Newsweek: The Next AIG Scandal

[Winehole23]

The Next AIG Scandal?







By Michael Hirsh | Newsweek Web Exclusive
March 18, 2009







Outrageous. It's the preferred adjective used by Barack Obama and Ben Bernanke to describe AIG, the crippled giant that has turned into a national money pit. AIG has swallowed at least $170 billion in taxpayer money so far while funneling $165 million of it onward in bonuses to its incompetent executives, along with tens of billions more to equally privileged "counterparties" like Goldman Sachs.


But I suspect that—with apologies to a famous American patriot—we have not yet begun to get outraged. At least if some of the insurance experts I've been talking to are correct.


Thomas Gober, a former Mississippi state insurance examiner who has tracked fraud in the industry for 23 years and served previously as a consultant to the FBI and the Department of Justice, says he believes AIG's supposedly solvent insurance business may be at least as troubled as its reckless financial-products unit. Far from being "healthy," as state insurance regulators, ratings agencies and other experts have repeatedly described the insurance side, Gober calls it "a house of cards." Citing numerous do ents he has obtained from state insurance regulators and obscure data buried in AIG's own 300-page annual reports, Gober argues that AIG's 71 interlocking domestic U.S. insurance subsidiaries are in hock to each other to an astonishing degree.




Most of this as-yet-undiscovered problem, Gober says, lies in the area of reinsurance, whereby one insurance company insures the liabilities of another so that the latter doesn't have to carry all the risk on its books. Most major insurance companies use outside firms to reinsure, but the vast majority of AIG's reinsurance contracts are negotiated internally among its affiliates, Gober says, and these internal balance sheets don't add up. The annual report of one major AIG subsidiary, American Home Assurance, shows that it owes $25 billion to another AIG affiliate, National Union Fire, Gober maintains. But American has only $22 billion of total invested assets on its balance sheet, he says, and it has issued another $22 billion in guarantees to the other companies. "The American Home assets and liquidity raise serious questions about their ability to make good on their promise to National Union Fire," says Gober, who has a consulting business devoted to protecting policyholders. Gober says there are numerous other examples of "cooked books" between AIG subsidiaries. Based on the state insurance regulators' own reports detailing unanswered questions, the tally in losses could be hundreds of billions of dollars more than AIG is now acknowledging.


One early sign of trouble came when Christian Milton, AIG's vice president of reinsurance from 1982 to 2005, was convicted last year in federal district court of conspiracy, securities fraud, mail fraud and making false statements to the Securities and Exchange Commission. (Milton was sentenced in January; his lawyers have indicated plans to appeal.)


AIG spokesman Mark Herr took strong exception: "We strongly disagree with Mr. Gober's analysis, which lacks a fundamental understanding of our commercial insurance operations' inter-company risk sharing agreements or even the basics of statutory accounting. Our primary regulators, including New York and Pennsylvania, regularly review our statutory filings as well as our intra-company risk sharing pool, and have raised no objections to this structure. They have repeatedly stated that we have sufficient financial strength to meet our obligations. In fact, in today's hearing on AIG, Joel Ario, Pennsylvania State Insurance Commissioner, commented that the insurance companies of AIG remain strong and well capitalized."



But if Gober is right, the implications are almost too awful to contemplate. Despite its troubles on Wall Street, AIG is still the largest insurance company in the United States, controlling both the largest life and health insurer and the second-largest property and casualty insurer. It has 30 million U.S. customers. AIG is also a major provider of guaranteed investment contracts and products that protect people in 401(k) plans, as well as being the leading commercial insurer in the U.S. It is one of the largest insurance companies in the world, with insurance and financial operations in more than 130 countries. These insurance businesses were once thought to be so solid that AIG was able to use the triple-A rating it was routinely awarded to start up its vast credit-default-swap business.


Public outrage has been building, along with the outcry about bonuses, over all the taxpayer money that has gone to keep AIG afloat by paying off the credit-default-swap counterparties. While some worries have surfaced about the various insurance companies' risky securities-lending practices, most have escaped scrutiny. But if millions of AIG policyholders are at risk too and no one's saying it yet, the populist backlash could get really ugly.


Gober has brought his allegations to the attention of the House Financial Services Committee, chaired by Rep. Barney Frank. A committee spokesman did not immediately return a call asking for comment. But over at the Senate banking committee, ranking member Sen. Richard Shelby during hearings last week raised questions about whether AIG's insurance side was as sound as the company maintained it to be. In response, Eric Dinallo, New York state's superintendent of insurance, said he thought "the operating companies of AIG, particularly the property companies, are in excellent condition." But Dinallo admitted he had examined only 25 of the domestic AIG companies and added: "There are problems with state insurance regulation. I've been a proponent of us revisiting it."


And therein lies the real problem. More than any other Wall Street rogue, AIG has been able to indulge in "regulatory arbitrage" on a global scale, creating totally unsupervised businesses that act beyond the purview of any government (AIG has repeatedly said that its problems were confined to the London-based financial-products unit). The company's ability to escape an umbrella regulator was one reason the financial-products group was able to sell, indiscriminately and without hedges, credit-default swaps around the world in the belief that they could never all come due at once. They did. Fed chairman Bernanke told lawmakers in early March that AIG "exploited a huge gap in the regulatory system" and was essentially a hedge fund attached to a "large and stable insurance company." But is that really an accurate description? Huge regulatory gaps also exist in insurance. "There is no federal insurance regulator," according to a senior government banking official, only individual state agencies. Are we missing something really big here? If so, there might be another terrible reckoning to come.

[RandomGuy]

Most of this as-yet-undiscovered problem, Gober says, lies in the area of reinsurance, whereby one insurance company insures the liabilities of another so that the latter doesn't have to carry all the risk on its books. Most major insurance companies use outside firms to reinsure, but the vast majority of AIG's reinsurance contracts are negotiated internally among its affiliates, Gober says, and these internal balance sheets don't add up. The annual report of one major AIG subsidiary, American Home Assurance, shows that it owes $25 billion to another AIG affiliate, National Union Fire, Gober maintains. But American has only $22 billion of total invested assets on its balance sheet, he says, and it has issued another $22 billion in guarantees to the other companies. "The American Home assets and liquidity raise serious questions about their ability to make good on their promise to National Union Fire," says Gober, who has a consulting business devoted to protecting policyholders. Gober says there are numerous other examples of "cooked books" between AIG subsidiaries. Based on the state insurance regulators' own reports detailing unanswered questions, the tally in losses could be hundreds of billions of dollars more than AIG is now acknowledging.

That the balance sheets don't add up should be cause for some alarm, depending on the scope of the imbalance.

Reinsurance is... complicated to say the least.

If AIG gets truly broken up, it could take years, if not a decade or more to fully disentangle the companies from what I read here.

The big problem with this is that what should be treated as "arms-length" transactions between affiliated companies under a parent company, often aren't anywhere near what a true "free market" transaction would be, if the parent wasn't pulling the strings.

[RandomGuy]

Consider:

When I say "company" a lot of you think "Here is the CEO, it has employees who do stuff for the company, and seperating it from the parent is a matter of simply moving the people to another buildign and VIOLA! a seperate company."

That isn't how it works.

Most insurance company subsidiaries are companies TOTALLY ON PAPER and have ZERO employees.

That's right, I said they have NO employees, even though they are worth billions, make decisions and contracts etc.

Here is the way it really works:

100 employees, including the CEO and everybody else all are technically employed by the parent company.

To set up the subsidiary companies, all that is needed is the wave of a pen.

Call the parent A, and it owns subsidiaries B, C, and D.

A, being the owner sets up a contract where B, C, and D. "buy" all the management services from A.

In essence the clerk who opens the mail, gets a paycheck from A, then for the first hour or two, works on stuff for B, then for an hour or two works for C, then ends the day doing stuff for D.

Sometimes, some employees spend most, if not all of their days as mostly dedicated to one company or another, but are still ultimately doing what is best for the parent, not the notional companies.

This becomes a problem when the parent of company A decides he wants to "raid the piggybank" of his captive subsidiaries to give parent company a big cash boost, or simply treats one of the subsidiaries like a whipping-boy.

Now what happens when you want to separate the companies?

Oops. Companies, B, C, and D have no employees of their own, and can't really act as seperate en ies.

You can simply "swap" owners, move B from being a paper company of A to another parent company, but you have to deal with a lot of disruption.

[RandomGuy]

There may be "too big to fail", but there is definitely "too big to adequately regulate".

I doubt ANYONE has any idea how such a large financial company truly works, including the CEOs of those companies.

[Winehole23]

Related: http://www.google.com/hostednews/ap/...UD2PwD97169KG1

[RandomGuy]

Proving how difficult it might be for lawmakers to agree on a plan for revamping market regulations, John C. Dugan, the Comptroller of the Currency, made some suggestions in his prepared remarks for regulatory reform that could likely incite turf battles among the various federal and state regulators.

The problem with all of this is that insurance is regulated at the state level, and all of the skills/knowledge of how to regulate insurance companies is held on a state by state basis.

If the federal government finally decides to jump in, after centuries of letting the states do it, there will be some major mistakes made.

I am not entirely sure what the best option going forward should be.

I really really really hate the knife held to our collective throats by the s who led their companies down the path that got us here.

BUT

I don't see how to avoid it in the future. A free market solution to such things, i.e. letting them fail is probably the best dis-incentive, but given how interlinked all of this is, if ONE big bank goes kerblewie (stop me when I get too technical) because of stupidity, then even well-managed banks become vulnerable.

VERY intractable problem overall.