Ever since the American International Group nearly collapsed, the conventional wisdom has been that the exotic derivatives that drove it to the brink were the product of a lone, unregulated subsidiary in London. The Federal Reserve chairman, Ben S. Bernanke, called the London branch “a hedge fund, basically, attached to a large and stable insurance company.”
But the suggestion that A.I.G.’s core insurance business did not dabble in derivatives is not quite true. One of its biggest insurance units, incorporated in Delaware, was also dealing in the derivatives known as credit-default swaps, according to regulatory filings with the state.
Though the Delaware division had a much smaller portfolio of those swaps than the London unit, and its portfolio did not pose a similar risk to the world financial system, the very presence of the swaps in a regulated insurance company points to a weakness in insurance oversight.
There is a continuing dispute over whether such swaps are insurance products or something else; who, if anyone, should regulate them; and whether insurers should have to set aside reserves to secure the promises that swap contracts make. A.I.G.’s insurance business did not set aside such reserves.
Efforts afoot now in Washington to strengthen financial regulation tend to focus on banking, with insurance, which is regulated by the states, almost an afterthought. The Senate Banking Committee plans to consider a financial regulatory overhaul on Tuesday. The House has already passed a measure that would create a national office to gather information on insurance but would leave insurance regulation to the states. The bill does not treat credit-default swaps as a form of insurance.
“You have this blind spot on insurance companies,” said Christopher Whalen, a co-founder of Institutional Risk Analytics, a research firm.
The National Association of Insurance Commissioners says insurers were the third-biggest issuers of credit-default swaps, after banks and hedge funds, with 18 percent of the market in 2007.
“We have a desperate need for federal regulation and federal disclosure by the insurance companies,” Mr. Whalen said. “But even after A.I.G., we still don’t have a proposal for federal regulation, or even enhanced disclosure, and that’s the dirty secret here.”
Credit-default swaps, in essence, work like bond insurance, in which the issuer promises to make a bondholder whole in case of problems like a default. But the swaps differ from conventional insurance in important ways. There are no required reserves, for instance. And any institution can buy the swaps — not just bondholders.
That has led critics to liken the use of swaps to buying insurance on a neighbor’s house, in hopes of a payday when he has a fire. A.I.G.’s London branch used these swaps in huge volume, causing a disaster when the purchasers all descended at once, demanding payments, and A.I.G. ran out of money.
The Delaware insurance unit with the credit-default swaps is one of A.I.G.’s biggest. Known as Alico, or the American Life Insurance Company, the unit does its conventional insurance business overseas in more than 40 countries. Its counterparties on the swaps, though, are big United States banking companies.
If the measure passed by the House became law, an insurer like Alico that used swaps to sell protection against bond defaults would be designated a “swap dealer,” and have to comply with capital requirements and other rules. That way, the company would be required to have money to stand behind its promises, said Andrew Williams, a spokesman for the Treasury Department, which supports the provision.
Insurance regulators said Delaware did not consider credit-default swaps to be insurance.
“I don’t think an insurance commissioner should tread on the toes of the banking industry,” said Karen Weldin Stewart, the commissioner in Delaware. “This started out as a bank product.”
Her special deputy for examinations, John Tinsley, explained the reasoning. “In insurance, you’re putting together a pool,” he said. Each customer would be charged a premium based on the total risk of the pool.
A credit-default swap cannot be insurance, Mr. Tinsley said, because it does not involve a pool. There is just one seller and one buyer for every contract.
“It’s an investment product,” he said. “It’s closer to buying an option.”
Not everyone agrees. Eric R. Dinallo, New York State’s insurance superintendent when A.I.G. imploded, said he believed credit-default swaps were insurance and should be regulated as such.
Even at its peak, in 2007, Alico’s portfolio of credit-default swaps was just a fraction of the one at A.I.G. Financial Products, the London shop whose collapsing business led the United States government to prop up A.I.G., the biggest bailout in American history.
If Alico’s entire portfolio had blown up that year, the maximum possible loss — a little more than $1 billion — would not have wiped out the company’s total reported surplus of $7 billion.
Alico’s executives said they considered their swap program much safer as well. Michael Buthe, the chief investment officer, said that the company had sold protection only on investment-grade bonds, which the company considered unlikely to default.
Alico’s chief financial officer, Christopher J. Swift, added that the bonds were issued by companies in many commercial sectors, which diversified the portfolio. That differed starkly from A.I.G. Financial Products, whose swaps gave A.I.G. a vast, undiversified exposure to the housing markets.
“This isn’t tied to real estate,” Mr. Swift said of his company’s program. “It diversified our holdings and increased yield.”
When the markets soured in 2008, the company realized a $52 million loss as it terminated many of the contracts. “We’re constantly monitoring the market, and we saw the economics changing,” Mr. Buthe said.
The program has been unwound, with only a few swaps remaining, and Mr. Buthe said the company was not planning to rebuild it.