AIG Accounting Scandal

By:
Ghazanfar Ali
Zafar
Rahmat
Introduction
AIG, American International Group Inc., is one of the top multinational
insurance corporations. Its primary activities include General Insurance and Life
Insurance & Retirement Services 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. According to the 2008 Forbes Global 2000
list, AIG was once the 18th-largest public company in 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.

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 AIGs
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. Generals 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. 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 plotted to draft a deal.
AIG bought insurance from General Re and accounted for it in a
way that overstated revenue. Transactions with General Re were
improperly recorded as a reinsurance deal. At the time, some AIG
shareholders were questioning whether the insurance company
had enough money set aside to cover potential claims, known as
reserves. Under the transaction, AIG shifted $500 million of
expected claims to itself from General Re, along with $500 million
of premiums. AIG booked the premiums as revenue, and then
added $500 million to its reserves to reflect its obligation to pay
the claims. If AIG was receiving the premiums to ensure that it
didn't lose anything in the deal, then it faced no risk. In that case,
it wasn't really insuring anything and the $500 million shouldn't
have been treated as premium revenue. General Re received a
$5 million commission for the deal. For its part, General Re did
not treat the transaction as an insurance policy; instead, it
booked it as a finance deal.

Other Accounting frauds

AIG also admitted to: using insurers in Bermuda and Barbados

that were secretly controlled by AIG to bolster its financial results,
including shifting some liabilities off its books a broad range of
improper accounting that could slash its net worth by $1.77
billion, improperly accounting for a reinsurance transaction with
Berkshire Hathaway Inc.s General Re in 2000-2001.
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, AIGs 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 CRDs
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

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 Loss 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 AIGs own
board of directors had repeated stated that it could not verify the AIGs
accounting methods, but PwC ignored the red flags regarding AIGs poor
accounting practices. If PwC was on high alert, it might have worked closely
with AIG and prohibited AIG from classifying the $ 500 million as revenue.

Conclusion
In the end of the civil case trial, 4 executive members of General Re and AIG
were convicted. However, the charges were all overturned by the federal court of
appeal in 1st Aug, 2011, including Greenberg and Ferguson. However the
damage was done. Because of this scheme, it was estimated on Oct 31, 2008
that shareholders lost around $544 million to $597 million. AIG almost went
bankrupt at the start of the finical crisis. It is obvious that there were many
internal controls problems for AIG. But can the fraud be prevented in this case?
We can analyze the situation using the Fraud Triangle.

Pressure
* Downgrade of Stock
* Decline in Loss Reserve
* Avoid Critism

Opportunity
* AIG being big client of General Re

Rationalization
* Increase stock price
* Splizer file civil suit just for election
Pressure
* Downgrade of Stock
* Decline in Loss Reserve
* Avoid Critism

Opportunity
* AIG being big client of General Re
Rationalization
* Increase stock price
* Splizer file civil suit just for election

We can see that that all three elements. Pressure, Opportunity and
Rationalization exist in this case. Also with the lack of internal control in AIG
and the negligence of its auditor PwC, it almost seemed that fraud was
inevitable. However, after the financial crisis, we have experienced the financial
frauds and illegal acts incurred huge costs with far reaching damages affecting
the lives of many people for years Government agencies all over the world have
been working hard to improve regulations for tighter controls. In addition, I
believe that large corporations and audit firms alike should learn from mistakes
and exercise high professional and ethical principles to prevent frauds and
account scandals.

References
AGREED STATEMENT OF FACTS. (n.d.). Retrieved from justice.gov:
http://www.justice.gov/criminal/pr/documents/01-20-1%20gen-re-
agreedstatement.pdf
AIG SECURITIES LITIGATION-PwC SETTLEMENT. ( 2010, December 2).
Retrieved from AIG SECURITIES LITIGATION-PwC SETTLEMENT:
http://www.aigsecuritieslitigationpwcsettlement.com/
AIG: What Went Wrong. (2005, 4 10). Retrieved from businessweek.com:
http://www.businessweek.com/stories/2005-04-10/aig-what-went-wrong
American International Group. (20, September 2013). Retrieved from
Wikipedia: http://en.wikipedia.org/wiki/American_International_Group
CALLAHAN, D. (2010, November 8). AIG: Before the Crash, There Was the
Fraud. Retrieved from cheatingculture.com:
http://www.cheatingculture.com/accounting-fraud/2010/11/8/aig-before-the-
crash-there-was-the-fraud.html
Kay, J. (2005, March 24). Top insurance company mired in allegations of
accounting fraud. Retrieved from International Committee of the Fourth
International (ICFI): http://www.wsws.org/en/articles/2005/03/aig-m24.html
Schonfeld, M. (2005 ). John Houldsworth: Securities and Exchange Commission
Litigation Complaint. New York.
Starkman, D. (2005, June 1). AIG Comes Clean on Accounting. Retrieved from
The Washington Post: http://www.washingtonpost.com/wp-
dyn/content/article/2005/05/31/AR2005053101589.html
Wilkinson, P. (2009, February 11). PwC Off Hook In AIG Shareholder Fraud
Suit. Retrieved from law360.com: http://www.law360.com/articles/87034/pwc-
off-hook-in-aig-shareholder-fraud-suit
Young, D. R. (2009, May 6). Actuarial Accounting:A Cautionary Report.
Retrieved from casact.org:
http://www.casact.org/education/spring/2009/handouts/young.pdf

Faltu
After the admission, Investigators now are examining actions of
top AIG officials. The SEC could bring civil fraud charges against
the company or executives. AIGs shares fell 1.8% continuing to
sliden Feb. 14, 2005 AIGs shares are down 22% since closing on
Friday, Feb.

11. Standard & Poors and Moodys downgraded AIGs long-term

bonds and certain other

debt by a notch from its top AAA and Aa1 rating. A.M. Best put
AIG under review with negative implications. Fitch Ratings put
AIG under Rating Watch Negative. Company says accounting
problems probably will not deplete its net worth (shareholders
equity) by more than 2%. AIG CEO Hank Greenberg resigns in
March 2005 and retired as AIGs chairman days later.
Shareholders equity would still be above $80 billion. Mr.
Greenberg had been running AIG for nearly four decades and
was responsible for moving AIG into China which is now one of
its most promising regions. Many say Mr. Greenberg was the
most powerful executive in the history of insurance. Mr.
Greenberg took AIG from $300 million market value to about
$160 billion. However, Spitzer praises AIG for changing some top
management.

In late 2000 and 2001, Gen Re shifted $500 million of expected

claims to AIG along with

$500 million of premiums. Gen Re accounted for this transaction

properly. AIG recorded the premiums as reveue and added $500
million to its reserves to show its obligation to pay claims