Insurers got themselves confused between the subtle difference of writing a diversified portfolio of credit default swaps (essentially a bet that credit spreads were too wide and the future level of defaults would more than compensate the risk taken) and investing in a diversified portfolio of corporate bonds  (also a bet that credit spreads were too wide and the future level of defaults would more than compensate the risk taken).

The reason the comments in brackets are exactly the same is that it is in fact the same bet.  But insurance companies are supposed to take their premium income (customers paying the insurers to shoulder risks) and invest them in financial markets.  Writing credit default swaps, however diversified a spread of risk that is written, is not the business of insurance companies trying to acquire or write premium income.  They should not double-up on their risk but should simply invest their “float” of premium income in such financial assets they deem most attractive at any point in time.

This was essentially the mess AIG got itself into and other insurance companies should steer well away from writing credit default swaps (other insurers have dabbled in the CDS market but none to the extent AIG did).  The end result will be wider credit spreads than otherwise prevailed when AIG was in its CDS writing prime, but these will compensate real-money investors for the risks they take in lending money to companies.

If credit spreads get too wide then eventually investment money will be attracted to the asset class and spreads will tighten, which is how the world is supposed to work.

In the meantime avoid any insurer which writes Credit Default Swaps.