Nigam Mehta IPMX09035

The American International Group (2005)

On 14th March 2005, Maurice Greenberg resigned as CEO of American International Group (AIG) due to
allegations of fraud and accounting manipulations at the company. The company also fired two more top
executives including CFO, Howard Smith on March 21. The evidence of fraud suggested that AIG
arranged deals to manipulate financial figures, both its own and those of other companies.
The major trigger to the current crisis involved a set of transactions made in year 2000, between AIG and
General Re, a Berkshire Hathaway unit. AIG used the transaction to help tide over the financial difficulties
by misrepresenting financial statements.
As an insurer AIG sells plans to individuals and organizations, where it assumes the risk of financial loss
arising out of particular situations in return of premium payment. A primary requirement for an insurance
company is to maintain a healthy reserve to pay off the claims that arise during a certain time period. The
investors monitor the companys reserve levels to gauge its financial health. Low reserves would mean
that the company is susceptible to financial crisis.
The analysts had criticized the AIGs reduced provision levels earlier. To deal with this, the company took
help from General Re, a reinsurance company. A reinsurance company insures the insurers. An insurance
company would pay a reinsurance company to cover potential losses the insurance company might face.
As part of the deal General Re and AIG switched roles. General Re agreed to pay AIG a $500 million
premium, and in exchange AIG took the risk from a number of policies General Re had sold to other
companies. Though not illegal, as per investigators, the policies handed over to AIG by General Re had
little or no risk: The claims that AIG would pay out over time would almost equal the same premium of
$500 million.
The result of the deal, therefore, was that AIG got $500 million from General Re, money that it would
eventually have to pay back without the risk of having to pay more. General Re received a significant fee
from AIG. However, because of differences in accounting rules, to classify the $500 million as a loan
would reduce the companys income, something that AIG was averse to do.
Instead, according to investigators, AIG classified 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 fourthquarter increase in reserves of more than $100 million for 2000.
This was a financial statement dressing exercise rather than a risk transfer. This misleading accounting
and financial reporting, projected an unduly positive picture of AIG's underwriting performance for the
investing public. In Feb 2, 2006 - SEC filed complaint in US District Court against AIG to resolve claims
related to improper accounting, bid rigging and practices involving workers compensation funds. On Feb
9, 2006 SEC and the Justice Department came to as settlement in excess of $1.6 billion with AIG. Along
with this, AIG had to undertake corporate reforms to prevent similar misconduct from occurring in future.
The above is a case of Agency cost. Agency costs arise because of core problems such as conflicts of
interest between investors and management (Maurice Greenberg and his Senior Managers). Investors
wish for management to run the company in a way that increases their value. But management may
choose to grow the company in ways that increased their personal power and wealth and that may not be
in the best interests of investors. The improper execution of duties by the management (agent) here can
be attributed to the lack of moral incentives for the agents. The agents kept the principal (investors and
shareholders) in dark and eventually the shareholders suffered the most losses. About $1.77 Billion in
shareholder value was threatened due to the Senior Managements actions.