Releasing reserves based on early developments is an optimist’s view, [Evan Greenberg, chairman and chief executive officer of ACE Limited] said. “Good news comes early in the casualty business. The bad news always comes late,” he said.

“I do think some companies have released reserves early in an effort to goose earnings,” he said. “It may come back to bite them.”

As discussed in my prior post P&C fundamentals are pretty bad. According to reports, the only way that insurers showed profits in recent periods was by playing games with their reserves. That is, they revised downward their view of prospective losses to allow them to release reserves, improving the bottom line (on paper, anyway). Such releases covered up “a multitude of sins.”

A report of a Standard & Poor’s June conference on the subject is enlightening and alarming:

… insurers will likely face “temptation to help earnings by underreserving,” particularly if there isn’t a strong recovery. “And we’re not expecting that either,” [John Iten, a Standard & Poor’s credit analyst] said. “We think that any hardening of the cycle will be fairly modest over the next couple years.”

The trend in the industry of releasing reserves possibly prematurely raises questions on reserve adequacy for the future. “Currently, we are witnessing a healthy amount of reserve releases for recent accident years, with a particular focus on longer-tail, commercial product lines,” Mr. Gross said. In 2008, prior-year commercial line reserve releases nearly doubled to approximately $11 billion in 2008 from $5.7 billion in 2007.”

D&O line reserves are of particular concern according to Michael Angelina, Chief Risk Officer and Chief Actuary at Endurance Specialty Holdings Ltd..

“Now is not the time to be releasing reserves,” he said. “It’s a little premature to be taking good news on that business.” At the same time, he said insurers are celebrating that rate decreases have declined, which is not a sign of a hard market. Also, in the 2007-2008 period, given the credit crisis and the associated exposure to directors’ and officers’ (D&O) liability for financial institutions of a number of commercial lines writers, he said it’s unclear whether insurers have underreserved. Many market observers expect a $6 billion-$10 billion reserve need for the D&O product line.

This week, alarm bells have gone off concerning Chubb, a major D&O writer:

The investor report released Monday by Barclays Capital, a unit of London-based Barclays Bank P.L.C., said D&O insurer losses could reach as high as $10 billion, which “implies up to a $2 billion loss (over several years) at (Chubb) based on its market share.”

Barclay’s said, “given a potential for a wave of D&O litigation, Chubb does not appear appropriately reserved because its 2008 U.S. D&O loss ratio (estimate) of 78% is mostly in line with its median developed loss ratio over the past 10 years, despite D&O prices declining 50% from the peak in 2002.”

Michael Gross, an S&P analyst said:

“Predicting future claims is key to profitability and financial strength,” … “The question for me is why are they emptying their tanks?”

The answer is obvious, to make abysmal quarterly financials look better. As the Wall Street Journal reported in April:

At Travelers, 34% of net income came from reserve releases in 2008, up from 7.6% in 2007. For Chubb, 31.3% of net income in 2008 was due to reserve releases, compared with 16.2% in 2007.

But this “buffing” cannot go on forever.

“You just won’t be able to keep your combineds low based on reserve releases, the way you could in ’07 and ’08,” says [Adam Klauber, director of U.S. equity research for Fox-Pitt Kelton Cochran Caronia Waller].

Earlier this spring, Moody’s issued a report estimating that, of the $5 billion to $12 billion in excess loss reserves the industry had at the start of 2008, about $9 billion had been depleted in the first nine months, with estimates rising to $14 billion for the entire year. Moody’s Vice President Paul Bauer says he believes the industry has exhausted its cushion, portending dipping profits for 2009.

“In addition, the decline in reserve adequacy implies a further weakening of balance sheet strength in what is already a difficult market environment,” he says.

Eventually, analysts will sit up and take notice, as S&P did last month and Barclay’s did this month. After those flares have gone up, soon-to-be-released second quarter reports should be interesting. Stay tuned.