AIG stumbles over its casualty business and finally reacts
The insurer’s management claims that the actions taken in recent months suffice to turn around the business, but only time will tell.
While presenting a full year and fourth quarter net loss on Feb. 15, executives tried to explain why it took the company several years to realise the severity of the business deterioration and purchase an adverse development cover.
AIG recorded a net loss of $3.04 billion for the fourth quarter of 2016, down from the $1.84 billion loss it made in the same period of 2015. The results were impacted by a $5.6 billion prior year adverse reserve development, driven by the US casualty operations. It was high time. In the fourth quarter of 2016, total commercial insurance combined ratio was 241.6 percent, up from 163.3 percent in the same period a year ago.
For the full year of 2016 AIG booked a net loss of $849 million compared to a net income of $2.20 billion in 2015.
In addition to the reserve increase, AIG entered into an adverse development reinsurance agreement with National Indemnity Company, a Berkshire Hathaway subsidiary, in the first quarter of 2017. The agreement retroactively covers the majority of US long tail lines reserves for accident years 2015 and prior.
The consideration for this agreement is $9.8 billion payable in full by June 30, 2017, with interest at 4 percent per annum from January 1, 2016 to date of payment.
AIG is paying a “hefty sum” for the protection, CreditSights analysts Rob Haines and Josh Esterov commented in a note.
Although the decline in the US casualty market has been going on for several years, AIG’s management only realised the severity of the problem in the fourth quarter of 2016.
One factor delaying a reaction was, at least at the beginning, the fact that the business appears better in a high interest rate environment which allows for net investment income to offset a higher combined ratio, CEO and President Peter Hancock explains during the presentation. But from 2013 on a continued quantitative easing and very low interest rates made the business much less attractive, Hancock notes. In addition, there was a recovering economy, which pushed up car miles driven and economic activity, causing an uptick in frequency and severity of losses, Hancock says. There was therefore a cyclical element affecting loss cost trends and a persisting challenge on the net investment income, he concludes.
But AIG already suspected that something was going badly wrong, and this was confirmed through a review of the operations in the second half of 2016. It revealed that there was an increase in frequency and severity of claims in US casualty which became more material in the third quarter and accelerated in the fourth quarter, causing AIG to increase its trend of loss development factors across those lines, CFO Sid Sankaran explains. In addition, there was an increase in both paid and incurred claims for recent accident years, particularly 2015, in excess casualty, Sankaran notes.
The 2016 reserve study found a significant increase in actual claims vs. actuarial estimates with severity trends in US auto, medical malpractice and excess casualty impacting most recent accident years.
After the review, the accident year loss ratios in commercial insurance were significantly revised upwards for the years back to 2011, according to the 2016 results presentation.
While the accident year loss ratio would, for example, have been at around 61 percent in 2016, after the review it stood at 66.7 percent.
But why did it take AIG so long to react?
“Given the long standing client relationships and longstanding presence in lines of businesses that were affected you have a lot of inertia,” Hancock explains.
AIG has, however, during the past years been reducing its exposure to the problematic lines of business. “In 2004, we were effectively a commercial casualty portfolio that wrote some other business,” comments Robert Schimek, CEO of Commercial. “We wrote $15 billion of US casualty business representing 58 percent of our total portfolio.”
In comparison, “in 2016 we wrote $3.3 billion of net written premiums [commercial casualty] representing 21 percent of our commercial portfolio. In 2017 we anticipate writing 2.5 billion dollars of net written premiums in commercial casualty,” he notes.
While the casualty book could theoretically have been reduced faster, this would likely have had negative consequences in other lines, the executives suggest.
“The nature of our business is of very interconnected nature when we think about it from the perspective of our client,” Schimek explains, pointing to the fact that 90 percent of AIG’s major account clients have revenues of over $500 million. These are long-term clients to which AIG’s relationship is not only restricted to one line, but crosses multiple lines of business with various degrees of profitability, he notes.
For AIG executives the way the casualty business issues have been addressed was therefore appropriate, because as a result, AIG retained over 92 percent of its best clients. Hancock notes: “If we had tried to shrink it faster, the number [of retained best clients] might have been a lot lower and that might have cost us a lot more in terms of profitable financial lines and other lines of business.”
Nevertheless, analysts were wondering if a decision on a reinsurance solution could have had been taken earlier, which could have reduced the damage.
“While we have been considering an adverse development cover for some time and we initiated our exploration of this at the beginning of the  year, it was only when we concluded our reserves studies after Christmas that it became clear to us that this was a transaction that made excellent economic sense,” Hancock says.
Total full-year 2016 booked adverse development on subject lines of $5.3 billion was included under, and will be to 80 percent, or $4.2 billion, covered by the adverse development reinsurance agreement with National Indemnity Company, according to AIG.
“The economics and the reduction in risk associated with this agreement will provide benefits for many years to come. With lower risk of impairments to book value, higher quality earnings, ultimately a lower cost of capital,” Hancock comments.
He notes that the trends witnessed in US casualty were broad and were materially impacting the overall market with rates at inadequate levels. “What we have learned recently confirms our existing strategy to adjust volumes, limit and increase rates in our US casualty book, maintaining our focus on our most valued clients,” Hancock says.
Sankaran chimes in: “We expect that this transaction will dramatically reduce operating earnings volatility, and improve ROE in the long term.”
As a consequence of the insight gained through the review, AIG also took a series of other measures to improve the performance of the US casualty business.
AIG is negotiating rates harder with clients and it claims to have managed to achieve increases over several quarters.
In addition, AIG is shifting its casualty business away from its US to become more internationally focused as the financial lines in international casualty business appear to be more valuable.
Furthermore, the company is prioritising value creation and utilising more rigorous data and pricing tools to enhance the quality of its portfolio.
For this purpose, AIG is cooperating with Swiss Re not only sharing the risk but working together to bring data, tools and additional expertise to design a long-term path for sustainable progress in US casualty.
“I am confident that our actions taken puts us on a path to better quality earnings, growth in earnings as we move forward,” Sinkaran says.
It remains unclear if the actions taken will also convince ratings agencies such as AM Best, which placed the financial strength ratings (FSR) of AIG and its insurance subsidiaries under review with negative implications because of concerns over its reserves in January.
The rating agency said the 'under review' status followed AIG’s announcement that its fourth quarter 2016 financial statement would include a material adverse reserve adjustment, as well as a capital supporting reinsurance transaction for its US commercial business, referring to the Berkshire Hathaway deal.
But Hancock remains confident: “With the extremely strong holding company liquidity position we put the financial strength of the subsidiaries at the top of the hierarchy of goals in the immediate term to maintain utter confidence in our claims paying ability.
“I am very hopeful that we’ll achieve a good outcome with all the ratings agencies including AM Best.”
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