No insurance company in the world is in the news more these days than AIG. These are just a few of the headlines since March 1:
We have all read and heard about the devastation that would befall the world's economy if AIG was allowed to go under, and the billions of dollars lent/given to AIG by both the Federal Government and the State of New York. But can one company really have such an impact on world finance?
Yes, it can, says The Motley Fool's columnists, when companies are heavily diversified and become and empire unto themselves. They refer to history, specifically, ITT, a company that started down the road to becoming a huge conglomerate in the 1960's, and owned everything from The Hartford Insurance Group to Sheraton Hotels. By 1995, amid disasterous financial results and scandal, the company had to be broken up.
As Morgan Housel puts it:
Almost everyone underestimated how complex the intertwining relationships between Wall Street and Main Street were, and more importantly, the relationships between the global economies. China needed demand from American consumers; American markets needed capital from Chinese savers; consumers relied on that capital to fund a free-for-all real estate market; banks rerouted the proceeds into a secondary credit market that couldn’t care less about
loanquality. It was a disaster waiting to happen, and as soon as one end of the self-fulfilling cycle shut off, the entire house of cards came crumbling down in a historic way.
Andrew Sullivan backs this up, agreeing that AIG did well in its insurance business, particularly personal lines. But Sullivan states three rules for insurance companies, only two of which AIG followed:
Insurance is terribly simple, as long as you follow the Three Rules:
- Price your risk correctly.
- Invest conservatively so you can pay out claims when they come due.
- Don't do anything else.
Sit back and collect the spread. That's it, folks.
Seriously, that is it. Ask Warren Buffett, and he'll probably tell you that if you follow those three rules, you'll be fine. You won't be the biggest or fastest grower, but you'll be absolutely fine.
The problems come when you get greedy and aren't satisfied with the spread. And your greed can lead to certain actions that aren't stated anywhere in the rules, including:
- Diversifying into fast-money proprietary trading.
- Leveraging your company 11-to-1.
Neither of these is a goal of a well-run insurance company, yet AIG embraced both with open arms.
This isn't restricted to just insurance companies, by the way. I hope General Electric is listening.