Watchdogs With Eyes Wide Shut

Business Week Online
April 25, 2005

Watchdogs With Eyes Wide Shut As investigators pore over the books of AIG, it's becoming clear that for years regulators failed to detect lapses.

Where were the watchdogs?

State and federal investigators are examining the accounts of insurance giant American International Group Inc. (AIG), drawing out super-investor Warren E. Buffett, and sparring over Fifth Amendment rights with ousted AIG Chairman and CEO Maurice R. "Hank" Greenberg. But the feverish enforcement activity obscures the fact that AIG's admitted misstatements -- so far worth, by the company's estimate, $1.7 billion to shareholders -- and other industry transgressions went undetected by many of the same agencies, in some instances for 14 years or longer.

What's emerging from the probes is a portrait of failed regulation. Unlike banking or Wall Street, which answer to federal regulators, the $1.2 trillion insurance industry is overseen by small, usually obscure state offices. Outgunned by the insurance giants, state commissioners, interested in pleasing voters, usually focus on such consumer issues as setting rates and taking complaints on auto and homeowners' insurance. Many admit that they're out of their depths on sophisticated financing deals with offshore reinsurers, like those that fogged AIG's books and snarled Berkshire Hathaway Inc.'s General Re Corp. subsidiary in disputes from Memphis to Melbourne. "State regulators are doing the best they can, but they're not equipped to police multistate or international scams," says Jay Aughtman, a Montgomery (Ala.) lawyer who represents insurance regulators in Tennessee and other states.


Other guardians also failed. Outside auditors didn't penetrate AIG's structure to detect supposedly independent reinsurers that AIG now says it secretly controlled, or hidden side agreements between insurers. Nor did the financial industry specialists who reviewed the insurers' filings at the Securities & Exchange Commission. More broadly, rulemakers at the Financial Accounting Standards Board failed to provide clear, enforceable standards for reinsurance deals. That left the way clear for insurers to polish their financial image with deals that appeared to meet technical tests but in fact had no business purpose or were improperly portrayed, such as AIG's $500 million reinsurance pact with General Re.

In this vacuum, the task of cleaning up insurance has fallen to the SEC's Enforcement Div. and New York Attorney General Eliot Spitzer. They summoned Buffett to New York to testify as a witness on Apr. 11. The next day, they hauled in Greenberg after Spitzer refused to delay his deposition. Greenberg invoked his right to avoid self-incrimination and refused to answer more than 100 questions -- including naming the company he'd headed for nearly 40 years.

State regulators defend the job they've done. The problem, they say, is that insurers lied to them. "AIG has acknowledged misleading the New York State Insurance Dept. several times," says Acting New York State Superintendent of Insurance Howard Mills. "We take those transgressions very seriously."

Regulatory sources say that the New York department tangled with AIG in 1996 over Coral Re, a reinsurer that state authorities contended was secretly controlled by AIG. Since 2000, they say, the department has had an ongoing probe of suspect claims on AIG's financial statements. After the Coral Re dispute, these sources say, AIG pledged in writing to reveal any ties with its reinsurers -- and filed statements certifying the independence of specific companies that it now acknowledges controlling or backing. "When there's lying of this magnitude -- in annual reports, everywhere -- it's no different than any other financial debacle," says one regulator.


Still, critics contend that the fragmented system of state regulation lacks the checks that can expose frauds before they compound. In some states, insurers have the upper hand: They dominate state legislatures, keep commissioners on tight budgets, and maintain a revolving door between the commissioner's office and insurers' headquarters. "The general pattern is that the industry makes sure regulators don't have very much clout," says Joseph M. Belth, professor emeritus of insurance at Indiana University.

States do examine insurers for financial solvency -- but often miss the big picture. They can't uncover financial weaknesses in affiliated companies, especially those based offshore. "Regulators are interested in the licensed insurer doing business in their states," says Mark Puccia, managing director, financial services at Standard & Poor's, a credit-rating agency owned (like BusinessWeek) by The McGraw-Hill Companies. To coordinate efforts, state regulators have banded together in the National Association of Insurance Commissioners. But the NAIC doesn't regulate or investigate. Instead, it proposes laws and rules that states are free to adopt or ignore. The recent focus on reinsurance as a tool for earnings management has spurred NAIC to set up a task force, but it has met only twice. "We need to do more," says NAIC President-elect Alessandro A. Iuppa, Maine's insurance superintendent.

The obvious solution: national regulation. State oversight of insurers is a relic of 19th century finance, until recently defended by insurers. Now, however, the industry is splitting. Many big underwriters crave the uniformity and cost savings of replacing 50 regulators with one. A dual system -- modeled on banking -- has been under discussion for decades: Small insurers would be chartered by states; big insurers would answer to a federal regulator, most likely in the Treasury Dept. Meanwhile, the Federal Reserve Board would continue to oversee financial companies that mix insurance with other businesses.

Problem is, even if today's Republican White House and Congress created a new regulator -- a big if -- they would be unlikely to give it tough powers like those the SEC enjoys with brokers and banks. The furthest GOP leaders may go now is the so-called SMART bill drafted by House Financial Services Committee Chairman Michael G. Oxley (R-Ohio), which would create a super-NAIC with federal help to press for uniform, streamlined state regs.

Further revelations might force action. Five other big reinsurers, including Swiss Re, MBIA (MBI), and St. Paul Travelers (STA), have disclosed that the SEC and Spitzer have subpoenaed records from them. "There's a lot more to come" on insurance companies collaborating to buff up each others' financials, warns a source close to the probes.


But even absent a strong new federal agency, current watchdogs can do more. The SEC must use its broad authority to review filings of public companies to focus on insurers' financial reporting until it's confident the industry has cleaned up its act.

Auditors, too, must become more vigilant. The suspect reinsurance deals at AIG bear an eerie resemblance to Chewco Investments LP, the LJM partnerships, and other "special purpose entities" that brought down Enron. Like the SPEs, the reinsurers AIG used were supposed to be independent -- but were in fact closely linked to the parent company. Why didn't such deals arouse more suspicion? In both cases, auditors focused narrowly on whether the deals met technical benchmarks to qualify for favorable treatment, without looking at whether they made sense. Just as important, auditors need to force into the open any side deals that soften or negate the terms of contracts. Such deals already violate insurance and accounting regs, but that hasn't stopped their use.

Accounting-rule writers must also move faster to clarify standards for "structured finance" -- a category that includes off-balance-sheet SPEs and the finite reinsurance that AIG allegedly used to beef up its numbers. FASB is on its third round of post-Enron clarifications for rules governing off-balance-sheet financing. Rulemakers must also set reinsurance standards that genuinely measure risks insurers transfer.

Insurance is a devilishly complicated business, and the industry often plays by no-holds-barred rules. "Insurance is like the Wild West -- it makes Wall Street seem quite orderly and gentlemanly," says an analyst. It's also an increasingly sophisticated industry in which players take advantage of every international loophole available to move operations offshore in order to decrease scrutiny and cut tax liabilities. In this high-stakes business, regulators can't afford to be caught napping. When they snooze, investors lose.

Copyright 2005 by The McGraw-Hill Companies Inc.

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