Who’s next in casualty?

The insurance sector seemed relatively immune to the sub-prime plague that was spreading across global financial markets. Until last week when AIG, the world’s largest insurer, announced the biggest sub-prime hit so far.

European insurance stocks fell on the news of $5bn (£2.6bn) losses in one of its investment portfolios.

And on top of the this, Tom Cholnoky, analyst at Goldman Sachs, estimated that AIG could suffer an additional $5bn loss for December – giving a fourth-quarter write-down of about $10bn.

XL and Swiss Re have also recently announced big hits: $1.5bn and $1.1bn respectively. And it seems likely that others will follow.

The consequences can be severe. Since the write-down was announced by AIG, Fitch, Moody’s and Standard & Poor’s have all hinted at a possible ratings downgrade.

AIG’s internal auditors and accountants had originally estimated the write-down at $1bn. But when external auditor PricewaterhouseCoopers (PWC) took a look at the books, it upped the estimate to a whopping $5bn.

PWC increased the initial estimate because it was not happy with the internal auditor’s assessment of one segment of AIG’s investments – the laboriously named ‘super senior credit default swap portfolio’.

In fact, PWC said AIG had “a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation” of this portfolio – strong words indeed.

The Financial Reporting Council (FRC) is the UK’s independent regulator for corporate reporting. At the end of last year, it called for extra vigilance during the credit crunch and released guidelines to corporate auditing committees.

A spokesman said: “Recent credit market conditions mean that the risks to confidence in corporate reporting and governance are higher than they have been for some years. These increased risks require additional diligence on the part of preparers of accounts, members of audit committees and auditors this year.”

In January, the Auditing Practices Board (APB) – a division of the FRC – released a bulletin advising auditors on credit crunch issues.

It said that the risk of misstatements in financial reports had increased due to current credit conditions, as had the potential for miscalculating the fair value

of assets.

The APB said: “For some investments there may be a severe curtailment or cessation of market trading, introducing particular difficulties for valuation measurements.”

The question of what is fair value relates directly to AIG’s problems. The securities in question, credit default swaps (CDS), had suffered a sharp fall in trading, which made them difficult to value. Because assets in an investment portfolio, or losses on these assets, cannot always be given a precise value, they are instead accorded a fair value by the company.

The methods involved when setting this value are therefore key and, if the methodology is found to be lacking, the eventual valuation may not be accurate.

It is the task of both internal and external auditors to decide whether the methodology is good, but not to decide what is fair value. A spokesman from the Institute of Internal Auditors said: “Internal audit does not exist to make financial calculations and forecasts. That is a job for the senior management team who, in [AIG’s] case, are taking issue with their external auditors.”

Internal auditors monitor the major risks facing their organisation, and provide its audit committee with an independent view of how well these risks are being managed. They are concerned with all types of risks, including financial risks, but unlike external auditors, these are not their only focus. Internal audit may be provided by in-house staff, or by an outsourced team. Either way, they usually report directly to an audit committee.

The spokesman continued: “It would be interesting to know to what extent the internal audit function at AIG had highlighted the risks associated with the techniques used and to what extent any concerns raised were addressed.”

One suggestion is that AIG’s internal accountants did not look outside the box, so to speak, using only internally generated valuations without also looking at market valuations – and the flaw in the methodology was missed by the internal auditors, but picked up instead by PWC.

There has been no suggestion that AIG was trying to cook the books. External auditors are regularly called by companies to ensure compliance with both legal and regulatory requirements. In this case, PWC spotted the weaknesses in the course of a routine audit, and AIG reported back promptly.

Other insurers in the market may well be worried about the prospect of external auditors uncovering poor methodology in their own portfolio valuations.

Aggressive accounting practices have caused write-downs in the past as companies try to hang on to investors. Also, asset valuation itself is difficult in the current climate, and write-downs may occur simply because one valuation method does not give the same result as another.