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ITEM 7 / CRITICAL ACCOUNTING ESTIMATES.....................................................................................................................................................................................90 percent. The result of 63 percent would be applied to the earned premium of $10 million resulting in an estimatedunreported loss of $6.3 million. Actual reported losses would be added to arrive at the total ultimate losses. If thereported 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 ofbusiness. Loss development methods generally give full credibility to the reported loss experience to date. In theexample above, loss development methods would typically indicate an ultimate loss estimate of $10 million, as thereported 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 forthe class of business. Therefore, if loss experience is unexpectedly deteriorating or improving, the loss developmentmethod gives full credibility to the changing experience. Expected loss ratio methods would be slower to respond tothe change, as they would continue to give more weight to the expected loss ratio, until enough evidence emerged tomodify the expected loss ratio to reflect the changing loss experience. On the other hand, loss development methodshave the disadvantage of overreacting to changes in reported losses if the loss experience is not credible. Forexample, the presence or absence of large losses at the early stages of loss development could cause the lossdevelopment method to overreact to the favorable or unfavorable experience by assuming it will continue at laterstages of development. In these instances, expected loss ratio methods such as ‘‘Bornhuetter Ferguson’’ have theadvantage of recognizing large losses without extrapolating unusual large loss activity onto the unreported portion ofthe losses for the accident year.Frequency/severity methods generally rely on the determination of an ultimate number of claims and anaverage severity for each claim for each accident year. Multiplying the estimated ultimate number of claims foreach accident year by the expected average severity of each claim produces the estimated ultimate loss for theaccident year. Frequency/severity methods generally require a sufficient volume of claims in order for the averageseverity to be predictable. Average severity for subsequent accident years is generally determined by applying anestimated annual loss cost trend to the estimated average claim severity from prior accident years. In certain cases,a structural approach may also be used to predict the ultimate loss cost. Frequency/severity methods have theadvantage that ultimate claim counts can generally be estimated more quickly and accurately than can ultimatelosses. Thus, if the average claim severity can be accurately estimated, these methods can more quickly respond tochanges in loss experience than other methods. However, for average severity to be predictable, the class ofbusiness must consist of homogeneous types of claims for which loss severity trends from one year to the next arereasonably consistent. Generally these methods work best for high frequency, low severity classes of business suchas personal auto.Structural drivers analytics seek to explain the underlying drivers of frequency/severity. A structuraldrivers analysis of frequency/severity is particularly useful for understanding the key drivers of uncertainty in theultimate loss cost. For example, for the excess workers’ compensation class of business, we have attempted tocorroborate our judgment by considering the impact on severity of the future propensity for deterioration of an injuredworker’s medical condition, the impact of price inflation on the various categories of medical expense and cost ofliving adjustments on indemnity benefits, the impact of injured worker mortality and claim specific settlement and lossmitigation strategies, etc., using the following:• Claim by claim reviews to determine the stability and likelihood of settling an injured worker’s indemnity andmedical benefits – the claim file review was facilitated by a third party expert experienced in workers’compensation claims;• Analysis of the potential for future deterioration in medical condition unlikely to be picked up by a claim file reviewand associated with potentially costly medical procedures (i.e., increases in both utilization and intensity of medicalcare) over the course of the injured worker’s lifetime;• Analysis of the cost of medical price inflation for each category of medical spend (services and devices) and forcost of living adjustments in line with statutory requirements;• Portfolio specific mortality level and mortality improvement assumptions based on a mortality study conducted forAIG’s primary and excess workers’ compensation portfolios and AIG’s opinion of future longevity trends for theopen reported cases;..................................................................................................................................................................................................................................AIG 2012 Form 10-K 177