FINITE OR FINESSE

With Spitzer spitting subpoenas, Murphy’s getting morphed, documents capering out the door, mighty CEOs being told to step down; it’s getting downright interesting. Though it may seem complex, you still need to give it some quality thinking time. 

            Why?  As a Bermuda resident, you are possibly – I believe probably – at the edge of a deep gully down which we all may soon tumble.

            The New York Times: “The issues under inquiry are whether reinsurance companies controlled by A.I.G. were treated as separate entities in order to help hide A.I.G.’s exposure to risk; whether reinsurance transactions are tantamount to loans that should have been so listed; whether assets and liabilities were swapped to smooth earnings; and, finally, whether A.I.G. used finite reinsurance to smooth earnings.

            It’s a modern problem, so it is complex. However, like most things, it still comes down to simple issues. Will Bermuda’s Insurance and Re-Insurance industry survive unchanged? Will some Bermuda jobs vanish?

            Academics say that in the developed West, in the last part of the last century: “Speculative finance has replaced industrial and manufacturing activity as the primary source of profitability.” This Western shift from making money by making things to making money by ‘investing’; or through ‘accounting procedures’; or by following questionable business practices; is the reality that underlies the Enron, WorldCom, and Parmaalat debacles.  It’s part of the problem here.

            The use of contingent commissions – the originating issue – has seen the world’s largest insurance brokerage firm, Marsh & McLennan [M&M], agree to end the practice and pay a penalty of $850m. AON and a few other insurance entities have also ‘fessed up. All have sworn off the contingent commission practice. So, first blood to the wolves.

            Spitzer and the other investigators learned that American International [AIG] is beneficially connected to a number of reinsurance companies that were represented as independent entities. Companies like Richmond Re and Astral Reinsurance [Bermuda], and Capco Re and Union Excess [Barbados]. Investigators say that AIG was thus dealing with itself and using that process to enhance its overall position by reporting some large amounts of money as income or assets. Investigators say these amounts should have been treated differently.

            AIG now agrees that there were accounting errors and has said it will correct them. AIG says that it will now be worth some $1.77bn less than it was previously worth.

            Still probing, investigators have uncovered the use of ‘side letters’.  A ‘side letter’ is an agreement between the two parties in an insurance contract. It appears that the practice of using ‘side letters’ in insurance contracts is about twenty years old. ‘Side letters’ are not usually disclosed to third parties such as investors or bankers. This means that third parties are deprived of important and relevant information about the true worth of an agreement.

            If a ‘side letter’ negates or varies one or more of the key provisions of the written insurance policy, it can have the effect of removing some or all of the risk. An insurance premium must transfer a risk to the insuring company. If the risk is eliminated or reduced, insurers and their accountants should treat the actual dollar amount, or a portion of it, as a loan or a deposit – not as premium income.

            On 31^st March 2005, Alastair Barr of Market Watch reported: “In the wake of AIG’s accounting missteps, the New York State Insurance Department issued new rules this week aimed at eradicating side letters.”

            From all reports, it seems that there were ‘side letters’ in the overall group of finite insurance transactions between Warren Buffett’s General Re, AIG, and FAI Insurance [a collapsed Australian insurance company]. Finite insurance, side letters, ‘income smoothing’, and FAI Insurance all play a part in the 2001 collapse of HIH Insurance Ltd, Australia’s second largest insurance company. The Aussies are vexed about that. Federal investigators will question Warren Buffet about this, and other matters, on 11 April. Next day, it’s Hank Greenberg’s turn.

            Everything may seem board-room, offshore, and not relevant to ordinary Bermudians. A quick examination shows these realities.

 End – Part one-0-0-0-  “FINITE OR FINESSE?” 

Richard Galant, Newsday:  “Now, though, Bermuda faces a storm of a different kind. Bermuda-related companies are caught in the web of a wide-ranging investigation by spitzer and the securities and exchange commission.” So, if everything seemed board-room, offshore, and not relevant, just consider these easy-to-see connected realities.

            Guilty pleas. So far, ten executives have entered guilty pleas. Four from AIG, three from M&M, one from ACE. So 80% of the guilty pleas involve big insurance entities with a major presence in Bermuda.

            Marsh&McLennan, a major player in Bermuda’s insurance world, has already paid a penalty of $850m and cut its global staff. Jeffrey Greenberg [son of Maurice ‘Hank’ Greenberg] was required to ‘step down’ as M&M’s CEO. Insurance broker AON has paid a $190m penalty. That’s $1.04bn, so far, in penalties.

            AIG, the biggest player in Bermuda’s insurance world, is under investigation for questionable accounting practices that may go back fourteen years. AIG has admitted to recent ‘irregularities’. In its 30^th April 10-K, AIG will admit to a new accounting loss of $1.77bn. To avoid harsh legal action, Maurice ‘Hank’ Greenberg [father of Jeffrey and Evan] had to step down as CEO. Michael Murphy and four other Bermuda based AIG executives have made hasty departures.

            ACE, highly visible in Bermuda’s insurance world, has been hit with 43 subpoenas – so far. ACE’s CEO is Evan Greenberg [son of Maurice and brother of Jeffrey]. In connection with Spitzer’s investigation, ACE has fired two top execs and, like AIG, remains under investigation.

            PwC [PricewaterhouseCoopers], the Bermuda-based global accounting and audit firm, profitably audited AIG’s books for thirty years. Accusations of accounting legerdemain, especially if they stick, have the potential to place PwC in the same embarrassing position as Arthur Andersen was with ENRON.

            Finite Risk Insurance. Bermuda is the leader in the development and sale of this new insurance specialty. However, this particular insurance product, as it is actually applied in the marketplace, is causing accounting headaches and difficulties and is upsetting some investors and oversight agencies. Many Bermuda reinsurance companies sell this product.

            Investigations. USA state investigators, the SEC, and the Federal Justice Department, are investigating everything thing I’ve written about. They are probing deeper and wider, and are questioning even more insurers, transactions, and accounting statements. ‘Hank’ Greenberg is under increasing pressure and is using his Fifth Amendment rights.

            Ultimately, what does this mean to us – to you – here in our Bermuda?

            It means that AIG and its subsidiaries may downsize as they ‘adjust’ and ‘restate’ dollar numbers in order to ‘correctly state’ true values. AIG could slide from its current position as the world’s biggest insurance entity and the web of inter-connected companies that do huge slices of their business with AIG could all have reduced incomes, lower profitability, and lower levels of employment. Even if, because of the magnitude of difference, AIG remains as the world’s largest insurer, it is still likely to emerge a leaner entity.  

            With ‘finite risk insurance’ taking this major hit, Bermuda’s whole insurance industry could shrink. Bermuda could find that employment of both local and permit workers could fall.

            In the global elephant fight, the Irish are happily knocking back extra Guinnesses as they contemplate a possible flight of ‘insurance’ capital from reputationally damaged Bermuda to ‘cleaner’ Ireland.           

            Already, some Irish websites are touting that Ireland has no term limits on work permits, is “a couple of times cheaper” than Bermuda, has more affordable housing, a good family environment, and more parking. Ireland also claims unlimited access to the larger and affordable pool of millions of highly educated EU workers who are hungry for jobs. Ireland does admit though, that it doesn’t have Bermuda’s warm and sunny climate.

            Lastly, regulatory agencies in the EU are planning to apply a new set of insurance regulations for all insurers and insurance transactions in the EU. The New York Times reports: “A European Union directive currently under discussion and scheduled to take effect next year [2006] will establish a regulatory framework spanning the 25-country union.”

            As a dependent territory of the UK – now the seventh state in the EU – it’s possible that under our current constitutional arrangement, these regulations can be made to apply to us in Bermuda. If there is any kind of dispute in this matter, then, under current constitutional arrangements, resolution may well lie within the EU’s supranational judicial system, and not within our own island system.

            On 19 November 2004, I wrote: “The stronger of Bermuda’s two national pillars is now under attack and the assaulting forces are still forming-up and massing their resources. The main assault is yet to come.”

            Four and a half months later, the main assault has begun.