BACKGROUND:
The insurance sector has been
immersed in a permanent updating process, fostering the changes needed to adapt
both to the new economic environments and to the growing levels of safety,
transparency and effectiveness which are increasingly being demanded by financial
markets and citizens. Their growingly frequent uncertainty necessarily leads
supervisors and companies to look for higher levels of safety through new
approaches to solvency, supervision and risk management procedures.
Basically ‘insurance’ is all about
‘risk pooling’. Where many people invest their money to get protection against
the future loss. Insurance companies are in the business of taking risks.
Worldwide these companies write policies that deal with specific risks, and in
many cases, even underwrite exotic risks. As a direct corollary, therefore,
insurance companies should be good at managing their own risks. However the
truth is a little far from that! Most insurance companies are very good at
assessing insurance risks but are not very good at setting up structures in their
own home to manage their own operating and business risks. And failure to
manage such risks can be proved fatal to their business.
AIG SAGA:
AIG stands for American
International Group. It was founded in 1919 in Shanghai. Today, AIG is the
biggest insurance company in the world. But something went wrong during the USA
subprime crisis (2007-08) that eventually led to the situation where Federal
government had to come to the rescue in bailing out this insurance giant. The
primary reason for this debacle was the failure of independence assumption
under their risk modeling. The company was exposed to real estate risk. The
reason why their risk model failed was they assumed that house prices can never
go down. But ironically what actually happened was house prices fell everywhere
in the country. They were taking risk,
1. by insuring against defaults on
companies whose credit depended on the real estate market.
2. by directly investing in the
housing sector.
So because of the collapse of
housing sector in USA, AIG was about to fail. At that time the federal
government had to bail out the company by pouring in $182 billion through TARP
(Troubled Assets Relief Program). This was a massive amount so some people
protested it but this was necessary step that the fed had to take as AIG, being
such a large corporation, was linked to lot of other financial institutions,
banks and other insurance companies as well. Now they all were subject to
failure as their investments stuck too! So it was feared that this may lead to
the destruction of the whole financial system. And that is why Fed took this
outrageous decision.
So this is how AIG failed in managing
the risk and almost went bankrupt. This case was also a deterrent example to
the other corporations.
NEW PARADIGM:
“Change is the end result of all true learning”-- Aristotle
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