Aig's Accounting Practices and Financial Statements

AIG's accounting practices and financial statements

One of the ethical principles of accountants who are in compliance with Generally Accepted Accounting Principles (GAAP) of the United States is the concept of full disclosure. All of the relevant information pertaining to a financial decision should be openly disclosed. (1)

However, this was not the case in the dealings between AIG and General Re, the former unit of Berkshire Hathaway. AIG used the questionable transaction to help cover its recent financial difficulties. In a reversal of common practice, the reinsurance firm General Re paid AIG a $500 million premium so AIG would assume the risk of General Re's policies. Though this was not illegal, what was illegal was the method used to disclose this upon the AIG balance sheet. (2)

The result of the deal was that AIG received $500 million from General Re - money that would eventually have to be paid back to General Re but without the risk of having to pay more money. General Re received a substantial fee plus interest in return from AIG in exchange for this deal. Similar arrangements are generally categorized as loans on financial statements, as AIG essentially received an amount of cash. However AIG chose not to categorize the $500 million as a loan - as it would reduce the company's income on its balance sheet. Instead, AIG categorized the deal as a normal insurance contract, and accounted the $500 million it earned as income to improve its financial image, although according to GAAP a transaction of this kind is a loan, as it was virtually risk-free. (3)

The fraudulent transaction came to light in 2004 as part of a continuing investigation into the insurance industry's accounting practices, during which the Attorney General's office and NY Insurance Department began looking more closely into AIG. The SEC had previously expressed curiosity in AIG's business practices; in particular, the SEC was troubled by a product called "loss mitigation insurance" which AIG advertised to corporations through a brochure. The SEC brought charges against AIG and several companies they believed AIG helped hide losses in their financial statements. All of these trials were settled out of court. The investigation then turned to whether AIG had manipulated its own financial statements, which brought to light the shady accounting of the reinsurance transaction, as well as several international entities practically owned by AIG. (4)

The SEC, working with the U.S. Department of Justice, New York Attorney General, and New York State Department of Insurance, again filed charges against AIG shortly thereafter. In 2005 court proceedings, General Re executives admitted they knew ahead of time that AIG would plan to use a reinsurance transaction to increase its loss reserves, as AIG had been under scrutiny by analysts because of the low balance in their reserves. Many AIG executives admitted the transaction should have been classified as a loan, not as insurance. Many questions were raised about the Sarbanes-Oxley Act, since it did not address how reinsurance should be categorized, whether it should be a loan or a debt. (4)

Insurance companies such as AIG traditionally use reinsurance to protect themselves from risk. Reinsurance involves one company, AIG, ordering insurance from another company, Gen Re, to cover an insurance policy they wrote to a customer (buying insurance for insurance). In particular AIG has been criticized for wrongly categorizing the finite insurance they purchased from Gen Re. Finite insurance, in essence, distributes the cost of a large insurance policy over several years. In the event that AIG is forced to pay a claim to its customer during the first few years of the policy being in effect, they would file a claim with Gen Re. During this short time period AIG is paying Gen Re a large premium, in effect paying the cost of the insurance policy it granted to its customer over several years. If no claims are made, most of the premium AIG paid is returned to AIG. (5)

The biggest issue here is that the reinsurance roles were switched in this case. AIG paid Gen Re $5 million to move $500 million of insurance contracts and their corresponding $500 million worth of premiums to AIG. Then, AIG claimed their cash reserves increased by $500 million, where as they really had actually taken out a loan. If no claims were made to Gen Re within the specified time period, AIG would return the majority of the $500 million, therefore making this transaction as a loan, based on GAAP standards. Therefore in this case, the $500 million should have been classified as a loan, thus increasing AIG's liabilities. The intent of the Sarbanes-Oxley Act is to prevent companies from hiding losses or reporting unearned revenue, in this aspect AIG followed to the Sarbanes-Oxley Act perfectly fine - but they were aware of the loop holes and they just used them to better their financial position with investors. (5)

One of the primary goals of the Sarbanes-Oxley