What do many corporate buyers of insurance have in common with American International Group? Perhaps more than they would like to admit. Like AIG, many companies in the past few years have bought finite insurance, which transfers a prescribed amount of risk for a particular liability. What regulators now want to know is, how many companies, like AIG, have used finite insurance to artificially inflate their financial results?
It’s a tough question to answer, since there’s nowhere near enough disclosure in corporate financial statements to determine whether buyers are properly accounting for such contracts. Consider the case of Delta Air Lines. Several years ago, when the financially troubled carrier wanted to remove from its balance sheet at least part of its growing liability for free mileage grants to frequent fliers, Delta used its captive insurance subsidiary, Aero Assurance, to buy reinsurance for the purpose. (Reinsurance was necessary because a captive’s results are otherwise consolidated on a parent’s balance sheet.)
The deal enabled Delta to take “a very large liability” off its balance sheet, the company’s risk director at the time, Chris Duncan, told CFO in an interview for the March 2001 online article “Delta’s Strategy for Reducing Turbulence.” But Duncan would not go into further detail, and nothing about the transaction was disclosed in Delta’s 10-K. Indeed, Delta has said very little about the deal. Duncan has since left Delta to join insurance brokerage giant Marsh Inc., a division of Marsh & McLennan, and did not respond to a request for comment. Delta also failed to respond to such a request. But experts say a frequent-flier program is the type of liability that lends itself to finite coverage.
Loans in Drag
Delta, of course, is hardly alone in using insurance in this way. Indeed, there’s nothing legally wrong with doing so. The trouble is, regulators suspect that much of the activity in this arena is really financing masquerading as insurance, because it involves little or no transfer of risk. Without more significant risk transfer, the accounting rules say there should be no change in the liabilities recorded on a buyer’s balance sheet.
Given the general lack of disclosure, it is impossible to say how far the abuse goes. But AIG has been on the other end of similar deals with PNC Bank and with a Plainfield, Indiana-based cell-phone distributor named Brightpoint. In settling charges of aiding and abetting accounting fraud in the PNC case in late 2004, AIG acceded to a Securities and Exchange Commission demand that it install an independent monitor to oversee its operations. Reportedly, the monitor is not only supervising new AIG deals, but also investigating others that the company engaged in around the same time.
Meanwhile, the SEC and other authorities, including New York State Attorney General Eliot Spitzer, the National Association of Insurance Commissioners, the Financial Accounting Standards Board, and the Federal Bureau of Investigation are hunting for problems elsewhere. General Electric, which like AIG both sells and buys finite insurance, is the latest company to be subpoenaed by the SEC in connection with the product. As Scott Taub, the SEC’s deputy chief accountant, told a conference on financial reporting at Baruch College in early May: “Finite insurance is not solely an insurance company issue. It affects buyers as well as sellers. Any number of companies have this issue.” The potential upshot for CFOs of offending companies: a new round of SEC enforcement actions, followed inevitably by shareholder lawsuits.