INTRODUCTION

The Agency Problem can be best described as a dispute that arises when agents charged with
the duty of taking care of the needs of the principals have decided to use the power or control
for their gain, and in corporate finance, it can be said as a conflict of interest between the
management of the business and its stakeholders. It is a very common and general issue that
can be found in any kind of organization. It is a conflict of interest that takes place when
individuals who are involved in obligations abuse or misuse their influence and power for
personal gain. This will only be resolved if the organizations are able to fix it. A company has
its own set of long-term and short-term goals and objectives that it aims to accomplish over a
predetermined period of time. In this sense, it must also be remembered that the priorities of
the management will not always be compatible with those of the shareholders.

The management of a company may have goals and objectives that are more likely to be
extracted for the purpose of maximizing its personal gains when on the other hand, the
shareholders of the entity are most likely involved in wealth maximization. This contrast
between the goals and objectives of the Management and the shareholders of the company can
also become the foundation for the Agency's problems. The main cause or reason behind this
type of problem is the same in all situations where there is mismatch or conflict of interest.
When the stockholder's agenda is in competition with the other parties, the agency problem is
certainly going to happen. In the case of workers, the cause will be the inability of
shareholders to satisfy employees' standards in terms of salaries, incentives, working hours,
etc. In the case of consumers, the explanation will be the inability of shareholders to satisfy
the demands of customers, such as the selling of low-quality products, poor supply, high
costs, etc. In the case
of administration, the reasons for the difficulties of the Agency may be the misalignment of
priorities, the division of ownership and management, etc.
This resulted in Agency Problem between stockholders and customer of company

The types of Agency Problems are as follows:

STOCKHOLDERS VS. MANAGEMENT

STOCKHOLDERS VS. CREDITORS

STOCKHOLDERS VS. OTHER STOCKHOLDERS

ABOUT THE COMPANY

American International Group, Inc. (AIG) is a leading global insurance organization serving
customers in more than 100 countries and jurisdictions. AIG companies serve commercial,
institutional, and individual customers through one of the most extensive worldwide property
casualty networks of any insurer. In addition, AIG companies are leading providers of life
insurance and retirement services in the United States. AIG common stock is listed on the
New York Stock Exchange and the Tokyo Stock Exchange.

As of January 1, 2019, AIG companies employed 49,600 people. The company operates
through three core businesses: General Insurance, Life & Retirement, and a standalone
technology-enabled subsidiary. General Insurance includes Commercial, Personal Insurance,
U.S. and International field operations. Life & Retirement includes Group Retirement,
Individual Retirement, Life, and Institutional Markets
AIG's corporate headquarters are in New York City and the company also has offices around
the world. AIG serves 87% of the Fortune Global 500 and 83% of the Forbes 2000. AIG was
ranked 60th on the 2018 Fortune 500 list. According to the 2016 Forbes Global 2000 list, AIG
is the 87th largest public company in the world. On December 31, 2017, AIG had $65.2
billion in shareholder equity.

In Australia and China, AIG is recognized as an enormous financial institution and provider of
financial services including credit security mechanisms. [citation needed] In the United States,
AIG is the biggest financier of business and industrial insurance.

AIG offers property setback insurance, disaster protection, retirement items, contract
insurance and other financial services. In the second from last quarter of 2012, the worldwide
property and-loss insurance business, Chartis, was renamed AIG Property Casualty.
SunAmerica, life coverage and retirement-services division, was renamed AIG Life and
Retirement; other existing brands continue to be utilized in certain geologies and market
portions.

Agency problem of AIG.

Even though AIG is such a giant corporation, it has encountered financial problems in the
early 2000s. Under financial pressure and a lack of internal control, AIG has committed
frauds resulting in several scandals. One of the accounting scandals was disclosed during
2005 which involved a material mis-statement due to false transactions during 2000. This
scandal set to prelude leading the downfall of AIG in 2008. In this paper, we will analyse the
cause, the transactions and finally effects of the scandal.

Review of Literature

The US State and federal regulators notified the agreements that resolve pending litigation and
investigations of fraudulent and improper accounting by the insurance company. Under the
agreements, American International Group (AIG) has acknowledged and admitted the
misconduct that adopted a series of ground-breaking reforms and agreed to pay more than
$1.6 billion in restitution and penalties. The agreements were announced simultaneously by
the New York Attorney General, the New York Insurance Department, the Securities and
Exchange Commission (SEC) and the United States Department of Justice. State Insurance
superintendent Howard Mills said that AIG has admitted itself that the company over a period
of years has intentionally misled the investors, regulators and policyholders about the
company’s financial condition and operations. In 2004, the Attorney General’s office and the
Insurance Department began and started its investigation against AIG for bid-rigging as part
of an ongoing probe of misconduct in the insurance industry. The probe had resulted in more
than $1 billion in restitution to policyholders and guilty pleas from 20 insurance company
executives and officers, including four former AIG employees. In early 2005, the Attorney
General, the Insurance Department and the SEC began jointly investigating a series of
allegedly fraudulent transactions by AIG and its senior officers, including the transfer of “loss
reserves” from the General Re Corporation to AIG in late 2000 and early 2001 to bolster the
public view of AIG’s underwriting performance. On May 26, 2005, the Attorney General and
the Insurance Superintendent sued AIG and its former Chairman and CEO and Chief
Financial Officer for violations of New York’s Martin Act and other state laws in connection
with the Gen Re transaction and other efforts to inflate reserves, other transactions designed
to conceal underwriting losses by converting them into capital losses, misleading the New
York Insurance Department about offshore AIG affiliates and improper reporting of workers
compensation premiums. Also, AIG admitted and acknowledged itself that it did not provide
the correct and true information to the investing public and regulators and also it regrets and
apologizes for its misconduct. Under the agreements, $800 million will go to investors
deceived by false financial statements, $375 million to AIG policyholders harmed by bid
rigging activities and $344 million to states harmed by AIG’s practices between 1986 and
1995 involving workers’ compensation funds. In addition, New York and the SEC have each
assessed $100 million in penalties against the company. The SEC’s penalty will go into the
fund for investors. As a result of these settlements, AIG will make payments of
approximately $1.64 billion. A substantial portion of the amount of money will be available
to resolve claims asserted in various regulatory and civil proceedings, including shareholder
lawsuits. Specifically, AIG will pay $800 million, including $100 million as a penalty, into a
fund under the supervision of the SEC to be available to make payments to investors,
including investors involved in shareholder litigation relating primarily to AIG’s accounting
and financial reporting practices.
Explanation of case

The Accounting Scandal (AIG)

The Players
The CEO of AIG was Maurice “Hank” Greenberg. Greenberg joined AIG in 1962 and led
AIG for thirty-eight years until his retirement in March 2005. Greenberg was not only the
CEO, but also the chairman of the board of AIG. AIG also has several subsidiaries, which
include National Union Fire Insurance Company of Pittsburgh (NUFIC) and Hartford Steam
Boiler Inspection (HSB). Their financial information is consolidated in AIG’s financial
statements.
The scandal also involves another corporation General Re Corporation. General Re is a
subsidiary of Berkshire Hathaway, Inc., an investment group run by the billionaire Warren
Buffet. General Re also has subsidiaries all over the world and together and it is one of the
biggest reinsurance companies in the World. Reinsurance companies are entities that insure
the insurance companies. They help insurance companies share risk by selling reinsurance
plans that would help pay off a share of a claim from the insurance companies. The CEO of
General Re was Ron Ferguson when the fraud was committed. General’s RE subsidiary in
Dublin, Ireland, known as Cologne Re Dublin (CRD) was also heavily involved in the fraud.

Detailed analysis

The Deal –

On October, 26, 2000, AIG released its third quarter earnings. It showed that there was an
increase of premium, but a decrease in loss reserves by 59 million. Loss reserve is a liability
account which represents the estimate of loss future claims. Loss reserve is an important
indicator for whether management of a company is sufficiently anticipating future claims.
Since the premiums have increased, AIG’s loss premium should be increased as well. A
decline could imply that AIG had cash or reserve problems. Because of the decline in loss
reserves, analysts have downgraded AIG two days after release of earnings. Hence, the stock
price of AIG dropped 6% from $99.6 to $93.3 on NYSE. It was then that Greenberg called
Ferguson.
Greenberg wanted to increase AIG loss reserves. Therefore, he and Greenberg had drafted a
deal. By using both the subsidiaries of AIG and General RE, NUFIC and CRD. NUFIC (AIG)
would assume the risk of losses from CRD’s policies for about $600 million for $500 million
of premium. The $500 million represented two contracts where each contract was paid in
different times. Of that $500 million, 10 million would be paid to NUFIC (AIG) and $490
million would be withheld in CRD. The transaction itself is called Loss Portfolio Transfer and
it is legal. However, AIG actually did not want to assume any risk. The contracts that CRD
transferred were in fact risk-free. The claim would eventually be paid out by AIG for exactly
$500 million. Also, AIG secretly agreed to AIG NUFIC

Asset
+ 10M Premium Paid by CDR
+ 490M Premium Receivable (withheld by CDR)
Liability
+ 500M Loss Reserve

Transaction recorded by AIG:

AIG NUFIC
Asset
+ 10M Premium Paid by CDR
+ 490M Premium Receivable (withheld by CDR)
Liability
+ 500M Loss Reserve

Transaction recorded by AIG:

Pay General Re 5 million as a fee for doing the deal. Following GAAP (generally accepted
accounting principle), the nature of the transaction could not be classified as Loss Portfolio
Transfer as there was no transfer of risk. However, senior management of AIG and General
RE agreed to engage in “non-mirror image accounting”, which NUFIC recorded the
transaction as a Loss Portfolio Transfer, while CDR (General Re) recorded the transaction as
a deposit which did not violate GAAP.
How CDR paid $10 million without paying:
In order for AIG to pay General Re $5.2 million fees secretly and for CDR to pay $10 million
in order to make the transaction believable and under the radar from investigators. Senior
management of AIG and General Re constructed a paper trail which would hide the
transaction
of $5.2 million directly to General RE from AIG. There was existing contract between where
General Re owned $31.8M payable to AIG. Therefore, General Re paid $7.5 million to
commute an existing contract with AIG subsidiary, HSB. Furthermore, General Re paid
NUFIC $9.1 million premium to reinsure the loss that was just commuted to HSB. CDR then
paid General RE $0.4 million premium for a fake reinsurance and received a loss payment
$13 million. Finally, CDR made the $10 million payment to NUFIC. In the end,
CDR/General Re was left with $5.2 million in total.
Reinsurance $0.4 M
Reinsurance $9.1M

AIG
HSB
NUFIC
General RE
($31.8 payable to HSB)
Commute $7.5 M
Loss Payment
$13 M
CDR
$10 M Premium
Gen Re = 31.8 -7.5-9.1-13 +0.4 = $2.6M
CDR = 13 – 10 – 0.4 = $2.6 M

Effects after the transaction -

With the reserves set up and a lack of transparency, AIG was able to manipulate numbers and
added $106 million of loss reserves in Q4 2000 and $63 million Q1 2001 to the balance sheet
masking the actual decline of loss reserves of $144 million and $187million. With the
additional premium and loss reserve, analysts thought that the earnings of AIG in those two
quarters were great. In the release of earnings in Q1 2001, Greenberg even wrote “"AIG had a
solid first quarter... We added $63 million to AIG's general insurance net loss and loss
adjustment reserves for the quarter, bringing the total of those reserves to $25.0 billion at
March 31, 2001."

During the Financial Crisis of 2008, people were losing a lot of money and the employment
rate increased drastically. Sensing such non-availability of funds, banks decided not to give
loans to individuals or business firms. As a result, businesses were highly affected. However,
AIG found an opportunity to maximise its profits by finding a loophole in Basel II regulation.
The Basel II regulation determines how much amount the banks are supposed to keep with
themselves. They used somewhat called CDS, CREDIT DEFAULT SWAP ➔ A CDS is an
over-the-counter derivative ➔ As a derivative financial product, it derives its value from
something else—for CDS bonds ➔ People use CDS to manage risk in simple words, the seller
of the Swap (AIG) will pay the buyer (Banks) in the event of loan default. So, banks gave out
money which was supposed to be kept as reserve. AIG gave banks a way to maximise their
profits. Also because of something called Market to Market Accounting, AIG was allowed to
book the profit from CDS based on expected profits. There were no profits they were making.
They were writing those profits which they expected to make and they would write it down in
their books and act as if it was real profit. That was FRAUD!

Aftermath- (What went wrong)-

The Securities and Exchange Commission (SEC) had already been probing into AIG during
early 2000 due to various misconducts of AIG. They were already suspicious of the integrity
of the financial information provided by AIG. In January 2005, the counsel of General RE
phoned SEC representatives to disclose the entirety of the LPT transaction. On February 14
2005, AIG received a subpoena from SEC relating to finite reinsurance accounting. And 3
days later, AIG disclosed the LPT scheme to the public. In March 2005, Greenberg stepped
down from the CEO position. In May 2005, AIG issued a restated financial statement for
fiscal years from 2000 through 2003, which reduced the income for 2004 for 1.32 billion.
Also, Eliot Splicer, the New York Attorney General filed a civil case against AIG.
Responsibility of the Auditors
With litigation going on for AIG, its auditor PricewaterhouseCoopers LLP were also under
scrutiny because they signed off the financial statements of AIG. Many criticized PwC that it
did not detect the unusual transactions. The AIG shareholders filed several complaints on PwC
to have violated the securities laws in providing AIG auditing services and giving unqualified
opinions on AIG financial statements and demanded damages. On 2nd December, 2010, a
settlement finally reached that PwC had to provide 97.5 million in settlement for the AIG
shareholders.
PwC has a long business relationship with AIG for over 30 years, but it appears that PwC has
not been exerting full professional efforts. The investigation of the charges against PwC
revealed that the Audit Committee of AIG’s own board of directors had repeatedly stated that
it could not verify the AIG’s accounting methods, but PwC ignored the ‘red flags’ regarding
AIG’s poor accounting practices. If PwC was on high alert, it might have worked closely with
AIG and prohibited AIG from classifying the $ 500 million as revenue.

AIG Management Team

American International Group, Inc. today reported that David McElroy, at present President
and Chief Executive Officer of the North American tasks of General Insurance, has been
elevated to Chief Executive Officer, General Insurance, and Executive Vice President, AIG, as
of now.

Mr. McElroy will lead the General Insurance Executive Leadership Team and join the AIG
Executive Leadership Team, answering to Peter S. Affine, AIG's President and Global Chief
Operating Officer.

Dave has assumed an instrumental part in the turnaround of our General Insurance business
and the situating of AIG as a market chief. The company is satisfied to report this merited
advancement and anticipate proceeding to work intimately with Dave and our a-list General
Insurance initiative group. We remain laser zeroed in on endorsing discipline and operational
greatness, which permit us to tackle complex danger issues and convey an incentive to our
customers, appropriation accomplices and different partners."
 Mr. McElroy joined AIG as President and Chief Executive Officer of Lexington Insurance
Company in October 2018 and was elevated to President and Chief Executive Officer of
North America, General Insurance in June 2019. Prior to joining AIG, Mr. McElroy held
various influential positions inside the protection business, including Executive Chairman of
Arch Insurance Group Inc. what's more, Vice Chairman of Arch Worldwide Insurance Group.

President Chief Executive Officer and Director (PEO) – Martin J. Sullivan

Executive Vice President and Chief Financial Officer (PFO) – Steven J.

Bensinger
Senior Vice President and Comptroller (PAO) – David L. Herzog

List of Directors
Bernar d Yuan Chia William S. Marti n S. Ellen V. Hammer man Richar d C. Lang hha Georg e L. Offi t
Carl a A. Holbro oke mm Miles, JR
Aidino ff Marshall A. Cohen Feldst ein Futter Mo rris W.
Stephen L. Hills Fred H. er
M. Pei Cohen

Learnings -
Functional knowledge of accounting management and its application.
Agency conflicts can occur when the incentives of the agent do not align with those of the
principal.
• The agency view of the corporation posits that the decision rights (control) of the
corporation are entrusted to the manager to act in shareholders ‘interests. Control
 systems in corporate governance can help align managers’ incentives with those of
shareholders and other stakeholders.
• The principal – agent problem concerns the difficulties in motivating one party (the

“agent”), to act on behalf of another (the “principal”). The two parties have different
interests and asymmetric information. Moral hazard and conflict of interest may thus
arise.
• The deviation from the principal’s interest by the agent is called “agency costs.” Agency
costs mainly arise due to contracting costs and the divergence of control, separation of
ownership and control, and the different objectives (rather than shareholder
maximization) of the managers.
• Much recent interest in corporate governance is concerned with mitigation of the

conflicts of interests between stakeholders. These occur when an individual or

organization is involved in multiple interests that may lead to conflicts in their ability
to act in the best interest of one party.

The agency view of the corporation posits that the decision rights (control) of the corporation
are entrusted to the manager to act in shareholders’ (and other parties’) interests. Partly as a
result of this separation, corporate governance mechanisms include a system of controls
intended to help align managers’ incentives with those of shareholders and other stakeholders.

Conclusion -
At the end of the civil case trial, 4 executive members of General Re and AIG were convicted.
However, the charges were all overturned by the federal court of appeal in 1st Aug, 2011,
including Greenberg and Ferguson. However, the damage was done. Because of this scheme,
it was estimated on Oct 31, 2008 that shareholders lost around $544 million to $597 million.
AIG almost went bankrupt at the start of the financial crisis. It is obvious that there were
many internal controls problems for AIG. But can the fraud be prevented in this case? We can
analyse the situation using the Fraud Triangle.

Pressure
* Downgrade of Stock
* Decline in Loss Reserve
* Avoid Criticism
Opportunity
* AIG being big client of General Re

Rationalization
* Increase stock price
* Splizer file civil suit just for election

We can see all three elements. Pressure, Opportunity and Rationalization exist in this case.
Also with the lack of internal control in AIG and the negligence of its auditor PwC, it almost
seemed that fraud was inevitable. However, after the financial crisis, we have experienced the
financial frauds and illegal acts incurred huge costs with far reaching damages affecting the
lives of many people for years Government agencies all over the world have been working
hard to improve regulations for tighter controls. In addition, we believe that large
corporations and audit firms alike should learn from mistakes and exercise high professional
and ethical principles to prevent frauds and account scandals.

References

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https://web.archive.org/web/20170329061330/http://www.aig.com/content/dam/aig/america
canada/us/documents/investor-relations/december-31-2016-10k.pdf
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AIG Settles Fraud, Bid-Rigging and Improper Accounting Charges with SEC, N.Y. (n.d.). Retrieved
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