AIG: What Went Wrong

A look at how the icon of insurance got itself in such a mess -- and where all the probes are headed

Investors in embattled American International Group Inc. (AIG ) may have breathed a sigh of relief at the Mar. 28 announcement that Chairman Maurice R. "Hank" Greenberg would step aside two weeks after being pressured to give up the chief executive's role. But the complex $99 billion insurance and financial empire he leaves behind remains mired in turmoil.

What began as an investigation into two reinsurance transactions has mushroomed into a growing scandal that has tarnished the reputation of one of America's premier corporations. On Mar. 30, AIG acknowledged that it had improperly accounted for the reinsurance transaction to bolster reserves, and detailed numerous other examples of problematic accounting. It also announced the delay of its annual 10-K filing, and said the moves may have inflated its net worth by up to $1.7 billion. While AIG says it does not yet know if the review will force a restatement of prior results, its stock dropped 2.1% on the news; all together, AIG shares have dropped 22%, to $57 apiece, since the company was served with subpoenas by state and federal regulators six weeks ago. The announcement also caused Standard & Poor's (MHP ) to downgrade AIG's debt rating from AAA to AA+. Here's a look at where the AIG mess stands and where the probes are headed:

What is it that has regulators up in arms?

Investigators believe that AIG may have goosed its financial performance with dubious transactions and improper accounting. Last fall, the insurer paid $126 million in fines to the Securities & Exchange Commission and Justice Dept. for deals it structured for outside clients that allegedly violated insurance accounting rules, although AIG admitted no wrongdoing. The company also came under the glare of New York Attorney General Eliot Spitzer for its role in bid-rigging with broker Marsh & McLennan Cos. (MMC ), which led to the ouster of Hank's son Jeffrey as CEO there. AIG admitted no wrongdoing, but two of its executives plead guilty and left the company.

This time, investigators initially focused on two transactions involving Berkshire Hathaway's (BRK ) General Re Corp. unit. The deals essentially amounted to a $500 million loan that was dressed up on the books as premium revenue. That allowed AIG to boost its sagging reserves at a time when investors thought they were too low. The problem: AIG never assumed any of the risk associated with insurance underwriting. On Mar. 30, the company acknowledged that "the transaction documentation was improper" and should never have been classified as insurance premiums.

Since then, AIG 's problems have escalated. In its Mar. 30 release, the company itself identified several problem areas. They include transactions with supposedly independent companies that were in fact controlled by AIG; bond transactions that may have allowed it to claim gains without actually selling the bonds; misclassified losses; and questionable estimates on deferred acquisition costs. Investigators and state regulators are looking into some 60 transactions involving these and other possible accounting shenanigans. "Greenberg strived for a steadily rising stock price," says a source in Spitzer's office. "He used mechanisms now being revealed as deceptive and improper."

What is the company doing at this point?

It has installed longtime AIG exec Martin J. Sullivan, 50, as the new CEO, and named independent director Frank G. Zarb as chairman. In addition, it has launched its own internal investigation, which has so far revealed several arrangements and deals that were not properly accounted for. The company says that its review is not yet complete. Moreover, AIG has pledged to change how it accounts for deferred compensation that's now paid to senior executives through Starr International Co. (SICO) -- one of several controversial private entities that also are under investigation.

What are these private entities and why are they under scrutiny?

AIG has a highly unusual arrangement with three private entities, governed and controlled by Greenberg and other AIG executives. Each serves a different purpose and raises unique concerns. SICO is a holding company that owns about 12% of AIG stock -- making it the company's largest shareholder -- and pays out some of that stock to an elite group of AIG managers as deferred compensation. Greenberg and other AIG directors sit on the board, have large personal stakes, and decide who gets paid what. Regulators believe SICO hides executive pay and takes away powers that should rightly lie with the compensation committee of the board.

C.V. Starr & Co., on the other hand, is a group of agencies that develops business and issues specialized policies for AIG. It's owned and operated by AIG executives -- many of whom perform functions similar to what they do at AIG -- and controls 1.8% of AIG shares. Critics worry that the opaque nature of its transactions, for example, could allow C.V. Starr to become a convenient tool for managing earnings at AIG, which has been a model of earnings consistency in a notoriously volatile industry. The arrangement also creates endless possibilities for conflicts of interest. Says North Carolina State Treasurer Richard H. Moore, who oversees a stake in AIG worth more than $300 million: "I don't think you can have a publicly traded company that allows board members to own a private entity that does business with the publicly traded company. [It's] impossible to know if shareholders are being taken advantage of."

Finally, there's the Starr Foundation, a charitable entity which Greenberg also chairs and which has a 2% share in AIG. It has come under fire for doling out money for political causes and for giving $36.5 million to the American Museum of Natural History shortly after museum President Ellen V. Futter joined AIG 's board.

What pressure does Sullivan now face?

Insiders say the new chief, who began his AIG career at the age of 16, is aggressively leading the charge for changes necessary to create a more transparent organization. But the longtime AIG manager -- formerly a vice-chairman and co-chief operating officer -- is also under scrutiny by regulators. A close confidante of Greenberg, who essentially hand-picked Sullivan as his replacement, he also serves as a director in C.V. Starr and SICO. Sullivan has not been accused of any wrongdoing, but regulators are looking for signs that he knew of or oversaw the dubious transactions. Any hint of that and he, too, could be forced out. An AIG spokesman says Sullivan has no comment on his future or the company's direction while AIG cooperates with investigators.

Is Greenberg out of the picture?

The 79-year-old insurance legend is due to appear before Spitzer for a deposition on Apr. 12 and may face continued scrutiny for his actions, sources say. But Greenberg still retains significant control of AIG through his 1.7% personal shareholding and stakes in the private entities that together own another 15.7%. Although the full extent of his influence is unknown, Greenberg controls 8.3% of SICO's voting stock, is president and CEO of C.V. Starr, where he owns 16.4% of the common stock, and is chairman of the Starr Foundation. The structure of SICO, in particular, has also given Greenberg enormous control because anyone who left the company -- or was fired -- prior to retirement often forfeited lucrative payments. "It was like joining some elite brotherhood where, if you toed the line, you were set for life," says one insider. Investigators and directors may be hard-pressed to force Greenberg out of a private company, and he could continue to exert influence from the background.

Where was the board through this mess?

For years, AIG had a board that was notoriously clubby and close to Greenberg. Says Patrick McGurn of Institutional Shareholder Services: "Was there a reform Hank ever put in place that he liked?" But, thanks to shareholder pressure and new governance regulations, the board has become more independent in recent years. More important, perhaps, the investigations have made directors nervous about their own liability -- and determined to take proactive action to distance themselves from any scandal, insiders say. They even demanded Greenberg's resignation -- an unthinkable act just months ago.

How do regulators or other critics propose to fix these conflicts of interest?

One answer is to disband the entities, ban business dealings with the public company, or force AIG executives to end any direct roles in those companies. While a source familiar with the federal probe says regulators haven't yet demanded any specific action, he notes that "none of this is stuff I've seen in other walks of life."

Is AIG doomed?

Sources close to the investigation are quick to point out that this is no "Enron situation, [although] there were a lot of shenanigans going on. "The insurer sells real products and produces real earnings. The main allegation is that managers went to extreme lengths to smooth those earnings and boost the stock price. Strip out those machinations, and AIG may turn out to be a typical insurer, with big earnings swings up and down, rather than the superior underwriter it appeared to be.

But AIG remains a powerhouse in the industry. It has a diverse mix of industry-leading insurance and financial-services businesses. Moreover, it's a global force with a particularly strong foothold in fast-growing Asian markets, especially China.

At the very least, the company's shares may no longer command the kind of premium that they did during the glory days. Despite the crisis, AIG's stock has been trading at an average multiple of 16.6, vs. 15.1 for the S&P 500 Insurance Industry index. Investors, already irate over losing more than $40 billion since the scandal broke, may have to come to terms with the fact that AIG is just a normal insurer -- subject to the same lousy years and volatility as others. That means more air may still come out of AIG's shares.

But that's without factoring in the substantial hurdles that AIG faces. Transforming a culture as secretive and ingrained as the one that Greenberg built over four decades would be a monumental task for any CEO -- and perhaps an impossible one for a leader who forged his entire career there, as Sullivan did. Moreover, the extent of the company's liability is unknown. There may be huge fines; there could even be more serious charges. Investors can only guess how much that will batter AIG from here.

By Diane Brady and Marcia Vickers with Mike McNamee in Washington

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