3. AIG Scandal 2005

AIG

AIG Accounting

Accounting Scandal

Scandal

By:

By:

Ghazanfar Ali

Ghazanfar Ali

Zafar

Zafar

Rahmat

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 illion, provides

insurance service for more than !5" different countries and it has over 6#", """ employees over the world. According to the 2008 Forbes Global 2000 list, AIG was once the 18th-largest public company in the world. $ven thou%h AIG is such a %iant corporation, it has encountered

financial prolems in the early """s. 'nder financial pressure and a lac( of internal control, AIG have committed frauds resultin% in several scandals. )ne of the accountin% scandals was disclosed durin% ""5 which involved a material mis*statement due to false transactions durin% """. +his scandal set to prelude leadin% the downfall of AIG in "".

The Accounting Scandal The Players

+he -$) of AIG was aurice /0an(1 Greener%. Greener% 2oined AIG in !36 and led AIG for thirty ei%ht years until his retirement in arch ""5. Greener% was not only the -$), ut also the chairman of the oard of AIG. AIG also have several susidiaries, which include 4ational 'nion ire

Insurance -ompany of ittsur%h 74'I-8 and 0artford Steam 9oiler Inspection 70S98. +heir financial information are consolidated in AIG:s financial statements.

+he scandal also involves another corporation General Re -orporation. General Re is a susidiary of 9er(shire 0athaway, Inc., an investment %roup run y the  illionaire ;arren 9uffet. General Re also has susidiaries all over the world

and to%ether and it is one of the i%%est reinsurance companies in the ;orld. Reinsurance companies are entities that insure the insurance companies. +hey help insurance companies share ris( y sellin% reinsurance plans that would help  pay off a share of a claim from the insurance companies. +he -$) of General

Re was Ron er%uson when the fraud was committed. General:s R$ susidiary in <ulin, Ireland, (nown as -olo%ne Re <ulin 7-R<8 was also heavily

The Deal 

)n )ctoer, 6, """, AIG released its third =uarter earnin%s. It

showed that there was an increase of premium, ut a decrease in loss reserves y 53 million. Loss reserve is a liaility account which

represents the estimate of loss future claims. Loss reserve is an

important indicator for whether mana%ement of company is sufficiently anticipatin% for future claims. A decline could imply that AIG had cash or reserve prolems. 9ecause of the decline in loss reserves, analysts have down%raded AIG two days after release of earnin%s. 0ence, the stoc( price of AIG dropped 6> from ?33.6 to ?3#.# on 4@S$. It was then that Greener% called er%uson. Greener% wanted to increase AIG loss reserves. +herefore, he and Greener% plotted to draft a deal.

AIG bought insurance from General Re and accounted for it in a way that overstated revenue. ransactions with General Re were im!ro!erly recorded as a reinsurance deal. At the time, some AIG shareholders were "uestioning whether the insurance com!any had enough money set aside to cover !otential claims, #nown as reserves. $nder the transaction, AIG shifted %&00 million of e'!ected claims to itself from General Re, along with %&00 million of !remiums. AIG boo#ed the !remiums as revenue, and then

added %&00 million to its reserves to reflect its obligation to !ay the claims. If AIG was receiving the !remiums to ensure that it didn(t lose anything in the deal, then it faced no ris#. In that case, it wasn(t really insuring anything and the %&00 million shouldn(t have been treated as !remium revenue. General Re received a %& million commission for the deal. For its !art, General Re did not treat the transaction as an insurance !olicy) instead, it

boo#ed it as a finance deal.

Other Accounting frauds

AIG also admitted to* using insurers in +ermuda and +arbados that were secretly controlled by AIG to bolster its financial results, including shifting some liabilities off its boo#s a broad range of  im!ro!er accounting that could slash its net worth by %.--billion, im!ro!erly accounting for a reinsurance transaction with +er#shire athaway Inc./s General Re in 2000200.

)n )ctoer, 6, """, AIG released its third =uarter earnin%s. It showed that there was an increase of premium, ut a decrease in loss reserves y 53 million. Loss reserve is a liaility account which represents the estimate of loss future claims. Loss reserve is an important indicator for whether mana%ement of company is sufficiently anticipatin% for future claims. Since the premiums has increased, AIG:s loss premium should e increased as well. A decline could imply that AIG had cash or reserve prolems. 9ecause of the decline in loss reserves, analysts have down%raded AIG two days after release of earnin%s.

0ence, the stoc( price of AIG dropped 6> from ?33.6 to ?3#.# on 4@S$. It was then that Greener% called er%uson.

Greener% wanted to increase AIG loss reserves. +herefore, he and Greener% had drafted a deal. 9y usin% oth the susidiaries of AIG and General R$,

 4'I- and -R<. 4'I- 7AIG8 would assume the ris( of losses from -R<:s  policies for aout ?6"" million for ?5"" million of premium. +he ?5"" million

represented two contracts where each contract was paid in different times. )f that ?5"" million, !" million would e paid to 4'I- 7AIG8 and ?3" million would e withheld in -R<. +he transaction itself is called Loss ortfolio

+ransfer and it is le%al. 0owever, AIG actually did not want to assume any ris(. +he contracts that -R< transferred were in fact ris(*free. +he claim would eventually e paid out y AIG for eBactly ?5"" million. Also, AIG secretly a%reed to AIG

4'I- Asset 

C !" remium aid y -<R 

C 3" remium Receivale 7withheld y -<R8  Liability

C 5"" Loss Reserve

Transection recorded by AIG: AIG

4'I-Transaction recorded by AIG:

ay General Re 5 million as a fee for doin% the deal. ollowin% GAA 7%eneral accepted accountin% principle8, the nature of the transaction could not e

classified as Loss ortfolio +ransfer as there was no transfer of ris(. 0owever, senior mana%ements of AIG and General R$ a%reed to en%a%e in /non*mirror ima%e accountin%1, which 4'I- recorded the transaction as a Loss ortfolio

+ransfer, while -<R7General Re8 recorded the transaction as a deposit which did not violate GAA.

0ow -<R paid ?!" million without payin%D

In order for AIG to pay General Re ?5. million fees secretly and for -<R to  pay ?!" million in order to ma(e the transaction elievale and under the radar

from investi%ators. Senior mana%ement of AIG and General Re constructed a  paper trail which would hide the transaction of ?5. million directly to General

R$ from AIG. +here were eBistin% contract etween where General Re owned ?#!. payale to AIG. +herefore, General Re paid ?E.5 million to commute an eBistin% contract with AIG susidiary, 0S9. urthermore, General Re paid

 4'I- ?3.! million premium to reinsure the loss that was 2ust commuted to 0S9. -<R then paid General R$ ?". million premium for a fa(e reinsurance and received a loss payment ?!# million. inally, -<R made the ?!" million  payment to 4'I-. In the end, -<RFGeneral Re was left with ?5. million in

total. Reinsurance ?".  Reinsurance ?3.! AIG 0S9  4'I-General R$ 7?#!. payale to 0S98 -ommute ?E.5  Loss ayment ?!#  -<R  ?!"  remium Gen Re  #!. *E.5*3.!*!# C".  ?.6 -<R  !# H !" H ".  ?.6  Reinsurance ?".  Reinsurance ?3.! AIG 0S9  4'I-General R$ 7?#!. payale to 0S98

-ommute ?E.5  Loss ayment ?!#  -<R  ?!"  remium Gen Re  #!. *E.5*3.!*!# C".  ?.6 -<R  !# H !" H ".  ?.6 

 Effects after the Transaction

;ith the reserves set up and a lac( of transparency, AIG was ale to manipulate numers and added ?!"6 million of loss reserves in  """ and ?6# million ! ""! to the alance sheet mas(in% the actually decline of loss reserves of ?! million and ?!Emillion. ;ith the additional premium and loss reserve, analysts thou%ht that the earnin%s of AIG in those two =uarters were %reat. In the release of earnin%s in ! ""!, Greener% even wrote /JAIG had a solid first =uarter... ;e added ?6# million to AIGKs %eneral insurance net loss and loss ad2ustment reserves for the =uarter, rin%in% the total of those reserves to ?5." illion at arch #!, ""!.J

What went wrong?

+he Securities and $Bchan%e -ommission 7S$-8 had already een proin% into AIG durin% early """ due to a various misconducts of AIG. +hey were already suspicious of the inte%rity of the financial information provided y AIG. In anuary ""5, the counsel of General R$ phoned S$- representatives to disclose the entirety L+ transaction. )n eruary ! ""5, AIG received a supoena from S$- relatin% to finite reinsurance accountin%. And # days later, AIG disclosed the L+ scheme to the pulic. In arch ""5, Greener% stepped down from the -$) position. In ay ""5, AIG issued a restated financial statement for fiscal years from """ throu%h ""#, which reduced the income for "" for !.# illion. Also $liot SpliMer, the 4ew @or( Attorney General filed a civil case a%ainst AIG.

Responsiility of the Auditors

;ith liti%ation %oin% on for AIG, its auditor ricewaterhouse-oopers LL were also under scrutiny ecause they si%ned off the financial statements of AIG. any criticiMed w- that it did not detect the unusual transactions. +he AIG shareholders filed several complaints on w- to have violated the securities laws in providin% AIG auditin% services and %ivin% un=ualified opinions on AIG financial statements and demanded dama%es. )n nd <ecemer, "!", a

the AIG shareholders.

w- has a lon% usiness relationship with AIG for over #" years, ut it appeared that w- has not een eBertin% full professional efforts. +he investi%ation of the char%es a%ainst w- revealed that the Audit -ommittee of AIG:s own  oard of directors had repeated stated that it could not verify the AIG:s

accountin% methods, ut w- i%nored the Nred fla%s: re%ardin% AIG:s poor accountin% practices. If w- was on hi%h alert, it mi%ht have wor(ed closely with AIG and prohiited AIG from classifyin% the ? 5"" million as revenue.

Conclusion

In the end of the civil case trial,  eBecutive memers of General Re and AIG were convicted. 0owever, the char%es were all overturned y the federal court of  appeal in !st Au%, "!!, includin% Greener% and er%uson. 0owever the

dama%e was done. 9ecause of this scheme, it was estimated on )ct #!, "" that shareholders lost around ?5 million to ?53E million. AIG almost went  an(rupt at the start of the finical crisis. It is ovious that there were many

internal controls prolems for AIG. 9ut can the fraud e prevented in this caseO ;e can analyMe the situation usin% the raud +rian%le.

ressure

P <own%rade of Stoc(  P <ecline in Loss Reserve P Avoid -ritism

)pportunity

P AIG ein% i% client of General Re

RationaliMation

P Increase stoc( price

P SpliMer file civil suit 2ust for election ressure

P <own%rade of Stoc(  P <ecline in Loss Reserve P Avoid -ritism

)pportunity

RationaliMation

P Increase stoc( price

P SpliMer file civil suit 2ust for election

;e can see that that all three elements. ressure, )pportunity and

RationaliMation eBist in this case. Also with the lac( of internal control in AIG and the ne%li%ence of its auditor w-, it almost seemed that fraud was

inevitale. 0owever, after the financial crisis, we have eBperienced the financial frauds and ille%al acts incurred hu%e costs with far reachin% dama%es affectin% the lives of many people for years Government a%encies all over the world have  een wor(in% hard to improve re%ulations for ti%hter controls. In addition, I  elieve that lar%e corporations and audit firms ali(e should learn from mista(es

and eBercise hi%h professional and ethical principles to prevent frauds and account scandals.

References

AGR$$< S+A+$$4+ ) A-+S. 7n.d.8. Retrieved from 2ustice.%ovD httpDFFwww.2ustice.%ovFcriminalFprFdocumentsF"!*"*!>"%en*re*

a%reedstatement.pdf 

AIG S$-'RI+I$S LI+IGA+I)4*w- S$++L$$4+. 7 "!", <ecemer 8. Retrieved from AIG S$-'RI+I$S LI+IGA+I)4*w- S$++L$$4+D

httpDFFwww.ai%securitiesliti%ationpwcsettlement.comF

AIGD ;hat ;ent ;ron%. 7""5,  !"8. Retrieved from usinesswee(.comD httpDFFwww.usinesswee(.comFstoriesF""5*"*!"Fai%*what*went*wron% American International Group. 7", Septemer "!#8. Retrieved from ;i(ipediaD httpDFFen.wi(ipedia.or%Fwi(iFAmericanQInternationalQGroup

-ALLA0A4, <. 7"!", 4ovemer 8. AIGD 9efore the -rash, +here ;as the raud. Retrieved from cheatin%culture.comD

httpDFFwww.cheatin%culture.comFaccountin%*fraudF"!"F!!FFai%*efore*the* crash*there*was*the*fraud.html

ay, . 7""5, arch 8. +op insurance company mired in alle%ations of accountin% fraud. Retrieved from International -ommittee of the ourth International 7I-I8D httpDFFwww.wsws.or%FenFarticlesF""5F"#Fai%*m.html Schonfeld, . 7""5 8. ohn 0ouldsworthD Securities and $Bchan%e -ommission

Liti%ation -omplaint. 4ew @or(.

Star(man, <. 7""5, une !8. AIG -omes -lean on Accountin%. Retrieved from +he ;ashin%ton ostD httpDFFwww.washin%tonpost.comFwp*

dynFcontentFarticleF""5F"5F#!FAR""5"5#!"!53.html

;il(inson, . 7""3, eruary !!8. w- )ff 0oo( In AIG Shareholder raud Suit. Retrieved from law#6".comD httpDFFwww.law#6".comFarticlesFE"#Fpwc* off*hoo(*in*ai%*shareholder*fraud*suit

@oun%, <. R. 7""3, ay 68. Actuarial Accountin%DA -autionary Report. Retrieved from casact.or%D

httpDFFwww.casact.or%FeducationFsprin%F""3FhandoutsFyoun%.pdf 

altu

After the admission, Investigators now are e'amining actions of  to! AIG officials. he 13 could bring civil fraud charges against the com!any or e'ecutives. AIG/s shares fell .84 continuing to sliden Feb. 5, 200& AIG/s shares are down 224 since closing on Friday, Feb.

. 1tandard 6 7oor/s and oody/s downgraded AIG/s longterm bonds and certain other

debt by a notch from its to! AAA and Aa rating. A.. +est !ut AIG under review with 9negative: im!lications. Fitch Ratings !ut AIG under 9Rating ;atch <egative:. 3om!any says accounting !roblems !robably will not de!lete its net worth =shareholders/ e"uity> by more than 24. AIG 3? 9an#: Greenberg resigns in arch 200& and retired as AIG/s chairman days later. 1hareholders/ e"uity would still be above %80 billion. r. Greenberg had been running AIG for nearly four decades and was res!onsible for moving AIG into 3hina which is now one of  its most !romising regions. any say r. Greenberg was the most !owerful e'ecutive in the history of insurance. r. Greenberg too# AIG from %@00 million mar#et value to about %0 billion. owever, 1!itBer !raises AIG for changing some to! management.

In late 2000 and 200, Gen Re shifted %&00 million of e'!ected claims to AIG along with

%&00 million of !remiums. Gen Re accounted for this transaction !ro!erly. AIG recorded the !remiums as reveue and added %&00 million to its reserves to show its obligation to !ay claims