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Billions In State Farm, AIG Underwriting Losses Bode Ill For P&C Results

The question is no longer whether the U.S. property and casualty industry will lose money from underwriting in 2016, but how much.

State Farm Mutual Automobile Insurance Co.'s 2016 financial results affirmed the magnitude of the challenges private-passenger auto insurers faced during the year. Taken in combination with the likely impact on select commercial lines of American International Group Inc.'s recently disclosed casualty lines-heavy reserve strengthening, the news suggests that the U.S. P&C industry's 2016 statutory financial results will face even more pressure than S&P Global Market Intelligence's January outlook contemplated.

A $7 billion auto underwriting loss

The $5.5 billion 2016 underwriting loss reported by State Farm's P&C companies in a February 28 announcement marked significant deterioration from the $2.1 billion underwriting loss they reported in a similar format for 2015. Through the first nine months of 2016, the State Farm P&C group as consolidated by S&P Global Market Intelligence saw its net underwriting loss widen to $3.89 billion from $1.63 billion in the year-earlier period, so the direction and size of the full-year result were not entirely unexpected.

Still, the historical significance of the portion of the loss attributable to the group's core auto insurance business offered reason for pause. State Farm said the auto business, which accounted for 63% of the group's 2016 net premiums written, produced an underwriting loss of $7 billion for the year. And figures included in the announcement imply a loss and loss adjustment expense ratio for the business of nearly 92.3%, up from 85.4% in 2015.

S&P Global Market Intelligence's historical results for the State Farm group differ to varying extents from those provided in the February 28 announcement, though they are directionally consistent. The release indicates that the results are based on data for 10 individual P&C companies as compared with the nine U.S.-domiciled entities named in State Farm's 2015 combined annual statement.

Our figures show that the group's private auto loss and LAE ratio increased to 85.9% in 2015 from 83.5% in 2014. To the extent the group's private auto loss and LAE ratio as calculated based on statutory data exceeds 90% for 2016, it would mark the first time since 2002 that State Farm produced such a result.

The group generated private auto loss and LAE ratios of 93.2% in 2000, 99.2% in 2001 and 91.5% in 2002. Berkshire Hathaway Inc. Chairman and GEICO Corp. champion Warren Buffett observed in his 2000 annual letter to shareholders that State Farm had been "very slow to raise prices" during a time in which loss costs around the industry were increasing.

Pretax losses, excluding investments, attributable to State Farm's private auto business in 2000 and 2001 totaled $4.53 billion and $5.27 billion, respectively. They did not exceed $4 billion in a calendar year again until 2015 when the company's loss attributable to the private auto business was nearly $4.80 billion. S&P Global Market Intelligence calculates that the group's private auto combined ratio increased to 112.1% in 2015 from 109.1% in 2014. A combined ratio over 100% generally signifies an underwriting loss.

The recently revised P&C industry projections call for a private auto combined ratio of 106.9% in 2016 from 104.6% in 2015, followed by an improvement to 104.9% in 2017. GEICO, Travelers Cos. Inc. and The Hartford Financial Services Group Inc. joined State Farm among leading private auto writers in reporting elevated loss ratios in the business line in 2016, but Allstate Corp. reported year-over-year improvement in its auto combined ratio and Progressive Corp. achieved its targeted underwriting margin in its personal auto business in 2016.

Large reserve build hits key commercial lines

Our January commercial lines outlook did not, however, contemplate the sort of deterioration in certain business lines that is likely to ensue as AIG bolstered reserves for prior accident years by $5.79 billion in 2016. The vast majority of that amount was revealed in connection with the company's February 14 earnings announcement.

AIG attributed $1.92 billion of the calendar year's unfavorable development to its U.S. workers' compensation business, $754 million to primary general liability, $352 million to commercial auto liability written on a primary basis and at least another $250 million to certain commercial auto claims in the excess casualty business, and $428 million to medical malpractice.

AIGs hypothetical impact on US P&C industry combined ratio projections

A portion of the remaining $800 million or so in U.S. excess casualty unfavorable development may roll up into what is classified in annual statement blanks as the other liability or product liability lines. So, too, may much of the $306 million in unfavorable U.S. financial lines development, which AIG attributed to directors' and officers' liability, errors and omissions, employment practices liability insurance and other professional liability coverages.

S&P Global Market Intelligence's revised 2016 outlook called for a workers' comp combined ratio of 96.0%, up from 93.9% on an adjusted basis for 2015. To the extent net incurred losses and/or LAE were to rise by $1.92 billion to account for the AIG reserve charge, the projected combined ratio would increase to 100.5%, all else being equal.

The general liability combined ratio was projected to improve to 101.5% in 2016 from 103.5% in 2015, but the addition of an estimated $1.80 billion in net incurred losses and/or LAE would push it above 105% for the year. That would represent the industry's highest such result since 2010.

The commercial auto liability combined ratio had been expected to improve from a very elevated level, with a projected decline to 109.9% in 2016 from an actual result of 111.2% in 2015. The addition of $600 million in additional losses and/or LAE incurred would push the projected 2016 result to more than 112.6%.

In medical malpractice, where the projected 2016 result contemplated a third-consecutive year of eroding margins, the addition of $428 million in additional incurred losses and/or LAE would boost the combined ratio by 5.1 points to 105.4% from 100.3% as originally estimated.

There remains considerable uncertainty as to the specific amounts of reserve development the U.S. P&C units of AIG will attribute to each business line as they are defined and presented on annual statement blanks. Wherever the adverse development falls, however, the outcome is likely to manifest itself in higher-than-expected combined ratios for the commercial lines on a combined basis and the U.S. P&C industry as a whole.

The recently revised projections call for a 2016 commercial lines combined ratio of 95.1% and overall P&C industry combined ratio of just under 100.3%. When incorporating the aforementioned assumptions pertaining to AIG's reserve charge, the commercial lines combined ratio rises by two full percentage points to 97.1% and the overall industry combined ratio climbs by 0.9 percentage point to nearly 101.2%.

Had AIG's results, which included $3.37 billion of adverse reserve development across business lines and prior accident years, been excluded from the 2015 adjusted industry aggregates, the commercial lines and industrywide combined ratios would have been approximately 2.2 and 0.8 percentage points lower than they otherwise were.

Beyond underwriting profitability, the manner in which AIG and Berkshire Hathaway's National Indemnity Co. account for the adverse development cover the parties revealed in January could materially impact the P&C industry's statutory income statements for 2016 and 2017.

AIG confirmed that the 2016 statutory results of certain of its P&C units would incorporate a $724 million increase in their aggregate surplus due to a permitted practice incorporating the impact of the National Indemnity agreement. Their capital and surplus, as reported by AIG, declined to $21.82 billion as of December 31, 2016, from $25.96 billion a year earlier.

National Indemnity's statutory results for previous years in which large retroactive reinsurance treaties were deemed to have incepted have included large losses accounted for as negative entries in a write-in field labeled assumed retroactive reinsurance pretax gains. That item is then rolled into the other income line of the company's income statement. While the AIG agreement will impact National Indemnity's 2017 statutory results, another adverse development cover with The Hartford Financial Services Group Inc. accounted for $660 million of the company's $835.6 million loss from assumed retroactive reinsurance in 2016.

Additional clarity about 2016 performance will continue to emerge as data from statutory statements, which are due for release in most jurisdictions on March 1, becomes available. But factors such as the sheer magnitude of the losses incurred by AIG and private auto insurers afford a higher degree of confidence to the previous conclusion that the industry's three-year run of underwriting profitability has come to an end. At the same time, the likely negative impact on 2016 results from a one-time event makes for an easier comparison in 2017, when S&P Global Market Intelligence projects the industry will again straddle the divide between an underwriting profit and an underwriting loss.

For a more complete discussion of the methodology employed and the limitations associated with it, please see the 2016 U.S. P&C Insurance Market Report.

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