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AIG: Before Credit Default Swaps, There Was Reinsurance

"the risk shifting shell game" The quote from the story is the absolute definition of insurance (without the provocative phrase "shell game").

It is true that reinsurance is basically "surplus renting". What's wrong with that? The side agreements basically say the the ceding company will stay with the reinsurer until the "loan" is paid back. Hardly a crime!

BTW there are four types of reinsurance although the article deals with only one-which one is undisclosed.

Every time an insurance company writes a piece of business it has to put aside capital as a cushion. The only way an insurance company can get larger than its capital base is by selling more capital, reinsuring the risk or cheating as AIG did by hiding in an unregulated jurisdiction and not putting up capital. Aside from the last method reinsurance is an obvious, rational and ethical choice.

AIG and the Free Lunch Myth

It's a very old story. It comes from arrogance. It comes from utter disrespect of the market. It comes from complete lack of experience with markets.

If you're standing on a trading floor (or in the OTC market) and people bid you for a security and have a seemingly limitless appetite for that security a couple of things should occur.

You should start increasing the price-fast! You should also pay sharp attention to that gnawing feeling in your stomach that these folks know a hell of a lot more than you do about what's going on.

Failing that, you certainly should not be handling anybody's money (maybe even your own) because you've just fit the classic definition of a certified idiot!

We saw "models" go bad in 1987 in the options market when Continental Illinois Bank bought a local options clearing firm and nearly brought down the entire banking system of the US in October of '87.

We saw it again in 1997 with Long Term Capital when their model didn't factor in a major volatility upswing.

As a matter of fact, to a lesser extent, we see this in all derivatives markets every single day. It's essentially trading the volatility in a rational manner that makes smart traders money.

AIG did the polar opposite!