Berkshire Hathaway
Gen Re Scandal

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By Tode
February 22, 2005

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I am puzzled after reading the Barron's article re the latest "scandal" involving AIG and Gen Re. Here's what the article says:

"Specifically, investigators are said to be looking at two reinsurance deals with General Re that allowed AIG to beef up its fourth-quarter 2000 and first-quarter 2001 reserves with a total of some $200 million in no-risk finite reinsurance transactions with Gen Re. In effect, investigators are looking at whether AIG borrowed the claims loss reserves from Gen Re, boosting the reserves carried on its balance sheet. AIG's offset, most likely a $200 million debit to some asset class, would be virtually undetectable in a balance sheet then boasting over $300 billion in assets.

The amount of the reserves boost may seem inconsequential to a company that at that time had nearly $25 billion in reserves against future claims losses. But at the time, security analysts following AIG were concerned that the company might be under-reserving against future claims in order to show greater-than-warranted earnings growth."

None of this makes any sense to me. I must be missing something and would appreciate it if somebody here can explain what all the fuss is over.

1. The allegation apparently is that AIG improperly INCREASED its reserves, which would have made its earnings LOWER than they otherwise been.

2. If the reinsurance deal increased AIG's reserves, then it must have been the opposite of the normal kind of Berkshire finite reinsurance transaction. Usually, we SELL the reinsurance, which increases OUR reserves and lets the buyer improve its earnings. I surmise that AIG must have been the seller here, and Gen Re the buyer, if the effect was to increase AIG's reserves.

3. The alleged motive for this crime is that AIG was suspected by Wall Street of under reserving in the prior quarter, which of course would have overstated its earnings if true. So to avoid that suspicion two quarters in a row and add credibility on Wall Street, AIG "borrows" $200M of reserves from Gen Re.

4. $200M is less than 1% of AIG's total reserves of $25B! Given the normal guesswork inherent in setting reserves (predicting liabilities for asbestos, environmental, mold, etc.), this is a rounding error.

5. More to the point, if AIG decided that it wanted to boost its reserves (for either the bogus reason of increasing credibility on Wall Street or the completely legitimate reason of recognizing that the liabilities for asbestos etc. were higher than previously estimated), why would it need Gen Re's assistance? Why not just increase reserves? The irony here is that AIG's reserves probably were too low all along (and probably still are today), yet it is getting in trouble for a transaction that allegedly increased its reserves without justification? This is very strange, Alice in Wonderland stuff.

6. I can understand the regulators' concern when a large reinsurance company like Berkshire sells a product that a soon to be insolvent insurer uses to hide its perilous financial condition from regulators and stay in business. But here neither AIG, or Berkshire is going broke. Who is the victim of this supposed crime?

Lord knows there are plenty of criminals and bad actors out there that deserve to be prosecuted and harassed by Spitzer.

But it seems to me that he is slicing a little too thin when he starts second-guessing the motives for increasing reserves by less than 1%. I doubt that Spitzer wants to assume the responsibility of calculating the actual amount of liability that the country's insurers face for environmental and asbestos exposures. Nobody knows. Everybody is guessing, and most are guessing way too LOW. Perhaps they are the ones that need to be prosecuted. I just don't understand why Spitzer thinks it is worthy of his attention even if it is true that a company has overstated its reserves by 1% in a given quarter. At most, that might be an issue for a state insurance regulator to look into, or perhaps an IRS agent.

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