Analysts divided on whether troubling disclosures are near an end

By Michael Ha and Dan Hays

American International Group, under intense regulatory scrutiny, made a startling admission last week that its ongoing internal review had unearthed “improper” finite reinsurance accounting with General Re and other problems in its bookkeeping methods, with possible adjustments adding up to a book-value loss of $1.66 billion.

The insurers review process is by no means over. AIG postponed its 2004 10-K filing with the Securities and Exchange Commission for a second time last weekuntil the end of Aprilas the company and its new top management continue to look for other accounting problems.

“The investigations and AIGs review are continuing, and AIG cannot presently determine whether additional matters will be discovered or further adjustments will be required,” noted the company, which said it has been examining various transactions going back 14 years.

Reactions from analysts came quickly. Standard & Poors Ratings Services, on the day of AIGs announcement, downgraded its long-term counterparty credit and senior debt ratings, as well as financial strength ratings on most of AIGs subsidiaries, from “AAA” to “AA-plus,” while Fitch Ratings placed its “AA-plus” long-term issuer rating and unsecured senior debt obligations on “Rating Watch Negative.”

Other analysts sounded alarm bells that while AIG is off to a good start in resolving its problems, the insurer will probably disclose more bad news before this is over.

In its candid review statement, AIG all but admitted that it massaged its accounting rules to make the companys numbers look better than they actually are. “Certain but not all of the original characterizations resulted from transactions which appear to have been structured for the sole or primary purpose of accomplishing a desired accounting result,” AIG said.

The biggest admission of accounting hanky-panky so far is what AIG now is calling “improper” booking of its finite reinsurance transaction with Berkshire Hathaways General Re unit, which has been drawing intense scrutiny from various regulators. The AIG/Gen Re deal also has become the center of industrywide probes into whether such non-traditional finite deals are legitimate transfers of risk, or whether insurers are simply using such contracts to burnish their financial statements.

AIG said its Gen Re deal should have been recorded as loans, not as insurance. “The Gen Re transaction documentation was improper and, in light of the lack of evidence of risk transfer, these transactions should not have been recorded as insurance,” the company said. “They will now be listed as deposits rather than consolidated net premiums.”

The AIG/Gen Re deal, in two separate transactions in late 2000 and early 2001, shifted $500 million of expected claims to AIG from Gen Re, along with $500 million of premiums. AIG recorded the premiums as revenue and added $500 million to its reserves to show its obligation to pay claims.

“You had income and expense that offset one another, so there was no impact on the bottom line,” A.M. Best analyst Karen Horvath told National Underwriter. “But what this effectively did was put additional reserves up in their books.”

The deal with Berkshires Gen Re, which is considered one of the biggest sellers of finite reinsurance, was only one of the several accounting problems AIG admitted last week. Among other irregularities AIG acknowledged are reinsurance deals with at least one offshore carrier that was effectively controlled by AIG and thus doesnt represent a true risk transfer, as well as masking underwriting losses as capital losses to burnish its operating income.

AIG hasnt yet determined whether the accounting errors found so far will require the company to materially restate any of its past financial results. However, it said the “maximum aggregate effect” of such financial restatements, if they were to occur, wouldnt knock off more than 2% from AIGs GAAP shareholders equity of $82.87 billion as of Dec. 31, 2004amounting to a book-value loss of $1.66 billion.

Bank of America Securities analyst Brian Meredith offered additional calculation in his analysis that the accounting errors described by AIG overstated the operating return on equity over the last five years by 100 to 150 basis points, bringing the return on equity to a 13%-14% range from 15%.

The disclosures didnt appear to shake the confidence of some analysts in AIG, which had $11 billion in earnings. “I mean, 2% from shareholders equity is still a lot of money, but when you put it in relative terms compared to AIGs overall shareholders equity, its not much at all,” said Horvath from A.M. Best.

She added, however, that her agency has placed AIGs “A-double-plus” ratingBests highestunder review with “Negative” implications because “we are not sure what will come out from all of this. We are waiting to see what AIG concludes by the time they file the 10-K.”

Alan Murray, an analyst with Moodys Investors Service, said he didnt believe there would be any “material impact on funding strategy or needs.” Moodys on March 15 said its outlook for the company was negative.

Seth Glasser, the AIG analyst at Barclays Capital, agreed that “the numbers involved look relatively moderate.” He said in a research note following the AIG disclosure that this “is the first time that the company has attempted to publicly quantify the potential impact of the ongoing investigation.”

“With the company coming out and saying they dont expect a restatement in excess of 2%, that should give comfort to the market,” added UBS Warburg analyst David Havens.

Still, other analysts, including those at S&P, said AIGs admission of accounting irregularities revealed serious problems and warned there might be more troubling disclosures from the accounting can of worms AIG just opened.

“The number and scope of inappropriate financial transactionssome characteristic of aggressive financial managementhave diminished our assessment of management and its internal controls, corporate governance and aggressive culture,” said S&P credit analyst Grace Osborne.

“In addition, the potential breadth of management involvement in these transactions raises broader enterprise risk-management concerns,” she said. Moreover, she added, AIGs competitive position could be weakened as regulators respond to continuing findings from ongoing internal and external probes.

William Wilt, the Morgan Stanley analyst covering AIG, echoed a similar sentiment. “The depth and breadth of troubles and apparent lack of accounting controls at AIG is alarming,” he warned. “The catalogue of matters under review provides insight into a company that has apparently sought to inflate operating earnings in ways ranging from discounting loss reserves to overstating net investment incomeWe are inclined to focus on the depth and breadth of the apparent accounting deceptions.”

Fitch Ratings, elaborating on its “Rating Watch Negative” status for AIG, also warned that the continued delay in 10-K filing heightens the possibility additional problems could surface as AIG continues its extensive review of its books and records.

Michael Ha is an assistant editor and Dan Hays is a senior editor of NUs Property & Casualty edition.


Reproduced from National Underwriter Edition, April 1, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.