Insurance companies have developed a product called finite insurance. Under finite insurance, a client firm enters into an insurance contract under which it pays annual premiums to the insurer that sum to an amount equal to or close to the policy coverage. For example, a firm may take out a three- year policy to protect itself against natural disasters, with coverage of, say, $ 1,500. It pays an annual premium of $ 500, or $ 1,500 over the policy term. If a loss occurs, the insurer pays up to the $ 1,500 coverage. If no loss occurs, the $ 1,500 of premiums are returned to the firm. The insurance company will charge a fee for this service.
From the insurer’s standpoint, the question arises whether the premiums received from the client represent premium income or simply a loan from the client. In this regard, the insurance industry has a 10/ 10 rule: The insurer should face at a minimum a 10% chance of losing 10% of the policy coverage if the premiums are to be regarded as income. Under this rule, if the total premiums to be paid are equal to or less than 90% of the policy coverage, and if there is at least a 10% chance of loss, the insurer is deemed to be bearing enough risk that premiums are regarded as income.
General Re Corporation is a large U. S. insurance company that had issued a large number of finite insurance contracts to various clients. American International Group (AIG) is a large multinational insurance company also based in the United States, with shares traded on the New York Stock Exchange. During 2000– 2001, AIG took over $ 500 million of finite insurance contracts from General Re Corp. General Re paid over the $ 500 million of premiums it had collected for these policies to AIG. Thus, AIG was now in the role of insurer, instead of General Re. AIG paid General Re a $ 5 million fee for taking over these finite insurance contracts.
At first glance, this deal seems illogical for AIG. When the finite insurance contracts expire, AIG would have to repay the $ 500 million received from General Re to the various firms that had taken out the finite insurance, less any claims it may have paid. Consequently, its net cash flows would be zero. Why would AIG pay a $ 5 million fee (instead of receiving a fee) for taking over the contracts when it had nothing to gain? On closer scrutiny, however, it turned out that investors had been concerned that AIG did not have sufficient reserves (insurance companies are required to create reserves to help ensure they can meet policy claims). AIG credited the $ 500 million received from General Re to revenue, then transferred the same amount from earnings to reserves. It was thus able to increase its reserves by $ 500 million, with only a $ 5 million reduction in earnings.
In February 2005, AIG received subpoenas from the Office of the Attorney General of the State of New York and the SEC relating to its accounting for this transaction. Its stock price plummeted, costing shareholders over $ 544 million. In March 2005, AIG’s directors dismissed CEO Maurice “Hank” Greenberg and CFO Howard I. Smith. AIG also issued a statement that due to the lack of risk transfer, the payment from General Re should have been accounted for as a loan rather than revenue. Financial statements for five years ending with 2004 were subsequently restated. Earnings over this period were reduced by 10%, about $ 3.9 billion, as a result of this and other accounting manipulations.
In 2006, AIG paid $ 1.64 billion to settle fraud claims, including the General Re transaction. The company also made changes to its corporate governance process. Greenberg and Smith also faced lawsuits of their own. In 2013, they agreed to pay a total of $ 115 million to settle shareholder claims. They still face a trial for fraud that could prevent them from serving in management or Board positions or in the securities industry, and that could result in repaying performance- based compensation.
a. From the standpoint of a firm that takes out a finite insurance policy, evaluate finite insurance as an income smoothing device.
b. A firm has just suffered a large special item, low- persistence uninsured loss. The firm is concerned about securities market reaction to lower reported net income this quarter if the loss is charged to current operations. The firm approaches an insurance company with a request to retroactively sell it a finite insurance policy with face value equal to the amount of the loss. Under such a policy, the firm would immediately receive a payment from the insurer equal to its loss, which would be credited to current net income. The firm would then pay the policy premium quarterly, over a five- year period, with each payment charged to insurance expense for that quarter. The insurance company agrees to this arrangement. You are the firm’s auditor and are debating whether or not to qualify your report. Should you? If you did qualify, what would be your basis for qualification?
c. Do you agree that the $ 500 million received by AIG from General Re should have been accounted for as a loan rather than as income? Explain.
d. Should a new accounting standard to prevent the use of finite insurance contracts be implemented? In your answer, draw on the question of rules- based versus principles-based accounting standards.