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AIG reserve charge to be offset by NICO adverse development reinsurance

14th February 2017 - Author: Steve Evans

Insurer AIG has reported its latest set of results and a significant loss, largely due to adverse reserve developments, demonstrates the importance of the recently completed retroactive adverse development reinsurance agreement between Warren Buffett’s Berkshire Hathaway and the firm.

American International Group (AIG) reported yet another quarterly loss, as the company’s reserve development showed that claims experience continues to worsen on some of its legacy business.

But luckily for AIG it now has a reinsurance agreement that retroactively transfers a large proportion of the adverse reserve development to Warren Buffett’s Berkshire Hathaway subsidiary National Indemnity Company (NICO), which likely makes the loss a little more palatable in the eyes of AIG’s shareholders.

AIG reported a loss of $3.04 billion for Q4 2016 as the company recorded a $5.6 billion or ($3.56) per share hit from prior year adverse reserve development in the fourth quarter.

AIG President & CEO Peter Hancock explained that the firm sees the reinsurance and these reserve strengthening exercises as a definitive response to “emerging severity trends that we believe are materially impacting the overall U.S. Casualty market.”

RMS

That suggests AIG may not be the only company which will find it needs to significantly strengthen its reserves, although to date no other company has made such huge moves to shore up legacy claims experience as the insurer has.

With the new retroactive adverse development reinsurance in place, thanks to NICO and Warren Buffett, AIG finds itself in a better position than the reserve charge and fourth quarter loss would lead you to believe.

Hancock explained that; “The comprehensive adverse reserve development cover significantly reduces the risk of further reserve additions in some of the most volatile lines,” adding that “Going forward, we expect to see the results from our improved underwriting platform, reduced expense base, and the strong improvement in our business mix.”

The adverse development reinsurance plays a significant role in this, offloading 80% of AIG’s U.S. casualty insurance reserve development hit (from accident years 2015 and prior) to the reinsurer NICO.

The company explained; “Total full-year 2016 adverse development on subject lines of $5.3 billion is included under, and will be 80%, or $4.2 billion, covered by the adverse development reinsurance agreement with National Indemnity Company.”

“This agreement covers roughly half of total Commercial Insurance loss reserves at the company and should generate a deferred pre-tax gain before discounting of approximately $2.6 billion in the first quarter of 2017,” the company continued.

Rating agency Standard & Poor’s noted that “generally accepted accounting principles accounting does not fully reflect the underlying economics of the reserving risk transfer.”

S&P explained that AIG will book some of the benefits in the coming quarter. “The ADC treaty will be accounted for in first-quarter 2017 as a retroactive reinsurance agreement, and at that point AIG will recognize a deferred gain on contract of about $1.1 billion,” S&P explained.

Going forwards AIG will still have $9 billion of adverse development reinsurance limit available to cover reserve developments, split $7.2 billion to NICO, $1.8 billion to AIG.

“Therefore, we believe the ADC should reduce reserve volatility in economic terms, and similarly reduce risk-based capital requirements in our capital-assessment model,” S&P continued.

S&P said that AIG’s ratings would not be affected by the weak quarterly results, which clearly look a lot less weak (although still not stellar by any means) when the adverse development cover is taken fully into consideration.

S&P said that it believes AIG’s recent actions taken in strengthening reserves, offloading risk and shedding business, all needs time to “season” before the future performance of the portfolio can be fully understood and any improvement in performance be seen.

Clearly the reinsurance cover has been put in place to attempt to draw a line under these legacy U.S. casualty reserves, which were always expected to develop negatively. At this time the impact of the reinsurance agreement is clear, it has the desired effect of reducing the charge falling to AIG, ultimately this will improve results.

Whether it will be sufficient over the long-term to help AIG turn around its business is unlikely on its own, but the reinsurance cover alongside other steps the company has been taking, could just provide the breathing room AIG needs to turn its portfolio around and get its shareholders back on-side.

It will be interesting to see the impact the assumption of the reserve charge has on NICO and ultimately Berkshire Hathaway, especially given the suggestion that the retroactive adverse development reinsurance agreement with AIG could be the first deal big enough to jeopardise an underwriting profit for Berkshire Hathaway’s P&C business.

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