AIG 2008 Annual Report Download - page 95

10 percent of the losses are expected to be reported at the end of the accident year, the expected loss ratio would be
applied to the 90 percent of the losses still unreported. The actual reported losses at the end of the accident year
would be added to determine the total ultimate loss estimate for the accident year. Subtracting the reported paid
losses and loss expenses would result in the indicated loss reserve. In the example above, the expected loss ratio of
70 percent would be multiplied by 90 percent. The result of 63 percent would be applied to the earned premium of
$10 million resulting in an estimated unreported loss of $6.3 million. Actual reported losses would be added to
arrive at the total ultimate losses. If the reported losses were $1 million, the ultimate loss estimate under the
“Bornhuetter Ferguson” method would be $7.3 million versus the $7 million amount under the expected loss ratio
method described above. Thus, the “Bornhuetter Ferguson” method gives partial credibility to the actual loss
experience to date for the class of business. Loss development methods generally give full credibility to the reported
loss experience to date. In the example above, loss development methods would typically indicate an ultimate loss
estimate of $10 million, as the reported losses of $1 million would be estimated to reflect only 10 percent of the
ultimate losses.
A key advantage of loss development methods is that they respond quickly to any actual changes in loss costs
for the class of business. Therefore, if loss experience is unexpectedly deteriorating or improving, the loss
development method gives full credibility to the changing experience. Expected loss ratio methods would be slower
to respond to the change, as they would continue to give more weight to the expected loss ratio, until enough
evidence emerged for the expected loss ratio to be modified to reflect the changing loss experience. On the other
hand, loss development methods have the disadvantage of overreacting to changes in reported losses if in fact the
loss experience is not credible. For example, the presence or absence of large losses at the early stages of loss
development could cause the loss development method to overreact to the favorable or unfavorable experience by
assuming it will continue at later stages of development. In these instances, expected loss ratio methods such as
“Bornhuetter Ferguson” have the advantage of properly recognizing large losses without extrapolating unusual
large loss activity onto the unreported portion of the losses for the accident year. AIG’s loss reserve reviews for long-
tail classes typically utilize a combination of both loss development and expected loss ratio methods. Loss
development methods are generally given more weight for accident years and classes of business where the loss
experience is highly credible. Expected loss ratio methods are given more weight where the reported loss experience
is less credible, or is driven more by large losses. Expected loss ratio methods require sufficient information to
determine the appropriate expected loss ratio. This information generally includes the actual loss ratios for prior
accident years, and rate changes as well as underwriting or other changes which would affect the loss ratio. Further,
an estimate of the loss cost trend or loss ratio trend is required in order to allow for the effect of inflation and other
factors which may increase or otherwise change the loss costs from one accident year to the next.
Frequency/severity methods generally rely on the determination of an ultimate number of claims and an
average severity for each claim for each accident year. Multiplying the estimated ultimate number of claims for each
accident year by the expected average severity of each claim produces the estimated ultimate loss for the accident
year. Frequency/severity methods generally require a sufficient volume of claims in order for the average severity to
be predictable. Average severity for subsequent accident years is generally determined by applying an estimated
annual loss cost trend to the estimated average claim severity from prior accident years. Frequency/severity
methods have the advantage that ultimate claim counts can generally be estimated more quickly and accurately than
can ultimate losses. Thus, if the average claim severity can be accurately estimated, these methods can more quickly
respond to changes in loss experience than other methods. However, for average severity to be predictable, the class
of business must consist of homogeneous types of claims for which loss severity trends from one year to the next are
reasonably consistent. Generally these methods work best for high frequency, low severity classes of business such
as personal auto. AIG also utilizes these methods in pricing subclasses of professional liability. However, AIG does
not generally utilize frequency/severity methods to test loss reserves, due to the general nature of AIG’s reserves
being applicable to lower frequency, higher severity commercial classes of business where average claim severity is
volatile.
Excess Casualty: AIG generally uses a combination of loss development methods and expected loss ratio
methods for excess casualty classes. Expected loss ratio methods are generally utilized for at least the three latest
accident years, due to the relatively low credibility of the reported losses. The loss experience is generally reviewed
separately for lead umbrella classes and for other excess classes, due to the relatively shorter tail for lead umbrella
business. Automobile-related claims are generally reviewed separately from non-auto claims, due to the shorter-tail
AIG 2008 Form 10-K 89
American International Group, Inc., and Subsidiaries