AIG 2009 Annual Report Download - page 98

American International Group, Inc., and Subsidiaries
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 nature of
the automobile-related claims. Claims relating to certain latent exposures such as construction defects or exhaustion
of underlying product aggregate limits are reviewed separately due to the unique emergence patterns of losses relating
to these claims. The expected loss ratios utilized for recent accident years are based on the projected ultimate loss
ratios of prior years, adjusted for rate changes, estimated loss cost trends and all other changes that can be quantified.
The estimated loss cost trend utilized in the year-end 2009 reviews averaged approximately five percent for excess
casualty classes. Frequency/severity methods are generally not utilized as the vast majority of reported claims do not
result in a claim payment. In addition, the average severity varies significantly from accident year to accident year due
to large losses which characterize this class of business, as well as changing proportions of claims which do not result in
a claim payment.
D&O: AIG generally utilizes a combination of loss development methods and expected loss ratio methods for
D&O and related management liability classes of business. Expected loss ratio methods are given more weight in the
AIG 2009 Form 10-K 90