The AIG/ General Re Scandal

By Pratibha Singh, MBA-I, Finance

First came investment banking; then mutual funds; now the insurance industry is mired in scandal-Eliot Spitzer, New York's formidable Attorney-General on October 14th, 2004, filed charges against AIG (American International Group Inc.), the world's biggest insurer. The charges were part of an ongoing investigation into industry practices that suggested insurers and brokers had acted collectively to betray customers. In 2005, after an AIG scandal on insurance and mutual funds the year before, AIG was once again under investigation for accounting fraud. The company has already lost over $58 billion worth of market compensation because of the AIG scandal. Here’s a look at the story so far.

About AIG
AIG was founded in 1919 by Cornelius Vander Starr in Shanghai, China. Starr was the first Westerner in Shanghai to sell insurance to the Chinese.
AIG owns ILFC, the world's largest aircraft leasing company, with hundreds of aircraft like Boeing 747-400. It also is the world's leading international insurance and financial services organization, with operations in more than 130 countries and jurisdictions.
AIG member companies serve commercial, institutional and individual customers through the most extensive worldwide property-casualty and life insurance networks of any insurer.
In the United States, AIG companies are the largest underwriters of commercial and industrial insurance and AIG American General is a top-ranked life insurer. Maurice Hank Greenberg till recently led AIG.
The scandal
The AIG scandal involves the unusually arcane and obscure world of reinsurance. Insurers don't simply take premiums and hope you don't collect. They insure themselves with other insurers. By doing so, they move risk and liabilities off their balance sheets and onto others'. Because the transactions are complicated and ambiguous, both insurers and reinsurers may be tempted to engage in transactions that seem to be insurance but are really just deals to make earnings or balance sheets look better. AIG seems to have done that to keep its stock price healthy.
In February 2005, AIG received subpoenas from the Office of the Attorney General of the state of New York (NYAG) and the Securities and Exchange Commission (SEC) relating to "investigations of non traditional insurance products and certain assumed reinsurance transactions and AIG’s accounting for such transactions." One of the deals involved a loss portfolio transfer from Gen Re, which is owned by Warren Buffet’s Berkshire Hathaway (the primary user) to AIG (the reinsurer). AIG booked as income $500 million in premium for the loss portfolio transfer and then added $500 million in reserves against future claims to its balance sheet. AIG counted the transaction as an insurance deal but later concluded that the Gen Re transaction documentation was improper and that it should not have been recorded as insurance. What makes this deal "scandalous" is the fact that there was no underwriting risk transferred in the deal. Instead the loss portfolio transfer was essentially a $500 million loan from Gen Re to AIG that AIG would repay through $500 million in claims payments to Gen Re. AIG did not face any chance of loss in this deal, its limit of liability was evidently capped at $500 million. Because of this, it is argued that the $500 million should have been accounted for as deposits on AIG’s books. But by recording the deal as "insurance", AIG was able to effectively boost its loss reserves by $500 million.
It has been reported that 10 other similar transactions have now come under the microscope.
The result 9
The AIG/Gen Re scandal has put financial reinsurance in the limelight and has caused the industry to revaluate such products. The financial devastation caused by the scandal is not trivial.
~Forthright~ Research Factory
On May 31st, 2005, AIG came out with its restated financial statements and issued a reduction in book value of USD $2.7 billion; a 3.3 percent reduction in net worth. AIG also adjusted its shareholders’ equity for the year 2004 downward by $2.26 billion or 2.7%. Between February 2005 and May 2005, its stock price fell by 25%.
Maurice "Hank" Greenberg was forced out as Chairman and CEO of AIG in March.
On the Gen Re side- Richard Napier (former Gen Re senior VP) and John Houldsworth pleaded guilty to conspiracy to file false financial records, falsify books, records and also mislead auditors in connection with the AIG deal.
The auditor’s role
The AIG fraud once again put pressure on the auditors, questioning their credibility. In this case, PwC, AIG’s major auditor has been engulfed in controversy over the series of accounting restatements.
Beginning with Enron, large accountancy firms have seen their reputations shattered by corporate scandals. Auditors are being blamed to varying extents for failing to spot fraud and accounting errors, and Andersen - one of the erstwhile big five firms - was destroyed by its role at Enron. Deloitte is facing billion-dollar lawsuits over the role of its Italian firm as joint auditor of Parmalat. The rigour of auditing has been further thrown into the spotlight after the Refco fiasco last year (Covered in an earlier issue of Forthright). PwC however believes that in the AIG case, its audit work was "appropriate". To the extent they were not aware of situations; they should not have been expected to be aware.
As per section 404 of the 2002 Sarbanes-Oxley law on accounting and corporate governance all companies are required to evaluate their internal controls. However this is a costly affair. As a result auditors have had to double their fees and thus accused of going over the top and doing too much testing.
Although PwC supports the Sarbanes-Oxley law, it argues that the US has to wean itself off its rules- based system of accounting and corporative governance. It calls for a mixed model involving principles as well as rules. The principles could set the tone inside companies by stressing the importance of "doing the right thing", although rules would still be necessary in financial reporting. One essential ingredient to achieving such a change would be the willingness of companies and auditors to exercise greater judgment in their accounting work-and not just following rules.
Despite all the turmoil surrounding the AIG/Gen Re scandal, however, it is important to realize that it is not financial reinsurance itself that is scandalous; rather it is the misuse of it that is wrong. The various scandals in the financial field in the last couple of years are enough to signal that it’s high time not just for the auditors and legislators to take their roles more seriously, but also for the companies to realize that ethical practices have to be followed if they wish to survive and compete.