America International Group (AIG) is one of the world’s largest insurer. They faced allegations of accounting fraud by making transactions which would enhance their financial statements by massaging the figures.
AIG were facing low reserves and to deal with this problem, they sought the aid of General Re, a reinsurance company. This was done so as to off load some risks AIG acquired from corporations and individuals. Therefore it is expected for AIG to pay General Re to cover for potential losses.
However, in the deal that they negotiated, they switched roles. General Re agreed to pay AIG a $500 million premium, and in return, AIG took the risk from a number of policies General Re had sold to other companies. These policies that AIG took were seen to have little or no risk hence it was certain that the claim that AIG would have to pay would be the same as this $500 million. Hence AIG received $500 million and paid General Re a substantial fee. This was similar to taking a loan and paying back with interest (which is the fee). This was supposed to have been accounted as a loan which would reduce the companies income and AIG was unwilling to do that.
Instead, according to investigators, AIG categorized the deal as a normal insurance contract, and the $500 million was counted as income that went toward reserves to pay future claims. This was used to enhance their reserves. Accounting regulations by the Federal Accounting Standards Board stipulate that any transaction that does not involve a significant amount of risk should be classified as a loan. the meaning of a “significant” amount of risk has never been classified but in this case, the risk was negligible. This could have led to prosecutions and fines if the risks were rendered negligible.
Insurance companies carry out transactions to help companies massage their financial statements through the sale of so-called “finite risk insurance”. For example, Brightpoint Inc were wanting a way to reduce their large losses and asked for aid from AIG. Brightpoint paid monthly premiums and AIG paid the money back in from of insurance claims which was used to offset the years losses as insurance receivables. In other words, Brightpoint bought “insurance” to cover losses that had already occurred, the exact opposite of how insurance normally works. This led to AIG paying $10 million in fines.
In summary, don’t cook the books!