Academic

The Insurance Section meeting at AALS focused on AIG. The section heard from the Louisiana Insurance Commissioner on how state-regulated AIG entities remained solvent ? he called them gold bricks left in the mud ? and that the real regulatory failure occurred with AIG?s London affiliate. Dean A V Narsimha Rao, a scholar from India gave the perspective of Asian regulators on AIG?s operations. Dr. Tom Murphy (Valuation Risk & Strategy LLC) discussed the inherent limitations of models used to price credit derivatives.

Jeffrey Thomas (UMKC) outlined some of the basics of credit default swaps and made a compelling case that traditional insurance regulation is an ill fit for regulating credit derivatives.

This of course leaves open the 60 trillion dollar question of how should credit derivatives be regulated? The panel considered only briefly the question of whether credit derivatives are socially useful (with the general sentiment of two of the panelists being that they are).

I didn?t find persuasive arguments that imposing capital requirements or collateral requirements on derivative counterparties would not work given the astronomic notional size of credit derivatives. If those types of regulations were enforced, it would cut down on the total notional size of the credit derivative market, which might not be a bad thing at all.

A separate question is whether regulated entities, like insurance companies, should be restricted from trading in credit derivatives. There are huge potential problems when regulated entities with a government guarantee can cross-subsidize risk taking through derivatives. And then risk from derivatives can flow the other way and put the assets of regulated affiliates in jeopardy. Some of the panelists seemed to agree with me on this.

One often overlooked fact about the crisis is that many of the entities that seem to have gotten in the most trouble and supposedly presented the greatest systemic risk with their imminent failure were not unregulated hedge funds, but regulated entities like AIG and Bear Stearns ? often conducting risky bets through lightly regulated affiliates (like AIG?s London operations and Bear?s hedge funds).