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Case Presentation

Circumstances of the scandal, how it was discovered and why the legislation was needed

 American International Group (AIG) is one of the biggest companies in the US that provide insurance and financial services. Edwin Cornelius Vander Starr established it in 1919 and so far it has offices in over one hundred and thirty countries, it is a company that had been considered as too big to experience failure. Its main business is provision of insurance and retirement service through three subsidiaries which are Chartis, Sun America Financial Group and Financial Services (Saporito, 2009).

The scandal in this company was discovered through an investigation in the year 2000 by Security Exchange Commission. This investigation that impelled AIG into admission of improper accounting in its dealings, was started from a wider investigation of nontraditional insurance where there was a lot of concern in finite risk insurance. The regulators major concern was in reinsurance business which is a business that sells insurance to insurance companies so that huge claims than those anticipated can be covered. Their worry was that some insurers were making good use of these policies to improperly bolster their financial results since for a contract to be taken as insurance, risk had to be transferred to the insurer selling the policy.  Some finite risk policies appeared to look like loans instead of insurance policies. Hence, an inquiry was opened on at least twelve insurance and reinsurance companies where it was significance to find out the way in which finite transactions were structured and treated on the financial statement of the companies or clients. One of the companies probed was General Re which had dealings with AIG; the lawyers in General Re keenly looked in to their finite risk deals and came up with a number of transactions that they realized were not clear that adequate risk had been transferred to treat them as insurance. They then alerted the SEC and NewYork attorney general’s office about these deals which resulted into the probe of AIG Company (Hulburt, 2005).

This investigation led to a growing scandal that tarnished the reputation of AIG and it was forced to acknowledge that it had improperly accounted for reinsurance transaction to increase reserves and other detailed examples of wrong accounting. The evidence of fraud obtained from the investigation revealed that AIG organized deals to manipulate financial figures of other companies and its own; the incident that resulted directly to this scandal involved a transaction discovered by General Re between AIG, General Re and a unit of Berkshire Hathaway, which is investment group rum by billionaire investor Warren Buffet. The problem was that whether AIG used the transaction to help it overcome some impending financial difficulties. The insuring business of AIG is selling plans to companies and individuals in return for premiums being paid to them. AIG takes up risk of financial losses that are caused by specific happenings therefore, it has to maintain a reserve of cash enough to claims it expects to payout in a given duration of time. Investors are keen on the level of reserves maintained by an insurer since low reserves means an insurer is vulnerable to experiencing a financial crisis in case it has to cover a large number of claims in a short period of time. Investigations revealed that in 2000 AIG reserves were very low and to handle this issue they looked for assistance from General Re which is a reinsurance company that sells plans to insurance companies that intend to offload some of the risks they have acquired from individuals and corporations. A deal was negotiated in but the two companies switched their roles, General Re agreed to pay AIG five hundred million dollars and in return AIG assumed the risk from a number of policies General Re had sold to other companies (Hulburt, 2005).

This transaction would have resulted to being illegal if the investigators did not  find out that the policies given to AIG had minimal or no risk at all and the claim AIG would have to pay out over time would almost certainly equal the same premium of $500 million. The resulting deal was that AIG received five hundred million dollars from General Re that it would have to pay back and also give a considerable fee to General Re. Arrangements such as these are presented as loans in financial statements since amount received would have to be repaid back plus interest. Categorizing it as a loan also means the corporations income would be reduced but AIG would not desire that to happen. Investigators found out that the deal was categorized by AIG as a normal insurance contract and the cash of five hundred thousand million dollars taken as income that was set aside in reserves to make payment of future claims. This ensured an increase of fourth quarter of more than one hundred million in 2000 for AIG Company. Legislation was needed in this case because AIG violated insurance accounting rules since according to set accounting regulations by the Federal Accounting Standards Board, such a transaction must be taken as a loan since it does not involve a significant amount of risk. In this case the risk of the deal was negligible and AIG was subjected to civil prosecution and fines. In 2003 AIG paid a penalty of $10 Million as settlement between AIG, SEC and Justice Department. In 2004 the federal grand jury filed a complaint against the company after the Company’s smoothing products were investigated. In February 2006 the issue was again taken to court where it agreed to pay fraud charges of $165Million to SEC after the allegations of violation of sixteen counts, one count conspiracy, seven counts of securities fraud, five counts of false statements and three counts of mail fraud (Hulburt, 2005).

Players in the Scandal

The players in this scandal were about sixteen members of the top level management of AIG however; the CEO Hank Greenburg was the major player behind this scandal. He played the role of making sure loans were recorded as revenues and influenced traders to inflate the stock prices. CFO, Howard Smith was another major player who gave the CEO a lot of support in this scandal. Re insurance Company General Re was another player since it entered a back ward deal with AIG. The government was also responsible because it did not keep an eye on AIG company accounts to check if there were any fraudulent activities (Saporito, 2009).

Outcome of the crime or circumstances

The outcome of the scandal was firing of the top level management and the company was also bailed out by the Government with the use of the tax payer’s money (Greider, 2010). This had both negative and positive effects, the positive effect being that the bailout ensured the company could continue with its operations such that the investors would not lose entirely after the scandal. The negative effect was that tax payer’s money was used to pay bonuses to company ex executives who had committed fraudulent activities.

Punishment to the right people

Those greatly responsible for the scandal were the top level management and they were punished by being fired from the company and paid a lot of money in terms of legal fees. However, they were later given bonuses from the government amounting $165 million, those highly responsible did were therefore not greatly punished due to their unethical misconduct (Greider, 2010). Facing a jail term as well as being fired from their positions would have been a better punishment.

Legislation work

The legislation worked in ensuring that the company was heavily fined in engaging in fraudulent activities. The most responsible players in the scandal like the CEO and CFO were also fired and the company put under new management. However none of them was jailed or prosecuted for their deeds and in fact were awarded bonuses by the Government (Greider, 2010). Legislature would have done a better job in punishing those involved to ensure that such unethical practices would not happen in other companies.

Red flags that might have preceded the unethical behavior

The major red flag was the switching of reinsurance roles between AIG and General Re. General Re was paid five million dollars by AIG so that they could move five hundred million dollars of insurance contracts and their corresponding premiums worth five hungered million. This situation was a red flag because the two companies entered into the deal backwards. Auditors had also noted over a long period that it could not easily verify accounting methods used by AIG. There were also a number of other questionable accounting cases uncovered that would have acted as red flags. One of these other red flags is there insurer contracts taken by AIG with Barbados reinsurer, Union Excess.  It allowed AIG to pass its risks to other companies and remove them from their books. Union was owned partly by Starr International Company Inc (SICO) in which AIG was a large shareholder. SICO’s risks were therefore AIG’s and shareholders equity reduced by one point one billion dollars due to this discovery. The second involved Richmond Insurer Company a Bermuda insurer that was controlled secretly by AIG. A third one related to Barnados Insurer named Capco Reinsurance that had created a wrong structure to classify underwriting losses as capital losses worth two hundred million dollars. Fourth case AIG had claimed to have made income worth three hundred dollars from gains in bond from 2001 to 2003 while it actually had not sold the bonds. There existed also bad debts in terms of property casualty policies which could not be collectible resulting to after tax charge of three hundred million dollars (Hulburt, 2005).

 Lasting implications the situation

The company’s corporate social responsibility was negatively affected because its actions did not reflect its responsibility to the society. Investors lost confidence in the company resulting to negative effect on the share prices. A lot of company’s money had to pay heavy fines and penalties so as to settle lawsuits that were brought against it. The company employees were also negatively affected, they had to purchase AIG shares to assist in sustaining the company’s losses. The general public lost a lot because their insurance was also at risk due to the scandal; their trust in the company was lost because there was misrepresentation by the company (Saporito, 2009)

 Those hurt by unethical behavior

The procedures that were carried out to overhaul the company would distract the remaining employees of the company and make them unstable in their jobs. Investors were also greatly hurt by this unethical behavior since they had lost their confidence in the company, the shareholders equity had also been greatly affected due to the reduction in the share prices. AIG company public reputation was greatly hurt and it would take a number of years to restore its public image. Government also suffered from blame directed to it by the public since it was its obligation to ensure the public is well protected from such unethical activities in companies (Saporito, 2009).

References

Hulburt, H. M. (2005). Financial reinsurance and the AIG/General Re Scandal.CPCU eJournal58(11), 5.

Saporito, B. (2009). How AIG became too big to fail. Time Magazine173(12), 24-30.

Greider, W. (2010). The AIG bailout scandal. The Nation. Retrieved January2, 2011.