AIG Bodes Ill for Insurer Stocks

Wall Street auditors who have long signed off on opaque accounting methods for valuing mortgage-related derivatives are starting to get worried.

On Monday, American International Group AIG disclosed in a regulatory filing that PricewaterhouseCoopers has concluded that the world's largest insurance company had "a material weakness in its internal control" related to its accounting for its portfolio of credit default swaps.

So, is the insurance industry next in line for billions of dollars in writedowns as a result of the U.S. housing downturn?

In early December, as mortgage woes were leading to billions of dollars in writedowns for major Wall Street banks, AIG soothed frayed nerves by assuring investors that it had "little to no exposure" to asset-backed commercial paper, structured investment vehicles or collateralized debt obligations tied to residential mortgage-backed securities.

Now, the New York insurer is reporting a $4.88 billion writedown in gross market value for its credit default swap portfolio in October and November -- more than four times the $1.15 billion executives reported earlier.

AIG sold credit default swap contracts to holders of collateralized debt obligations, or CDOs, guaranteeing payments in the event of defaults on their underlying debt. Now that mortgage foreclosures are spiking as the U.S. housing market grapples with a decline of historic proportions, the estimated market value of AIG's portfolio is in a tailspin.

With the company set to report its quarterly results in late February, its latest estimate for losses on derivatives in the quarter don't include December, a month when the financial markets deteriorated dramatically.

It has yet to determine the full extent of "the amount of the increase in the cumulative decline in fair value" of its super senior credit default swap portfolio, it said in a filing with the Securities and Exchange Commission.

Shares of AIG dropped 11.7% after the disclosure. Bond insurers MBIA MBI and Ambac ABK, both of which have huge exposures to similar securities, were down 7% and 4.6%, respectively.

Investment banks that already have suffered huge writedowns on mortgage-related investments like Citigroup C, Merrill Lynch MER and Bank of America BAC declined despite a broader rally in the stock market.

Also, AIG's announcement raised the prospect that other insurers would see such losses. Allianz AZ closed down 2%. Hartford Financial Services HIG shed 4.6%, and Chubb CB was off 2.4%.

Insurers such as AIG invest in a wide range of securities, bonds and derivatives to build up their capital reserves. That being the case, it's not surprising AIG would have exposure to credit default swaps, which became increasingly popular amid the housing boom of the past several years.

Chubb CFO Michael O'Reilly told investors on a conference call in January that the company has no exposure to CDOs. Other major insurers couldn't be immediately reached for comment for this story.

Fitch Ratings analyst Mark Rouck says AIG is unique in the insurance industry for its exposure to credit default swaps on mortgage-backed securities.

"AIG has a unit that competed with investment banks and commercial banks for this business," says Rouck. "It's different than the traditional property and casualty or life insurance company."

Fitch responded to AIG's disclosure by putting its issuer default rating on "negative" credit watch, signaling the possibility of a downgrade. It noted that AIG had $505 billion in exposure to its credit derivative portfolio in late September, including $62.4 billion of CDOs backed by subprime mortgages.

Still, the company's disclosure harkens back to warnings about trafficking in such trades that came years ago from a giant of the insurance industry: Berkshire Hathaway BRKA Chairman Warren Buffett.