program as well as its size by reinvesting
the cash collateral in mortgage-backed securities with long maturity dates, thereby
creating maturity mismatches once the housing market heated up (Thomas, 2014). AIG
had issued a large amount of credit default swap contracts to investors. When its ratings
were downgraded, AIG was required to put up additional collateral requirements (Henry
et al., 2008).
In 2007, the fall in the market price of underlying debt security made seriously
effect to AIGs liquidity which was adversely affected by requirements to post collateral.
Certain of the credit default swaps written by AIGFP contain collateral posting
requirements. The amount of collateral required to be posted for most of these
transactions is determined based on the value of the security or loan referenced in the
documentation for the credit default swap (Vasudev, 2010). This makes default swaps
more risky and onerous than regular insurance contracts.
As a lesson learned from this situation, the state regulators, acting through the
National Association of Insurance Commissioners, instituted new reporting requirements
for securities lending activities so that now state insurance regulators can easily identify
any maturity mismatch or other concern with these programs (Thomas, 2014).
Besides, the regulatory black holes in the financial system must be eradicated.
One black hole concerns regulation of financial derivatives the exotic instruments that
threw AIG into virtual insolvency. In 2000, Congress prohibited such regulation by law.
When regulation are finally adopted, as they almost certainly will be, they should prohibit

certain kinds of financial derivatives altogether and require that new ones prove their
safety and social value before being placed on the market (Robert, 2009).
In addition, renewed attention must be paid to corporate structure and prohibitions
on whole categories of activity. Insurance companies should be prohibited from operating
affiliates that function as de facto hedge funds. Commercial banks husbanding depositors
assets should be prohibited from operating securities firms or making securities firm-style
speculative bets (Robert, 2009).
Moreover, the unregulated use of credit default swaps and other high-risk
instruments by AIG Financial Products, a federally regulated noninsurance unit with
wildly insufficient reserves, caused AIG to stumble and threatened the financial system.
The essential lesson of AIG and of the broader crisis is the need to reform financial
regulation. And that reform should learn from state insurance regulation (Eric, 2010).
Furthermore, AIGs default swaps business was handled by its subsidiary, AIG Financial
Product Corp. (AIGFP), based in London, UK. Interestingly, AIG had a committee
specifically to deal with derivatives risk management which is the Derivatives Review
Committee. But, this was not a committee of directors. The Derivatives Review
Committee, which apparently consisted of company executives, did not look into the
credit derivatives business of AIGFP, which was treated as independent (Vasudev, 2010).
Last but not least, the lesson that should be kept in mind is that AIG should pay
serious attentions which in the monitoring of the default swap transactions, its potential
obligations and logistical issues such as valuation of securities (Vasudev, 2010). AIGFP
should be reporting all their derivatives transactions to committee that set up by AIG in
order providing convenient platform for them to monitor and examine their activities
regularly.

(d) Four (4) recommendations on how the problems could have been avoided
We suggest that stricter rules and regulations should be set on Credit Default Swap
(CDS) market. Calistru (2012) mentions that CDS markets are unregulated due to the
fact that this kind of derivative is traded OTC. Unlike exchanges, OTC market involves
less transparency and more counterparty risk (Stulz, 2010). First, standardization on
every credit derivatives contract must be as a precondition to enter into the market
(Calistru, 2012). Lack of clearing arrangements and standardization causes OTC market
to expose to systematic risks easily. Standardization ensures less risk of disputes from
both buyers and sellers, since quantity, quality, delivery date and other details from the
contract are revealed to both parties. As a result, all contracts are transparent to the parties,
and fewer risks would be incurred. Standardization also helps to reduce time for settling
the contract (Coudert & Gex, 2010). Second, disclosure requirement on credit derivatives
must be imposed (Archaya & Johnson, 2007; Calistru, 2012). Underestimation on risk
exposure might occur if no disclosure requirement. This makes company to take less
prudent approach in managing exposure risks in CDS market. This might be a reason
why AIGs Derivatives Review Committee overlooked their derivatives activities.
Disclosure requirement at least provides protection basic knowledge of contract and
counterparty for the trader, so that trader can take effective measures for overcoming
related risks. These regulations are so useful that they can help in suppressing any
misconduct in the financial markets, especially in CDS market.
Besides that, a party which acts as middleman should be available in CDS market
in order to reduce risks in the market. Centrally cleared market must exist in CDS
market (Calistru, 2012; Bolton & Oehmke, 2013). Many central clearing platforms (CCP)
are established as a consequence of subprime crisis 2007-2009. CCPs help in reducing
the counterparty risks by assuming the credit risk through credit risk mitigation method.
CCP must be an impartial party: it is independent from buyers and sellers, and cannot be
influenced by decision of buyers and sellers (Arora & Rathinam, 2011). As compared to a
normal OTC market, CDS market with CCP assure safer investment, as management of
counterparty risk can be run effectively, multilateral netting of exposures and payments
can be performed, centralized information on market activity and exposure can be

gathered by this party. Each party would not need to take more risks then since there is
mutualization of losses: CCP helps in assuming the counterparty and credit risks occur
in OTC market (Arora & Rathinam, 2011; Calistru, 2012; Hull, 2012; Bolton & Oehmke,
2013). Hull (2012) mentions that operations of CCPs should be regulated and monitored
well so that CCPs would not engage in risky investment activities. This ensures the
independent role of CCPs is carried out effectively. Presence of CCPs in CDS market
alleviates the financial integration in the market. Many companies, including AIG, could
reduce the costs of monitoring their credit derivatives activities in OTC market. Having
reduction on both risks (counterparty and credit risks) and costs (costs of monitoring) is
like killing two birds with one stone.

References