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(New throughout, adds details, Hartford campaign, background, updates AIG share price to close)
By Michael Flaherty and Richa Naidu
Oct 28 (Reuters) - Billionaire investor Carl Icahn on Wednesday urged American International Group Inc to break itself apart, targeting a $78 billion insurer in one of the largest activist campaigns this year.
AIG shares jumped almost 5 percent in heavy trading after the release of the proposal, which Icahn said was supported by hedge fund manager John Paulson.
Around two weeks ago, Icahn gave the company a heads up that he was taking a stake and was publishing a letter, according to a person familiar with the matter. The person added that AIG has hired an outside advisor to help it deal with Icahn's campaign, a sign the two sides may be girding for a fight.
The bet by Icahn shows how top tier activists are targeting larger companies, and that no management team in Corporate America is immune from a dissident approach.
Icahn published a letter on Wednesday advising CEO Peter Hancock to spin off AIG's life and mortgage units into public companies. The move would return more cash to shareholders, Icahn said, and help AIG rid itself of a regulatory burden.
AIG shares surged 4.9 percent to $63.89. Paulson, who owns 1.1 percent of AIG, added a quote to Icahn's letter that said AIG can trade at over $100 per share.
Icahn's regulatory angle refers to part of the 2010 U.S. financial reform known as Dodd-Frank. The legislation mandated that the Federal Reserve regulate all banks with assets exceeding $50 billion as well as certain non-bank entities.
AIG's near collapse in 2008 was the driving force for Dodd-Frank's inclusion of non-bank entities. The insurer received $182.3 billion in federal bailout money.
Four U.S. companies labeled non-bank "Systemically Important Financial Institutions" (SIFIs) are subject to enhanced regulation and supervision by the Fed: AIG, GE Capital, Prudential Financial and MetLife Inc.
Some analysts said it will be tough for AIG to get rid of that kind of oversight, which also entails higher capital cushions.
"We think a spin-off of AIG's mortgage insurer, coupled with an aggressive cost cutting campaign, are the most likely outcomes. However, we do not see AIG avoiding SIFI status given its previous government bailout," said Cathy Seifert from S&P Capital IQ.
General Electric Co announced this year that it was selling off large sections of GE Capital, in part to avoid being labeled a non-bank SIFI.
Icahn's letter to AIG said the separate companies would be small enough to avoid the designation. He also said AIG should begin "much needed" cost cuts to better compete. (bit.ly/1M1Sxtf)
AIG's Hancock said in a statement the insurer maintains a dialog with all its shareholders "and welcomes their feedback and ideas." AIG is not expected to say anything further until its earnings call on Monday, according to the person familiar with the matter.
Icahn, who did not disclose the size of his stake, said several large shareholders, including Paulson, were frustrated and supported a break-up of AIG. Icahn's campaigns have forced changes at companies such as Apple Inc, eBay Inc , and Chesapeake Energy Corp.
"AIG is frankly overdue in following in the footsteps of all other major multi-lines in breaking up Life and P&C into separate companies," Paulson said in a statement in Icahn's letter.
In February 2012, Paulson urged The Hartford Financial Services Group to break itself up into two companies, but that campaign failed to significantly boost the company's stock price, and Paulson began cutting his stake later that year.
Icahn's go at AIG comes even after the company more than doubled its quarterly dividend and raised its share-repurchase target by $5 billion. AIG has also sold around 30 businesses for more than $90 billion since the financial crisis, and paid back the U.S. government.
But its cost structure remains bloated, and its underwriting operations have suffered from falling rates for commercial property and casualty insurance as pension funds have flooded the industry in search of yield.
AIG is trading below its book value of $79.74. Rival Prudential Financial Inc's book value is $92.33, and its shares traded up 2.3 percent to $82.93 on Wednesday.
Hancock has targeted a return on equity (ROE) of 10 percent over the long-term, up from 8 percent in the second quarter - a target Icahn said would still lag its peers.
Some analysts expressed doubt at the prospect of a breakup, which for a $78 billion insurer like AIG is likely a complex and potentially disruptive maneuver.
"It would be a mistake to think such a split could be accomplished quickly or easily considering the company's substantial regulatory oversight and holding company obligations that are ultimately backed by the full organization," RBC Capital Markets analyst Mark Swelle wrote in a research note.
Additional reporting by Mike Stone; Editing by Savio D'Souza, Christian Plumb and David Gregorio