2007 Annual Report - AIG.com

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American International Group, Inc. and Subsidiaries Management’s Discussion and Analysis of Financial Condition and Results of Operations Continued Actuarial methods used by AIG for most long-tail casualty A key advantage of loss development methods is that they classes of business include loss development methods and respond quickly to any actual changes in loss costs for the class expected loss ratio methods, including ‘‘Bornhuetter Ferguson’’ of business. Therefore, if loss experience is unexpectedly deteriomethods described below. Other methods considered include rating or improving, the loss development method gives full frequency/severity methods, although these are generally used by credibility to the changing experience. Expected loss ratio meth- AIG more for pricing analysis than for loss reserve analysis. Loss ods would be slower to respond to the change, as they would development methods utilize the actual loss development patterns continue to give more weight to the expected loss ratio, until from prior accident years to project the reported losses to an enough evidence emerged for the expected loss ratio to be ultimate basis for subsequent accident years. Loss development modified to reflect the changing loss experience. On the other methods generally are most appropriate for classes of business hand, loss development methods have the disadvantage of which exhibit a stable pattern of loss development from one overreacting to changes in reported losses if in fact the loss accident year to the next, and for which the components of the experience is not credible. For example, the presence or absence classes have similar development characteristics. For example, of large losses at the early stages of loss development could property exposures would generally not be combined into the cause the loss development method to overreact to the favorable same class as casualty exposures, and primary casualty expo- or unfavorable experience by assuming it will continue at later sures would generally not be combined into the same class as stages of development. In these instances, expected loss ratio excess casualty exposures. Expected loss ratio methods are methods such as ‘‘Bornhuetter Ferguson’’ have the advantage of generally utilized by AIG where the reported loss data lacks properly recognizing large losses without extrapolating unusual sufficient credibility to utilize loss development methods, such as large loss activity onto the unreported portion of the losses for for new classes of business or for long-tail classes at early stages the accident year. AIG’s loss reserve reviews for long-tail classes of loss development. typically utilize a combination of both loss development and Expected loss ratio methods rely on the application of an expected loss ratio methods. Loss development methods are expected loss ratio to the earned premium for the class of generally given more weight for accident years and classes of business to determine the loss reserves. For example, an business where the loss experience is highly credible. Expected expected loss ratio of 70 percent applied to an earned premium loss ratio methods are given more weight where the reported loss base of $10 million for a class of business would generate an experience is less credible, or is driven more by large losses. ultimate loss estimate of $7 million. Subtracting any reported paid Expected loss ratio methods require sufficient information to losses and loss expense would result in the indicated loss determine the appropriate expected loss ratio. This information reserve for this class. ‘‘Bornhuetter Ferguson’’ methods are generally includes the actual loss ratios for prior accident years, expected loss ratio methods for which the expected loss ratio is and rate changes as well as underwriting or other changes which applied only to the expected unreported portion of the losses. For would affect the loss ratio. Further, an estimate of the loss cost example, for a long-tail class of business for which only 10 per- trend or loss ratio trend is required in order to allow for the effect cent of the losses are expected to be reported at the end of the of inflation and other factors which may increase or otherwise accident year, the expected loss ratio would be applied to the change the loss costs from one accident year to the next. 90 percent of the losses still unreported. The actual reported Frequency/severity methods generally rely on the determination losses at the end of the accident year would be added to of an ultimate number of claims and an average severity for each determine the total ultimate loss estimate for the accident year. claim for each accident year. Multiplying the estimated ultimate Subtracting the reported paid losses and loss expenses would number of claims for each accident year by the expected average result in the indicated loss reserve. In the example above, the severity of each claim produces the estimated ultimate loss for expected loss ratio of 70 percent would be multiplied by the accident year. Frequency/severity methods generally require a 90 percent. The result of 63 percent would be applied to the sufficient volume of claims in order for the average severity to be earned premium of $10 million resulting in an estimated unre- predictable. Average severity for subsequent accident years is ported loss of $6.3 million. Actual reported losses would be generally determined by applying an estimated annual loss cost added to arrive at the total ultimate losses. If the reported losses trend to the estimated average claim severity from prior accident were $1 million, the ultimate loss estimate under the ‘‘Bornhuet- years. Frequency/severity methods have the advantage that ter Ferguson’’ method would be $7.3 million versus the $7 million ultimate claim counts can generally be estimated more quickly amount under the expected loss ratio method described above. and accurately than can ultimate losses. Thus, if the average Thus, the ‘‘Bornhuetter Ferguson’’ method gives partial credibility claim severity can be accurately estimated, these methods can to the actual loss experience to date for the class of business. more quickly respond to changes in loss experience than other Loss development methods generally give full credibility to the methods. However, for average severity to be predictable, the reported loss experience to date. In the example above, loss class of business must consist of homogeneous types of claims development methods would typically indicate an ultimate loss for which loss severity trends from one year to the next are estimate of $10 million, as the reported losses of $1 million reasonably consistent. Generally these methods work best for would be estimated to reflect only 10 percent of the ultimate high frequency, low severity classes of business such as personal losses. auto. AIG also utilizes these methods in pricing subclasses of professional liability. However, AIG does not generally utilize 54 AIG 2007 Form 10-K
American International Group, Inc. and Subsidiaries frequency/severity methods to test loss reserves, due to the relatively consistent loss development from one accident year to general nature of AIG’s reserves being applicable to lower the next. AIG is a leading writer of workers compensation, and frequency, higher severity commercial classes of business where thus has sufficient volume of claims experience to utilize average claim severity is volatile. development methods. AIG does not believe frequency/severity methods are as appropriate, due to significant growth and Excess Casualty: AIG generally uses a combination of loss changes in AIG’s workers compensation business over the years. development methods and expected loss ratio methods for excess AIG generally segregates California business from other business casualty classes. Expected loss ratio methods are generally in evaluating workers compensation reserves. Certain classes of utilized for at least the three latest accident years, due to the workers compensation, such as construction, are also evaluated relatively low credibility of the reported losses. The loss experiseparately. Additionally, AIG writes a number of very large ence is generally reviewed separately for lead umbrella classes accounts which include workers compensation coverage. These and for other excess classes, due to the relatively shorter tail for accounts are generally priced by AIG actuaries, and to the extent lead umbrella business. Automobile-related claims are generally appropriate, the indicated losses based on the pricing analysis reviewed separately from non-auto claims, due to the shorter tail may be utilized to record the initial estimated loss reserves for nature of the automobile related claims. The expected loss ratios these accounts. utilized for recent accident years are based on the projected ultimate loss ratios of prior years, adjusted for rate changes, Excess Workers Compensation: AIG generally utilizes a combinaestimated loss cost trends and all other changes that can be tion of loss development methods and expected loss ratio quantified. The estimated loss cost trend utilized in the year-end methods. Loss development methods are given the greater weight 2007 reviews averaged approximately five percent for excess for mature accident years such as 2001 and prior. Expected loss casualty classes. Frequency/severity methods are generally not ratio methods are given the greater weight for the more recent utilized as the vast majority of reported claims do not result in a accident years. Excess workers compensation is an extremely claim payment. In addition, the average severity varies significantly long-tail class of business, with loss emergence extending for from accident year to accident year due to large losses which decades. Therefore there is limited credibility in the reported characterize this class of business, as well as changing propor- losses for many of the more recent accident years. Beginning with tions of claims which do not result in a claim payment. the year-end 2005 loss reserve review, AIG’s actuaries began to utilize claims projections provided by AIG claims staff to help D&O: AIG generally utilizes a combination of loss development determine the loss development factors for this class of business. methods and expected loss ratio methods for D&O and related management liability classes of business. Expected loss ratio General Liability: AIG generally uses a combination of loss methods are given more weight in the two most recent accident development methods and expected loss ratio methods for years, whereas loss development methods are given more weight primary general liability or products liability classes. For certain in more mature accident years. Beginning with the year-end 2005 classes of business with sufficient loss volume, loss development loss reserve review, AIG’s actuaries began to utilize claim methods may be given significant weight for all but the most projections provided by AIG claims staff as a benchmark for recent one or two accident years, whereas for smaller or more determining the indicated ultimate losses for accident years 2004 volatile classes of business, loss development methods may be and prior. For the year end 2007 loss reserve review, claims given limited weight for the five or more most recent accident projections for accident years 2006 and prior were utilized. In years. Expected loss ratio methods would be utilized for the more prior years, AIG’s actuaries had utilized these claims projections recent accident years for these classes. The loss experience for as a benchmark for profitability studies for major classes of D&O primary general liability business is generally reviewed at a level and related management liability business. The track record of that is believed to provide the most appropriate data for reserve these claims projections has indicated a very low margin of error, analysis. For example, primary claims made business is generally thus providing support for their usage as a benchmark in segregated from business written on an occurrence policy form. determining the estimated loss reserve. These classes of busi- Additionally, certain subclasses, such as construction, are generness reflect claims made coverage, and losses are characterized ally reviewed separately from business in other subclasses. Due by low frequency and high severity. Thus, the claim projections to the fairly long-tail nature of general liability business, and the can produce an accurate overall indicator of the ultimate loss many subclasses that are reviewed individually, there is less exposure for these classes by identifying and estimating all large credibility in the reported losses and increased reliance on losses. Frequency/severity methods are generally not utilized for expected loss ratio methods. AIG’s actuaries generally do not these classes as the overall losses are driven by large losses utilize frequency/severity methods to test reserves for this more than by claim frequency. Severity trends have varied business, due to significant changes and growth in AIG’s general significantly from accident year to accident year. liability and products liability business over the years. Commercial Automobile Liability: AIG generally utilizes loss development methods for all but the most recent accident year for commercial automobile classes of business. Expected loss ratio methods are generally given significant weight only in the most recent accident year. Frequency/severity methods are generally Workers Compensation: AIG generally utilizes loss development methods for all but the most recent accident year. Expected loss ratio methods generally are given significant weight only in the most recent accident year. Workers compensation claims are generally characterized by high frequency, low severity, and AIG 2007 Form 10-K 55
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AMERICAN INTERNATIONAL GROUP, INC.
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FINANCIAL HIGHLIGHTS (in millions,
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overall financial condition, althou
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Group Executive Committee We are ad
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AIG’s life insurance network is t
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We have also begun to address the e
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WHAT WE SEE The ability to see and
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The Major Accounts Practice within
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Around the world, the middle class
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WE SEE GROWTH OPPORTUNITIES IN EMER
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To grow the strength of the AIG glo
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Since 2003, the AIG Disaster Relief
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RESPECT Respect encompasses how we
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Life Insurance & Retirement Service
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Domestic Brokerage Group— Gross P
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In the summer of 2007, widespread f
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in gross premiums written. It launc
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It grew new business premiums from
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emerging markets for its services,
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ILFC—Revenues by Region Total = $
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AIG Investments acquired a 94 perce
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and changing interest rates, as wel
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American International Group, Inc.
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UNITED STATES SECURITIES AND EXCHAN
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Index of Notes to Consolidated Fina
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SHAREHOLDER INFORMATION Corporate H
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