American International Group Insurance - Case Study Example

AIG Insurance: Case Study ID Institute Table of Contents Introduction Analysis and evaluation 2 Discuss how and whatmotivated AIG to be part of the derivatives business. 2 2- What are (if existed) the ethical and unethical sides of AIG’s derivative business? 2 3- Discuss whether the AIG management team was aware of the level of insolvency risk. 4 Recommendations 6 Conclusion 7 References 8 Introduction American International Group (AIG) went bankrupt and the US government had to intervene to save it during the financial crunch. The companys financial products division sold a lot of derivatives called the Credit Default Swaps. The American and international investors purchased these financial instrument on their Collateralized Debt Obligations. The problem was that these instruments were sold by credible institutes such as Lehman brothers, Goldman Sachs and Morgan Stanley therefor people trusted the authenticity and credibility of these instruments. The AIG did not have a credible collateral against the coverage it was providing so aggressively to these investors. The risk management division at AIG knew very well of the risks they were taking but still they carried on with this unstable, fraudulent yet lucrative opportunity. In the end, the company almost got to the brink of bankruptcy. Analysis and evaluation 1- Discuss how and what motivated AIG to be part of the derivatives business. Greed and negligence led AIG to be a part of the derivative business. The derivatives are risky investments and many wise investors avoid these instruments because of their highly unpredictable nature as well as the loopholes for exploiting them through scams and frauds. This payment comes in the form of collateralized debt obligations (CDOs). Before the crisis began these instruments were in huge demand because they were offering higher returns than other bonds that had the same credit ratings. Therefore, speculators as well as investors heavily purchase these instruments from insurers such as AIG. Before the crisis the US financial market was going through bullish trends and it appeared improbable for bond issuers to go through bankruptcy (Xinzi, 2013). Hence, CDS seemed the most lucrative selling financial tools for collecting premiums. By the end of 2007 the CDS contract grew to about $60 trillion and there was no doubt that when the times were good CDS were generating huge revenues for AIG (Xinzi, 2013). In addition, many banks and underwriters of CDS covered their short positions in one instrument while staying long in other CDS (Xinzi, 2013). AIG did not play on both sides of the trade (Xinzi, 2013). 2- What are (if existed) the ethical and unethical sides of AIG’s derivative business? The unethical side of AIGs derivative business was not to fully cover the insurance it was providing. When the risk management is underwriting the risks they should keep track of the companys resources in case they have to pay the claim. The company was not oblivion about the risky nature of the securities it was insuring. The management only considered the quarterly premium that kept coming in. In other words AIG failed to comprehensively establish a prudent risk management for its balance sheets. The company had an immense ethical responsibility considering the stakeholders involved and affected in this case. On one hand the company was supposed to take care of its employees and management while on the other side there were stakeholders like the investors, the buyers and the sellers. Interestingly the government was also a stakeholder because of the companys immense global credibility. In case there is objection on or a liquidity crisis in a huge company such as AIG it puts a huge question mark on the financial and auditory regulations at local as well as at international level. Ethical Dilemma AIG was also facing an ethical dilemma where it was supposed to give benefits to its shareholders. A company that brings in a lot of revenues is able to give healthy dividends and other perks to its shareholders. On the other hand, the business that is coming in can bring a lot of risk. This was the dilemma with AIG where they were supposed to comprehensively provide coverage to the people getting insurance from the company while on the other hand the company was under pressure to give more dividends to its shareholders. Especially when the economic trend is bullish the investors expect the company to rise in the stock value and dividend payouts. From an ethical perspective the company was supposed to take care of both sides of the business. A company cannot exploit one side of the business to take care of the other side especially when their major interests lie with the interest of the shareholders. 3- Discuss whether the AIG management team was aware of the level of insolvency risk. The AIG management team was fully aware of the level of insolvency risk. It was a judgmental and predictive error about the financial situation. They thought that the economy was doing well and it would continue to do so in the future. They ignored the immense risks they were taking in insuring the derivative instruments. Interestingly the CDS was conceptualized as an important risk management tool. It was supposed to prevent concentration of risks by distributing them through the financial system (Xinzi, 2013). This swap contract involves two counterparties. The disadvantage of this tool is that it is an OTC product which means it is subjected to less regulations. Before the financial crisis began AIG underwrote many CDS against mortgage-backed securities. The mortgage-backed security is a financial tool that creates its value from a pool of underlying mortgages (Xinzi, 2013). This tool pools the principal and interest payments from individuals with underlying mortgages and then redistribute it to individuals and investors. This payment comes in the form of collateralized debt obligations (CDOs). Before the crisis began these instruments were in huge demand because they were offering higher returns than other bonds that had the same credit ratings. Therefore, speculators as well as investors heavily purchase these instruments from insurers such as AIG, and the management team gladly provided them the coverage because of the lucrative premiums flowing in. 4- What are the outcomes of the AIG’s business practices on the company and its shareholders? What alternatives and solutions you would suggest to prevent this from happening? The outcomes of AIGs business practices on the company and its shareholders are devastating. The company lost its credibility among investors. The general perception is that the AIG got greedy and blindly kept ensuring highly risky securities. The shareholders invest in a big company such as AIG with the assumption that there will be stability in the company because of its global resources and credibility. Now shareholders would ask questions about the code of ethics and professionalism being implemented in the company. They would be thinking whether there is a stringent code of conduct in the company while they underwrite risky securities. Even though the company made a lot of profit before the crisis but the blow to the credibility is almost irreversible. Now the shareholders would be extra careful while purchasing their stock and investing with the company. Risk assessment or underwriting is a justified process, the insurers hold the right to know the risks they are taking before accepting them (Sorell, 2002). AIG ran into trouble when financial companies bought a lot of increasingly risky investments such as subprime mortgages and got insured by AIG to cover this risk. When the securities downgraded during the financial crisis the firm that purchased the securities demanded AIG to pay for their coverage (Trevino & Nelson, 2010). The company did not have collateral which it was in dire need of and hence it went bankrupt until the US government came into rescue. Recommendations It is true that a lot of factors were involved in the financial crisis as well as the bankruptcy of AIG. However, if one aspect is singled out as the most crucial factor that played a role in shaping or destroying the system it was deviation from the ethics. One needs to ask the question was the AIG risk management team aware of the unnecessary risks they were taking? It was obvious that they knew the risk when they were underwriting those securities. However, they were not supposed to take excessive risk which they could not pay. Undoubtedly the economy was doing really good when they were insuring derivatives in mortgage-backed securities but they should have reconsidered the volume of securities they were insuring. To ensure quality, top-notch customer service, compliance and ethical dynamics an insurance company cannot claim ignorance that misconduct occurred, in other words, a system should be in place ensuring that all ethical standards are met (Abromovitz and Abromovitz, 1997). Even though there cannot be a foolproof system ensuring that the company does not drive itself to bankruptcy however, making the checklist that all necessary ethical requirements are met before engaging into business can save a company from the dire situation that AIG faced. Conclusion The code of ethics and professionalism is there for a reason. It is not only to save the customer or the investors. It is also to keep the company that is issuing the security or the bonds as well is the one which is ensuring against the loss or devaluation of the securities. AIG is among the biggest companies in the world and no one expected such a huge name to ignore the rules of ethics. It is true that the time was very good for the US economy and it was quite lucrative to score premiums by ensuring risky securities. However, they were supposed to gauge the risk and make a contingency plan for a crisis. Securities get devalued, the rating companies make sure that the investors get to choose credible securities and become fully aware of the risks they are taking. The whole story can be concluded in a few words that if the time had remained the same, meaning that the economic trend had remained bullish, companies like AIG would have been raking in tons of cash. It is also true that if they had complied with ethical obligations while underwriting the risks they would have avoided a probable bankruptcy and the Federal Reserve would not have to intervene to save them. To conclude, compliance to the ethical rules and obligations is paramount and it is in the best interest of all stakeholders. References Abromovitz, L. & Abromovitz, H. (1997) Insuring quality: How to improve quality, compliance, customer service, and ethics in the insurance industry. CRC Press. Desmond, M. (2008) AIG CDOs CDS: It’s a Mess. Forbes. Retrieved December 9, 2014 http://www.forbes.com/2008/11/15/aig-credit-default-markets-equity-cx_md_1110markets24.html Sorell, T. (2002) Health care, ethics and insurance. London: Routledge. Trevino, L. K. & Nelson, K. A. (2010) Managing business ethics. John Wiley & Sons. Xinzi, Z. (2013) AIG, Credit Default Swaps and the Financial Crisis. Risk Management Society. Retrieved December 9, 2014 http://clubs.ntu.edu.sg/rms/researchreports/AIG.pdf Read More