Tuesday, March 10, 2009

Insurance (3) - Finance and AIG

The huge AIG insurance conglomerate has just received a second bailout from the US Government. The principles outlined in my previous posts explain why they got into trouble. AIG was insuring various kinds of debt instruments (CDOs) against the risk of default. Most of the CDOs were based on residential mortgages in the United States.

Insurance made sense while the risk of mortgage default was low likelihood and high impact. In normal times, the risk of a homeowner defaulting on their mortgage is quite low, even though the loss could be quite large, on the rare situations when they did default. Pooling the risk of mortgage default due to the vagaries of life was sensible.

Everything changes in a housing boom. When credit is flowing freely and every man and his dog is flipping houses, the nature of the risk changes. The boom eventually collapses and house prices fall. The risk of default ceases to be low likelihood, as default becomes widespread. The insurance companies set their fees as, if the risk was low, but now the risk is widespread and high impact, they are unable to compensate all those who face losses.

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