(FORTUNE Magazine) – HOW CIGNA TOOK A $1.2-BILLION BATH When the big insurance company saw its property and casualty claims shoot up in 1984, it decided to assume the bad news was an aberration. By the end of 1985 it could no longer ignore the evidence pointing to a colossal error in its financial statements. Company after company has recently announced that it took a financial bath in 1985. ITT and Cigna Corp., the subjects of this and the following story, climbed out of the tub with higher stock prices. But ITT's write-off has soured its growth prospects. Cigna's charge against earnings demonstrates how very slippery the financial statements of property-and- casualty companies can be. LIKE MANY another insurance analyst, Myron Picoult of Oppenheimer & Co. got the late-January flash about Cigna Corp. from the Dow Jones news wire: ''Cigna said it is strengthening its property and casualty reserves, which will result in a charge of $1.2 billion against . . . earnings.'' Picoult fell to muttering about ''those damn fools'' at Dow Jones: ''They put the decimal in the wrong place. No one could be off $1.2 billion.'' Dow Jones did not misplace the decimal. Cigna was owning up, with shocking suddenness, to a massive misestimate of costs. Its $1.2-billion correction says a lot about profits in the property and casualty insurance business: they are singularly unsolid stuff. The accounting practices in Cigna's industry virtually invite errors. The premiums earned on a policy and all the costs associated with the policy must be reflected in the same accounting period. But some claims are not made, or are not paid, until years later. So insurance companies must estimate future claims costs and charge them, right now, to earnings. These future payouts, commonly called reserves, then move to the liability side of the balance sheet. A company's total reserves are all the claims costs it has charged against earnings but not yet paid. Precision in this game is impossible: one company or another is always announcing it has ''strengthened'' reserves -- that is, added to the amounts set up in prior years, making a new estimate to correct one now judged too low. But no other company has strengthened reserves in a single year by anything close to $1.2 billion. Obviously, costs recognized in 1985 that should have been recognized earlier misstate results. Cigna reported a loss in 1985 of $733 million. But the $1.2- billion addition to reserves was a cost that the company says should have been assigned to earlier years. One might expect the stock market to punish a company suddenly announcing itself $1.2 billion poorer. Cigna's news did cause a sharp one-day drop in its stock price, but the price snapped back and was recently near its 12-month high. A $250-million issue of convertible preferred stock that Cigna sold last May is likewise above its offering price. That protects Cigna from litigious shareholders who might wish to claim they had bought on the basis of misleading financial information. It is hard for shareholders to prove they have been injured when a stock price goes up. Cigna's stock has been buoyed by the market's general enthusiasm for the property and casualty industry, which is rapidly recovering from its worst period ever. But some Wall Street analysts also like Cigna because it has put an enormous addition to reserves behind it (a view that suggests Cigna could have done even more for its stock price by announcing still bigger additions to reserves and a bigger loss for 1985). Suppose, say the analysts, that Cigna is now overreserved. That would be good news for future profits, which would be pumped up as Cigna revised its reserves downward. Yet nothing about Cigna's misadventures inspires much confidence in the figures at hand. According to the company's chairman, Robert D. Kilpatrick, 62, and two other executives, Cigna felt quite good about its reserves at the end of 1983. At the time, it was looking back on ten years of ''very stable patterns'' in claims. In 1984, however, the incidence and severity of claims suddenly worsened. At the year's end, therefore, the company had ten years of one kind of claims experience and a single year of another. In a figurative sense, it had 40 quarters of picture-perfect apples and four of wormy ones. It also had doubts, says the company, that the worms were to be taken seriously. Executives say they suspected that these ugly, newly visible claims patterns were an aberration. This hope was encouraged by a mid-1984 study done by an actuarial consulting firm that assessed Cigna's reserves in relation to those of seven competitors. The verdict: Cigna looked conservative, ranking second best by some measures, third by others. Weighing all the evidence, Cigna decided to assume the 1984 data were largely aberrant. Nonetheless, it strengthened reserves for 1983 and earlier years by $224 million. That amount left Cigna making money for 1984, though only $103 million. Kilpatrick says he thought the reserve strengthening was ''way on the conservative side.'' Events in 1985 were peculiar. Despite the red flag thrown up by the 1984 data, Cigna conducted only its normal, relatively simple monthly and quarterly reviews of reserves. One reason a closer look did not seem necessary, says the company, was that claims experience appeared to have taken a distinct turn for the better. But then came an intensive year-end review. And it showed -- wow! -- that the favorable claims data applied only to policies covering occurrences in 1985. The bad experience of 1984 had continued for policies applicable to that year and before. For those years, the company now had eight quarters of wormy apples and premonitions that the worms were taking over. So up stepped Cigna with its $1.2 billion of new reserves. The additions apply entirely to U.S. business. About one-third involve asbestos claims and specialized lines such as directors' and officers' insurance. But nearly two-thirds of the reserves apply to garden-variety insurance -- coverage for small businessmen, liability policies for large corporations, workers' compensation, auto liability, and the like. The errors clearly covered a lot of ground.

After Cigna determined the need for added reserves, its auditor, Price Waterhouse, was required to sign off on the figures. When the auditor's certificate appears in Cigna's 1985 annual report, it will say that the company's statements ''present fairly'' its financial position. Price Waterhouse said the same about last year's financial statements, the ones that Cigna now says contained a $1.2-billion flaw. At the least, this raises a question as to whether auditors of insurance companies should be using uncompromising language about such wobbly data. Other questions arise. Cigna has 11 fully certified actuaries in its property and casualty division. Why did this platoon not see during 1985 that the bad patterns of 1984 were repeating themselves? Why, also, does Cigna (or any other insurance company) find it sufficient to make an intensive study of reserves just once a year, as if it were a groundhog surfacing for its annual inspection of weather conditions? Does the company not need to be on top of its costs, both for quarterly profit reports and for setting prices? FORTUNE would have liked to explore these questions and others with Howard V. Dempster, until recently Cigna's chief property and casualty actuary and now the division's chief financial officer. But Cigna would not allow Dempster to be interviewed. Hearing that, John R. Cox, who used to head Cigna's property and casualty operations, laughs: ''They're muzzling him. I would too.'' Bob Kilpatrick, asked his opinion of what went wrong at Cigna, startlingly rejects the premise of the question. Things worked well, he says. He argues that the company identified its problem expeditiously, in early 1984, and then monitored the data until it had accumulated the eight quarters of experience necessary to judge what should be done. Then, says Kilpatrick, ''we stepped up to the problem with forthrightness.'' STEPPING UP has left Cigna with other problems. Some of its credit ratings have been lowered. That will reduce the role Cigna can play in the Municipal Bond Insurance Association, a highly profitable insurer of municipal bonds backed by Cigna and four other companies. State regulators are asking how Cigna, a holding company, plans to shore up the finances of its subsidiaries that write property and casualty insurance. The regulators worry about the size of the surpluses in these subsidiaries. Surplus is a figure roughly equivalent to net worth. A regulatory rule of thumb holds that insurers should write no more than $3 of net premiums (that is, excluding premiums passed along to reinsurers) for each $1 of surplus. Cigna's subsidiaries met this standard last year: they wrote $4 billion in net premiums and looked set to end the year with about $1.4 billion in surplus. But that was before the tremendous $1.2-billion charge, which comes straight out of surplus. Cigna proposes to replace the vanished surplus in part by contributing about $600 million to its subsidiaries, borrowing to raise the money. It also wants to create another $600 million or so of surplus out of thin air, by making accounting changes that would in effect allow it to recognize income immediately that ordinarily would be recognized over a period of years. The regulators are unhappily pondering this proposal. One way or another, Cigna will continue to write billions in premiums. As claims are paid, furthermore, the adequacy of both Cigna's reserves and those of its competitors will be measured. It could turn out that Cigna is ahead of the pack, fully reserved when others are not. It could also turn out just the opposite. In the meantime, do not expect the financial statements of property and casualty insurers to ''present fairly '' a truth you can count on.

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CHART: INVESTOR'S SNAPSHOT CIGNA ASSETS (AS OF 12/31/85) $44.7 BILLION CHANG FROM YEAR EARLIER UP 15% NET LOSS (LATEST FOUR QUARTERS) $732.5 MILLION CHANGE PROFIT YEAR EARLIER RETURN ON COMMON STOCKHOLDER'S EQUITY -17% FIVE -- YEAR AVERAGE 5% RECENT SHARE PRICE $69.75 PRICE/EARNINGS MULTIPLE N.A. TOTAL RETURN TO INVESTORS (12 MONTHS TO 2/14) 55% PRINCIPAL MARKET NYSE Explanatory notes: page 129