What's up guys and welcome back to wall street millennial on this channel, we cover everything related to stocks and investing. Imagine that you are in charge of running a company worth hundreds of billions of dollars. If you had an extra 500 million dollars of cash lying around. What would you do with it? Would you commission, an iconic skyscraper for your offices, maybe left the empire state, building that historic skyscraper costs about half a billion dollars to construct or 41 million dollars back when it was built in the 1930s adjusting for inflation? Would you require a smaller company to boost the financial performance of your main company, or maybe you'd rather use it for something more conservative? If you lead an insurance company, you could use it to bolster your company's loss reserves in case a hurricane hits and the company receives an influx of insurance claims.

Unfortunately, most companies don't regularly find themselves in a position with an excess half billion dollars to allocate it's much more likely to have a problem that requires money to resolve about 20 years ago. That's the situation that american international group was in. They were coming off a decades-long hot streak of exploding, revenue and profits, but with the exponential growth they found it increasingly difficult to keep up with a constantly rising expectations when a company gets so big that they start to saturate their own market. Exponential growth cannot last forever, there's simply not enough demand in their entire industry for them to keep growing at the same rate.

Every single year. Faced with this pressure, aig held nothing sacred and started dipping into parts of their balance sheet that they shouldn't have in order to inflate their profits. When analysts realized that aig was doing this, their stock got punished, so if they couldn't get away with inflating their profits by cannibalizing their balance sheet, they decide to pump fake money into their balance sheet. At the same time, ultimately, they conjured up half a billion dollars of fake money to duke their shareholders in wall street.

The lengths they went to in order to make this financial facade are almost comically blatant if it weren't for the unthinkable, destruction and value that it caused we're talking about the infamous aig accounting scandal of 2000.. Before we get into the fraud itself, we need a brief refresher on the insurance industry and financial reporting of insurance companies in the u.s insurance companies generate value and make money by reducing the aggregate risk incurred by the population of policyholders. When you buy an insurance policy, you are paying a fixed rate for protection from unknown future losses on average policyholders pay more in premiums than they receive in claims. This is how the insurance companies make money, but that doesn't mean that policyholder is on the losing side of the trade.

Unlike some other parts of the finance industry, insurance is not a zero-sum gain. Policyholders gain value from owning a policy because, in the event that an unforeseen cost occurs, the losses of the policyholder may be more detrimental than the nominal cost of the event. Consider this example: a hypothetical real estate company owns an apartment building in a northern u.s state. In the winter, the sidewalk in front of the apartment frequently freezes over if a pedestrian were to slip on the ice and get injured, the resulting lawsuit may bankrupt the company putting them out of business forever.

However, by taking out an insurance policy that covers this liability, the company can preclude such a situation from ever bankrupting the company, even if the statistical probability of this type of lawsuit is so low, such that on average, the insurance premiums paid every year are more than The cost of the lawsuits owning the insurance policy is a value add to the real estate company. In this example, the insurance company makes money because they collect more money and premiums than they have to pay out in claims. The real estate company gains value because without the insurance, if they do get hit with a lawsuit, not only would it cost them the amount of the lawsuit, but also the cost of not being able to do business ever again. So the value that the insurance industry provides is that large infrequent costs can be more damaging to a company than the actual dollar amount of the costs.

This even applies to insurance companies themselves. There's an entire industry called reinsurance, which basically is an insurance market for insurance companies. If an insurance company receives too many claims at the same time, for example, if there's a hurricane in their insured area, they might not be able to service all those claims. Reinsurance is the practice of trading insurance policies between two insurers to manage this risk.

Big companies plan the reinsurance industry, including names like berkshire hathaway, aig's, half billion dollar accounting scandal was intimately related to reinsurance. In the words of the sec aig's reinsurance transactions with general reed corporation, a reinsurance company were designed to falsely inflate aig's loss reserves by 500 million dollars. Loss reserves are cash reserves that insurance companies keep on their balance sheets for the purpose of paying out insurance claims. Aig wanted to inflate this number to address analyst criticism that their reserves have been declining too much around the beginning of 2001.

Aig entered into two fake reinsurance transactions with gen re that had no real economic substance, but were instead designed to allow aig to improperly add a total of 500 million dollars in fake loss reserves to its balance sheet. The transactions were motivated in order to quell the analyst criticisms of aig aig and gen re structured, two distinct reinsurance transactions. The specific purpose of the transactions was to make the appearance of support for aig to add a total of half a billion dollars in fake loss reserves to aig's balance sheet. However, in reality, the transaction entailed january paying 500 million dollars in purportedly reinsurance premiums.

In return. For aig re-ensuring, 500 million dollars of risk, in essence, 500 million dollars was sent from gen re to aig and then immediately back to gen 3. There was no legitimate net payment between the two parties, except for a 5 million fee that aig paid to generate for executing the transactions. They were specifically designed to appear like genuine reinsurance transactions, creating the illusion of a better than reality, accounting position aig and gendry even created a fake paper trail of false communications that gave the appearance that january had solicited the reinsurance transactions with aig.

At one point, gen re sent to fax to aig appearing to ask aig for their quote, help and support unquote in doing these transactions. In reality, aig was a driver of them in the quarter before these phony transactions were made. Aig's financial reports showed a decrease of nearly 60 million dollars in general insurance reserves. This drew criticism from many wall street analysts who accused aig of releasing loss reserves in order to inflate profits after a six percent drop in stock price.

Following the third quarter, 2000 earnings release aig ceo called generis ceo to propose the fake transactions aig explicitly told gen re that they did not want to take on any actual insurance risk from the proposed transactions any legitimate. Such transactions would have involved aig taking on risk, but because aig was a major source of january's business. Gen re did not want to deny the proposal. The sham transactions with january only made up one out of 66 different items which aig eventually had to restate on its financials one of the most significant other items involved, a company partially owned by aig called capco.

The goal of this was to make insurance losses less financially embarrassing to aig the sham was structured as follows: capco's preferred shareholders was an aig subsidiary through this subsidiary aig ceded insurance underwriting losses to capco in return for capital investments into capco, in other words, aig transferred Insurance losses to capco and repaid those losses through other means, while in terms of cash balances, there is no net benefit to either party. This allowed aig to report those insurance losses instead as capital losses on their investment in capco, as an insurance company aig having high insurance losses, is embarrassing and reflects poorly on the quality and profitability of their insurance operation. Capital losses, on the other hand, can be affected by anything, including simply market fluctuations. For this reason, capital losses are less harshly viewed by wall.

Street analysts than insurance losses are aig, ultimately transformed 200 million dollars of insurance losses into capital losses by this sham arrangement. In 1991, aig established union xs reinsurance company, an offshore re-insurer for similar purposes, aig, ultimately ceded approximately 50 reinsurance contracts to that company for its own benefit. Although aig controlled union excess, they improperly failed to consolidate union excesses. Financial results within their own, in fact, aig even took steps to conceal their control over union excess from auditors and regulators.

As a result of these actions and other accounting, improprieties aig fraudulently improved its apparent financial condition in the early 2000s regulators, caught on to aig's, gimmicks after being informed by regulators of investigations into their misconduct, aig eventually carried out their own internal investigation. The internal investigation led to a restatement of its prior accounting for 66 different transactions in its restatement aig admitted that it's accounting for certain transactions had been improper and that the purpose behind some of those transactions was to improve financial results. That aig believed to be important to the stock market. For example, they said that certain transactions quote involve documentation that did not accurately reflect the true nature of the arrangements and misrepresentations to members of management, regulators and aig's independent auditors unquote.

Aig subsequently revises shareholders equity downward by approximately 2.26 billion dollars or 2.7 percent in 2006. Aig settled the sec on the accounting scandal. The resulting court order stipulated that aig pay a civil penalty of 100 million dollars and discourage ill-gotten gains of 700 million dollars. Aig agreed to certain undertakings to ensure that future accounting gimmicks will not happen and also replace their ceo and cfo.

The billion dollar series of aig accounting scandals from the 90s and early 2000s is often forgotten by the general public because of their bankruptcy in 2008, 2008 saw aig destroyed by their own enthusiasm in chasing profitability at the expense of risk management. They sold insurance on billions of dollars worth of collateralized debt obligations or cdos. When the real estate market collapsed, they found themselves vastly unprepared to service their liabilities. As a result of that debacle, they almost took down the entire financial sector if it weren't for historic government bailout.

But it's important for history's sake to remember that 2008 was not the first time that aig got wrapped up in a financial scandal at the billion dollar scale. Alright guys that wraps it up for this video did you remember aig's non 2008 financial woes before watching this video? Let us know, in the comments section below also make sure to smash that like button and subscribe, so you don't miss future videos like this one. In the meantime, thank you so much for watching and we'll see in the next one wall, street millennial signing out.