The Hindu Business Line : Probe into Berkshire Hathaway under way

THE on-going probe into the accounting for finite insurance contracts by some Berkshire Hathaway insurance subsidiaries — especially American International Group (AIG) — may be gaining traction with regulators now studying their books.

The US regulators, including the Securities and Exchange Commission, apparently suspect that some companies may have used finite insurance to buff their financial results or to generate income which can be brought in as earnings when their performance flags.

It may be recalled that, in 2000, a transaction between AIG and General Re, Berkshire's Re subsidiary, had attracted regulatory attention because it had pumped up the former's reserves by $500 million in accounting 2000-01.

Mr Maurice R. Greenberg, the AIG chief executive, had lost his job even though he maintained that the company's accounting was entirely in order.

However, two former General Re executives, Mr Richard Napier, a senior vice-president, and Mr John Houldsworth, chief executive of an Irish subsidiary, had pleaded guilty to conspiring to file false financial reports intended to enhance AIG's financial results. This time around, Mr Milan Vukelic, chief executive of a British affiliate of a General Re subsidiary, has been let go, according to the quarterly filing by Berkshire, the holding company controlled by well-known investor, Mr Warren E. Buffett.

The filing further states that "governmental authorities are also inquiring about the accounting by certain of Berkshire's insurance subsidiaries" with regard to finite insurance dealings.

What exactly is finite risk reinsurance? It is a form of reinsurance that specifically incorporates the time value of money, something which is not allowed under US statutory accounting principles.

Unlike most reinsurance contracts, finite risk contracts are usually multi-year: they spread risk over time and typically take into account the investment income generated over the relevant period.

Finite reinsurance is accepted as an appropriate form of risk transfer when insurance risk is transferred and it is properly accounted for in a manner, which accurately reflects financial reality. However, in many cases, the US authorities have discovered that finite risk reinsurance has been used as a low-cost loan to mask liabilities and thereby conceal financial realities.

While a custom-tailored contract can take diverse forms, it usually involves a limited period — and a very large premium. An insurer, say re-insurer X, writes a finite policy for a corporate client or another insurance company, which covers potential claims up to a given limit. Over a period of time agreed upon, say three years, the client pays premiums which, in aggregate, come close to the maximum coverage.

If there is no claim made by the end of the relevant period, the insurer returns all or most of the premium to the client.

The insurer receives a fee and, as the premiums are large, does not risk a major loss.

As for the client, by paying such large premiums, the entity, for all practical purposes, bears nearly all the cost of a catastrophic event by itself. However, by spreading the premiums over several years, the client avoids taking the hit all at once. It follows that finite insurance can be used to smooth out a client's financial results...

In the case of AIG, in 2000 and 2001, the company allegedly talked General Re into an unusual deal involving a bunch of finite contracts the latter had written for clients. As part of the deal, AIG took over the obligation to pay up to $500 million in claims on the contracts. Simultaneously, General Re passed on to AIG $500 million in premiums the clients had paid.

AIG paid General Re a $5 million fee for moving these contracts to AIG's books. Subsequently, last year, General Re reported this arrangement to investigators who were investigating several re-insurers in connection with their finite policies.

The deal was red-flagged because it worked backwards: Normally, it was AIG which would have sought a finite policy to shift risk to General Re. Further, as the $500 million in premiums had to be paid back to General Re, AIG seemed to be losing money on the deal.

Finally, in accounting for the deal, AIG showed the premiums as $500 million in revenue and applied that amount to its reserve funds used to pay potential claims, making those of its shareholders who had doubts about whether AIG had enough in reserve very happy indeed.

Initially, the accounting practices under investigation did not look very serious when AIG had issued a statement in March this year in which it set out the issues involved and noted that about $1.77 billion in shareholder value was in jeopardy. The general sentiment was that $1.77 billion was not a very big figure for a multinational company then valued over $81 billion. In any event, finite insurance was thought of as an obscure product of no major consequence.

However, public perception changed when it became apparent that certain documents might have been removed from an AIG building — or even destroyed. The swash-buckling New York Attorney General, Mr Eliot Spitzer, had then threatened to file criminal charges against AIG — and this got the attention of the public because it knew that no financial firm could survive such an accusation.

The question that is foremost in the public mind is: How many companies have used finite insurance to artificially inflate their financial results?

The US regulators have their work cut out for them in answering this question, as there is simply not enough disclosure in corporate financial statements to determine whether buyers are properly accounting for such contracts.

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