According the FCIC report, in the late 90s, AIG leveraged its superior credit rating—its “most valuable asset”—to branch out beyond standard insurance products and become a major over-the-counter derivatives dealer. Through its subsidiary AIG Financial Products, AIG eventually amassed a derivatives portfolio with $2.7 trillion in notional value.
A significant portion of AIG’s derivatives business was devoted to credit default swaps (CDS’s) that “insured” debt held by financial firms and institutional investors. A CDS is a contract under which the party writing the CDS agrees to reimburse the party purchasing protection if there is a default on the underlying debt. In exchange, the party purchasing protection makes a series of payments to the issuer of the CDS—essentially premium payments.
AIG’s credit protection business grew rapidly, swelling from $20 billion in 2002 to $211 billion in 2005 and $533 billion in 2007.
Although insurance policies and CDS’s are similar, crucial differences between the two played a critical role in the crisis. An insurance company is obligated to set aside reserves to balance against potential losses; but a credit default swap, not being an insurance policy, is not subject to a reserve requirement. As a result, AIG was not required to put up collateral when it issued hundreds of billions in CDS’s. What the company did do, however, was promise to post collateral if its credit rating was downgraded.
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William Byrnes' Tax, Wealth, and Risk Intelligence 