AIG and Leasing

The information that is coming out about AIG and finite risk insurance is fascinating. It also raises the question of whether the current leasing standard needs a complete overhaul. Based on a NY Times article it appears that AIG used finite risk insurance to get favorable lease accounting treatment. Here is the relevant portion of the article:

International Lease bought a residual value insurance policy - a policy that was meant to cap liability in its leases - from General Re, according to a former senior executive of A.I.G. General Re is the reinsurance unit of Berkshire Hathaway, the holding company run by the billionaire Warren E. Buffett.

International Lease, based in Los Angeles, undertook the transaction to reduce, by at least hundreds of millions of dollars, the amount of debt it had taken on to finance a certain number of aircraft, according to the former executive.

But the transaction also contained a provision in which International Lease effectively guaranteed that General Re would not suffer any losses from any waning residual values, or what the aircraft would be worth when their leases expired.

Not only was International Lease able to reduce its reported liability on the aircraft, but the transaction enabled the company to treat the leases on the planes as finance leases. The transaction allowed a more favorable accounting treatment for the leases that enabled the International Lease to recognize income from the leases more quickly than before.

So it appears that Lease Finance Corp. purchased airplanes on credit and then leased the aircrafts to others. However, in order to get favorable capital lease accounting, it had to structure the deals with higher than normal residual values in order to get above the 90% test.
Lease Finance Corp. did not get the lessee's to guarantee the residual values because then they would not be able to get operating lease treatment (keep the airplane and any related debt off of their balance sheets).

So, Lease Finance Corp. went to General Re and had them guarantee the residual values. It appears that they did this by paying an upfront "insurance claim" on residual value losses to Lease Finance Corp. which turned around and used the claim to pay off some of its debt.

Debt payments were turned into "insurance premiums".


Here is how I think the journal entries would go:

Lease Finance Corp:

airplane debit
debt obligation credit

Lease receivable debit
airplane` credit
Unearned income credit

Cash (insurance claim) debit
???Leasepayment rec. credit

debt obligation debit
Cash (insurance claim) credit