American International Group (AIG) is the 10th largest corporation and a leading international insurance and financial services organization in the U.S. It is one of the largest writers of commercial, industrial, and life coverage in the U.S and has operations in 130 countries in life and non life coverage. The company also participates in other financial services including aircraft leasing, consumer finance, asset management, and commodities and derivatives trading.Scenario:
The current crisis orginated with a transaction in 2000 between AIG and General Re, a unit of Berkshire Hathaway, the investment group run by billionaire investor Warren Buffett. AIG sells insurance plans to corporations or individuals. In return for payment of premiums, AIG assumes the risk of financial loss resulting from particular events. To pay off filed claims, AIG must maintain a sufficient cash reserve to cover the claims it can expect to pay out during a given period. Investors look closely at the level of reserves, because low reserves indicate that the insurer is susceptible to a financial crisis if it receives a number of large claims from its clients in a short period of time.
The U.S Securities and Exchange Commission's (SEC) Enforcement Division investigates possible violations of the federal securities laws. This includes violations as insider trading, market manipulation, fraud regarding securities offering, and failure to report or disclose certain material information or fraud by a broker or investment adviser. Where wrongdoing is alleged, the SEC can bring a civil suit seeking monetary penalties, disgorgement of illegal profits, orders prohibiting future violations or orders barring individuals from holding certain corporate positions.
According to investigations led by New York Attorney General Eliot Spitzer, AIG's reserves were too low in 2000. To deal with this problem, the company sought the aid of General Re, a reinsurance company. A reinsurance company insures the insurer, that is, it sells insurance plans to insurance companies that are seeking to offload some of the risk they have acquired from corporations and individuals. Normally, an insurance company will pay General Re or another reinsurance company to cover potential losses the insurance company might face.
In the deal negotiated in 2000, General Re and AIG switched roles. General Re agreed to pay AIG a $500 million premium, and in return AIG assumed the risk from a number of policies General Re had sold to other companies. This by itself would not have been illegal. However, according to investigators, the policies General Re handed over to AIG had little or no risk. The claims that AIG would have to pay out over time would almost certainly equal the same premium of $500 million.
The result of the deal, therefore, was that AIG received $500 million from General Re, money that it would eventually have to pay back without risk of having to pay more.For this, General Re received a substantial fee from AIG. Similar arrangements are generally categorized as loans on financial statement.AIG received an amount of cash that it would later have to pay back plus interest (the fee to General Re). However, because of differences in accounting rules, to categorize the $500 million as a loan would reduce the company's income, something that AIG was hesitant to do.Instead, AIG categorized the deal as a normal insurance contract, and the $500 million was counted as income that went toward reserves to pay future claims. AIG reported a fourth-quarter increase in reserves of more than $100 million for 2000.
Accounting regulations set by the Federal Accounting Standards Board, US stipulate that any such transaction that does not involve a significant amount of risk must be considered a loan, though the definition of "significant" has never been clearly outlined. If, in fact, the risk of the deal was negligible, then AIG could be subject to civil prosecution and fines.
Hank Greenburg, CEO of AIG, Ron Ferguson, CEO of Gen Re, Christopher Garand, Senior VP and Chief Underwriter of GenRe's Finite Reinsurance in US, Elizabeth Monrad, CFO of Gen Re and Robert Graham, Senior Vice President and Assistant General Counsel at GenRe were charged with misleading accounting and financial reporting, projecting an unduly positive picture of AIG's underwriting performance for the investing public and engaging in sham insurance transactions under Security Investor Protection Law, Security Investor Protection Law, Conspiracy Law and Mail Fraud Law.
The investigation into Pricewaterhouse Cooper's(PwC) who were the auditors of AIG revealed that it had been dishonest in its long-time auditing relationship with AIG, and that PwC had knowingly ignored warning signs regarding AIG's poor accounting methods.Consequences:
- The participants were sentenced time in prison and a fine ranging from $100,000 to $200,000 fine along with revoking of their insurance license.
- AIG acknowledged misconduct, adopted a series of reforms and agreed to pay more than $1.6 billion in restitution and penalties. The agreements were announced simultaneously by the New York Attorney General, the New York Insurance Department, the Securities and Exchange Commission (SEC) and the United States Department of Justice. Out of the $1.6 billion, $800 million will go to investors deceived by false financial statements, $375 million to AIG policyholders harmed by bid rigging activities and $344 million to states harmed by AIG's practices between 1986 and 1995 involving workers' compensation funds. In addition, New York and the SEC have each assessed $100 million in penalties against the company. The SEC's penalty will go into the fund for investors.
- AIG curtailed the use of "contingent commissions" and will not pay contingent commissions in excess casualty lines of insurance henceforth. AIG has also agreed to stop paying commissions in any line of insurance where companies with 65 percent of gross written premiums do not do so. The company has also agreed to support legislation banning contingent commissions.
- As a result of the scandal, the SEC was now granted the power to subpoena documents and compel testimony without the approval of the agency's five commissioners which would increase the pace of similar investigations.
- The Sarbanes-Oxley Act of 2002 came into existence. One of the act's primary goals is to enforce auditor independence and require companies like AIG to have their own independent audit committees to monitor the company interaction with it auditor.
The scandal resulted in lose of face of one of the world's premier financial institutes and the downfall of a financial icon, Hank Greenburg. Other direct consequences include the tightening of auditing laws and more power to the SEC to prevent such illegalities again.
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