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.
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 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.