Barron’s Misses the Mark on AIG

8 May

In a downbeat article about AIG this weekend, Barron’s stated that “Chartis [AIG’s international property and casualty operation – and largest unit made] additions to its reserves…in nine out of 10 years. This means, of course, that claims overwhelmed the premiums they had collected…” Emphasis mine. As a loyal reader of the weekly magazine, I was a little disappointed at their characterization of reserving. Hopefully, this post will provide a little more clarity on the practice of reserving. While AIG may have taken writedowns, Barron’s incorrectly concludes that claims overwhelmed premiums. This gives the reader the false impression that any time an insurance company adds to reserves they are taking a loss. This is not the case.

Black Box

Here is a quick primer for the uninitiated. Let me start by saying that in insurance, like many other financial firms, “earnings are what management says they are – until they aren’t.” What I mean by this is that management holds the key to the black box. For example, take a school bus operator who purchases insurance for his vehicles. In a hard market (that is, a market which premiums are high), the insurance company can exclude certain terms, such as actions taken by the bus driver (think harming a child on his/her bus – like sexual harassment). In a “soft market” (when premium volume is falling), the easiest way to maintain the top line – continuing with my example – is for the carrier to add coverage of the bus driver’s actions. This allow the carrier to keep the premium the same as the previous year – sales will show a flat-line. If you read the fine print, you may learn that “terms and conditions” were loosened. However, you – the studious reader of SEC filings such as 10Q’s and 10K’s – won’t know the full extent to which the risk has truly increased.

Reserves

Reserves are set aside to pay for future claims. In good years, insurance companies tend to put away more reserves than necessary. This has two effects, it lowers the tax burden and it smoothes earnings. This occurs because reserves are an expense item and reduce income. Earnings smoothing occurs because, in bad years, those reserves can be “released” or added back to earnings. This makes it appear as though losses in the current year are not as bad. Without taking you deep into the weeds, here is an overly simplistic example:

You buy car insurance and pay the carrier (like Allstate) $1,000. The insurance company expects to pay out $500 in claims (on average) for drivers like you. Thus, the insurance company will put $500 of the $1,000 you paid into reserves. To make the numbers easy, let’s assume that the other expenses associated with getting you to buy a policy from them (advertising, paying your broker, ect.) costs $300. That means the insurer made $200 on your policy. Fast forward to the end of the year. Congratulations, you didn’t have an accident! The insurance company is now free to add back that $500 to their earnings. The reserves are said to be “released.” Now let’s say your neighbor’s son gets into a minor fender bender. They have the same policy as yours. The payout on their claim is $600. The insurance company now must add $100 to reserves. Did they lose money? No. In fact they still made $100 on the policy. If the claim had been over $300, then yes, there would have been a loss.

A good way to review reserves is to look at a company’s loss triangles. If they are not in the Form 10K, they can be found in Schedule P of the Statutory Statements that every insurance company must file with the insurance commissioner of their home state – these are the insurance equivalent of quarterly reports. In the schedule, you will be able to follow how well an insurance company did on an underwriting year basis. This will give the reader a better understanding of which years they “cut corners” because it will show when reserves needed to be added by year the policy was written.

As you can see, reserving is not as cut and dry as Barron’s would have you believe. Moreover, insurance investing is tricky – just as Warren Buffet.

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5 Responses to “Barron’s Misses the Mark on AIG”

  1. Nick Gogerty May 9, 2011 at 9:59 am #

    Quick question. I am studying insurance etc. and am curious. Is there a tax advantage to over allocating reserves in a low yield environment or another strategic rationale other than actual underwriting loss anticipation?

    another question could the reserves shift be made in anticipation of portfolio losses / low gains as a way of protecting ratings? These might be silly questions, but thought I would ask and learn as many firms right policies at or near the margin hoping to profit from portfolio gains on the float, which would have been easier earlier for heavy fixed income portfolios. Thanks.

    • georgetownjack May 9, 2011 at 10:20 am #

      Thanks for the insightful and very good questions – the answer is no. In fact, you are actually taxed on reserves! You don’t receive the tax shield until the actual claim is paid and reserves are lowered. The IRS ostesnibly is trying to keep companies honest. So there are two sets of books, tax and accounting (which is why Statutory Filings are important – they are essentially the cash based books).

      As for the reserve shift question – no. Rating agencies don’t like companies that can’t reserve properly. Moreover, outside actuaries provide their best estimates for where reserves should be set. If a company goes outside of the range, the agencies would call it into question. So you should look at where the range is set, if the companies are at the low end of the range, you should ask why.

      • Nick Gogerty May 9, 2011 at 11:30 am #

        Thanks. I learn something everyday, much appreciated.

        I curious about your thoughts on the NYT article on state regulators looking for business.
        http://www.nytimes.com/2011/05/09/business/economy/09insure.html

        Regulatory bingo seems to be going on in the US insurance industry. A gresham’s process in insurance could be under way.

        If states are now chasing insurers for business and chasing business at the underwriter, re-insurer or regulatory level it seems bad. This would be bad business for everyone, quick money today leading to catastrophe tomorrow.

        Could these event unfold like a Gresham’s process as regulatory shopping becomes a way to increase ROE’s attracting looser regulation to bring in more premium in the form of captives and re-insurers. Those with the lowest standards gain the most business. It would be tough for a major insurance exec to explain to their board, why they aren’t “making” money like everyone else playing the game.

        any thoughts on this? Chasing business always seems dangerous in banking and insurance. Just curious about what the natural breaks on such things would be? Ratings, negative analysts?

        • georgetownjack May 9, 2011 at 11:58 pm #

          Captives are a topic for another time. I wouldn’t do the discussion justice in this small space. There is definitely a time and a place for them, as with most things – it’s about moderation. If the rating agencies weren’t asleep at the wheel, it would be possible to catch some of the abuses sooner. One can dream, right!

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