Insurance companies are in the business of taking risks. Reinsurance is the way that insurance companies "lay off part of the bet", that is, cede some of the risk, to other insurers, in a fashion not entirely dissimilar to the way in which bookies might "lay off" part of a particularly large bet by a bettor, in order to spread the financial risk that the horse will win the race among other book-makers. This helps to prevent a "winner" (in this context, a large loss) from causing a catastrophic financial impact on an insurer. Reinsurance is a bedrock of the insurance industry. Insurance companies are permitted to take accounting "credits" against their loss reserves for appropriate reinsurance with appropriate reinsurers. In simplest terms, the reinsured not only can "lay off part of its bet" to another company, but can also take credit for the arrangement on its financial statement, reducing the amount of money it has to hold "in loss reserves" for the payment of claims.
The current AIG crisis caused me to begin reading up on the the convictions arising from the previous AIG crisis, a heady tale of financial reinsurance transactions between affiliates in which a cool quarter billion dollars was allegedly added to an insurance company's stated reserves for losses through a transaction in personnel from two companies allegedly rigged up a "financial" reinsurance deal.
A "true" reinsurance transaction works in a sophisticated yet fundamentally simple way. Reinsured company x pays to reinsurer company y a portion of the premium on the insurance policies which company x has written, and reinsurer company y in return agrees to pay a portion of the losses (a percentage, say, or losses in excess of a given number) to insurance company x. Stated in schoolyard terms, Joe bet me five dollars that he would win the race, and I made a deal with Josie that she would get half of Joe's money if Joe loses the bet, but pay half of what I have to pay if Joe wins.
The AIG criminal trial earlier this year accused a handful of executives with General Reinsurance and one executive with an AIG affiliate of rigging up a reinsurance transaction in which the paperwork was drawn to give the illusion that risk was being transferred to one company, when in fact a side deal ensured that no real risk transfer would occur. Such an arrangement is problematic, to say the least, because if one files a financial statement that takes credit for having ceded a risk, when in fact the risk transfer was made a sham by a side agreement, then the parties to the transaction could claim in their financial statements a benefit to loss reserves when in fact no true benefit took place.
The jury found the executives guilty. They were undone, apparently, by the fact that they did not realize that an affiliate of their company recorded telephone conversations. The jury accepted the government's case that the executives' own words indicated that they knew of the impropriety. The verdict does not sound surprising given the evidence and transaction involved.
Three things stood out to me about this criminal matter. One is that the amount of reserve manipulation alleged was a cool quarter billion dollars. The second is that the government named the then-highest level of executives of AIG as unindicted co-conspirators in the 2006 indictments, but has not, to my knowledge, indicted them as yet in this matter. The third thing is that this transaction dates back to 2001, and the accounting restatements when the impropriety was admitted took place in 2005.
I am intrigued that so little media coverage was given to this story. Indeed, during this past week's travails, media outlets seemed surprised to hear of any problems at AIG, although its top management had been replaced over this and related scandals. Like all of America, I am intrigued that a company can be "too large to allow to fail", and aware that we are going to have to change the way we regulate corporations "too large to fail". In this particular instance, it's worth noting that while insurers are subjected to state regulation, insurance holding companies do not receive the same level of scrutiny. Also, I do not want to give the impression that everyone at AIG is problematic--like in any such matter, thousands of innocent employees of AIG affiliates who did their job right will suffer for the actions of a few. Apparently, the conventional insurance business of AIG is not really the issue in this week's crisis. State regulation of this conventional business does not appear to be the issue.
I am always a bit wary of criminal convictions, until the appellate court has spoken on the convictions at trial. I have not seen or heard all the evidence, and a weblog is a poor place to prognosticate litigation results.
Yet I think that it's fair to say that I have a half billion reasons why it's inaccurate for politicians to argue that we have just now discovered there is a problem with corporate greed or fraud at AIG. After all, these indictments handed down in 2006. The convictions handed down months ago. The medium size fish have been well-fried and packaged with the chips, . The top officials swim free still.
In the current crisis, taxpayers will fund 85 billion dollars in a short-term loan to AIG in light of AIG "betting the farm" on issuing guarantees of the performance of "collateral mortgage obligations", that is, of "real estate loans supporting debt instruments". We "ordinary Americans" might get our money back, and in some scenarios could even profit from the deal--but do not count on that. If AIG cannot repay the 85 billion, then we will have lost the amount it cannot in the long run repay.
I handle cases which involve insurance company insolvencies. I do not write at great length about my work in this weblog, as I think that client confidences, the problems of talking about legal matters in a public forum, and my own sense of whimsy sends me down other paths.
Yet today it bears mention that throughout my career I have been permitted, through the grace of my clients, to work on large insurance insolvencies and insurance rehabilitations. Some of these are among the largest in history. Of the many dozen such matters I have handled through my career, we could have rehabilitated each and every company, all the companies combined, for a few billion dollars. An 85 billion dollar check to solve one insurance group's liquidity crisis is a staggering notion.
We have had decades of people arguing that the unfettered market is the only way to prosperity. They argue against regulation, and argue for minimal interference by the government in any economic matter. This theory has been once more discredited this week. A new breeze is blowing, and the wisps of shadow we see passing into the West is the ghost of Milton Friedman, receding into history. I am a very pro-business person, and unabashedly so--but the notion that people handling other peoples' money should do so free of solvency and integrity regulation is and should be completely discredited.
The new wind blowing in is the wind of change. This week marks the end of our 21st Century gilded age, for once, and for all. Let's see what the next era brings. Let's hope that Main Street does not have to suffer too much for the sins of Wall Street--and Pennsylvania Avenue.