AIG 2005 Annual Report Download - page 90

Management’s Discussion and Analysis of
Financial Condition and Results of Operations Continued
class of coverage to determine the quarter’s total estimated net claims handling. Loss reserve development can also be affected
incurred loss and loss expense. The change in loss reserves for by commutations of assumed and ceded reinsurance
the quarter for each class is thus the difference between the agreements.
net incurred loss and loss expense, estimated as described AIG’s annual loss reserve review does not calculate a range
above, and the net paid losses and loss expenses in the quarter. of loss reserve estimates. Because a large portion of the loss
reserves from AIG’s General Insurance business relates to long-
tail casualty lines driven by severity rather than frequency of
Details of the Loss Reserving Process
claims, such as excess casualty and D&O, developing a range
The process of determining the current loss ratio for each
around loss reserve estimates would not be meaningful. An
class or business segment is based on a variety of factors. These
estimate is calculated which AIG’s actuaries believe provides a
include, but are not limited to, the following considerations:
reasonable estimate of the required reserve. This amount is
prior accident year and policy year loss ratios; actual and
then evaluated against actual carried reserves.
anticipated rate changes; actual and anticipated changes in
coverage, reinsurance, or mix of business; actual and antici-
pated changes in external factors affecting results, such as Volatility of Reserve Estimates and Sensitivity
trends in loss costs or in the legal and claims environment. Analyses
Each profit center’s current loss ratio reflects input from There is potential for significant variation in the develop-
actuarial, profit center and claims staff and is intended to ment of loss reserves, particularly for long-tail casualty classes
represent management’s best estimate of the current loss ratio of business such as excess casualty, when actual costs differ
after reflecting all of the factors described above. At the close from the assumptions used to test the reserves. Such assump-
of each quarter, the assumptions underlying the loss ratios are tions include those made for loss trend factors and loss
reviewed to determine if the loss ratios based thereon remain development factors, as described earlier. Set forth below is a
appropriate. This process includes a review of the actual claims sensitivity analysis demonstrating the estimated effect on the
experience in the quarter, actual rate changes achieved, actual loss reserve position of alternative loss trend or loss develop-
changes in coverage, reinsurance or mix of business, and ment factor assumptions as compared to those actually used to
changes in certain other factors that may affect the loss ratio. test the carried reserves.
When this review suggests that the initially determined loss For the excess casualty class of business the assumed loss
ratio is no longer appropriate, the loss ratio for current business cost trend was approximately six percent. A five percent
would be changed to reflect the revised assumptions. change in the assumed loss cost trend from each accident year
A comprehensive annual loss reserve review is conducted in to the next would cause approximately a $600 million change
the fourth quarter of each year for each AIG General Insurance (either positively or negatively) to the net loss and loss
subsidiary. These reviews are conducted in full detail for each expense reserve for this business. For the D&O and related
class or line of business for each subsidiary, and thus consist of management liability classes of business the assumed loss cost
literally hundreds of individual analyses. The purpose of these trend was four percent. A five percent change in this assumed
reviews is to confirm the appropriateness of the reserves carried loss cost trend would cause approximately a $300 million
by each of the individual subsidiaries, and thereby of AIG’s change (either positively or negatively) to the net loss and loss
overall carried reserves. The reserve analysis for each business expense reserve for such business. The effect of the loss trend
class is performed by the actuarial personnel who are most assumption for the D&O class decreased in 2005 as a result of
familiar with that class of business. In completing these AIG’s change in methodology, as described above, whereby
detailed actuarial reserve analyses, the actuaries are required to claim projections through accident year 2004 are utilized as a
make numerous assumptions, including for example the selec- benchmark for the actuarial indications. For the excess workers
tion of loss development factors and loss cost trend factors. compensation class of business, loss costs were trended at six
They are also required to determine and select the most percent per annum. A five percent change in the assumed loss
appropriate actuarial method(s) to employ for each business cost trend would cause approximately a $250 million change
class. Additionally, they must determine the appropriate (either positively or negatively) to the loss and loss expense
segmentation of data or segments from which the adequacy of reserve for this class. Actual loss cost trends in the early 1990’s
the reserves can be most accurately tested. In the course of were negative for these classes, whereas in the late 1990’s loss
these detailed reserve reviews for each business segment, a costs trends ran well into the double digits for each of these
point estimate of the loss reserve is generally determined. The three classes. The sharp increase in loss costs in the late 1990’s
sum of these point estimates for each of the individual business was thus much greater than the five percent changes cited
classes for each subsidiary provides an overall actuarial point above, and caused significant increases in the overall loss
estimate of the loss reserve for that subsidiary. The ultimate reserve needs for these classes. While changes in the loss cost
process by which the actual carried reserves are determined trend assumptions can have a significant effect on the reserve
considers not only the actuarial point estimate but a myriad of needs for other smaller classes of liability business, the
other factors. Other crucial internal and external factors potential effect of these changes on AIG’s overall carried
considered include a qualitative assessment of inflation and reserves would be much less than for the classes noted above.
other economic conditions in the United States and abroad, For the excess casualty class, if future loss development
changes in the legal, regulatory, judicial and social environ- factors differed by five percent from those utilized in the year-
ments, underlying policy pricing, terms and conditions, and end 2005 loss reserve review, there would be approximately a
38 AIG m Form 10-K