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AIG Scandal 2005

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  Introduction  AIG, American International Group Inc., is one of the top multinational insurance corporations. AIG, with asset of 556 billion, provides insurance service for more than 150 different countries and it has over 630, 000 employees over the world. Even though AIG is such a giant corporation, it has encountered financial problems in the early 2000s. Under financial pressure and a lack of internal control, AIG have committed frauds resulting in several scandals. One of the accounting scandals was disclosed during 2005 which involved a material mis-statement due to false transactions during 2000. This scandal set to prelude leading the downfall of AIG in 2008. In this paper, I will analyze the cause, the transactions and finally effects of the scandal. The Accounting Scandal   The Players   The CEO of AIG was Maurice “Hank” Greenberg. Greenberg joined AIG in 1962 and led AIG for thirty eight years until his retirement in March 2005. Greenberg was not only the CEO, but also the chairman of the board of AIG. AIG also have several subsidiaries, which include National Union Fire Insurance Company of Pittsburgh (NUFIC) and Hartford Steam Boiler Inspection (HSB). Their financial information are consolidated in AIG‟s financial statements. The scandal also involves another corporation General Re Corporation. General Re is a subsidiary of Berkshire Hathaway, Inc., an investment group run by the  billionaire Warren Buffet. General Re also has subsidiaries all over the world and together and it is one of the biggest reinsurance companies in the World. Reinsurance companies are entities that insure the insurance companies. They help insurance companies share risk by selling reinsurance plans that would help  pay off a share of a claim from the insurance companies. The CEO of General Re was Ron Ferguson when the fraud was committed. General‟s RE subsidiary in Dublin, Ireland, known as Cologne Re Dublin (CRD) was also heavily involved in the fraud. The Deal On October, 26, 2000, AIG released its third quarter earnings. It showed that there was an increase of premium, but a decrease in loss reserves by 59 million. Loss reserve is a liability account which represents the estimate of loss future claims. Loss reserve is an important indicator for whether management of company is sufficiently anticipating for future claims. Since the premiums has increased, AIG‟s loss premium should be increased as well. A decline could imply that AIG had cash or reserve problems. Because of the decline in loss reserves, analysts have downgraded AIG two days after release of earnings.  Hence, the stock price of AIG dropped 6% from $99.6 to $93.3 on NYSE. It was then that Greenberg called Ferguson. Greenberg wanted to increase AIG loss reserves. Therefore, he and Greenberg had drafted a deal. By using both the subsidiaries of AIG and General RE,  NUFIC and CRD.  NUFIC (AIG) would assume the risk of losses from CRD‟s  policies for about $600 million for $500 million of premium. The $500 million represented two contracts where each contract was paid in different times. Of that $500 million, 10 million would be paid to NUFIC (AIG) and $490 million would be withheld in CRD. The transaction itself is called Loss Portfolio Transfer and it is legal. However, AIG actually did not want to assume any risk. The contracts that CRD transferred were in fact risk-free. The claim would eventually be paid out by AIG for exactly $500 million. Also, AIG secretly agreed to AIG NUFIC Asset + 10M Premium Paid by CDR + 490M Premium Receivable (withheld by CDR) Liability + 500M Loss Reserve Transection recorded by AIG: AIG NUFIC Asset + 10M Premium Paid by CDR + 490M Premium Receivable (withheld by CDR) Liability + 500M Loss Reserve Transaction recorded by AIG: Pay General Re 5 million as a fee for doing the deal. Following GAAP (general accepted accounting principle), the nature of the transaction could not be classified as Loss Portfolio Transfer as there was no transfer of risk. However, senior managements of AIG and General RE agreed to engage in “non -mirror image accounting”, which NUFIC recorded the transaction as a L oss Portfolio Transfer, while CDR(General Re) recorded the transaction as a deposit which did not violate GAAP. How CDR paid $10 million without paying: In order for AIG to pay General Re $5.2 million fees secretly and for CDR to  pay $10 million in order to make the transaction believable and under the radar from investigators. Senior management of AIG and General Re constructed a   paper trail which would hide the transaction of $5.2 million directly to General RE from AIG. There were existing contract between where General Re owned $31.8M payable to AIG. Therefore, General Re paid $7.5 million to commute an existing contract with AIG subsidiary, HSB. Furthermore, General Re paid  NUFIC $9.1 million premium to reinsure the loss that was just commuted to HSB. CDR then paid General RE $0.4 million premium for a fake reinsurance and received a loss payment $13 million. Finally, CDR made the $10 million  payment to NUFIC. In the end, CDR/General Re was left with $5.2 million in total. Reinsurance $0.4 M Reinsurance $9.1M AIG HSB  NUFIC General RE ($31.8 payable to HSB) Commute $7.5 M Loss Payment $13 M CDR $10 M Premium Gen Re = 31.8 -7.5-9.1-13 +0.4 = $2.6M CDR = 13  –   10  –   0.4 = $2.6 M Reinsurance $0.4 M Reinsurance $9.1M AIG HSB  NUFIC General RE ($31.8 payable to HSB) Commute $7.5 M Loss Payment $13 M CDR $10 M Premium Gen Re = 31.8 -7.5-9.1-13 +0.4 = $2.6M  CDR = 13  –   10  –   0.4 = $2.6 M  Effects after the Transaction  With the reserves set up and a lack of transparency, AIG was able to manipulate numbers and added $106 million of loss reserves in Q4 2000 and $63 million Q1 2001 to the balance sheet masking the actually decline of loss reserves of $144 million and $187million. With the additional premium and loss reserve, analysts thought that the earnings of AIG in those two quarters were great. In the release of earnings in Q1 2001, Greenberg even wrote “ AIG had a solid first quarter... We added $63 million to AIG's general insurance net loss and loss adjustment reserves for the quarter, bringing the total of those reserves to $25.0  billion at March 31, 2001. What went wrong? The Securities and Exchange Commission (SEC) had already been probing into AIG during early 2000 due to a various misconducts of AIG. They were already suspicious of the integrity of the financial information provided by AIG. In January 2005, the counsel of General RE phoned SEC representatives to disclose the entirety LPT transaction. On February 14 2005, AIG received a subpoena from SEC relating to finite reinsurance accounting. And 3 days later, AIG disclosed the LPT scheme to the public. In March 2005, Greenberg stepped down from the CEO position. In May 2005, AIG issued a restated financial statement for fiscal years from 2000 through 2003, which reduced the income for 2004 for 1.32 billion. Also Eliot Splizer, the New York Attorney General filed a civil case against AIG. Responsibility of the Auditors With litigation going on for AIG, its auditor PricewaterhouseCoopers LLP were also under scrutiny because they signed off the financial statements of AIG. Many criticized PwC that it did not detect the unusual transactions. The AIG shareholders filed several complaints on PwC to have violated the securities laws in providing AIG auditing services and giving unqualified opinions on AIG financial statements and demanded damages. On 2nd December, 2010, a settlement finally reached that PwC had to provide 97.5 million in settlement for the AIG shareholders. PwC has a long business relationship with AIG for over 30 years, but it appeared that PwC has not been exerting full professional efforts. The investigation of the charges against PwC revealed that the Audit Committee of AIG‟s own board of directors had repeated stated tha t it could not verify the AIG‟s accounting methods, but PwC ignored the „red flags‟ regarding AIG‟s

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