Feb. 11 (Bloomberg) -- American International Group Inc., the insurer divesting units to repay a government loan, is in talks to sell a U.S. auto business to Zurich Financial Services AG, two people familiar with the situation said.

The sale of 21st Century Insurance, which one person said would be valued at about $2 billion, would be AIG’s biggest divestiture since its bailout in September. The companies are still working on a formal agreement, said the people, who declined to be identified because talks are private.

Paula Reynolds, AIG’s restructuring chief, is seeking to unload as much as two-thirds of the company and has struck $2.3 billion of deals. Once the world’s biggest insurer, AIG was overwhelmed by bad bets tied to U.S. housing and has posted about $43 billion in net losses over four quarters. It had tapped $38.9 billion of a $60 billion government credit line as of year-end.

“This will certainly be one of the bigger contributors for AIG to get to their goal,” David Bradford, an executive vice president of consultant Advisen Ltd., said in a telephone interview. “21st Century is a well-regarded company and to the extent Zurich wants to expand their footprint in auto insurance, it’s a strong acquisition for them.”

A significant portion of the purchase price may be paid in non-cash considerations, one of the people said. That would require special permission from the Federal Reserve, whose arrangement with AIG requires at least 90 percent of asset-sale prices be paid in cash.

Zurich’s Expansion

Christina Pretto, an AIG spokeswoman, and Sean Kevelighan of Zurich declined to comment yesterday.

Zurich Financial declined 1.3 francs, or 0.6 percent, to 200.9 francs in Swiss trading, valuing the insurer at 28.5 billion francs ($24.6 billion) and extending this year’s fall to almost 12 percent.

For James Schiro, Zurich’s chief executive officer, adding 21st Century would help fulfill his ambition to expand offerings to individual consumers in the U.S.

“I hope Schiro isn’t overpaying,” said Rene Locher, a Zurich-based analyst at Bank Sal. Oppenheim, adding “it would be positive if the price tag is around 1.5 billion francs.” The purchase would help the company “re-balance” its non-life business in the U.S. by adding a distribution channel and helping Zurich Financial to cut costs, he said.

21st Century

21st Century, based in Woodland Hills, California, sells auto policies over the telephone and Internet, avoiding the expense of using agents. Zurich’s Farmers Group Inc. unit, and rivals including Allstate Corp. and Travelers Cos., rely on agents for most of their sales.

Insurers expect Internet sales, the model used by the Geico unit at Warren Buffett’s Berkshire Hathaway Inc., to expand over the next 10 years and they should plan for changes in customer behavior, said Jay Fishman, Travelers’ CEO, in an interview in November.

The combination would make Zurich, including the Farmers unit, the largest auto insurer in California, according to 2007 data from the National Association of Insurance Commissioners.

AIG first took a stake in 21st Century in 1994 and acquired a majority stake in 1998. It bought the remaining portion in 2007 for $22 a share, valuing the entire company at $1.9 billion.

After consolidating its ownership, AIG changed the name of the unit to aigdirect.com, only to change it back to 21st Century after AIG was rescued from collapse by a government bailout last year.

21st Century has been on the market since before Oct. 3, when AIG’s CEO, Edward Liddy, confirmed on a conference call that it was among the units on the auction block. He and Reynolds are also trying to sell life-insurance units from Hong Kong to Houston and an aircraft-leasing business.

To contact the reporters on this story: Hugh Son in New York at hson1@bloomberg.netZachary R. Mider in New York at zmider1@bloomberg.net

Last Updated: February 11, 2009 12:32 EST