Insurance was once about spreading risk. It was once about underwriting. It was once about using actuarial valuations to work out the likelihood of certain events taking place and then pricing that risk via premium payments.
But recent events at AIG, once the world's largest insurer, have exposed how insurers have dramatically moved away from their core missions in the past 30 years. While insurance companies always had a 'float' – money taken in from premiums and available for investment – the uses to which this money has been put by supposedly risk-averse insurers has shocked the entire financial world.
For example, a key reason for the demise of AIG (it ended up in conservatorship) was its massive presence in subprime mortgage-backed securities and Alt-A mortgages – the same assets that brought about the demise of Lehman Brothers.
The insurer was also brought low by the credit ratings agencies. As long as it was AAA-rated, AIG was able to deal with counter-parties without having to put up additional collateral, required of other mere mortals. But once the agencies cut the company to A-, it was forced to put up billions of dollars in extra collateral, sealing its fate.
However, the reason the company ended up in this sorry position originally was because it sold insurance as normal, but on products linked to the US subprime market and the slumping property market. AIG was the king of writing credit default swaps (CDSs), a form of bond insurance, but the problem was AIG was insuring toxic assets linked to subprime. These were things like Collateralised Debt Obligations (CDOs) which increasingly went sour as house prices plummeted.
AIG's drift into credit default swaps mirrored a wider global trend – big insurers are no longer interested in low-margin personal customers and prefer the high margins available from insuring corporate clients and their assets. AIG, for example, made the move away from personal insurance only in the 1960s, when chief executive Hank Greenburg took over. Before that its main product line was insuring automobiles.