Tag Archives: reserve strengthening

Creepy Things

It has been a while since I looked at the state of the reinsurance and specialty insurance markets. Recent market commentary and insurers’ narratives at recent results have suggested market rates are finally firming up, amidst talk of reserve releases drying up and loss creep on recent events.

Just yesterday, Bronek Masojada the CEO of Hiscox commented that “the market is in a better position than it has been for some time”. The Lancashire CEO Alex Maloney said he was “encouraged by the emerging evidence that the (re)insurance market is now experiencing the long-anticipated improvements in discipline and pricing”. The Chubb CEO Evan Greenberg said that “pricing continued to tighten in the quarter while spreading to more classes and segments of business, particularly in the U.S. and London wholesale market”.

A look at the historical breakdown of combined ratios in the Aon Benfield Aggregate portfolio from April (here) and Lloyds results below illustrate the downward trend in reserve releases in the market to the end of 2018. The exhibits also indicate the expense disadvantage that Lloyds continues to operate under (and the reason behind the recently announced modernisation drive).

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In the Willis Re mid-year report called “A Discerning Market” their CEO James Kent said “there are signs that the longstanding concern over the level of reserve redundancy in past year reserves is coming to fruition” and that in “some classes, there is a clear trend of worsening loss ratios in recent underwriting years due to a prolonged soft market and an increase in loss severity.

 In their H1 presentation, Hiscox had an exhibit that quantified some of the loss creep from recent losses, as below.

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The US Florida hurricane losses have been impacted by factors such as assignment of benefits (AOB) in litigated water claims and subsequently inflating repair costs. Typhoon Jebi losses have been impacted by overlapping losses and demand surge from Typhoon Trami, the Osaka earthquake and demand from Olympics construction. Arch CEO Marc Grandisson believes that the market missed the business interruption and contingent BI exposures in Jebi estimates.

The fact that catastrophic losses are unpredictable, even after the event, is no surprise to students of insurance history (this post on the history of Lloyds is a testament to unpredictability). Technology and advances in modelling techniques have unquestionably improved risk management in insurance in recent years. Notwithstanding these advances, uncertainty and the unknown should always be considered when model outputs such as probability of loss and expected loss are taken as a given in determining risk premium.

To get more insight into reserve trends, it’s worth taking a closer look at two firms that have historically shown healthy reserve releases – Partner Re and Beazley. From 2011 to 2016, Partner Re’s non-life business had an average reserve release of $675 million per year which fell to $450 million in 2017, and to $250 million in 2018. For H1 2019, that figure was $15 million of reserve strengthening. The exhibit below shows the trend with 2019 results estimated based upon being able to achieve reserve releases of $100 million for the year and assuming no major catastrophic claims in 2019. Despite the reduction in reserve releases, the firm has grown its non-life business by double digits in H1 2019 and claims it is “well-positioned to benefit from this improved margin environment”.

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Beazley is one of the best insurers operating from London with a long history of mixing innovation with a balanced portfolio. It has doubled its net tangible assets (NTA) per share over the past 10 years and trades today at a 2.7 multiple to NTA. Beazley is also predicting double digit growth due to an improving rating environment whilst predicting “the scale of the losses that we, in common with the broader market, have incurred over the past two years means that below average reserve releases will continue this year”.

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And that’s the rub. Although reserves are dwindling, rate improvements should help specialty (re)insurers to rebuild reserves and improve profitability back above its cost of capital, assuming normal catastrophe loss levels. However, market valuations, as reflected by the Aon Benfield price to book exhibit below, look like they have all that baked in already.

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And that’s a creepy thing.

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.

Is AIG overvalued or undervalued at $52?

Following on from my initial post on AIG and before AIG’s Q3 results due on Halloween, I spent some time digging into the main drivers of the new AIG’s performance. In the interests of full disclosure, I do not currently own, nor have I in the past owned, stock in AIG.

AIG’s valuation has improved recently breaking through $50 in September before briefly retreating and again breaking above $52 currently as we run-up to the Q3 results, as can be seen in the latest price to book multiple graph below.

click to enlargeAIG stock price to book values 2009 to October 2013In the new AIG, there are 3 main business drivers – P&C, life & retirement, and a hodgepodge under the title of other (made up of the mortgage business, global capital markets (GCM), and the direct investment book (DIB), legal reserves, interest and corporate expenses).

Their Q2 presentation showed that capital is approximately 50%, 40% and 10% split against the businesses in P&C, life & retirement, and the other section, as per the graph below. Clearly, the P&C division has not contributed to operating income in proportion to its capital base in recent years.

click to enlargeAIG Equity BreakdownThe 2012 employee count of 63,000 is split 45,000 in the P&C division (with 30,000 in international), 12,000 in the life & retirement division and 6,000 in the other business units.

P&C Division

Over the past 5 years, AIG has shifted their business mix away from an US commercial focus to a more balanced commercial & consumer (60:40) and US & international (60:40) mix, as per the graph below.

click to enlargeAIG NWP Mix 2007 to 2012The focus for AIG is on higher value commercial and consumer products and geographical diversity with a greater emphasis on technical underwriting discipline.  In particular, following significant reserve strengthening in 2009 and 2010, AIG has refined its approach to underwriting and reserving excess casualty, exited excess workers compensation (WC) and dramatically reduced their exposure to the specialty WC business (with small monocline guaranteed cost risks) that grew so rapidly in the early to mid 2000s.

These changes in business mix make the usefulness of historical results difficult. However, I do think it’s important to try to understand the future through the past. Although the current segment reporting by AIG is detailed in terms of US & International commercial and consumer lines shown separately, this was not the case in the past. I went through past reports to get the combined loss ratio details on the US commercial & consumer and the International business segments, as per the graph below. I excluded previous business segments that are not relevant to the new AIG such as the Transatlantic Re and other P&C lines (other included the excess WC business that blew up in 2009 and 2010). Again, I would caveat any of the following statements with a warning about the changes in business mix.

click to enlargeAIG Historical Loss Ratios 2000 to Q2 2013I then recalibrated the historical ratios using the 2012 business mix to get the “as if” graph below. Although these ratios need to be treated with caution, they do give some insight into the profile of the current portfolio. There is a clear favourable trend towards underwriting profitability with 2013 heading below 100% in the absence of significant catastrophe losses.

click to enlargeAIG Combined as if Loss Ratio 2000 to Q2 2013Positives for the US commercial business include a favourable pricing environment, as per the graph below, and a restructuring of the reinsurance protection including a new excess casualty quota share treaty and global per risk property treaty. Negatives remain question marks over the adequacy of reserves and the loss of senior underwriting talent to Berkshire’s new E&S insurer.

click to enlargeUS Primary Pricing TrendAlso, the bad press around the brand must have impacted the quality of AIG’s business in the US. It is arguable that the impact may be less pronounced outside of the US and the ratio graphs above show that the results have been better from international business. The higher acquisition ratios in consumer, particularly on the international side, and the higher overhead as a result of the build out of the international business and the greater technical focus on underwriting & reserving is impacting the expense ratio and is not expected to level off until next year.

The increased diversification in AIG’s business mix is an obvious plus and makes AIG less dependent upon the volatility and uncertainty of excess long tail business. Whether AIG can succeed on a larger scale in the competitive and less specialty consumer lines is an unknown.  After all, they are not getting the new business from thin air and are competing against strong local and global insurers for the business. Diversity for diversity’s sake (or more likely because of some quant misestimation of tail correlations in capital models) will, I suspect, become the industry achilles’ heel in the years to come. Notwithstanding this risk, at least AIG is growing in business lines where it has previous experience.

The graphs above exclude the asbestos and excess WC reserve strengthening from 2010 and 2009. I assume the 2011 deal with Berkshire on the bulk of AIG P&C’s net domestic asbestos takes care of any future deterioration with approx $1.5 billion of limit above the reserves transferred. As at year-end 2012, the gross reserve split is as per the graph below.

click to enlargeAIG Gross P&C Reserve BreakdownI also had a quick look through AIG’s Schedule P as at year-end 2012. The gross and net ratios, on an accident year basis, show that AIG has gained little benefit in the 2007 to 2012 period and likely justify AIG’s restructuring of their reinsurance programme. The increased percentage of reserves ceded in accident year 2012 indicates more use of their reinsurance. Without doing a complete actuarial review, it’s difficult to tell whether reserves are adequate. Based upon my experiences, my gut would say that the reserves look okay, not overtly strong or obviously weak. The 2007 to 2010 accident years look potentially vulnerable.

click to enlargeAIG Schedule PThe excess casualty adverse development (approx $260m) in 2012 were based in part upon a refined actuarial analysis considering the impact of changing attachment points on frequency of excess claims and limit structures on the severity of excess claims. It amazes me that so many (re)insurers still use claims triangle chain ladder methods for excess business (check out the annual reports or SEC filings of some well know global insurers and you’ll see what I mean). AIG has strengthened its corporate actuarial function and its ERM framework is attempting to increase the feedback loop between accounting, claims, underwriting and actuarial. Time will tell whether the new processes will result in more timely reserve estimates and less prior year deterioration.

Investment income at AIG P&C has been remarkably stable in recent years when measured against net earned premium as the graph below illustrates. A healthy return on alternative investments of 14% in 2013YTD (compared to 7% 2012YTD) gave the returns in H1 2013 an additional boost. Compared to London based specialty insurers, the asset profile at AIG looks aggressive. Compared to other US based insurers, less so although the allocation of a third in municipal and structured bonds does put AIG on the aggressive side.

click to enlargeAIG Investment & Historical Net Investment Income Breakdown P&CAIG stated that in 2013 “we expect to continue to refine our investment strategy, which includes asset diversification and yield enhancement opportunities that meet our liquidity, duration and credit quality objectives as well as current risk-return and tax objectives”.

Based upon the trends in the P&C business continuing and assuming no  material reserve deterioration or catastrophe losses, I estimate that a base case for the P&C technical results for 2014 of $1.15 billion, whereby 2014 is a “normal” year. If investment income maintains a 14% of NEP return, my estimates would mean P&C pre-tax income of $5.85 billion for 2014.

Life & Retirement Division

A quick review of the historical results of the US life and retirement business shows both the operating strength of the business and its exposure to market risk, as per the graph below.

click to enlargeAIG US Life & Retirement Results 2000to2013Q2A breakdown of the products sold by AIG’s life & retirement division, as per the graph below, show the lower yields resulting from the global macro-economic quantitative easing has reduced demand for low yielding fixed annuity products and increased demand for variable annuity products with guarantee features. Positives cited by AIG in its increased focus on VA products include favourable market dynamics for these products (reduction in the number of suppliers & increased market demand) and strong de-risking features such as VIX indexing of rider fees, volatility control funds and required minimum allocations to fixed accounts.

click to enlargeAIG US Life & Retirement Product & OpIncome SplitThe graph above shows a trend in operating income towards spread investment products away from protection (e.g. mortality & morbidity) products. To maintain the profits in its spread business, AIG invests approximately 75% of its life and retirement assets in corporate and structured bonds. As the graph below shows, since 2010, AIG is increasingly looking to enhanced yields by way of assets like commercial mortgage loans, private equity, hedge funds, other alternative investments, and common and preferred stock. AIG states that “opportunistic investments in structured securities and other yield enhancement opportunities continue to be made with the objective of increasing net investment income”.

click to enlargeAIG Investment & Historical Net Investment Income Breakdown Life RetirementThe jump in net realised gains in H1 2013 is coming primarily from RMBS and CDO/ABS assets. It is impossible to predict where this item will go for the remainder of 2013 so I would simply select a base target of $4.25 billion in pre-tax annual income for the L&R division for a 2014 “normal” year, assuming stable markets and a continuation of low interest rate expectations for the medium term.

In relation to the challenges the low interest rate environment presents an insurer like AIG, they highlight the following mitigants they can take:

  • Opportunistic investments in structured securities and re-deployment of cash to increase yields.
  • Continued disciplined approach to new business pricing.
  • Actively managing renewal credited rates.
  • Re-priced certain life insurance and annuity products to reflect current low rate environment.
  • Re-filed certain products to continue lowering minimum rate guarantees.

All of these actions sound fine in theory. Reality may present different challenges, particularly if interest rates increase sharply. Results from this business remain highly correlated to macro-economic events.

Other Business

And so, to the hodgepodge! This is the area of most uncertainty for the results of the new AIG. First, I looked at the items in this segment after excluding the recent impacts of AIA, Maiden Lane III, and discontinued businesses. The graph below shows the items to be considered.

click to enlargeAIG Other Segment 2010 to H12013AIG’s overall debt has reduced considerably over the recent past from over $100 billion at the end of 2010 to approx $43 billion as at June (split $15B financial debt, $21.5B operating debt, and $6.5B sub-debt). The interest expense relating to the other segment is projected to reduce by $200 million for 2014. Corporate expenses also look like running at approximately $1 billion per year, up from 2012, due to group wide initiatives like enhanced ERM. Legal reserves and other items, primarily charges on the extinguishing of debt, look impossible to predict in the short term. A base case for expenses of $3 billion looks realistic for a “normalised” 2014. Although an additional buffer of $o.5-1 billion for surprises could be justified, I am not assuming such in the base case.

On the income side, we need to look at the mortgage business, GCM and DIB.

Mortgage Insurance Business

The mortgage guarantee business has obviously had an interesting ride through the financial crisis. The graph below tells its own story.

click to enlargeUCG Results 2000 to H1 2013There has been some debate on whether the United Guaranty units were strategically important to the new AIG. With a new capital maintenance agreement from group in July, that issue has been resolved. After taking their hits on their legacy business and with competitors withdrawing from the market, I am relaxed about AIG continuing in this business as the risk adjusted returns of new business looks attractive. As at Q2 2013, profitable business written from 2009 onwards represented over 60% of their risk in-force, which compares favourably to their peers still in the market. I would be comfortable with pencilling in $200 million of net income from this business in the short to medium term.

Global Capital Markets (GCM) and Direct Investment Book (DIB)

AIG describes GCM as follows:

GCM consist of the operations of AIG Markets, Inc. (AIG Markets) and the remaining derivatives portfolio of AIG Financial Products Corp. and AIG Trading Group Inc. and their respective subsidiaries (collectively AIGFP). AIG Markets acts as the derivatives intermediary between AIG and its subsidiaries and third parties to provide hedging services (primarily of interest rate and currency derivatives). The AIGFP portfolio continues to be wound down and is managed consistent with AIG’s risk management objectives. Although the portfolio may experience periodic fair value volatility, it consists predominantly of transactions that AIG believes are of low complexity, low risk or currently not economically appropriate to unwind based on a cost versus benefit analysis.

A slide from AIG’s Q2 presentation further outlines the portfolio of GCM and DIB, as reproduced below.

click to enlargeAIG DIB & GCM Slide Q2 2013 PresentationAIG describes the DIB as follows:

DIB consists of a portfolio of assets and liabilities held directly by AIG Parent in the Matched Investment Program (MIP) and certain subsidiaries not related to AIG’s core insurance operations (including certain non-derivative assets and liabilities of AIGFP). The management of the DIB portfolio is focused on an orderly wind down to maximize returns consistent with AIG’s risk management objectives. Certain non-derivative assets and liabilities of the DIB are accounted for under the fair value option and thus operating results are subject to periodic market volatility.

Another slide from AIG’s Q2 presentation further outlines the profile of DIB and is also reproduced below.

click to enlargeAIG DIB Slide Q2 2013 PresentationI really do not have any great insights on these two items. The average contribution of $1.3 billion from both items ($1B from DIB and $300M from GCM) since 2010 has obviously had the benefit of reducing interest rates and improving credit profiles. These favourable trends, particularly reducing interest rates, will likely not continue. Again, the results are heavily correlated to the macro-economic situation. The slides above also make it clear that whatever income these units have provided, they (particularly DIB) will have a reducing impact over time.

As a base case (and this is really nothing more than a guess), I would assume annual income of $1.0 billion a year reducing by 25% from 2014 onwards (may be pessimistic given 2013 YTD is at $1.3 billion!).

Conclusion and Valuation

My first observation would be how surprised I was to find that almost every aspect of the old AIG’s business model was impacted by the financial crisis and subsequent poor underwriting results. I obviously haven’t looked over the discontinued businesses like AIA which may have performed better and provided some balance. I had thought that the old AIG’s problems were centred around the losses from AIGFP and the securities lending programme, and the subsequent liquidity strains those businesses resulted in (in particular AIGFP’s decision to write CDS that allowed the counterparty to demand collateral at a level equal to their marks, akin to letting an insured dictate the reserves!). However, the red ink was all over the US investment life business, the mortgage business, the P&C business and the asset side. It would be fascinating to see a hypothetical analysis on the old AIG excluding the AIGFP business to see if it would have survived without a major recapitalisation.

The new AIG puts a lot of emphasis on its new ERM framework and importance of a more diversified and balanced business model. It is surprising therefore to see how much of the new AIG remains exposed to macro-economic events. A more balanced business may emerge as the life & retirement portfolio adjusts and as businesses like DIB runs off and GCM downsizes to a pure internal group AIG hedging intermediary.

Taking the base case estimates for a normalised 2014 outlined above and making some other assumptions on items such as tax, I am coming out with net income of slightly above $6.5 billion for 2014. This estimate may look pessimistic given H1 2013 net income is already at $5 billion but I am assuming that the income from DIB & GCM and that the realised gains and alternative investment yield for H1 2013 do not continue above trend going forward.

For what it is worth (and really this is nothing more than a guess), I estimate net income for AIG for H2 3013 of $2.25 billion, bringing the net income for 2013 to a whopping $7.25 billion!. It will be interesting to see the Q3 results, particularly to see if the realised gains and DIB/GCM positive results continue.

Assuming 40% of net income is used for dividend or buybacks, I therefore could see AIG reaching a book value per share of $70 by year-end 2014. If the trading multiple for AIG were to increase from the near 80% today to 90% by then, that’s a share price target of $63 or 20% above today’s $52. A 100% book multiple means a 34% upside. Obviously, if AIG’s execution was flawless and the “AIG discount” were to disappear into history and a more normal premium of 120% of book were to apply, then the upside is 60%!

The risks for AIG are however not insignificant and include:

  • Risks from aircraft leasing business, whose sale is uncertain. Although not legally guaranteed by the Group, there is an implicit liability there to maintain value.
  • The success of the new P&C business, particularly internationally, & the reserves, particularly for commercial business and business written from 2008 to 2010.
  • Life margins given the pressures on yields and the enhanced market risk required to chase yield.
  • The run-off of the DIB business and the operations at GCM. Exposure to sudden blow-up in risk positions always a concern
  • Legal reserves could really explode now that cases are getting settled. Also, the new AIG remains exposed to claims on businesses they have sold, such as ALICO.
  • As at the end of 2012, AIG had approximately $40 billion of NOL carry forwards. To maintain their value AIG had to put restrictions in place on ownership over 5%. Loss of these item could depress net income if full tax was paid.
  • Finally, this is AIG and there is no doubt some potential for unexploded bombs that observers, like me, have missed

So bottom line, is AIG over or undervalued at $52? My response would be that I think its undervalued and a 12 to 18 month target of $60 to $70 per share doesn’t seem outrageous to me. That said, will I be running out and buying it? No, the upside/downside doesn’t feel right yet. I’d like to see what Halloween brings, particularly in relation to P&C reserves, realized gains and the items in the other bucket. I (as always with me) run the risk of being too late to the party if Q3 results are good and/or they announce juicy dividends or some similar shareholder action.

If you really fancy AIG and have the appetite, the 10 year warrants issued in January 2011 may be your thing. The strike is $45 and they currently trade around $21. There is some adjustment for dividends that I need to understand further. If I get more comfortable with AIG after the Q3, the warrants may be my preferred route to play (unless the dividend adjustment doesn’t compensate for not owning the stock) if the price is right.