AiG said that nearly 80% of the total charge relates to four classes of business: asbestos, excess casualty, excess workers' compensation and primary workers' compensation. A majority of the reserve increase relates to policies sold before 2006.
Some insurance analysts have long suspected that AIG has been too optimistic about the profitability of its giant property and casualty insurance business, which sells coverage on everything from damage caused by natural disasters to product liability.
While other insurers have lowered estimates of their future claims and "released" reserves, AIG has instead added to them. A year ago, the insurer pumped $2.3 billion into Chartis when it reported 2009 results. The company said at the time it was for claims before 2003, and primarily for excess casualty and excess workers compensation. "Excess" coverage kicks in only when a company has claims above the amount covered by its primary insurance policy.
The reserve increase comes just months before AIG is likely to launch a long-anticipated share sale, dubbed a re-IPO, that will help end the U.S. government's involvement with the company. David Havens, a managing director at Nomura Securities, said the charge is "a pothole—a rather big pothole—along the road to recovery."
"We would regard this action as an effort by the company to get its arms around its legacy issues so that it can be re-IPO'ed with a clean balance sheet that would approximate its peers," Mr. Havens said.
The increase in AIG's reserves will strengthen the company's balance sheet before it sells shares to investors. But the charge could also fan concerns about the potential for additional reserve increases on policies AIG sold in more recent years. In fact, investors flagged the issue in discussions with investment bankers, who canvassed feedback from the investing community before pitching for roles in the upcoming AIG share offering.
AIG also said it signed a letter of agreement with the U.S. Treasury to retain $2 billion of the proceeds from the sale of AIG Star Life Insurance Co. and AIG Edison Life Insurance Co. to support Chartis's capital. Prudential Financial Group Inc. bought the two subsidiaries from AIG for $4.8 billion on Feb. 1 to expand its presence in Japan.
The latest addition to the reserves follows AIG's annual year-end review, a process that all property-and-casualty insurers conduct to determine whether they have enough money set aside to pay claims. The types of liability coverage cited by AIG as being deficient are called "long tail" lines, since claims can emerge years—or even decades—after a policy is sold.
The year-end review was done in consultation with outside actuaries—experts in assessing risk and the likelihood of insurance claims—and took into account "the potential implications of new data and new and emerging trends," the company said.
The largest reserve addition was for its exposure to asbestos claims, a type of coverage that has been excluded from AIG policies since 1985. The insurer said it added $1.3 billion to its asbestos reserves after "taking into consideration recent, higher industry-wide trends regarding expanding coverage theories for liability."
But the next largest expense, of $1 billion, was for coverage sold by its excess casualty line far more recently. AIG said that claims in the fourth quarter "significantly exceeded expectations, particularly in more recent accident years." An AIG spokeswoman confirmed that the reference to more recent years meant policies sold in 2006 or later.
The company also flagged claims from 2006 and later as the reason for a $420 million reserve increase at its primary workers' compensation line.
"Continuing medical inflation, additional treatment specialties, and longer claim-payment periods are all contributing factors, further compounded by reduced return-to-work opportunities in today's high unemployment environment."
Chartis's reserve increases show that the policies sold years ago didn't meet initial profit assumptions, said Paul Howard, director of research at Solstice Investment Research. "In the long term, the truth comes out. There could also be business written today by AIG that will have adverse developments in the future," he added.
In the months immediately after being bailed out by the U.S. government in late 2008, some executives from rival insurers accused Chartis of drastically cutting prices on some of its policies to keep corporate customers from going to rivals while AIG was struggling. AIG executives vehemently rebuffed those allegations, and an investigation by Pennsylvania insurance regulators found the company's behavior was "not out of line" with competitors in late 2008 and early 2009.
Still, running with the pack doesn't mean an insurer is charging an adequate price. Commercial insurance in general is in the middle of a years-long pricing slump, and some industry executives have warned recently that workers' compensation in particular is being underpriced across the insurance market.
Liberty Mutual Chief Executive Edmund "Ted" Kelly in November called the most recently issued workers' compensation coverage a "time bomb" for the industry that will turn out to be highly unprofitable in coming years.
John Doyle, the president and chief executive of AIG's U.S. property-casualty operations, said in November that his unit had cut back on how much workers' compensation coverage it sells. It now has annual premiums of about $800 million, compared with $3 billion in 2007, he said.
In a note to investors he titled "The Canary in the Coal Mine Coughs," insurance analyst Meyer Shields of Stifel Nicolaus wrote Wednesday that AIG's announcement may have implications for the entire industry. The reasons AIG cited for increasing its reserves "are relevant to many or most of its competitors as well," he wrote.
At the end of the third quarter, AIG estimated its entire general insurance liability for unpaid claims costs was $63.7 billion.
AIG said Wednesday that the agreement with the Treasury to retain some of the proceeds from its most recent asset sale means that Chartis's statutory surplus will remain "largely unaffected." Statutory surplus is used by regulators to measure an insurer's ability to pay claims.
AIG said separately on Wednesday it plans to report fourth-quarter results Feb. 24 and the next day will hold a conference call with investors—its first under its current CEO, Robert Benmosche.