Tag Archives: AIG undervalued

A Tale of Two Insurers

My negativity on the operating prospects for the reinsurance and specialty insurance sector has been articulated many times previously in this blog. Many of the same factors are impacting the broader commercial insurance market. Pricing conditions in the US and globally can be seen in the graph below.

click to enlargeUS and Global Commercial Insurance Pricing

Two insurers, at different ends of the size scale, which I have previously posted on, are AIG (more recently here and here) and Lancashire (more recently here and here). Given that a lot has happened to each since I last posted on them, I thought a quick update on both would give an interesting insight into the current market.

First up is AIG who have been under a lot of pressure from shareholders to unlock value, including a break-up plan for the insurance giant from the opportunistic rascal Carl Icahn. The graph below shows a breakdown of recent operating results (as ever with AIG longer term comparisons are hampered by their ever changing reporting segments). The improvement in the UGC mortgage insurance business has been dwarfed by the poor non-life results which were impacted by a significant reserve strengthening charge.

click to enlargeAIG PreTax Operating Income 2012 to 2015

In January, Peter Hancock (the 5th CEO since Hank Greenberg left in 2005) announced a new strategic plan to the end of 2017, the main points of which are

  • Return at least $25 billion of capital to shareholders through dividends and share buy-backs from operating profits, divestitures and other actions such as monetizing future life profits by $4-5 billion through reinsurance purchases.
  • Enhance transparency by separating into an operating portfolio with a goal of over 10% return on equity and a legacy portfolio that will focus on return of capital. Reorganize into at least nine modular, more self-contained business units to enhance accountability, transparency, and strategic flexibility.
  • Reduce general operating expenses by $1.6 billion, 14 percent of the 2015 expenses.
  • Improve the commercial P&C accident year loss ratio by six points.
  • Pursue an active divestiture program, including initially the 20% IPO of UGC.

The non-life reserve charge in 2015 amounted to $3.6 billion. 60% of the charge came from the (mainly US) casualty business, 16% from financial lines (again mainly in the US) and 15% from the run-off business. After the last material reserve strengthening in 2010, the worrying aspect of the 2015 charge is that approximately two thirds comes from accident years not yet 10 years old (which is relatively immature for long tail casualty business particularly when 42% of the charge is on excess casualty business). The impact of the reserve hikes on the commercial P&C segment can be clearly seen in the graph below.

click to enlargeAIG Commercial P&C Combined Ratio Breakdown 2008 to 2015

Perhaps the most aggressive target, given current market conditions, in the strategic plan is the 6% improvement in the commercial P&C accident year loss ratio by the end of 2017. The plan includes exiting approximately $1 billion of US casualty business, including poorly performing excess casualty business, primary and excess auto liability, health-care and financial lines business. Growth of $0.5 billion is been targeted in multi-national, financial lines, property upper middle market and major accounts which involve specialist engineering capabilities, international casualty and emerging risks such as cyber and M&A insurance. AIG also recently announced a two year reinsurance deal with Swiss Re on their US casualty book (it looks like a 25% quota share). The scale of the task for AIG in meeting this target can be seen in the exhibit below which takes a number of slides from the strategy presentation.

click to enlargeAIG Commercial P&C Metrics

I was struck by a quote from the firm on their turnaround plan – “We will use the data and analytical tools we have invested in to significantly differentiate and determine where we should focus our resources.” I suspect that every significant insurer would claim to have, or at least aspire to have, similar analytical capabilities. Big data and analytical driven underwriting is undoubtedly the future for large insurers with access to large amounts of quality data. Fortune had an interesting recent article on the analytical firm Palantir who are working with some insurers on sharpening their underwriting criteria for the social media age. An analyst in Citi even suggested that Goggle should look at buying AIG as a fintech play. The entry of the big internet firms into the insurance sector seems inevitable in some form or other, although I doubt AIG will be part of any such strategy.

As to the benefits of staying a large composite insurer, AIG cited an analysis commissioned by consultants Oliver Wyman supporting the benefits of diversification between the life and non-life business of AIG. Using the S&P consolidated model as a proxy, Oliver Wyman estimate a $7.5 billion capital benefit to AIG compared to separate life and non-life businesses, as envisaged in Icahn’s plan.

So, can AIG achieve the aggressive operational targets they have set themselves for the P&C business? Current market conditions present a considerable challenge. Combined with their recent results, an end of 2017 target for a 6% improvement is extremely aggressive. Too aggressive for my liking. However, the P&C results should improve somewhat over the short term (particularly if there is no more big reserve charges) and actions such as expense reductions, monetizing future life profits and divestitures will give AIG the fire power to hand out sweeties to shareholders. For those willing to take the punt, the return of a chunk of the $25 billion target in dividends and share buy-backs over the next 2 years for a firm with a current market value of $61 billion, trading at a 0.72 multiple to book value (trading around 0.92 of book less AOCI and DTA), may be too tempting to resist. It does have a certain allure…..

Lancashire, a London market specialty insurer and reinsurer with a mantra of disciplined underwriting, is at the opposite end of the scale spectrum with a niche focus. Long cherished by investors for its shareholder friendly dividend policies, Lancashire has been under pressure of late due to the heavy competition in its niche markets. The energy insurance sector, for example, has been described by the broker Willis as dismal with capacity chasing a smaller premium pool due to the turmoil in the oil market. A number of recent articles (such as here and here) highlight the dangers. Alex Maloney, the firm’s CEO, described the current market as “one of the most difficult trading environments during the last twenty years”. In addition, Lancashire lost its founder, Richard Brindle, in 2014 plus the CEO, the CFO and some senior underwriters of its Lloyds’ Cathedral unit in 2015.

The graph below shows the breakdown of reported historical calendar year combined ratios plus the latest accident year net loss ratio and paid ratio.

click to enlargeLancashire Ratio Breakdown 2008 to 2015

The underwriting discipline that Lancashire professes can be seen in the recent accident year loss ratios and in the 30% drop in gross written premiums (GWP), as per the graph below. The drop is more marked in net written premiums at 35% due to the increase in reinsurance spend to 25% of GWP (from approx 10% in its early years).

click to enlargeLancashire GWP Breakdown 2008 to 2015

The timely and astute increase in reinsurance protection spend can be seen in the decrease in their peak US aggregate exposures. The latest probable maximum loss (PML) estimates for their US peak exposures are approximately $200 million compared to historical levels of $300-350 million. Given the lower net premium base, the PML figures in loss ratio terms have only dropped to 40% from 50-60% historically. Lancashire summed up their reinsurance purchasing strategy as follows:

“Our outwards reinsurance programme provides a breadth and depth of cover which has helped us to strengthen our position and manage volatility. This helps us to continue to underwrite our core portfolio through the challenges posed by the cycle.”

As with AIG, the temptation for shareholders is that Lancashire will continue with their generous dividends, as the exhibit below from their Q4 2015 presentation shows.

click to enlargeLancashire Dividend History 2015

The other attraction of Lancashire is that it may become a take-over target. It currently trades at 1.4 times tangible book level which is rich compared to its US and Bermudian competitors but low compared to its peers in Lloyds’ which trade between 1.58 and 2.0 times tangible book. Lancashire itself included the exhibit below on tangible book values in its Q4 2015 presentation.

click to enlargeInsurance Tangible Book Value Multiple 2012 to 2015

It is noteworthy that there has been little activity on the insurance M&A front since the eye boggling multiples achieved by Amlin and HCC from their diversification hungry Japanese purchasers. Many in the market thought the valuations signaled the top of the M&A frenzy.

Relatively, AIG looks more attractive than Lancashire in terms of the potential for shareholder returns. However, fundamentally I cannot get away from current market conditions. Risk premia is just too low in this sector and no amount of tempting upside through dividends, buy-backs or M&A multiples can get me comfortable with the downside potential that comes with this market. As per the sentiment expressed in previous posts, I am happy with zero investment exposure to the insurance sector right now. I will watch this one play out from the sidelines.

Quick check on AIG

My last post on AIG concluded that a target of $60-$70 per share over the medium term did not seem unreasonable. However, given the difficulty in predicting a number of moving items in their results and the competitive insurance market, AIG didn’t excite me enough to get involved. Based upon a quick review of the results over H1 2014, that remains my view.

Q2 results were flattered by a gain of over $2 billion on the aircraft leasing sale. Overall the operating results were steady for H1, as the graph below shows, trending towards an approximate $10 billion operating income for 2014. Core earnings from P&C and life & retirement have been steady at approximately $2.5 billion each for the year to date.

click to enlargeAIG OpIncome 2011 to 2014H1

Analysts have an average EPS estimate of $4.62 for 2014, roughly the same as 2013, and $5.00 for 2015 which supports a target share price in the low to mid sixties. The AIG “discount” continues with the stock trading around 80% of book (excluding Accumulated Other Comprehensive Income), as per the graph below.

click to enlargeAIG Book Multiples 2009 to Sept2014

Some may argue that this discount is harsh given how far AIG has come. I’m not yet convinced that AIG deserves to come off the naughty step and get a more normal valuation.

AIG still below $50: an explanation

In a previous post on AIG I tried to unpick each of the main drivers of the business and predict a “normalised” net income for 2014. Well, my estimate of $7.25 billion of net income for 2013 was blown out of the water by over $4 billion for H2 bringing the 2013 total to $9 billion. This is a massive increase on the $3.4 billion from 2012. A follow-on post in October outlined how I was surprised by a $1 billion tax benefit in Q3.

At $49, the stock currently trades at a discount of 71% to book value (incl AOCI) and 76% to book value (excl AOCI). Given the 2013 results and the successful sale of the aircraft leasing business, why is AIG not trading well above $50? Well, one reason may be that outlined in the graphic below.

click to enlargeAIG Net Income 2013 10K vrs 2012 10K

After the amount of change that AIG has gone through, reinstatements were to be expected. However, you should expect AIGs’ numbers to have stabilized by now and to be more consistent than movements of between $1.6, $0.6 & $1 billion for 2009, 2010, and 2011 as reported between the 2012 and 2013 10Ks. And a staggering $6.4 billion for 2012! How can that be? To be honest, my desire to dig deeper and find an explanation evaporated by the simple fact that it should not happen and my conviction in AIG has dropped commensurate with by disbelief.

If you believe that the movements are for rational reasons and can be taken into account in future estimates, then good luck to you. The exhibits below represents what the latest 10K figures show.

The breakdown of “normalised” pre-tax income below (excluding items from AIA, ML III, aircraft leasing & debt restructures) shows consistent contributions from the “hodge-podge” of the mortgage business, GCM and DIB (combined up to $2.4 billion in 2013 from $2.2 billion in 2012). The P&C contribution is up considerably from 2011 & 2012 around $2 billion to over $5 billion. Life & retirement is also up to $6.5 billion in 2013 from under $4 billion in 2012 and approx $3 billion in 2011

click to enlargeAIG PreTax income 2001 to 2013

The P&C improvement in pre-tax income is primarily due to improvements in the US commercial & other business lines. The US commercial business benefited from a light 2013 catastrophe year whilst the other business segment had a lower underwriting loss and high investment income. The expense ratio, particularly in the international segment, remains high.

click to enlargeAIG Inc - P&C PreTax income 2001 to 2013

Life & retirement benefited from good top-line growth, a $1 billion legal settlement, and $2 billion of realized capital gains.

After taking the 2013 trends into account and taking out some 2013 one-offs and including an average US catastrophe year, my previous estimate of a “normalised” $6.5 billion of net income for 2014 and a $60-$70 price target over 12-18 months does not seem unreasonable. That’s if you have confidence in the reported 2013 figures. Which, based upon the first exhibit above, I don’t.

Factors impacting AIG’s valuation

AIG stock has been the subject of much investor attention in recent times and has doubled over the past 24 months. The new AIG has become a hedge fund favourite, the 3rd most popular stock according to Goldman Sachs. I did briefly look over AIG at the end of 2010 when it traded around $35 but concluded there was too much uncertainty around its restructuring and I particularly didn’t like the P&C reserve deteriorations in 2009 and 2010. The stock fell below $25 in 2011 before reversing and beginning its recent accent above $45 as further clarity on its business performance emerged. I figured now is a good time to give the new AIG another look.

Unless you have been living on Mars, everybody is aware that AIG has had a very colourful history and, although it’s past is not the focus of this post, the graph below of the 10 year history of the stock is a reminder of the grim fate suffered by its equity holders with the current price still only about 5% of the pre-crash average. For what it is worth, the 2005 Fortune article “All I want in life is an unfair advantage” and the 2009 Vanity Fair article “The Man Who Crashed the World” by Michael Lewis are two of my favourites on the subject and worth a read.

click to enlargeAIG 10 year stock price

To understand the new AIG we need to review the current balance sheet and the breakdown of the sources of net income since 2010. The balance sheet (excluding segregated assets & liabilities) as at Q2 2013 is represented in the exhibit below.

click to enlargeAIG Balance Sheet & Assets

AIG’s liquid assets look reasonably diverse and creditworthy although these assets should really be looked at in their respective business units. The P&C assets are the more conservative and look in line with their peers. The life and retirement assets are riskier and reflect the underling product mix and risk profile of that business.

Another item to note is the $31.2 billion of aircraft leasing assets from ILFC against the $26.5 billion of liabilities representing $4.7 billion of net assets. AIG’s deal to sell 80% of ILFC to a Chinese consortium for book value looks like it may fall apart. If it does, the possibility of going down the IPO route is now a realistic option, absent a change in current market conditions.

The next item to note is the other assets representing 13% of total assets. These are primarily made up of $20 billion of deferred taxes, $9 billion of DAC, $14 billion of premium receivables, and $15 billion of various assets. This last item includes $2.8 billion of fair value derivative assets which correspond to $3.1 billion of fair value derivative liabilities. The notional value of these assets and liabilities is approximately $90 billion and $110 billion respectively from primarily interest rate contracts but also FX, equity, commodity and credit derivatives that are not designated for hedging purposes. The majority (about 2/3rd) of these are from the Global Capital Markets division which includes the run-off of the infamous AIG Financial Products (AIGFP) unit.

AIG’s non-life reserves, at $108 billion, have been a source of volatility in the past with significant strengthening required in 2002, 2004, 2005, 2009 and 2010. The life and retirement reserves are split $121 billion of policyholder contracts (including guaranteed variable annuity products like GMWB), $5 billion of other policyholder funds, and $40 billion of mortality and morbidity reserves.

A breakdown of AIG’s net income since 2010 shows the sources of profit and losses as per the graph below.

click to enlargeAIG Net Income Breakdown 2010 to Q22013

The graph shows that the impact of discontinued operations has been playing less of a part in the net income line. It also points to the need to understand the importance of the other business category in 2011 and 2012 as well as the relative underperformance in the P&C division in contributing to net income for 2010 to 2012.

In 2011, contributors to other pre-tax income included a $1.7 billion impairment charge on ILFC’s fleet and a net $2.9 billion charge due to the termination of the New York Fed credit facility. 2012 net income included a $0.8 billion gain on the sale of AIA shares and an increase of $2.9 billion in the fair value of AIG’s interest in Maiden Lane III (the vehicle created during the AIG bailout for AIGFP’s CDO credit default swap portfolio). These 2012 gains were partially offset by an increase of $0.8 billion in litigation reserves.

AIG bulls point to the 2013 YTD performance. Improved operating margins in the core P&C and life/retirement units have combined with income from the other activities (mortgage business, Global Capital Markets & Direct Investment portfolios) covering corporate and interest expenses and any other one off charges (such as those in the paragraph above). This performance has led analysts to predict 2013 EPS around $4.20 and 2014 EPS of $4.30 to $4.50.

AIG has traded at a significant discount to its peers on a book value basis as a result of its troubled past and currently trades at 0.73. The graphs below uses recently published book values and book value excluding Accumulated Other Comprehensive Income (AOCI) which have been the subject to adjustment and reinstatement and may not therefore reflect the book values published at the time.

click to enlargeAIG stock price to book values 2009 to August 2013

AIG Book Value Multiples 2009 to August 2013

In summary, the factors impacting the current AIG valuation are the significant book value discount as a result of AIG’s history, the uncertainty around the ILFC sale, the future prospects of the core P&C and life/retirement units, and the historical volatility in the other operating business lines (and the potential for future volatility!). Each of these items need to be understood further before any conclusions can be reached on whether AIG is currently undervalued or overvalued. In a follow-on post on AIG I will try to dig deeper into each of these factors and also offer my thoughts on future performance and valuation of the new AIG.