I think this might explain a few things:
American International Group, in a gloom and doom discussion paper, has warned regulators that unless it is kept afloat, there would be "turmoil in the U.S. economy and global markets."
...According to AIG’s draft, "systemic risk is principally centered in the ‘life insurance’ business because it is this subsector that has the greatest variety of investments and obligations that are subject to loss of value of the underlying investments."
The company predicted that if it were to fail, "it is likely to have a cascading impact on a number of U.S. life insurers already weakened by credit losses. State insurance guarantee funds would be quickly dissipated, leading to even greater runs on the insurance industry."
There potentially is a more serious point behind that, and it's only partially connected to life insurers.
Life insurers are major -- perhaps the largest -- purchasers of bonds. They have to be, because their claim obligations are often decades long. As of the end of 2007, life insurers held 73% of their assets in bonds.
Most bonds purchased by life insurers are required by regulation to hold the highest ratings available. So if you were purchasing bonds for a life insurer over the last decade or so, what high-rated bonds would you be buying?
Yup. Collateralized mortgage obligations and collateralized debt obligations -- what we now call "toxic debt." Can you tell that they will go sour? Probably not. But you might get concerned that you're holding too many, or you might reach a point where you see the cracks in the facade.
Now, these bonds likely already came with insurance against default, issued by a bond insurer. But since both excellent debt and so-so debt are packaged in these bonds, they may never actually default. Instead, they might decline in value, and you'll have to restate them on your books: mark them to market.
Your solution? Buy protection against that decline. In other words, a credit default swap. And who issued virtually all credit default swaps?
Yup. AIG.
But there's more. Remember I said that life insurers are major purchasers of bonds? Imagine what happens to the bond market if a few large life insurers fail. The credit market already seized once; consumer debt is parlous; the stock market is tanking. Can the Treasury afford to have the bond market fail too?
I suspect the answer is no; and I further suspect that's the real reason AIG is getting the treatment it is. It's entirely possible that significant holders of bonds might otherwise fail without the protection they purchased from AIG out of prudence, not out of speculation -- life insurer investments are heavily regulated, and it's highly unlikely that they indulged in speculation -- and the chain reaction that would occur if the bond market subsequently collapsed would be a strain the already overburdened economy could not bear.
I concede that I'm doing some guesswork here; but I have three decades of experience working for a life insurer, and if AIG's comment is valid, this may the real reason why the government is working so feverishly to keep AIG afloat.