AIG, Before Credit Default Swaps, There was
Reinsurance
Commentary
Location: New York
Author: IRA Staff
Date: Monday, April 6, 2009
AIG: Before Credit Default Swaps, There Was Reinsurance
"What do many corporate buyers of insurance have in common with American
International Group? Perhaps more than they would like to admit. Like AIG,
many companies in the past few years have bought finite insurance, which
transfers a prescribed amount of risk for a particular liability. What
regulators now want to know is, how many companies, like AIG, have used
finite insurance to artificially inflate their financial results?"
Infinite Risk?
CFO Magazine
June 1, 2005
"In the regulatory world, a 'side letter' is perhaps the
most insidious and destructive weapon in the white-collar criminal's
arsenal. With the flick of a pen, underhanded executives can cook the
books in enormous amounts and render a regulator helpless."
Fraud Magazine
July/August 2006
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For some time now, we have been trying to reconcile the apparent paradox of
American International Group (NYSE:AIG) walking away from the highly
profitable, double-digit RAROC business of underwriting property and
casualty (P&C) risk and diving into the rancid cesspool of credit default
swaps ("CDS") contracts and other types of "high beta" risks, business lines
that are highly correlated with the financial markets.
In our interview with Robert Arvanitis last year, "'Bailout: It's About
Capital, Not Liquidity; Seeking Beta: Interview with Robert Arvanitis',
September 29, 2008," we discussed the difference between high and low beta.
We also learned from Arvanitis, who worked for AIG during much of the
relevant period, that the decision by Hank Greenberg and the AIG board to
enter the CDS market was, at best, chasing revenue. No rational examination
of the business opportunity, assuming that Greenberg and his directors were
acting based on a reasoned analysis, could have resulted in a favorable
decision to pursue CDS and other "high beta" risks, at least from our
perspective.
In an effort to resolve this conundrum, over the past several months The IRA
has interviewed a number of forensic experts, insurance regulators and
members of the law enforcement community focused on financial fraud. The
picture we have assembled is frightening and suggests that, far from just
AIG, much of the insurance industry has been drawn into the world of
financial engineering and has thus become part of the problem. Below we
present our preliminary findings and invite your comments.
One of the first things we learned about the insurance world is that the
concept of "shifting risk" for a variety of business and regulatory reasons
has been ongoing in the insurance world for decades. Finite insurance and
other scams have been at least visible to the investment community for years
and have been documented in the media, but what is less understood is that
firms like AIG took the risk shifting shell game to a whole new level long
before the firm's entry into the CDS market.
In fact, our investigation suggests that by the time AIG had entered the CDS
fray in a serious way more than five years ago, the firm was already doomed.
No longer able to prop up its earnings using reinsurance because of growing
scrutiny from state insurance regulators and federal law enforcement
agencies, AIG's foray into CDS was really the grand finale. AIG was a Ponzi
scheme plain and simple, yet the Obama Administration still thinks of AIG as
a real company that simply took excessive risks. No, to us what the fraud
Bernard Madoff is to individual investors, AIG is to the global financial
community.
As with the phony reinsurance contracts that AIG and other insurers wrote
for decades, when AIG wrote hundreds of billions of dollars in CDS
contracts, neither AIG nor the counterparties believed that the CDS would
ever be paid. Indeed, one source with personal knowledge of the matter
suggests that there may be emails and actual side letters between AIG and
its counterparties that could prove conclusively that AIG never intended to
pay out on any of its CDS contracts.
The significance of this for the US bailout of AIG is profound. If our
surmise is correct, the position of Feb Chairman Ben Bernanke and Treasury
Secretary Tim Geithner that the AIG credit default contracts are "valid
legal contracts" is ridiculous and reveals a level of ignorance by the Fed
and Treasury about the true goings on inside AIG and the reinsurance
industry that is truly staggering.
Does Reinsurance + Side Letters = CDS?
One of the most widespread means of risk shifting is reinsurance, the act of
paying an insurer to offset the risk on the books of a second insurer. This
may sound pretty routine and plain vanilla, but what most people don't know
is that often times when insurers would write reinsurance contracts with one
another, they would enter into "side letters" whereby the parties would
agree that the reinsurance contract was essentially a canard, a form of
window dressing to make a company, bank or another insurer look better on
paper, but where the seller of protection had no intention of ever paying
out on the contract.
Let's say that an insurer needs to enhance its capital surplus by $100
million in order to meet regulatory capital requirements. They can enter
into what appears to be a completely legitimate form of reinsurance
contract, an agreement that appears to transfer the liability to the
reinsurer. By doing so, the "ceding company" - an insurance company that
transfers a risk to a reinsurance company - gets to drop that $100 million
in liability and its regulatory surplus increases by $100 million.
The reinsurer assuming the risk does actually put up the $100 million in
liability, but with the knowledge that they will never have to actually pay
out on the contract. This is good for the reinsurer because they are paid a
fee for this transaction, but it is bad for the ceding company, the insurer
with the capital shortfall, because the transaction is actually a sham, a
fraud meant to deceive regulators, counterparties and investors into
thinking that the insurer has adequate capital. Typically the fee is 6% per
year or what is called a "loan fee" in the insurance industry.
When it operates in this fashion, the whole reinsurance industry could be
described as a "surplus rental" proposition, whereby an insurer literally
loans another insurer capital in the form of risk cover, but with a secret
understanding in the form of a side letter that the loan will be reversed
without any recourse to the seller of protection. You give me $6 million in
cash today, and I will give you a promise that we both know I will never
honor.
Does this sound familiar? What our contacts in the insurance industry
describe is almost a precise description of the CDS market, albeit one that
evolved in the reinsurance industry literally decades ago and has been the
cause of numerous insurance insolvencies and losses to insured parties. Or
to put it another way, maybe the inspiration for the CDS market - at least
within AIG and other insurers -- evolved from the reinsurance market over
the past two decades.
As best as we can tell, the questionable practice of using side letters to
mask the economic and business reality of reinsurance transactions started
in the mid-1980s and continued until the middle of the current decade. This
timeline just happens to track the creation and evolution of the OTC
derivatives markets. In particular, the move by AIG into the CDS market
coincides with the increased awareness of and attention to the use of side
letters by insurance regulators and members of the state and federal law
enforcement community.
Keep in mind that what we are talking about here are not questionable risk
management policies but acts of deliberate and criminal fraud, acts that
often result in jail time for those involved. As one senior forensic
accountant who has practiced in the insurance sector for three decades told
The IRA:
"In every major criminal fraud case in which I have worked, at the center of
the investigation were these side letters. It was always very strange to me
that on-site investigators and law enforcement officials consistently found
that these side letters were being used to mask the true financial condition
of an insurer, and yet none of the state regulators, the National
Association of Insurance Commissioners (NAIC), nor federal law enforcement
authorities ever publicly mentioned the practice. They certainly did not act
like the use of side letters was a commonplace thing, but it was widespread
in the industry."
It is important to understand that a side letter is a secret agreement, a
document that is often hidden from internal and external auditors,
regulators and even senior management of insurers and reinsurers. We doubt,
for example, that Warren Buffet or Hank Greenberg knew the details of side
letters, but they should have. Just as a rogue CDS trader at a large bank
like Societe General (NYSE:SGE) might seek to hide losing trades, the
underwriters of insurers would use sham transactions and side letters to
enhance the revenue of the insurer, but without disclosing the true nature
of the transaction.
There are two basic problems with side letters. First, they are a criminal
act, a fraud that usually carries the full weight of an "A" felony in many
jurisdictions. Second, once the side letter is discovered by a persistent
auditor or regulator examining the buyer of protection, the transaction
becomes worthless. You paid $6 million to AIG to shift risk via the
reinsurance, but the side letter makes clear that the transaction is a fraud
and you lose any benefit that the apparent risk shifting might have
provided.
As the use of these secret side letters began to become more and more
prevalent in the insurance industry, and these secret side deals were
literally being stacked on top of one another at firms like AIG, the SEC
began to investigate. And they began to find instances of fraud and to crack
down on the practice. One of the first cases to come to the surface involved
AIG helping Brightpoint (NASDAQ:CELL) commit accounting fraud, a case that
eventually led the SEC to fine AIG $10 million in 2003.
Wayne M. Carlin, Regional Director of the SEC's Northeast Regional Office,
said of the settlements: "In this case, AIG worked hand in hand with CELL
personnel to custom-design a purported insurance policy that allowed CELL to
overstate its earnings by a staggering 61 percent. This transaction was
simply a 'round-trip' of cash from CELL to AIG and back to CELL. By
disguising the money as 'insurance,' AIG enabled CELL to spread over several
years a loss that should have been recognized immediately."
Another case involved PNC Financial (NYSE:PNC), which used various contracts
with AIG to hide certain assets from regulators, even though the transaction
amounted to the "rental" of capital and not a true risk transfer.
As the SEC noted in a 2004 statement: "The Commission's action arises out of
the conduct of Defendant AIG, primarily through its wholly owned subsidiary
AIG Financial Products Corp. ("AIG-FP"), (collectively referred to as "AIG")
in developing, marketing, and entering into transactions that purported to
enable a public company to remove certain assets from its balance sheet."
Click here to see the SEC statement regarding the AIG transactions with PNC.
The SEC statement reads in part: "In its Complaint, filed in the United
States District Court for the District of Columbia, the Commission alleged
that from at least March 2001 through January 2002, Defendant AIG, primarily
through AIG-FP, developed a product called a Contributed Guaranteed
Alternative Investment Trust Security ("C-GAITS"), marketed that product to
several public companies, and ultimately entered into three C-GAITS
transactions with one such company, The PNC Financial Services Group, Inc.
("PNC"). For a fee, AIG offered to establish a special purpose entity ("SPE")
to which the counter-party would transfer troubled or other potentially
volatile assets. AIG represented that, under generally accepted accounting
principles ("GAAP"), the SPE would not be consolidated on the
counter-party's financial statements. The counter-party thus would be able
to avoid charges to its income statement resulting from declines in the
value of the assets transferred to the SPE. The transaction that AIG
developed and marketed, however, did not satisfy the requirements of GAAP
for nonconsolidation of SPEs."
In both cases, AIG was engaged in transactions that were meant not to reduce
risk, but to hide the true nature of the risk in these companies from
investors, regulators and the consumers who rely on these institutions for
services. Keep in mind that while the SEC did act to address these issues,
the parties involved received light punishments when you consider that these
are all felonies that arguably would call for criminal prosecution for
fraud, securities fraud, conspiracy and racketeering, among other things.
Indeed, this is one of those rare cases where we believe AIG itself, as a
corporate person, should be subject to criminal prosecution and liquidation.
Birds of a Feather: AIG & GenRe
Click here to see a June 6, 2005 press release from the SEC detailing
criminal charges against John Houldsworth, a former senior executive of
General Re Corporation ("GenRe"), a subsidiary of Berkshire Hathaway (NYSE:BRKA),
for his role in aiding and abetting American International Group, Inc. in
committing securities fraud.
The SEC noted: "In its complaint filed today in federal court in Manhattan,
the Commission alleged that Houldsworth and others helped AIG structure two
sham reinsurance transactions that had as their only purpose to allow AIG to
add a total of $500 million in phony loss reserves to its balance sheet in
the fourth quarter of 2000 and the first quarter of 2001. The transactions
were initiated by AIG to quell criticism by analysts concerning a reduction
in the company's loss reserves in the third quarter of 2000."
But the involvement of the BRKA unit GenRe in the AIG mess was not the first
time that GenRe had been involved in the questionable use of reinsurance
contracts and side letters.
Click here to see an example of a side letter that was made public in a
civil litigation in Australia a decade ago. The faxed letter, which bears
the ID number from the Australian Court, is from an insurance broker in
London to Mr. Ajit Jain, a businessman who currently heads several
reinsurance businesses for BRKA, regarding a reinsurance contract for FAI
Insurance, an affiliate of HIH Insurance.
Notice that the letter states plainly the intent of the transaction is to
bolster the apparent capital of FAI. Notice too that several times in the
letter, the statement is made that "no claim will be made before the
commutation date," which may be interpreted as being a warranty by the
insured that no claims shall be made under the reinsurance policy. By no
coincidence, HIH and FAI collapsed in a $5.3 billion dollar fiasco that
ranks as Australia's biggest ever corporate failure.
Click here to read a March 9, 2009 article from The Age, one of Australia's
leading business publications, regarding the collapse of HIH and FAI.
In 2003, an insurer named Reciprocal of America ("ROA") was seized by
regulators and law enforcement officials. An investigation ensued for 3
years. According to civil lawsuits filed in the matter, GenRe provided
finite insurance to ROA in order to make the troubled insurer look more
solvent than it was in reality. Several regulators and law enforcement
officials involved in that case tell The IRA that the ROA failure forced
insurers like AIG and Gen Re to start looking for new ways to "cook the
books" because the long-time practice of side letters was starting to come
under real scrutiny.
"These reinsurance deals made ROA look better than it really was," one
investigator with direct knowledge of the ROA matter tells The IRA. "They
went into the ROA home office in VA with the state insurance regulators and
law enforcement, and directed the employees away from the computers and
records. During that three-year investigation, GenRe learned that local
regulators and forensic examiners had put everything together and that we
now understood the way the game was played. I believe the players in the
industry realized that that they had to change the way in which they cooked
the books. A sleight- of-hand trick that had worked for 25 years under the
radar of regulators and investors was now revealed."
Several senior officials of ROA eventually were prosecuted, convicted of
criminal fraud and imprisoned, but DOJ officials under the Bush
Administration reportedly blocked prosecution of the actual managers and
underwriters of ROA who were involved in these sham transactions, this even
though state officials and federal prosecutors in VA were anxious to proceed
with additional prosecutions.
AIG: From Reinsurance to CDS
While some reinsurers are large, well-capitalized entities that generally
avoid these pitfalls, AIG was already a troubled company when it began to
write more and more of these risk-shifting transactions more than a decade
ago. It is easy to promise the moon when people think that they can deliver,
but because AIG and their clients saw how easy it was to fool regulators and
investors, the practice grew and most regulators did absolutely nothing to
curtail the practice.
It was easy for AIG to become addicted to the use of side letters. The firm,
which had already encountered serious financial problems in 2000-2001,
reportedly saw the side letters as a way to mint free money and thereby help
the insurer to look stronger than it really was. AIG not only helped banks
and other companies distort and obfuscate their financial condition, but AIG
was supplementing its income by writing more and more of these reinsurance
deals and mitigating their perceived exposure via side letters.
A key figure in AIG's reinsurance schemes, according to several observers,
was Joseph Cassano, head of AIG-FP. Whereas the traditional use of side
letters was in reinsurance transactions between insurers, in the case of
both CELL and PNC neither was an insurer! And in both cases, AIG used sham
deals to make two non-insurers, including a regulated bank holding company,
look better by manipulating their financial statements. Falsifying the
financial statements of a bank or bank holding company is an felony.
AIG-FP was simply doing for non-insurers what was common practice inside the
secretive precincts of the insurance world. The SEC did investigate and they
did finally obtain a deferred prosecution agreement with AIG, which was
buried in the settlement with then-New York AG Elliott Spitzer.
The key thing to understand is that if you look at many of these reinsurance
contracts between ROA and Gen Re, they look perfect. They appear to transfer
risk and seem to be completely in order. But, if you don't get to see the
secret agreement, the side letter that basically says that the reinsurance
contract is a form of window dressing, then you cannot understand the full
implications of the transaction, the reinsurance agreement. Not, several
experts speculate, can you understand why AIG decided to migrate away from
reinsurance and side letters and into CDS as a mechanism for falsifying the
balance sheets and earnings of non-insurers.
Several observers believe that at some point in the 2002-2004 period,
Cassano and his colleagues at AIG began to realize that state insurance
regulators and the FBI where on to the reinsurance/side letter scam. A
number of experts had been speaking and writing about the issue within the
accounting and fraud communities, and this attention apparently made AIG
move most of its shell game into the world of CDS. By no coincidence, at
around this time side letters began to disappear in the insurance industry,
suggesting to many observers that the industry finally realized that the jig
was up.
It appears to us that, seeing the heightened attention from regulators and
federal law enforcement agencies such as the FBI on side letters, AIG began
to move its shell game to the CDS markets, where it could continue to
falsify the balance sheets and income statements of non-insurers all over
the world, including banks and other financial institutions.
AIG's Cassano even managed to hide the activity in a bank subsidiary of AIG
based in London and under the nominal supervision of the Office of Thrift
Supervision in the US, this it is suggested to hide this ongoing activity
from US insurance regulators. Even though AIG had been investigated and
sanctioned by the SEC, Cassano and his colleagues at AIG apparently were
recalcitrant and continued to build the CDS pyramid inside AIG, a financial
pyramid that is now collapsing. The rest, as they say is history.
Now you know why the Fed and EU officials are so terrified about an AIG
liquidation, because it will result in heavy losses to or even the
insolvency of banks and other corporations around the globe. Notice that
while German Chancellor Angela Merkel has been posturing and throwing barbs
at President Obama, French President Nicolas Sarkozy has been conciliatory
toward the US.
But for the bailout of AIG, you see, President Sarkozy would have been
forced to bailout SGE for a second time in two years. So long as the Fed and
Treasury can subsidize AIG's mounting operating losses, the EU will be
spared a financial bloodbath. But this situation is unlikely to remain
stable for long with members of the Congress demanding an investigation of
the past bailout, a process that can only result in bankruptcy for AIG.
Are the CDS Contracts of AIG Really Valid?
The key point is that neither the public, the Fed nor the Treasury seem to
understand is that the CDS contracts written by AIG with these various
non-insurers around the world were shams - with no correlation between
"fees" paid and the risk assumed. These were not valid contracts as Fed
Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy guru
Larry Summers claim, but rather acts of criminal fraud meant to manipulate
the capital positions and earnings of financial companies around the world.
Indeed, our sources as well as press reports suggest that the CDS contracts
written by AIG may have included side letters, often in the form of emails
rather than formal letters, that essentially violated the ISDA agreements
and show that the true, economic reality of these contracts was fraud plain
and simple. Unfortunately, by not moving to seize AIG immediately last year
when the scandal broke, the Fed and Treasury may have given the AIG managers
time to destroy much of the evidence of criminal wrongdoing.
Only when we understand how AIG came to be involved in CDS and the fact that
this seemingly illegal activity was simply an extension of the
reinsurance/side letter shell game scam that AIG, Gen Re and others
conducted for many years before will we understand what needs to be done
with AIG, namely liquidation. Seen in this context, the payments made to AIG
by the Fed and Treasury, which were then passed-through to dealers such as
Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must
be reversed once the US Trustee for the Federal Bankruptcy Court for the
Southern District of New York is in control of AIG's operations.
Editor's note: Officials of BRKA and GenRe did not respond
to telephonic and email requests by The IRA seeking comment on this article.
An official of AIG did respond but was not willing to comment on-the-record
for this report. We shall be happy to publish any written comments that BRKA,
AIG or GenRe have on this article.
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