A V Rajwade: And now, the insurers

WORLD MONEY

After Enron, the banks and the mutual funds, this is the next pillar with clay foundations.

Corporate scandals that have attracted headlines since the Enron case quickly engulfed major commercial and investment banks, mutual funds and other players in the financial services industry.

Lately, another pillar of the financial establishment, namely the insurance industry, has been shaken and was found to be have foundations of clay.

AIG, the giant American insurance company (and a partner of Tata in India), is a case in point. The legendary chairman, the senior Mr Greenberg, has been forced to retire, the CFO sacked and the comptroller asked to go on leave. The problems seem to fall under three major heads:

The use of offshore companies to hide some transactions under the carpet. The offshore companies were, in reality, under the control of the AIG management, but this fact was hidden.

The shareholdings had been so structured that consolidation was not necessary to conform to the letter of the rule.

Use of an offshore company, which had significant shareholdings in AIG itself, to compensate executives "" and, indeed, give money to NGOs in which AIG's "independent" directors were interested.

Some "finite" reinsurance transactions, also involving General Re, a part of Warren Buffet's Berkshire Hathaway Group.

(Another Indian connection "" Ajit Jain, perhaps the second closest confidante of Buffet "" heads Berkshire Hathaway's reinsurance group.)

Creative accounting, converting capital gains into investment income, and in hedge/ translation transactions.

Greenberg's sons, also in the insurance industry, are having their own problems. One headed the world's largest insurance broker, Marsh and McLennan, and the other an insurance company that settled criminal charges by paying a fine in excess of $ 100 million.

The broking company has been accused of price rigging of insurance contracts, kick-backs and so on. One, involving the receipt of hundreds of millions of dollars, which now have to be refunded, worked as follows.

The broker got extra commission if the business placed with an insurance company exceeded a specified threshold. To earn this so-called contingent commission, there was a temptation to place business with that company.

If its bid was not competitive, the broker would get artificially higher priced bids from other insurance companies and satisfy the client that the favoured insurance company's bid was the lowest.

The amount recently coughed up by the broker for paying back to clients for such practices, is as much as $850 million.

Incidentally, Mercer, a unit of the broker Marsh and McLennan, is active in India and, if I remember correctly, also advises on the restructuring of the provident funds and framing of new rules.

A series of cases in Australia as also in the US, and involving some top-notch reinsurers, focus on accounting for so-called "finite reinsurance" contracts.

As it is, insurance accounting is, perhaps, one of the most complex branches of accounting. Finite reinsurance adds to the complexities "" simply stated, an insurance company "reinsures" with a reinsurance company, claims that have already been incurred! Obviously, the premium is hefty "" more or less equal to the amount of the claims.

The purpose of such financial insurance is to "window dress" reported profits.

The rules require that such transactions qualify for insurance accounting only if there is a minimum chance of 10 per cent loss for the reinsurer.

Regulators are now investigating several transactions undertaken by General Re, as also other reinsurance companies, in Australia and in the US, to judge whether the contracts were really reinsurance and, thus, qualifying for insurance accounting, or merely financial transactions undertaken to massage the reported profits.

In some cases, documentation was done to evidence reinsurance but secret, side letters were exchanged to record the underlying understandings!

What is surprising is that even companies controlled by Buffett, the "sage of Omaha", seem to have indulged in such transactions (before he purchased them?).

Coming back to AIG, after Greenberg's departure it has acknowledged having discovered a number of transactions undertaken "for the sole or primary purpose of (achieving) a desired accounting result".

It is also consolidating the accounts of offshore companies hitherto hidden under the carpet. Overall, the restatements will reduce net worth by $2.7 billion.

Perhaps the largest question mark in terms of accounting treatment of some transactions involves the MBIA, a corporate bond insurer that is restating its accounts for the past seven years.

Any possible downgrading of the MBIA has serious implications for the corporate bond market in the US, as many issues have earned the current ratings based on the AAA rating of the MBIA.

A number of insurance companies are underwriting credit risks in the credit derivatives market. The amounts involved are huge (notional principal outstanding $5 trillion at the end of 2004) and the implications of more difficult economic conditions to the insurance companies, obvious.

Still on insurance, Equitable Life, the troubled UK insurer, has sued 15 former directors for some decisions taken by them "" and has claimed £2.2 billion from Ernst and Young, the auditors for their role!

Fannie Mae, the giant housing refinance company in the US, has been caught in another accounting scam. The top management has been dismissed, and the problem, once again, seems to be with accounting for derivatives.

This time, there is an added twist: the accounting treatment chosen brought the level of reported profits just above the threshold needed for the management to claim performance bonuses "" by pure coincidence, of course!

Email: avrco@vsnl.com