Aggressive reserves at AIG

Going up.

Blogger David Merkel, a CFA and life actuary, discusses AIG’s property-casualty reserving issues. The chart above is the heart of the matter, taken from 23 years of 10-Ks for AIG.

As you can see, until 2001, AIG had a history of (relatively) tiny reserve releases, typically less than $500 million, from the looks of the chart. Since 2001, the company has taken reserve hits of $1 billion or more five times in eight years, with four of those above $2 billion.

Merkel’s point:

Up until 2000 AIG generally released reserves for the business written in prior years.  Toward the end, they probably released more than they should have.

Merkel blames Hank Greenberg, head of AIG until 2005, whom he says

is responsible for the trouble that occurred at AIG, not [subsequent CEO Martin] Sullivan, or anyone that followed.  The huge reserve adjustments occurred under M. R. Greenberg’s watch, not anyone else.

The logic is forceful, but it is important to remember some other things that were going on in the aughts:

  • In 2002, much of the industry realized how bad things had gotten during the soft market of 1996 to 2001 and boosted reserves significantly.
  • In 2005, AIG’s accounting scandal had broken open. The company restated financials for 2001, 2002, 2003 and 2004. Presumably, Merkel is using the restated numbers. If so, the reserve hits that show up in 2001 to 2004 accounting statements actually took place in 2005.
  • Also in 2005, AIG got a new CEO, Martin Sullivan. That CEO was replaced in 2008 by Ed Lilly. It is not unusual for new CEOs to bump up reserves soon after taking the job. First off, they didn’t get the job because their predecessor ran a tight ship. And rumormongers will tell you an increase gives the new CEO a cushion that can be released in subsequent years, making those years more profitable and having some nontrivial impact on CEO bonuses. Were something like that to actually occur (note the subjunctive mood), it would imply that AIG has excess reserves. But something like that would look a lot like earnings manipulation, so maybe that’s not what happened here.

I should also point out that Merkel’s chart begins in 1987. Were he to add four or five earlier years, back to say 1983, he would probably see some jaw-dropping reserve increases caused by the soft market of the early 80s. That would blunt his argument somewhat.

Merkel’s larger point is that property/casualty companies need a valuation actuary, as life insurers have:

The actuaries would have to spell out their valuation methods down to all of the major parameters and methods by line of business, and then roll them forward from the last year in order to show the effects of parameter changes, method changes, and adverse or favorable development.

And he summarizes:

AIG was an outlier, but that does not mean it can’t teach us a few things.  First, don’t trust P&C reserving, particularly of big companies.  Second, look to see if management teams reserve conservatively — do they release reserves consistently year after year?  (Which means they set reserve high for the current year’s business.  Tough to do, because setting reserves low on the current year’s business is the easiest way to show good profits in the short run.

Third, someone paying attention to reserve strengthening would have exited AIG in 2003 or 2004, after two or three large reserve strengthenings.

Merkel also wrote a pointed missive last year regarding AIG’s corporate structure and the attendant surplus, which you can find here. Both are worth a read.

Tagged ,

One thought on “Aggressive reserves at AIG

  1. David Merkel says:

    I created this data series myself by going through the historical 10Ks — 2009, 2006, 2003, 2000, 1997, 1994, 1991, 1988, and 1987. I would have gone back further if the data was there at EDGAR. I have been interviewed by the Congressional Oversight Panel regarding AIG, and most of what I talked about was the securities lending fiasco, though they had curiosity about the P&C reserving as well. This piece was written to satisfy some of their curiosity, because they did not understand how reserves are set.

    I’m a life actuary, not a casualty actuary, though I had to learn enough to be an equity analyst of P&C companies. Your commentary on industry conditions is correct, and improves what I wrote, but in broad, there was a chane in reserving philosophy at AIG somewhere between 1998 and 2001.

    Thanks for writing on this, I appreciate it.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: