ÌìÃÀÍøÕ¾´«Ã½´«Ã½

AG Targets Ex-Execs Greenberg and Smith; ÌìÃÀÍøÕ¾´«Ã½´«Ã½ Restates Financials; Is Settlement Next?

– Maurice “Hank” Greenberg,

ÌìÃÀÍøÕ¾´«Ã½´«Ã½ CEO, 1992

From the 1980s until recently, insurance giant American International Group and its top executives “routinely engaged in misleading accounting and financial reporting, projecting an unduly positive picture of ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s underwriting performance for the investing public,” a lawsuit filed by New York authorities last month charged.

The alleged misdeeds included hiding auto warranty and Brazilian life insurance underwriting losses by converting them to investment losses; falsifying reserves through bogus reinsurance transactions; creating false underwriting income though manipulation of offshore trusts; booking workers compensation premiums to other lines to reduce state taxes and guaranty fund assessments and misleading regulators about the company’s control over various offshore affiliates.

In addition to naming ÌìÃÀÍøÕ¾´«Ã½´«Ã½ as a defendant, the complaint cites Maurice “Hank” Greenberg, former long-time chief executive officer and chairman, and Howard Smith, former chief financial officer, as personally and directly involved in the schemes. Greenberg retired and Smith was terminated in March.

The case was filed in the state’s Supreme Court on May 26 by David D. Brown, assistant attorney general, on behalf of state Attorney General Eliot Spitzer and Superintendent of Insurance Howard Mills. It is the culmination of months of investigations that began in February with a subpoena from Spitzer.

It remains to be seen whether a trial will be held. Spitzer’s office has shown a preference for out-of-court settlements with defendants, as it did with insurance broker Marsh over compensation and bid-rigging charges, as opposed to lengthy trials. However, it is possible a settlement could be reached with one or more but not all of three defendants in this case.

As for a remedy, the state is seeking “disgorgement, restitution, damages, including punitive damages, and costs and equitable relief.” The AG’s office would not discuss any settlement figure, however some observers indicated that ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s recent 2004 annual filing and restatements provide a starting point.

A grand jury is reportedly also weighing criminal charges, although Spitzer has downplayed the likelihood of such charges.

ÌìÃÀÍøÕ¾´«Ã½´«Ã½ is now under new management headed by CEO Martin J. Sullivan. According to both ÌìÃÀÍøÕ¾´«Ã½´«Ã½ and Spitzer, the new management has been cooperating fully in the investigations.

ÌìÃÀÍøÕ¾´«Ã½´«Ã½ acknowledgement

ÌìÃÀÍøÕ¾´«Ã½´«Ã½ has acknowledged the improper transactions and accounting entries cited in the complaint and by other authorities. On May 31, the insurer filed a delayed 2004 annual financial report Form 10-K along with adjustments for 2000 through 2003 with the Securities and Exchange Commission.

The SEC filing reflected revisions that lowered ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s profits by almost $4 billion for the five years starting in 2000. The biggest change was for 2004, with net income cut by $1.32 billion, or nearly 12 percent, to $9.73 billion from the $11.05 billion that had been reported on Feb. 9.

The 10K filing specifically acknowledges efforts to disguise certain underwriting losses as investment losses, improperly use reinsurance to bolster reserves and mislead regulators about the company’s control over various offshore affiliates, as well as other accounting adjustments that were not documented.

Spitzer’s complaint includes a critical memo to management from auditors evaluating the company’s internal financial controls. The memo concludes that Smith ordered “topside” adjustments to the financial books and that he and Greenberg overrode certain internal controls and kept information from financial personnel, regulators and ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s accounting firm. The complaint notes that when asked under oath about some of the questionable practices, both Greenberg and Smith declined to answer, asserting their right not to incriminate themselves.

The complaint does not appear to unearth any claims beyond those that have been circling about the insurer since last February. But it does provide details and evidence of the charges.

Both Greenberg and Smith owned hundreds of thousands of shares of ÌìÃÀÍøÕ¾´«Ã½´«Ã½ stock and, the complaint alleges, Greenberg in particular “was intensely focused on the daily movement of ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s stock and he repeatedly directed ÌìÃÀÍøÕ¾´«Ã½´«Ã½ traders to aggressively purchase ÌìÃÀÍøÕ¾´«Ã½´«Ã½ stock for the purpose of propping up its price.” In fact, Greenberg was so invested in ÌìÃÀÍøÕ¾´«Ã½´«Ã½ that a one-dollar fluctuation in ÌìÃÀÍøÕ¾´«Ã½´«Ã½ shares translated into a $65 million gain or loss for him, according to the court document.

Creating false reserves

The complaint details how in 2000 Greenberg appears to have utilized fake reinsurance contracts with General Reinsurance to inflate ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s actual reserves in order to “fraudulently support” the price of ÌìÃÀÍøÕ¾´«Ã½´«Ã½ stock and impress analysts who had criticized ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s reserving habits.

The reinsurance-reserving scheme began with a phone call by Greenberg to Ronald Ferguson, president of GenRe, which is in the business of selling not buying reinsurance, according to the lawsuit. Greenberg allegedly suggested a plan under which GenRe would purchase up to $500 million in reinsurance from ÌìÃÀÍøÕ¾´«Ã½´«Ã½ so that ÌìÃÀÍøÕ¾´«Ã½´«Ã½ could show increased reserves. Greenberg explained that the exchange was to be “risk free.” According to the complaint, “Greenberg wanted ÌìÃÀÍøÕ¾´«Ã½´«Ã½ to be able to book hundreds of millions of dollars in reserves from GenRe, but he did not want there to be any risk that ÌìÃÀÍøÕ¾´«Ã½´«Ã½ would actually have to pay any claims.”

By November 17, 2000, Ferguson told Greenberg a 24-month deal had been designed under which ÌìÃÀÍøÕ¾´«Ã½´«Ã½ “would not bear real risk” but would pay GenRe a $5 million fee in exchange for the deal. ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s subsidiary, National Union, would pay $500 million to ÌìÃÀÍøÕ¾´«Ã½´«Ã½ for $600 million in reinsurance from ÌìÃÀÍøÕ¾´«Ã½´«Ã½. This “fiction” allowed ÌìÃÀÍøÕ¾´«Ã½´«Ã½ to show $250 million of the fake reserves in the fourth quarter of 2000 and another $250 million in the first quarter of 2001.

According to the complaint, the deal was a fraud: “In fact, GenRe did not pay premiums. And in fact, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ did not reinsure genuine risks. To the contrary, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ paid $5 million and the only genuine service performed by either party was that GenRe created false and misleading documentation to satisfy Greenberg’s illicit goals.”

‘Topside’ adjustments

ÌìÃÀÍøÕ¾´«Ã½´«Ã½ is charged with boosting its reserves through other tricks as well, including “unsupported accounting entries” right before its quarterly reports. These “topside” or “top level” adjustments reportedly came from CFO Smith, who instructed employee Vincent Cantwell to have them entered into the official books. A clerk’s photocopies of some of Cantwell’s notes from his spiral notebook are included as evidence. As a result of these “topside” changes, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ reserves increased in the first quarter 2000 by some $32 million and by about $70 million in the first quarter 2001, the complaint maintains.

“For quarter after quarter, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ official books and records were altered on the basis of nothing more than Smith’s say-so and Cantwell’s handwritten sheets, with hundreds of millions of dollars shifting from account to account,” the court papers say.

The reinsurance and “topside’ schemes apparently had their desired effects. For fourth quarter 2000, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ reported a reserve increase of $106 million from the prior quarter. In first quarter 2001, the insurer again claimed increases in reserves. Analysts were impressed and praised the company’s apparent improved loss reserves.

ÌìÃÀÍøÕ¾´«Ã½´«Ã½ had a reputation for solid underwriting profits, yet in some cases officials bent the rules to achieve them, judging from the lawsuit. ÌìÃÀÍøÕ¾´«Ã½´«Ã½ officials allegedly hatched two schemes in which potentially embarrassing auto warranty and life settlement losses were made to look like more acceptable investment losses instead.

By 1999, a relatively recent experiment by ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s National Union in the auto warranty business was proving troublesome, with a projected loss of $210 million. The same year, ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s Brazilian life insurance business had unfavorable underwriting results as well. Spitzer’s investigators claim that Greenberg and Smith, with cooperation from Joseph Umansky and other executives, engineered a plot involving the use of offshore subsidiaries to conceal the true losses. Essentially, the schemes involved ÌìÃÀÍøÕ¾´«Ã½´«Ã½ having another corporation take over its losing business and then fail, leaving ÌìÃÀÍøÕ¾´«Ã½´«Ã½ with an investment loss.

For the auto warranty business, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ utilized CAPCO Reinsurance Co., a small Barbados subsidiary of Western General Insurance Ltd.

The losses from ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s Brazilian life insurance company (Unibanco Seguros) were similarly swapped for investment losses using a Taiwanese ÌìÃÀÍøÕ¾´«Ã½´«Ã½ company, Nan Shan Life Insurance Company Ltd, and a reinsurance deal involving Union Excess. There were two such transactions: one for $44 million in 1999 and another in 2000 for $56 million, according to the complaint.

In 2001, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ ventured into the life settlements business, in which an investor purchases a life insurance policy from a dying policyholder. ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s Greenberg was apparently concerned with the public relations aspects of this business, writing at one point, “I’m uneasy about this.”

Greenberg was also concerned about accounting issues. Purchasers of life settlements were required to carry the investment as a loss until the purchase price of the policy exceeded its cash surrender value at the time it was purchased. To avoid the public relations risk and the accounting issues, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ decided to conduct its life settlements business through a third-party trust. ÌìÃÀÍøÕ¾´«Ã½´«Ã½ had its Alaskan subsidiary, American International Specialty Lines Insurance Co., issue fake surety policies to the newly-created trust, Coventry Life Settlement Trust. Through a series of transfers, the arrangement allowed ÌìÃÀÍøÕ¾´«Ã½´«Ã½ to book its life settlement activities as underwriting income, “thereby enhancing ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s underlying insurance underwriting results.” In 2004, after questioning by the insurance department in Alaska, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ shifted its life settlements business offshore to American International Reinsurance.

Mischaracterizing workers comp premium

In another section, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ is accused of intentionally misreporting “substantial” portions of workers compensation premiums, despite warnings as far back as 1992 that this was illegal. The complaint alleges that ÌìÃÀÍøÕ¾´«Ã½´«Ã½ used secret agreements with customers so that some of the premiums paid for workers compensation would instead be identified as general or auto liability premiums. This succeeded in lowering ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s state premium taxes, guaranty fund and residual market assessments that are based on compensation premiums.

Internal memos suggest that from $300 to $400 million or more annually in premiums was not reported, saving ÌìÃÀÍøÕ¾´«Ã½´«Ã½ an estimated $60 to $80 million a year unlawfully. The companies would still collect fees and taxes from its insureds based on the full workers compensation premium. Other insurers had to make up for the assessments ÌìÃÀÍøÕ¾´«Ã½´«Ã½ avoided.

ÌìÃÀÍøÕ¾´«Ã½´«Ã½ is also said to have charged some customers more than the maximum premium permitted in states, used forms not approved by state regulators and cancelled some policies after 18 months without making proper adjustments

“The result is that ÌìÃÀÍøÕ¾´«Ã½´«Ã½ makes millions of dollars illegally each year,” a memo to Greenberg dated January 31, 1992 read. The memo warned there could be serious consequences if it did not change its ways. Some within the company called the scheme “illicit tax evasion” while a legal memo to Greenberg said it was “permeated with illegality” and warned it could expose ÌìÃÀÍøÕ¾´«Ã½´«Ã½ to penalties and jeopardize the careers of employees.

But would-be whistleblowers were informed on several occasions that Greenberg was aware of it and did not want it corrected, according to the court papers.

The practice reportedly continued for more than a decade. ÌìÃÀÍøÕ¾´«Ã½´«Ã½ now claims it has been stopped, although Spitzer’s filing indicates that it is not clear when it was halted. The court documents maintain that ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s filings with the New York Insurance Department as recently as 2000 continued to reflect the understated workers compensation numbers.

Control of offshore entities

The complaint cites several instances where ÌìÃÀÍøÕ¾´«Ã½´«Ã½ is said to have denied controlling certain offshore entities from which it bought reinsurance despite considerable evidence showing otherwise. The entities include Coral Re and Union Excess Reinsurance Company Ltd, both Barbados reinsurers, and Richmond Reinsurance Co., a Bermuda holding company with a Barbados reinsurance subsidiary. The relationship is significant because under accounting rules, an insurer cannot record as a reinsurance recoverable any reinsurance it purchases from a company it owns or controls.

By the early 1990s, state regulators in Delaware, New York and Pennsylvania were questioning ÌìÃÀÍøÕ¾´«Ã½´«Ã½’s relationship with Coral Re. In 1987 ÌìÃÀÍøÕ¾´«Ã½´«Ã½ set up Coral Re for the purpose of reinsuring its business. By 1991, ÌìÃÀÍøÕ¾´«Ã½´«Ã½ had reportedly purchased about $1 billion in reinsurance from the Barbados reinsurer, even though Coral re had a capitalization of only $15 million.

Topics Carriers Auto Profit Loss Workers' Compensation New York Underwriting Reinsurance ÌìÃÀÍøÕ¾´«Ã½´«Ã½