AIG Earnings: Will Hedge Funds Keep It Afloat?

(MoneyWatch)  When insurance companies buy "alternative investments," it's a bit like betting on the red at the roulette table. And when Bloomberg News suggests that, because Travelers and Chubb did well on their alternative investments, the same will hold true for XL Capital Ltd. and American International Group, it's doing the same thing.

Insurers put "mad money" in alternative investments because most of what they take in has to be kept in Triple A Bonds and Treasuries to pay claims. But they do put some in riskier "alternatives" such as private equity, hedge funds, and real estate. Since insurers can often invest large amounts, they get in on deals the rest of us only dream about, and they often make big bucks. However, lady luck is fickle and these funds can lose big time. That's why insurers only put money that they can afford to lose into these alternatives, usually a maximum of 4 percent of the portfolio.

The insurers that already reported this quarter had outsized gains in alternatives. Travelers' slam-bang earnings were due in part to investment income that jumped by nearly half from a year ago, when admittedly these funds were in the tank. The property insurer said this boost was "primarily due to private equity and hedge fund performance." In other words, by hanging on to what looked like bad investments last year, Travelers made money this year.

Chubb was even clearer. It reported a gain of $193 million in investments, before tax, in the fourth quarter compared to a $250 million loss a year ago. Just how significant was this? It added 37 cents after taxes to its earnings, or about 18 percent. On its investor call, Chubb noted that $169 million of that $193 million was alternatives, and, of that, "$90 million was from a single investment."

Bloomberg took this lead and ran with it, noting that XL's portfolio has about $1.19 billion in alternatives, "including holdings in alternative funds and private investments, according to its Web site." As for AIG, which had already seen improvements in its alternative portfolio for the third quarter, a whopping $18.9 billion in "partnership assets" could help it do even better when it reports in February.

So can we expect AIG will score big in the fourth quarter? It had better, because none of the property and casualty carriers are getting any traction on their bread-and-butter insurance premiums. They are down almost across the board, and Chubb's gloomy prediction - despite the fact it is a premier P-C company - is that it will make less income from operations in 2010 than 2009.

Meanwhile there's still that roulette wheel called "alternatives." It's no secret that private equity and hedge funds rebounded at the end of last year. The secret is in knowing what will happen this year. And in figuring out which funds insurers have their money in. That secret is more closely guarded than Fort Knox.