AIG Shocks the Industry with $1.8 Billion After-tax Reserve Strengthening

By | February 24, 2003

Neither the insurance industry nor the stock market was prepared for the announcement made by American International Group recently, that it would “incur a net, after tax charge of $1.8 billion in the fourth quarter of 2002 related to an increase of general insurance net loss and loss adjustment reserves.”

While the company tried to put the best spin it could on the news, indicating that it was simply a result of the “completion of AIG’s annual year-end loss reserve study,” the revelation by the world’s biggest insurer, in terms of capital, that it might have additional gross liabilities of up to $3.5 billion in claims in excess of its original estimates sent shock waves around the globe.

The avalanche of commentary about it has obscured exactly what AIG said. Chairman Maurice “Hank” Greenberg, laid out what the company had done and why in a written statement that accompanied the announcement: “AIG annually reviews and assesses its general insurance loss reserves and makes necessary adjustments as required. As part of the process, we take into consideration a number of external factors such as litigation trends. Having completed our review, we confirmed that judgments and settlements reached record high levels of severity and frequency in the course of 2002, and claims increased across a number of casualty lines. As a result, AIG has decided to make additions to its general insurance loss reserves.”

That may have explained the “why” from AIG’s viewpoint. What remains to be elucidated is how such a difference could have arisen so suddenly, and why it wasn’t foreseen, or some warning given.

Greenberg then described the “what” as follows: “Approximately 60 percent of the reserve increase will be applied to excess casualty loss reserves, including excess workers’ compensation; 25 percent to directors and officers liability; and 15 percent to other casualty, including healthcare liability.” He noted that “Virtually all of the reserve additions related to 2002 developments pertain to accident years 1997 through 2001. Since 2000, rates have risen in these classes of business after more than a decade of erosion, and are continuing to rise in 2003.”

He laid the blame directly on the U.S. system of personal injury litigation, stating, “Unlike the abrupt burst of the asset bubble, the liability bubble has yet to contract in our economy. The rampant rise in jury awards and a tort system in urgent need of reform are important aspects of the overall U.S. liability picture. AIG is working hard, as are others, to achieve meaningful tort reform in the current session of Congress.”

Perhaps those efforts will prove successful, but so far no one has proposed a viable alternative to the tort system, which is the root cause of the problem. It’s not all the fault of the powerful trial lawyers’ lobbies, either. Unlike most other modern industrialized countries, the U.S. has never developed an effective alternative body of social legislation to care for persons injured on the job, in traffic accidents, by fires, landslides, contaminated products or any other injury. Except for workers’ compensation, which has its own problems, the system remains based on identifying the party (ies) who caused the harm and assessing the payment of damages. Other countries go about it differently.

In France, for example, an accident victim is treated free of charge, or expenses are reimbursed, by the Securité Social, or “Secu,” the public health care system. His wages are paid as well while he is unable to work, and if the accident causes death or permanent disability the injured person, or his family, receives compensation for the loss based on his earnings and pension rights.

Legal actions can be brought, particularly by the Secu, to recover those costs from the person(s) who caused the injury, but the equivalent of losses for “pain and suffering” are much less than in the U.S., and punitive damages don’t exist.

Until the U.S. has a similar system, which frankly appears very unlikely, the only alternative Greenberg and those who support “tort reform” can offer are limits on the amounts of damage awards within the existing system and a curtailment of class actions.

AIG’s announcement also triggered a wave of speculation on two other fronts—asbestos and the stock market. Greenberg took pains to note that; “This action does not include an asbestos reserve increase. AIG’s reserves for asbestos-related claims continue to be appropriate.” He reiterated that the company’s exposure is limited, and that its policies have excluded any coverage for it since 1985.

He may be right, but a host of commentators, analysts and pundits unleashed a flood of speculation about what AIG might eventually have to do about asbestos, if he’s wrong. Greenberg’s remarks also acted as a catalyst, rekindling all the doubts about what the rest of the industry was going to do about rising claims figures. Even though companies like Chubb, Travelers, The St. Paul and others have substantially increased their reserves for asbestos, are they now going to face the problems AIG addressed? Conning Research came out with a report indicating that insurers needed to add $38 billion to cover all their claims—not including asbestos. Tillinghast-Towers Perrin just issued a study indicating that the U.S. tort system cost $205 billion in 2001, a 14.3 percent increase over 2000, and that the trend was expected to continue and even accelerate.

Figures like that are a powerful argument not only for reforming the tort system, but also for the passage of legislation to help people who are presently afflicted by diseases caused by asbestos.

Finally there’s the stock market. Feb. 4, 2003 was not Oct. 29, 1929, but a number of commentators had a hard time telling the difference. True, AIG shares sank like a rock, hitting their lowest level in four years, and dragged a lot of other insurance stocks along with them. But, unless there really is more bad news, it doesn’t have a serious affect on the company.

It hasn’t been downgraded, although Fitch did put its senior debt ratings on credit watch. Standard & Poor’s said plainly that it “is not taking any rating action on AIG or its subsidiaries as a result of this charge.” It then went on to note that, “Through Sept. 30, 2002, AIG’s GAAP equity grew 12.7 percent to $58.8 billion based on solid operating earnings, and GAAP equity is expected to be up from that figure at year-end.”

To put it in another perspective—Chubb’s market cap is around $8.6 billion, Travelers $15.76 billion and St. Paul $6.9 billion. Even after all the bad news, and a fall in its share price of over 50 percent since it reached its high in 2000, AIG’s market cap is still $123.7 billion.

AIG is to the insurance industry what GM used to be to the automobile industry and AT&T to telephones—the gold standard, absolute solidity. That’s no longer the case, and the reserve increase has demonstrated that sometimes even the best run companies have breakdowns.

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