One of the key issues a House-Senate panel reconciling different versions of financial services reform will have to address is the powers of an authority that would be created to liquidate failed large financial firms, including insurers.

The issue came up June 26 at a hearing on American International Group convened by the Congressional Oversight Panel on the Troubled Asset Relief Program.

In discussing AIG–a prime inspiration of the need for a resolution authority–Elizabeth Warren, chairman of the panel, called AIG “a corporate Frankenstein.”

AIG was “a conglomeration of banking and insurance and investment interests that defied regulatory oversight and that would not have fit easily into the existing bankruptcy structure,” Warren said.

She said its complexity, its general significance and the fragile state of the economy may all arguably have been reasons for unique treatment.

“But no matter the justification, the fact remains that AIG’s rescue broke all the rules, and each rule that was broken poses a question that must be answered,” she said.

The Senate bill would create a Resolution Authority housed in the Federal Deposit Insurance Corporation. Firms placed under it would be liquidated without use of taxpayer dollars.

The original Senate proposal would have created a pre-funded system paid for by assessing financial firms with $50 billion or more in assets.

This approach was opposed by the American Council of Life Underwriters, whose opposition played a role in the decision to drop the pre-funded system and replace it with an assessment on all financial institutions with assets of $50 billion or more.

Property and casualty insurers persuaded four New England senators to propose an amendment to the Senate bill that would have exempted insurers from any contribution to the fund. The industry already has a guaranty system that is used to pay for the liquidation of an insolvent insurer, they argued. But the provision failed to win a vote on the Senate floor.

The House bill still has a pre-event system that would be funded by assessments on financial firms with $50 billion or more in assets.

In her comments, Warren lauded the two proposals while charging that “regulators and regulations failed the American taxpayer” with AIG’s near failure.

“The House and Senate reform bills create a much better process for monitoring systemically important firms and winding them down if they falter– a process designed precisely as a response to the wildly expensive and unruly bailouts of companies like AIG,” Warren said.

She said its complexity, its systemic significance and the fragile state of the economy may all arguably have been reasons for giving AIG a unique treatment.

“But no matter the justification, the fact remains that AIG’s rescue broke all the rules, and each rule that was broken poses a question that must be answered,” she said.

In fact, “the rescue of the American International Group was so extraordinary that it bypassed the entire legal process of bankruptcy,” she said. “In saving AIG, the government invented a new process out of whole cloth, a parallel set of rules devised and executed for the benefit of only one company.”

Moreover, by the time the federal government intervened in late 2008, “AIG was a poster child for the need for a well-functioning bankruptcy system,” she said.