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American International Group (AIG) reported solid increases in income in 2006. Our results for 2006 were lead by our General Insurance business." - AIG President and CEO Martin J. Sullivan (no relation to myself), 3/1/2007.

I make it a point to talk to my friends about the businesses they work in. This is not an effort to get "inside" information about a company, but to learn more about the businesses they are in and the challenges and opportunities they face. Last summer several friends of mine who practice personal injury law (worker's compensation and auto) were lamenting that AIG just "stopped settling cases." Now, had this been one person in one office in one state, I would have brushed it off as being associated only with that person and not indicative of AIG business practices.

AIG Logo

But, when you have different lawyers in different states whose businesses are unrelated to each other saying the same thing, one has to wonder. Recently, I was talking to a few of them again and heard the same refrain: "AIG will not settle cases." I waited until AIG released their 2006 10-K and decided to dig through it to determine whether their claims had merit. Let's break down some numbers. The following pertain to the Domestic Insurance Operations.

Underwriting Profit. This is simple to determine. It is equal to Net premiums minus net losses (payments to insureds)

Personal (Auto) Underwriting Gain (Loss)-Millions

2005 $74
2006 $204

Domestic Brokerage (Workers Comp) Underwriting Gain (Loss)

2005 ($1.5) Billion
2006 $2.4 Billion

Conclusion? AIG experienced a gargantuan improvement in results in 2006. It should be noted that 2005 results here do not include losses from catastrophes like hurricanes, floods, etc. These numbers are from ordinary operations to make comparisons relevant. It should also be noted that Domestic Brokerage results are not all worker's comp [WC], but that is the category WC is classified in and AIG does not break it out. It is a fair comparison as WC is the largest single variable in this category, so WC results have the largest impact on this segment. This improved profit picture alone does not prove our point though, it is possible that AIG wrote more policies and from those new policies, netted more profits.

Well, let's look:

Domestic Lines Premiums Earned

2004 +5.6%
2006 +5%

For the past two years premium earned have been essentially flat so it cannot be responsible for the 540% increase in profits. Maybe they cut costs to the bone? Let's look more closely:

Combined Domestic Expense Ratio

2005 21.0
2006 21.5

By looking at the expense ratio, we can determine that the percentage of expenses associated with domestic operations remained the same so this eliminates expense cutting as the cause of the gain. This tells us that $21 of every $100 in premiums went to expenses, virtually identical in 2004 and 2005.

Once the insurance company has premiums (float), they invest them. It is possible that AIG had a banner year investing the money and that accounts for the profit difference. The answer?

Return On Invested Assets

2004 4.4%
2005 4.7%
2006 5.6%

While investing results were improved, they do not account for the surge in profits. The investing benefit to earnings was that they had more to invest, not that they earned that much more on what they invested. So we still need to find the reason they had "more to invest."

Let's review. Profits surged in 2006 and it was not due to additional premiums earned, expense cutting or abnormal investing gains. That leaves us only one way they could increase profits, pay out fewer claims. But that does not necessarily mean "they just stopped" settling claims and thus had to pay. Let's look closer again. In the insurance industry, there is a metric called the loss ratio. This number tells us out of every $100 in premiums, how many dollars are paid out as claims (losses). Barring a catastrophe, this number should be somewhat consistent year to year for a huge insurer like AIG. The following numbers are again excluding catastrophe losses in 2004 and 2005.

Combined Domestic Loss Ratio

2004 81.3
2005 82.5
2006 69.1

After consistent results in 2004 & 2005, AIG's results dramatically improved. These numbers mean that after paying out over 80 cents of every dollar in premiums in 2004 and 2005, AIG suddenly paid out only 69 cents of every dollar in 2006. While 11 or 12 cents of each dollar does not seem like much, when you consider AIG had $108 billion in revenue last year, a little bit easily becomes something big.

It is looking like my friends' complaints may be correct, but there is one more necessary step we need to do before we can know for certain. It is possible that there just were not as many claims in 2006, so AIG by default paid less settlements and thus realized more profits. If this is the case, then the rise in profits is perfectly understandable. We need to understand the claim process first. When a case (claim) comes in, the insurance adjuster for AIG sets a "reserve" on the it. This reserve is an approximate value of the case in terms of settlement. This allows AIG to gauge future liabilities. When the case is settled, the amount of the reserve is reduce by the amount the adjuster set aside and the settlement amount then goes into the "loss" column when the check is cut.

We can now accurately conclude that since AIG did not write more polices to grow income, did not cut expenses to do it and did not realize dramatically improved investing gains, the only way they could have grown income over 500% would have been to either had a large reduction in claims OR just not settle cases (and then be forced to pay). If it is a case where they refused to settle, we would see a surge in the "reserves" on the books for these claims as reserves are only lowered when cases are actually settled (this also lowers earnings), if the case is they did not have more claims, reserves would remain relatively constant. Here we go:

Workers Compensation Loss Reserves-Billions

2005 $11.6 Billion
2006 $13.4 Billion

BINGO...... AIG added $1.8 billion or 16% to its reserves for WC in 2006 (this is by far the largest reserve AIG maintains for all line of insurance business both domestic and international). This means that the surge in profits was due largely in part to AIG refusing to settle WC cases and thus not have to pay claims. This only pushes these liabilities off into the future. Here is the real irony: AIG is paying people who are out on WC a weekly wage check (the amount differs from state to state so I will not get into details, but it is normally about 60% of their gross wages).

In many cases AIG's weekly payments will eventually surpass what they would have paid if they just settled a year ago. It should also be noted that this does not absolve them of a settlement amount either. In most states there is a formula based on the employees loss of function, weekly wages, age and other factors that dictate a range of settlement amounts. AIG will have to pay, it is just a matter of "when," not "if." This means that AIG will eventually end up paying almost twice these cases initial value when all is said and done.

While AIG's strategy of refusing to settle claims may have helped them last year, there is a growing bulge in future liabilities out there that will have to get paid. Investors beware....

P.S. Does anyone else find it ironic that when an insurance company does what it is designed to do - pay a claim - they refer to it as a "loss"? Isn't it just a cost of doing business? Isn't this akin to a restaurant classifying the food people eat as a "loss"?

AIG 1-yr chart
AIG

Source: AIG's Insurance Business: An Odd Sense of Gains and Losses