American International Group (AIG) 1Q15: Management Focused on the Right Things

AIG reported 1Q15 earnings [Source] and it is a good report. Management is focused on improving operating performance and rightly so as this will be the source of future returns for shareholders. Most management teams, the smart ones anyway, tell shareholders that shareholder returns are important to them. However their actions demonstrate if this is in fact their focus. Each quarter it becomes clearer that AIG’s new CEO, Peter Hancock and his management team are in fact focused on operation improvement, risk management, and the pursuit of value not volume all beneficial for sustainable longer term shareholder returns.

The Upside:

Insurance companies’ share price are usually a multiple of book value and that multiple is a function of the return on equity (ROE). For example, an insurer’s earning a 10% ROE sell at a multiple of about 1X book value, and insurer’s with a 7% ROE sell at a multiple of about .7X. AIG’s 2014 ROE is 20-30% below peers so the shares sell 20-30% lower to make up for the performance deficit. Why pay full value for an under performing company?

If AIG continues to increase book value about 10% per year as it has done the past four years, repurchase shares at attractive discounts to book value, and achieves the company goal of a 9% ROE in three years; the book value will approach $100/share and the multiple will improve to about 0.9X for a $90/share stock price and a potential 70% further gain over today’s price. The additional potential returns are in excess of 20% per year.

Performance Targets:

During the 4Q14 conference presentation management outlined performance objectives. They are along the lines we felt needed to capture this opportunity and are reporting quarterly results along those lines:

AIG 1Q15 Financial Targets

[Source] AIG’s 1Q15 Conference Call Presentation, pg. 7

The CEO is front and center on reporting performance, no delegation of responsibility and accountability here. In his opening remarks on the conference call CEO Peter Hancock reported in part, “…book value per share excluding accumulated other comprehensive income and our deferred tax assets was over $60, up 4% for the quarter and 14% from a year ago. We’re confident that we will achieve our targeted book value growth of at least 10% this year through improving profitability and active capital management. Our ROE improvement is also on track…On the expense front…we made progress in the first quarter and remain committed to our annual targets through 2017 of 10% book value per share growth excluding AOCI and DTA and 50 basis points of normalized ROE improvement and 3% to 5% expense reductions through 2017. Our first quarter results demonstrated our commitment to balancing growth, profitability and risk.”

AIG’s underlying operating performance is improving with the combined ratio in the Commercial business declining to 97.1% from 98.9% last year, but it is up slightly in AIG’s Consumer businesses to 103.2 from 103.0. Management’s focus on risk adjusted returns may sacrifice some volume overtime but should generate expected progress and returns over the next three years. As shareholders are focus is on value not volume.

Financial Targets:

During the 4Q14 conference presentation management also described the new organization dividing the business into Commercial, Consumer and Corporate and Other.  They are now reporting financials along these lines.

AIG 1Q15 Financial Highlights

[Source] AIG First Quarter 2015 Conference Call Presentation page 5

The focus on operations improvement and risk management if successful will improve the company’s return on equity. It will be bumpy quarter to quarter, but improvement over time will increase book value and the price to book value multiple thereby leveraging AIG’s share price higher.

There’s always a Downside:

The risk of investing in AIG’s is similar to all insurers including, but not limited to; claims that are in excess of the amount reserved for payment of the claims. In AIG case there also continues to be adverse reserve development from past underwriting decisions. This seems to be decreasing but needs to be watched. It would nice to see this issue finally put to rest and an occasional favorable development to occur. As an insurer AIG also has a material exposure to catastrophe losses inherently unpredictable.

Financial Crises Residual Issues:

AIG has done an amazing job navigating through the myriad of issues they had to deal with as a result of the financial crises and government bailout. Although largely behind them, there are issues where various degrees of risk remain.

  • Systemically Important Financial Regulations (SIFI) Regulations Pending:

AIG management commented during the conference call with respect to the pending SIFI; “the balance sheet size, leverage and capital in non-insurance activities is comparatively low relative to our non-bank SIFI peers. We work closely with our many regulators and respect the value they bring to all stakeholders.”

AIG has taken a number of steps to exit non-core businesses and improve balance sheet strength, risk profile and sustainability of returns. It appears the company is working constructively with the regulators to help shape the outcome of the SIFI regulations, yet, the regulations are still to be defined and could be burdensome to the company.

  • Direct Investment Book:

AIG holds certain assets and liabilities of the former 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 a residual exposure that remains until completely wound down in 2018. The company has made significant progress in winding down the book. It size is sufficiently reduced that AIG will no longer report DIB as a separate component of corporate and other. Although the wind down has been accelerated it still remains, but now a much smaller risk.

  • AerCap:

AIG holds a 46% interest investment in AerCap, the company that purchased AIG’s former non-core aircraft leasing business. As ILFC was, the AerCap shares held by AIG IS a non-core business and the company continues to look at various options for the sale of the AerCap stake. This may ultimately result an impairment charge later this year if the market price of AerCap continues to trade below the carrying value.

  • Starr International Litigation:

Starr International Company, Inc. has brought suit against the United States challenging the government’s assistance of AIG, where AIG entered into a credit facility with the Federal Reserve Bank of New York and the United States received approximately 80 percent ownership interest in AIG. The United States has alleged that AIG is obligated to indemnify the United States for any recoveries should they occur in these lawsuits. The trial is concluding and a determination that the United States is liable for damages along with a determination that AIG is obligated to indemnify the United States for any such damages, could have a material adverse effect on AIG.

The Starr litigation is given a low probability of success by many. However, similar to catastrophe losses, a court decisions of this complexity are inherently unpredictable, certainly by me. The discussions seem to be:  (1) It is unlikely the government loses the case; (2) Starr International cannot prove AIG could have survived without the bailout, (3) if the government loses, AIG was coerced into the indemnification (by the government) thus invalidating the indemnification, (4) if AIG could have survived without the government bailout would that have been less costly to the pre-crises shareholders than the bailout to create damages? (5) In any event years of appeals will follow before resolutions.

All seem to be logical points but the litigation cannot be discounted by AIG investors until the judge rules on the litigation. The Starr International litigation in my view it is the largest unknown and seemingly the largest remaining risk of the financial crises.

AIG Bring on Tomorrow

Concluding on a positive note: AIG’s new CEO and the management team are focused on the key priorities of operations improvement and capital management. These are the keys to our investment thesis and shareholder realization of AIG’s full potential value. Yes, operations needs more work but in the meantime share repurchases are being made at accretive levels that should further leverage the operation improvements as they are realized. It is encouraging to see open and honest communications from management with their key objectives fully “owned” by CEO, Peter Hancock.

AIG 1Q15 Highlights

Summary:

We remain encouraged to know the key to unlocking and growing the intrinsic value of AIG on a sustainable basis is front and center. That will help assure operations improvement gets the attention it deserves. 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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