Did AIG's Reserve Charge Reveal An Underlying Weakness?

A $5.6 billion reserve charge led American International Group Inc (NYSE: AIG) to report a bigger loss of $3.04 billion for its fourth quarter, and Deutsche Bank believes the multi-billion dollar charge reflects weakness in the insurer’s underlying underwriting margins.

The reserve charge was related to the U.S. commercial insurance policies it has already written and indicates that AIG's underlying P&C business is in worse shape than formerly thought.

AIG Commercial segment closed 2016 with an accident-year loss ratio of 67.5 percent, a substantial improvement from an newly adjusted 72 percent for 2015, but significantly higher than anyone expecting somewhere near 60 percent for 2016.

“The 60% number now seems a fantasy, and underlying loss ratio forecasts are likely to rise.  Every 100bps of deterioration in Commercial underwriting margins is equivalent to $0.11 of annual EPS,” analyst Joshua Shanker wrote in a note.

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Shanker noted that AIG’s results cast doubt on its loss picking ability going forward as “management's credibility is challenged regarding its optimism about the extent of achievable improvement in 2016-2017.”

The analyst pointed out that all but $342 million of the $5.6 billion reserve charge appears to have come from U.S. Commercial Lines. This suggests that AIG mispicked the U.S. Commercial risk in 2015 by almost 1,000bps when it closed the books last year.

“Assuming that the reserve strengthening for 9M16 relates to U.S. Commercial lines (likely), management mispicked the loss margins on these risks (not protected by the NICO cover) by about 520bps,” Shanker elaborated.

Shares of AIG fell 8.79 percent to $61.01. Shanker has a Hold rating on the stock, with a target price of $64.