Actuarial Accounting: A Cautionary Report
Dan R. Young, Esq. Attorney at Law Law Offices of Dan R. Young Seattle, Washington danryoung@netzero.net
Presented the Spring Meeting of the CAS New Orleans, Louisiana May 6, 2009
The Story of the AIG Accounting Scandal
The Companies The Participants Regulatory Scrutiny Intensifies The Prosecution Case The Defense Case Relevant Laws and Regulations The Fate of the Participants
The Companies
AIG Overview (2007)
World’s largest insurance and financial services company 93,000 employees Business in 130 countries Led by Maurice (“Hank”) Greenburg Shareholder’s equity 2007: $95.8 billion Net Income 2007: $6.2 billion Premium written 2007: $59.8 billion
GenRe Overview
One of World’s largest reinsurers Established 1921 Headquartered in Connecticut Owned by Warren Buffet’s Berkshire Hathaway Led by Ronald Ferguson, FCAS, until he retired in 2002 Premium written 2007: $6.0 billion
The Participants
Hank Greenburg, CEO of AIG
Born 1925 Admitted to NY Bar in 1953 Joined AIG in 1962 Named CEO in 1968 Led AIG for 38 years Stepped down March 21, 2005
Ron Ferguson, CEO of Gen Re
Born 1942 Fellow of CAS Co-developer of B-F method Joined Gen Re in 1966 Named CEO in 1987 1998 Berkshire Hathaway acquired Gen Re Retired 2002
Others
Christopher Garand, FCAS Senior VP and Chief Underwriter of GenRe’s Finite Reinsurance in US from 1994 to 2005 Elizabeth Monrad, CPA CFO of Gen Re 2000 to 2003 Robert Graham, JD SVP and Assistant General Counsel at GenRe until 2005
Others
Christian Milton VP of AIG’s Reinsurance until 2005 Richard Napier SVP responsible for GenRe relationship with AIG John Houldsworth CEO of Cologne Re Dublin (CRD)
Eliot Spitzer, JD
Born 1959 Former Attorney General of NY Notable prosecutions: Mutual fund scandals (2003) Insurer bid rigging (2004) AIG accounting scandal (2005) Elected Governor of NY in 2006
Regulatory Scrutiny Intensifies
How AIG Came under Scrutiny
2001 – SEC learns that AIG has assisted a client company in bolstering its balance sheet through a bogus insurance transaction investigation ensues 2003 – SEC and Justice Department settle with AIG $10 Million Civil Penalty Independent consultant retained 2004 – Federal Grand Jury begins investigation of AIG’s income smoothing products 2004 – Bid rigging complaint filed against AIG and others
AIG Admits to Improper Accounting
February 9, 2005 – 2004 earnings released March 30, 2005 – AIG discloses that reinsurance deal with GenRe should have been accounted for as a deposit May 31, 2005 – Restatement amounted to reduction in 2004 net income of $1.32 Billion
The State Authorities Attack
May 27, 2005 – Spitzer files civil suit against AIG Alleges AIG "engaged in misleading accounting and financial reporting, projecting an unduly positive picture of AIG's underwriting performance for the investing public.“ In particular, engaged in "two sham insurance transactions" that gave investors the impression the company had larger reserves for claims than it did. Other wrongdoing
Greenberg Fires Back
"For the attorney general to use his office to prosecute, and persecute, people in the press for political gain is wholly against our legal principles," said Greenberg in an interview. "It's outrageous." … "It's simple: He's running for another office," Greenberg said. "It has nothing to do with right or wrong.“ CNBC’s Charles Gasparino reports that in an interview he previously conducted, Greenberg called Spitzer “a thug.”
The Federal Authorities Attack
Feb 2, 2006 – SEC files complaint in US District Court against AIG "This case is not about the violation of technical accounting rules. It involves the deliberate or extremely reckless efforts by senior corporate officers of a facilitator company (Gen Re) to aid and abet senior management of an issuer (AIG) in structuring transactions having no economic substance, that were designed solely for the unlawful purpose of achieving a specific, and false, accounting effect on the issuer's financial statements.“
SEC Settlement
Feb 9, 2006 – SEC and Justice Department settlement with AIG Total settlement in excess of $1.6 billion Related to alleged improper accounting, bid rigging and practices involving workers comp funds CEO and CFO replaced
Federal Criminal Action
Federal criminal charges filed against certain officers at AIG and Gen Re Alleged violation of 16 counts of the criminal code Conspiracy (1 count) Securities fraud (7 counts) False statements to SEC (5 counts) Mail fraud (3 counts)
Plea Bargained
Richard Napier SVP, Gen Re John Houldsworth CEO, CRD Witnesses for the Prosecution
The Prosecution Case
The Setting
Oct 26, 2000 – AIG announced that premiums increased in Q3, but reserves fell by $59 million Oct 26, 2000 – AIG share price dropped from $99.37 to $93.31 on NYSE (6%) October 31, 2000 – Greenberg called Ferguson
The Phone Call (Napier)
Greenberg asked Ferguson to temporarily transfer loss reserves to AIG: Amount of $200 to $500 million To occur by year end 2000 To last 6 to 9 months AIG should incur no losses (i.e., the deal should be riskless)
Initial Steps
Richard Napier Gen Re point person
Christian Milton AIG point person
Initial Steps
Parties agree to deal: Gen Re to transfer loss reserves to AIG in exchange for a payment of premium Two separate contracts transfer loss reserves:
$250 million in 2000 with cap of $300 million $250 million in 2001 with cap of $300 million
Gen Re “obligated” to pay AIG “premium” of $500 million ($250 million per contract) Gen Re to receive $5 million for doing the deal Contract to last 24 months
Other Issues with the Deal
Accounting problem: Deposit or Reinsurance accounting? AIG used reinsurance accounting Gen Re used deposit accounting The “North American problem”: Statutory reporting requires disclosure of premium and reserves related to each reinsurance transaction GenRe’s foreign subsidiary (CRD) not required to file US reports
Issues with the Deal
A paper trail had to be created to appear that Gen Re proposed the deal Gen Re had to appear to be on the hook for $500 million in “premium” without actually paying it AIG had to pay Gen Re’s $5 million fee for doing the deal without attracting the attention of regulators
The Loss Portfolio Transfer How AIG accounted for the Deal
AIG
National Union
Assets +$10M Premium Paid by CRD +$490M Premium Receivable withheld by CRD Liabilities +$500M Additional Reserves
Impact on AIG’s Loss Reserves
Reported 4Q 2000 1Q 2001 +$106 M +$63 M LPT Contracts -$250 M -$250 M Actual -$144 M -$187 M
Reaction from Analysts
“We think this quarter was a good example of AIG doing what it does best: growing fast and making the numbers…As important was the change in reserves: AIG added $106 million to reserves…” “Finally AIG put to rest a minor controversy from last quarter by adding $106 million to reserves…”
How CRD Paid $10M in Premium without Really Paying
Leverage existing contract, in which Gen Re holds $31.8M payable to AIG Gen Re pays only $7.5M to commute an existing contract with AIG’s Hartford Steam Boiler (HSB) Gen Re pays National Union $9.1M in premium to reinsure the HSB losses that were just commuted CRD pays $0.4M in premiums to Gen Re for a “sham” reinsurance contract and receives a loss payment of $13M shortly after ink dries CRD pays LPT “premium” of $10M to AIG Gen Re / CRD left with $5.2M to cover the fee
The “Round Trip of Cash”
AIG
Commute for $7.5 M
Gen Re
Existing Contract with HSB (Commute Value of $31.8M)
$400K Rein Prem
Hartford Steam Boiler (HSB)
Rein Prem of $9.1 M
Sham Loss Payments of $13.0 M
Cologne Re Dublin (CRD)
LPT Prem of $10 M
National Union
Gen Re: $31.8M - $ 7.5M - $9.1M + $0.4M- $13.0M = $2.6M CRD: - $0.4M + $13.0M - $10.0M = $2.6M
Prosecution Evidence
Napier’s Trial Testimony
Under secret side deal, AIG paid Gen Re $5 million fee, and did not actually pay the $10 million in premium specified in written contract He, Ferguson, and Monrad discussed draft contract as a no-risk deal Ferguson discussed terms of contract with Greenberg, including that AIG would bear no risk
Houldworth’s Trial Testimony
11-14-2000 (recorded): Houldworth: There is clearly no risk transfer. You know there is no money changing hands. Monrad: [AIG] may have a tough time getting the accounting they want out of the deal that they want to do… They are not looking for real risk…
Houldsworth (Cont.)
Sent to Ferguson email on 11-15-2000, with draft LPT contract, stating “[Gen Re] will not transfer any losses under this deal” Ferguson’s former secretary identifies his handwriting on email AIG did not ask Gen Re for information necessary to perform actuarial analysis of risk
Houldsworth (Cont.)
12-08-2000 (recorded): Monrad: We told AIG that there would not be symmetrical accounting here. Houldworth: Okay, fine. Monrad: We told them that was one of the aspects of the deal they would have to digest.
Evidence of Ferguson’s Knowledge
12-11-00 (recorded): Houldsworth: We’re going to ask . . . Ron [Ferguson] to sign off on the reputational risk. I think it’s Ron’s deal so he’s the one that ought to. Garand: Yep. Houldsworth: I mean he’s effectively done that by being involved but we may as well follow the rules. Garand: Sure. Make him sign in blood. Houldsworth: Well, I don’t care what he signs in as long as I know it’s him.
Other Evidence
12-22-2000 (email) "[T]he AIG project continues. It is now a two step loss portfolio deal between [CRD] and National Union. . . . Our group will book the transaction as a deposit. How AIG books it is between them, their accountants and God; there is no undertaking by them to have the transaction reviewed by their regulators. Ron [Ferguson] et al. have been advised of, and have accepted, the potential reputational risk that US regulators (insurance and securities) may attack the transaction and our part in it.“ - Robert Graham
Other Evidence
3-7-01 (recorded): Graham: We [GenRe] aren’t going to pay them [AIG] the fee [premium] yet. You know, we don’t intend to pay them until we get the cash. If they turn around and start kicking up a fuss, I don’t think they really want this made public, this transaction. I would be very surprised. There’s a whole pile of things.
Other Evidence
3-7-01 (recorded): Graham: Well, and their [AIG’s] organizational approach to compliance issues has always been pay the speeding ticket, so, which is different than our [GenRe’s] organizational approach to compliance. So I’m pretty comfortable that our own skirts are clean but they [AIG] have issues.
The Defense Case
Defense Case Overview
Two days Five character witnesses testified Defendants did not testify
Defense Strategy
Attacked reliability/credibility of Napier and Houldsworth Conversations and meetings that never occurred Insufficient evidence of side deals Also argued that LPT had minimal effect on AIG financials AIG share price not affected after AIG disclosure Common industry practice Absence of financial motive Recordings were taken out of context Buffet knew of and approved of LPT deal
Warren Buffet’s Involvement
Email from Ferguson to Buffet “Warren, just a quick note to let you know why I hesitated a moment when you mentioned the $5,000,000 fee on the reserve transaction. We are indeed charging a 1% fee but for some reason A.I.G. decided to split the deal in to two $2,500,000 tranches one to be registered in 2000 and one in 2001.”
Relevant Laws and Regulation
Relevant Laws & Regulations
US Code Security Investor Protection Laws Conspiracy Laws Mail Fraud Laws Code of Federal Regulations
Manipulative and deceptive devices (15 USC §78j)
Security Investor Protection Laws
It shall be unlawful … (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange … any manipulative or deceptive device or contrivance in contravention of [Rules 10b-5, 12b-20, etc.]
Rule 10b-5
Code of Federal Regulations
Employment of manipulative and deceptive devices.
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, a) To employ any device, scheme, or artifice to defraud, b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
Rule 12b-20
Additional information
Code of Federal Regulations
In addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading.
Rule 13b2-1
Falsification of accounting records
Code of Federal Regulations
No person shall directly or indirectly, falsify or cause to be falsified, any book, record or account subject to section 13(b)(2)(A) of the Securities Exchange Act.
Code of Federal Regulations
Other Rules
§ 240.13a–1 Requirements of annual reports § 240.13a–13 Qrtly reports on Form 10–Q
Periodical and other reports (15 USC §78m)
Security Investor Protection Laws
(b) Form of report; books, records, and internal accounting; directives (2) Every issuer which has a class of securities registered pursuant to section 78l of this title and every issuer which is required to file reports pursuant to section 78o (d) of this title shall— A. make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer; B. devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that …transactions are recorded as necessary … to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, …
Security Investor Protection Laws
Penalties (15 USC §78ff)
(a) Willful violations; false and misleading statements Any person who willfully violates any provision of this chapter (other than section 78dd–1 of this title), or any rule or regulation thereunder the violation of which is made unlawful or the observance of which is required under the terms of this chapter, or any person who willfully and knowingly makes, or causes to be made, any statement in any application, report, or document required to be filed under this chapter or any rule or regulation thereunder or any undertaking contained in a registration statement as provided in subsection (d) of section 78o of this title, or by any self-regulatory organization in connection with an application for membership or participation therein or to become associated with a member thereof which statement was false or misleading with respect to any material fact, shall upon conviction be fined not more than $5,000,000, or imprisoned not more than 20 years, or both, except that when such person is a person other than a natural person, a fine not exceeding $25,000,000 may be imposed; but no person shall be subject to imprisonment under this section for the violation of any rule or regulation if he proves that he had no knowledge of such rule or regulation.
§ 371. Conspiracy to commit offense or to defraud United States
Conspiracy Laws
If two or more persons conspire either to commit any offense against the United States, or to defraud the United States, or any agency thereof in any manner or for any purpose, and one or more of such persons do any act to effect the object of the conspiracy, each shall be fined under this title or imprisoned not more than five years, or both.
§ 1341. Frauds and Swindles
Mail Fraud Laws
Whoever, having devised or intending to devise any scheme or artifice to defraud, … for the purpose of executing such scheme or artifice or attempting so to do, places in any post office or authorized depository for mail matter, any matter or thing whatever to be sent or delivered by the Postal Service, …or knowingly causes to be delivered by mail …any such matter or thing, shall be fined under this title or imprisoned not more than 20 years, or both...
Fate of the Participants
Ron Ferguson, FCAS
Convicted of: Conspiracy (1 count) Securities fraud (7 counts) False statements to SEC (5 counts) Mail fraud (3 counts) Sentence: 2 years in prison 2 years supervised release $200,000 fine Personal recognizance pending appeal
Christopher Garand, FCAS
Convicted of: Conspiracy (1 count) Securities fraud (7 counts) False statements to SEC (5 counts) Mail fraud (3 counts) Sentence: 1 year & 1 day in prison 1 year supervised release $150,000 fine
Christian Milton
Convicted of: Conspiracy (1 count) Securities fraud (7 counts) False statements to SEC (5 counts) Mail fraud (3 counts) Sentence: 4 years in prison 2 years of supervised release $200,000 fine
Robert Graham, JD
Convicted of: Conspiracy (1 count) Securities fraud (7 counts) False statements to SEC (5 counts) Mail fraud (3 counts) Sentencing pending
Elizabeth Monrad, CPA
Convicted of: Conspiracy (1 count) Securities fraud (7 counts) False statements to SEC (5 counts) Mail fraud (3 counts) Gives pre-sentencing interview
Monrad’s Reaction to Conviction
Monrad’s response “I know I’m innocent” Plans to appeal Misgivings Expected to testify but was persuaded it wasn’t necessary She was afraid that her testimony would be used to try to harm innocent co-defendants Buffet’s ongoing involvement gave her comfort that the transaction was acceptable Gun to the Head Plead and cooperate and get probation or go to trial and risk prison for the rest of your life
Monrad Sentencing Hearing
Prosecutor refers to interview as lack of respect for judicial system Children, husband, colleagues address the court Monrad begged the judge for mercy: "My life is in your hands.“ Judge Droney’s comments: "There were many opportunities for her to come to her senses and shake this shady deal, but she never did," The fact that she didn't benefit personally from the scheme “doesn't excuse her conduct.” Her involvement with the fraudulent transaction "was central to its success," She knew the harm her conduct could cause. "She was the financial expert for General Re in this transaction." “A message must be sent to the business and financial communities that this kind of conduct will not be tolerated."
Monrad’s Sentence
18 months in prison 3 years supervised release $250,000 fine
Unindicted Co-conspirator
Hank Greenberg “Took the 5th”
Down in Shame
Eliot Spitzer Stepped down as Governor in 2008 amid allegations of patronizing a prostitution ring
Code of Professional Conduct
PRECEPT 1. An Actuary shall act honestly, with integrity and competence, and in a manner to fulfill the profession's responsibility to the public and to uphold the reputation of the actuarial profession.
ANNOTATION 1-2. An Actuary shall not provide Actuarial Services for any Principal if the Actuary has reason to believe that such services may be used to violate or evade the Law or in a manner that would be detrimental to the reputation of the actuarial profession. ANNOTATION 1-4. An Actuary shall not engage in any professional conduct involving dishonesty, fraud, deceit, or misrepresentation or commit any act that reflects adversely on the actuarial profession.
CAS Action
CAS has requested ABCD to investigate whether Garand and Ferguson violated the Code of Professional Conduct 