AIG Lies Down With Dogs

You know what happens when you lay down with dogs, don't you? You get fleas.

Insurance and financial services conglomerate American International Group (NYSE: AIG  ) , known for its rough treatment of analysts and journalists who are critical of the company, has more than likely been extremely busy in the last few weeks. Some of its business practices must have it scratching pretty good.

In short order, AIG agreed to a fine of $10 million by the Securities and Exchange Commission to settle fraud charges for its decision to provide another company "retroactive insurance," and has additionally entered into a lawsuit to recover its part of a $450 million investment in an Azerbaijani oil deal gone bad. In both cases, AIG showed, at a minimum, horrendous judgment in its quest for the almighty dollar.

These types of scandals make me wonder whether AIG is straining to maintain the growth rates that have encouraged investors to bid its stock into the stratosphere. For a company with 2002 revenues exceeding $67 billion and operations in 130 countries, there shouldn't be much question that most of the easy-to-reach trees have been shaken -- further growth opportunities will likely require some substantial creativity. Looks like AIG's already been a little too creative.

Isabel mauled my house
Can I get insurance? You have to love the term "retroactive insurance." The insurance industry, while hopelessly complex, has a pretty simple premise: It provides coverage against potential harm. Insurance companies generally break even, or lose money, on their underwriting. Where they make money is by taking the money paid by customers and investing it until it must be paid out in claims. The longer that "float" remains with the insurer, the more benefit it derives from what is in effect other people's money.

Retroactive insurance, on the other hand, is protection for damage that has already occurred. This throws the whole insurance model out the window, as claims on damages would have to be paid immediately. This makes no sense at all for insurers, unless the premiums are substantially larger than the actual damages. But why would a customer want to pay more in insurance than it would just to fix the damages? Good reasons do exist for insurers to provide this kind of coverage, but none of those are in evidence here.

In 1998, cellular phone distributor Brightpoint (Nasdaq: CELL  ) realized that it would have to report much larger losses from an international unit. So the company approached AIG to offer it insurance on these losses that had already occurred. AIG agreed and provided a retroactive policy of $15 million. This allowed Brightpoint to report an insurance receivable of nearly $12 million, wiping out most of the reported loss and effectively manipulating Brightpoint's GAAP financial statements.

But instead of insurance coverage, this transaction was little more than a round-trip of payments -- Brightpoint paid "premiums," AIG in turn sent money back as "refunds." This was no different than the sham telecom capacity swapping deals employed by Qwest (NYSE: Q  ) , Global Crossing, and others to make the appearance of much higher revenue growth. Such a transaction should be regarded in the same light as buying receivables -- certainly, it should not be treated on the income statement as a receipt of a legitimate insurance claim.

And Brightpoint's investors were none the wiser until the SEC inquired in 2001. The SEC has characterized AIG's statements to auditors as being materially false, and its response to the agency's requests for documents and information "woefully deficient." AIG, for its part, has acknowledged that mistakes were made in providing the coverage, and that it is conducting an internal audit to determine whether similar conduct is going on elsewhere in the company. Let me spoil the ending here: If Brightpoint's round-trip payments were in any way profitable for AIG, the chances that this program was replicated elsewhere approaches 100%.

Maybe they didn't Czech references
Interestingly enough, at about the same time, in another part of the world, AIG was making another aggressive, unconventional deal. Along with some American hedge funds, it purchased nearly $450 million in vouchers in Oily Rock and Minaret Group, headed by Czech businessman Viktor Kozeny.

These groups, in turn, had procured some $500 million in privatization vouchers of Azerbaijan's state-owned oil company, SOCAR, under the belief that the government would soon cut the company loose, giving them control. When Azerbaijan elected not to go the route of privatizing SOCAR, the riches from the deal that would have accrued to AIG -- and to Kozeny -- failed to materialize.

AIG has a suit against Kozeny, alleging that he defrauded the company by selling these vouchers at a huge markup, in contravention to their agreement. Kozeny sued the Azerbaijani government and its president, Haidar Aliev, saying that they had reneged on promises to him. Bafflingly, in court documents, Kozeny defends himself from the charge of fraud by stating that his attempts to bribe Azeri officials failed, and that the investors, including AIG, were fully aware of the risks of the scheme.

Viktor Kozeny already had a reputation for profiteering for his near-cornering of the privatization scheme in the Czech Republic in the early 1990s. In this case, American-educated Kozeny set up an investment management company in his home country called Harvard Funds, promising massive returns to investors. At the time, the Czech government had issued vouchers to every citizen for them to buy portions of the various state-run industries that were at the time being privatized. Several hundred thousand Czechs turned their vouchers over to him, but ended up holding the bag when Kozeny, along with hundreds of millions of dollars, suddenly disappeared, only to turn up in the Bahamas carrying an Irish passport and a "Who me?" look on his face.

As for the Azerbaijan oil deal, I'm not sure which would be worse: that AIG recognized the risks or that it did not. One has to wonder how in the world AIG got into such a mess in the first place. Certainly, it had to have known about Kozeny's history. After all, Fortune wrote a scathing piece on him and his activities in 1996. It's also pretty unlikely that he would come with great references from past clients, as the near unanimous sentiment in the Czech Republic is that he ought to be behind bars. Kozeny was charged by Czech police finally in July, and will be tried, most likely in absentia. He is apparently the next best thing to broke.

What happens to AIG's lawsuit is of minor interest. These are not enormous sums for a company as big as AIG. What ought to be of deep concern is that AIG is putting its reputation at risk both by helping bad people deceive individual investors and putting trust and financial backing into a scheme run by a guy who had played fast and loose with the investments of thousands more.

AIG is the largest insurance company in the world, one of the largest companies of any kind. Has the chase of growth and profitability become so all-encompassing that risky behavior has become the norm? If so, the trickle of embarrassments the company has suffered will become a flood.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Happiness is a September home stand against the Detroit Tigers. Bill Mann owns none of the companies mentioned in this article. The Motley Fool is investors writing for investors.

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