American International Group (AIG) 3Q14 Update

American International Group (AIG) reported 3Q14 earnings [Source]. This is CEO Peter Hancock’s first earnings report following his promotion effective September 1, 2014.

He summarizes the quarter this way: “The solid third quarter results were driven by consistent performance across our businesses. While no one quarter is a trend, our risk-adjusted return focus could be seen in various metrics including improved accident year loss ratios, modest net spread compression, and continued capital management. In the quarter and through early October, we repurchased $1.5 billion of AIG Common Stock and completed over $4.0 billion in liability management, excluding DIB activities. As a result of our strong capital position and a positive outlook for our businesses, the Board has authorized additional share repurchases of $1.5 billion.

In opening comments on the conference call the new CEO highlighted:

  • there would be no abrupt changes in strategy and objectives,
  • the need to improve operating efficiency,
  • eliminating layers in the organization,
  • a new operating committee to facilitate collaboration and reinforce the value of one AIG,
  • elevating the role of technology,
  • economic value as a discipline to access return on our capital, considering risk and sustainable growth,
  • continuing to work closely with the Fed as a non-bank regulated institution

AIG Collage

Financial Highlights:

AIG 3Q14 Financial Highlights

AIG Third Quarter Conference Call Presentation [Source]

AIG reported net income of $2.2 billion for the 3Q14 compared to $2.2 billion for the 3Q13 for a slight 1% increase. After tax operating income was $1.7 billion compared to $1.4 billion for the 3Q13. Diluted earnings were $1.52/share compared to $1.46/share for 3Q13 up 4%. After tax operating income was $1.21/share compared to $0.96/share in 3Q13 for a 26% increase. Operating earnings exclude realized capital gains and losses from the investment portfolio and other items considered nonrecurring. Operating earnings topped the $1.08/share estimate of analysts, surveyed by Zacks Investment Research, by 12%.

Book value was $77.35/share up 15% from 3Q13 and book value excluding accumulated other comprehensive income (AOCI) was $69.28/share up 11% percent over the year ago period 3Q13.

 

Capital Plan:

With AIG shares trading significantly below book value a wise allocation of capital is share repurchases. Accordingly the company repurchased $1.5 billion (24.8 million shares) of AIG Common Stock during the 3Q14 and $3.4 billion year to date. The share repurchases were at an aggregate price of $54.32/share for a discount of about 30% to the quarter end book value of $77.35/share. The board of directors increased its share repurchase authorization for another $1.5 billion on October 31, 2014.

AIG still holds certain assets and liabilities of AIG Financial Products (AIGFP), the division cited at the center of the company’s financial crises. This portfolio referred to as the direct investment book or DIB is residual exposure that remains until completely wound down in 2018. AIG announced during 3Q14 they made further progress reducing DIB debt by about $2.0 billion through the redemption of notes due in 2016 & 2017 using cash allocated to the DIB. In October AIG further reduced DIB debt by approximately $2.4 billion through redemption of 8.25% interest notes due 2018 and redemption of $405 million principal amount of 5.45% interest medium term notes using cash allocated to the DIB.

During the 3Q14 AIG repurchased $2.5 billion of high interest debt and continued in October 2014 with the repurchase $1.6 billion principal of 8.175% hybrid notes. Taking advantage of the low interest rate environment AIG also issued $1.0 billion of 2.300% notes due 2019 and $1.5 billion of 4.500% notes due 2044; in October 2014 issued an additional $750 million of 4.500% notes due 2044. The year to date annual net interest savings from these actions are $160 million.

AIG parent liquidity sources were $17.1 billion at 3Q14, including $12.6 billion of cash, short-term investments, and unencumbered fixed maturity securities, down from $18.5 billion in the 2Q14.

Dividend:

AIG announced [Source] that its Board of Directors declared a dividend of $0.125 per share on AIG common stock. The dividend is payable on December 18, 2014 to stockholders of record at the close of business on December 4, 2014.

Operating Performance:

AIG’s core businesses are AIG Property and Casualty (P&C), AIG Life and Retirement (L&R) and the mortgage insurance business, Mortgage Guaranty (MG).

After the initial recapitalization of the company in early 2011, management developed enterprise wide goals referred to as “aspirational goals” to be achieved by the year 2015 for the key operational metrics [Source]. We continue to use these goals as a measure of progress for AIG’s core businesses because they are believed to be the key to unlocking the intrinsic value of the company.

Return on Equity:

Insurance companies make money from writing profitable insurance policies (underwriting) as measured by the combined ratio; and from returns on the invested premiums (float) as measured by return on investments until the premiums are paid out as claims. Both sources of earnings are reflected in the return on equity the primary measure for shareholders of how much the company is earning on their investment in the company.

Although AIG showed improvement in return on equity (ROE) over the prior three quarters 3Q14 declined from 7.7% in 2Q14 to 7.2% but was up from 6.2% in 3Q13. The annualized quarterly ROE calculations are volatile and one quarter does not make a trend, but if a trend develops it is important and bears watching.

The sequential 3Q14 decline in ROE from the 2Q14 is due to a decline in after tax operating income from $1833 million to $1745 million. There are a lot of moving parts in after tax operating income but noteworthy is a $227 million adverse reserve adjustments in the Property and Casualty (P&C) business for accident years 2006 and earlier. Had this adverse reserve adjustment not been necessary the ROE, all other things equal, would have increased to 8.1% annualized, showing a nice improvement. Keep in mind we are annualizing one quarter’s results magnifying the actual impact by a factor of four.

AIG lags their peers and consequently the share price to book value multiple also lags. The company needs to demonstrate that a 10% ROE (the aspirational goal) can be achieved on average to command the 1.0X book value multiple anticipated.

AIG 3Q14 ROE

Improving ROE has the potential to increase the share price to $77/share or an additional 45% appreciation over the current price of about $53/share.

In the meantime each share repurchase at about $53/share is acquiring assets worth about $77.35/share (book value) for a 45% return on our equity dollar spent. It is good to see available cash used for the share repurchases at these discounted share prices.

A Note on Reserves:

A key indicator of reserve estimate accuracy is how much a company increases or decreases reserves due to claims from business written in prior years.  Good companies set initial reserves conservatively and if they prove conservative the claims will settle below reserve estimates and the company can adjust the reserves downward. The actuaries at the P&C insurers are not certain about the estimates; so as investors we want to be confident that the estimates are conservative or at least sufficient to cover future claims on average.

The adverse reserve adjustment in 3Q14 means AIG is adding to reserves; an indication that it underestimated the cost of claims. During the past decade, under prior management, AIG established a record of reserve deficiencies. Because AIG’s businesses are long duration lines, this raises concerns about the company’s ability to set adequate reserves and the potential size of needed adjustments. In 2011 AIG’s then new CEO Bob Benmosche, after a comprehensive loss review, took a $4.1 billion charge to set aside more reserve funds to cover deficiencies and hopefully clean the slate for the future.

This concern was raised in the 3Q14 earnings conference call when an analyst asked in part; “AIG clearly needs to finally put its legacy reserves issues to bed…typically, [peers intentionally] book conservative reserves and then consistently release reserves over time to be able to manage these issues without…investors…overly focusing on historic challenges, and making sure that you have a certain amount of conservatism in the business fronts…do you agree that ought to be your goal?”

The $227 million adverse reserve adjustment is a long way from a $4.1 billion adjustment. But given the history at AIG it’s a fair questions. New CEO Peter Hancock responded appropriately in my view: …we view our own practices as very much committed to a true north of giving our best estimates of reserves with the information that we have at hand. We don’t try and squirrel away reserves for a rainy day.

So what you see is what you get. It may lead to a little bit more quarterly EPS volatility than everybody would like from the outside, but we think that the long-term sustainability of our strategy is what is most important. And that comes from facing the truth on a timely basis, good news and bad news.

And I think that that is a philosophical belief that I would like to underpin the way we manage our business throughout. We want to create sustainable long-term growth, and that requires us to face the truth on a timely basis, good news or bad.”

As shareholders we need open and honest communication from management, good news or bad, not managed earnings. To be fair to the analyst, he was asking for more conservative reserve estimates not managed earnings, but that can become a slippery slope. Hopefully this quarter’s reserve adjustment will prove to be a random variation and an example of “bad news” we will hear infrequently. Reserve adequacy has been a past issue at AIG and only time will tell if it becomes a future issue.

I’m encourage by management’s response to the question and that Peter Hancock was hired in part due to his experience in risk management. He is demonstrating a focus on using data to govern management decisions and there are signs that improvement is underway. Management reported the overall experience for accident years 2007 and subsequent years were favorable due to reduced policy limits and re-underwriting of the excess casualty portfolio. Reserves were released from more recent years and the accident year combined ratio improved for the quarter to 95.6 from 98.0 in the year ago quarter. All signs risk is being price adequately.

Combined Ratio:

The key metric for the AIG Property and Casualty (P&C) is the combined ratio, a measure of how well management is pricing risk. A combined ration below 100 reflects profitable insurance policy underwriting and above 100 reflects underwriting losses. Management’s aspirational goal is a level between 90 and 95.

During the quarter, the P&C combined ratio increased from 98.8 in the 2Q14 to 102.0 in the 3Q14 a move in the wrong direction. This was also impacted by the prior years’ reserve adjustment discussed above and needs to be a continued point of focus.

AIG 3Q14 PC Combined Ratio

Return on Investments:

Returns on the invested premiums (float) as measured by return on investments contributes to return on equity until the premiums are paid out as claims. AIG Life and Retirement (L&R) aspirational goals were set for return on investment at 7.4% and assets under management (AUM) at $320 billion. Investment yields increased to 5.58% during 3Q14 from 5.48% during 2Q14. AUM increase to 334.0 billion from 332.8 billion the prior quarter and exceeds the 2015 goal of $320 billion.

AIG 3Q14 AUM and Yield

Life Insurance in Force:

AIG Life and Retirement (L&R) metric, Life Insurance in Force, ultimately determines assets under management and investment earnings. Although Life Insurance in Force increased 0.6% from 2Q14 level of $918.6 billion to 3Q14 level of $924.5 billion it lags considerably below what was targeted for 2015. If this is an indication of L&R disciplined underwriting where quality is chosen over volume to reduce risk and eventual losses, perhaps then it is worth the tradeoff.

AIG 3Q14 In Force

Mortgage Guaranty Combined Ratio:

The Mortgage Guaranty (MG) unit is the smallest core business unit within AIG reflecting about 2.4% of shareholders’ equity. MG reported pretax operating income increased from $43 million in 3Q13 to $135 million in 3Q14 or 214%. This company’s performance has been outstanding but unfortunately is too small to have a material impact on AIG. Management views it as a core business because of the insights it provides to the housing and mortgage markets. The key metric for the MG unit is the combined ratio a measure of how well management is pricing risk and the performance has been outstanding.

AIG 3Q14 Mtg Combined Ratio

Progress on AIG Investment Thesis:

AIG’s book value is already beyond our 3-5 year target but the share price is lagging considerably due to low returns on equity resulting in a low price to book value multiple.

AIG 3Q14 Investment Thesis

Third Quarter Key Themes:

AIG 3Q14 Key Themes

AIG Third Quarter Conference Call Presentation [Source]

Summary:

AIG’s new CEO and the management team remain focused on operations improvement and capital management. Operations needs more work and in the meantime capital management including share repurchases at accretive levels will further leverage the operation improvements when realized. Our investment thesis remains on track.

Disclosures: Long AIG common stock

You are encouraged to do your own independent research (due diligence) on any idea discussed here because it could be wrong. This is not an invitation to buy or sell any particular security and at best it is an educated guess as to what a security or the markets may do. This is not intended as investment advice, it is just an opinion. Consult a reputable professional to get personal advice that meets your specialized needs of which that the author has no knowledge. This communication does not provide complete information regarding its subject matter, and no investor should take any investment action based on this information.

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