NEW YORK (Bloomberg) - Just when American International Group Inc. (AIG) shareholders figured things could not get worse at the world's largest insurer, profit from the company's private equity and hedge fund investments is evaporating.

Earnings from so-called alternative holdings were probably close to zero in the second quarter, after soaring 77 percent to $1.02 billion a year earlier, said Citigroup Inc. analyst Joshua Shanker. The drop follows the worst first half for hedge funds in almost two decades and a 73 percent decline in the value of announced leveraged buyouts, according to data compiled by Chicago-based Hedge Fund Research Inc. and Bloomberg.

Private equity and hedge funds were seen as "something that provided more consistency and stability to AIG's earnings growth," said Henry Smith, who manages $6.5 billion as chief investment officer at Haverford Trust Co. and holds about 2.3 million AIG shares. "That's not the case right now."

The diminishing returns make CEO Robert Willumstad's task of reversing AIG's 54-percent stock slide this year and its record $7.81 billion first-quarter loss more difficult. Second-quarter adjusted net income probably fell 78 percent to $1.04 billion, analysts estimate. Mr. Willumstad, 62, the CEO since last month, will announce results August 6.

In what may be a precursor for New York-based AIG, Allstate Corp., the largest publicly traded US home and auto insurer, said July 23 that earnings from private equity, hedge funds and real estate funds dropped 65 percent from a year earlier to $30 million. The slide contributed to Allstate's 98 percent decline in net income. Hartford Financial Services Group Inc. this week said income from alternatives fell 77 percent to $25 million, and CNA Financial Corp. posted a 35 percent decline.

"Every company thinks they're special, that somehow they're more able than others to invest and deliver these returns without the volatility and losses," said Paul Newsome, a Chicago-based analyst at Sandler O'Neill & Partners. "It's not historically been a good plan."

Insurers reaching for higher returns than from bonds and stocks increased private equity and hedge fund assets by 48 percent last year to $49.8 billion, according to the National Association of Insurance Commissioners in Kansas City, Missouri, which compiles data from companies' US units. In 2006, the holdings rose 34 percent.

"There were a number of years where alternatives were booking 20 percent-type returns," Mr. Newsome said. "That looked awfully attractive versus a five percent bond."

The companies "will be happy" these days if alternative investments do not lose value, he said.

AIG's first-quarter returns from alternatives fell 84 percent from a year earlier to $197 million, an annualised gain of 2.7 percent. AIG expects 10 percent to 15 percent over the long term on the investments, chief investment officer Win Neuger told analysts in June, including start-up hedge funds and private equity stakes in power plants, waste-treatment facilities and shipping terminals.

The first quarter return was "a very good result given the market conditions," Mr. Neuger said last month. AIG spokesman Nicholas Ashooh declined to comment.

In the first quarter, AIG's then-CEO Martin Sullivan wrote down the value of contracts that protect fixed-income investors from losses on securities tied to sub-prime home loans.

AIG may have another $2.5 billion of writedowns for these credit-default swaps because of declines in the securities they guarantee, Citigroup's Mr. Shanker estimated.

Mr. Shanker cut second-quarter estimates for AIG, Allstate and Hartford earlier this month, citing catastrophe claims and investments.

"We've seen what hedge fund results were for the quarter - bad - and there weren't any private equity IPOs (Initial Purchase Offerings)," he said. "If there's a slot for alternative income in our models, we're putting a zero in it."

Thirteen of 16 companies in the KBW Insurance Index that reported second-quarter results through last Wednesday posted lower profit or a loss on claims from US tornadoes and writedowns tied to the sub-prime mortgage market.

Hedge funds, mostly private pools of capital whose managers participate in the profits from their speculation, declined by an average 0.7 percent in June, bringing the year-to-date loss through last month to 0.75 percent, according to Hedge Fund Research Inc. That's the worst start to a year since the firm began tracking returns in 1990.

AIG's private equity arm, operating since 1980, has about 200 employees in 24 offices. The insurer owns stakes in Bulgarian Telecommunications Co., that country's biggest telephone firm; ports in New Jersey; waste-management businesses in the US; Falcon Farms, an importer of flowers from Colombia, Ecuador and Mexico; and Sindicatum Carbon Capital Ltd., a London-based developer of greenhouse-gas-abatement projects. The insurer may profit from operations at the companies or by selling them.

AIG had $29.4 billion in alternatives as of March 31, about 3.5 percent of its $841.3 billion of investment holdings.

Allstate had $2.89 billion in about 300 alternative investments as of June 30, or 2.5 percent of total funds, and made commitments to invest another $2 billion, CEO Tom Wilson said in a July 23 interview.

The Northbrook, Illinois-based insurer opened an office in London in October to pursue private equity opportunities in Europe.