There's Value in No-Moat AIG

We do not believe that  American International Group (AIG) has an economic moat, but we do think the market is underestimating the firm's potential earnings power. New management brought in during the bailout has restructured the company, selling off noncore assets and reining in excessive risk-taking activities. While we don't expect the global multiline insurer to earn its cost of capital in the near term, we think the franchise value has improved, and if management executes on its strategy, shareholders could be rewarded over the long term.

Moats Are Hard to Come By in the Insurance Industry
For the most part, insurance is a commodity industry where sustainable excess returns are difficult to achieve. Competition is fierce, and participants can rapidly slash prices or undercut competitors in order to gain market share. Furthermore, insurance is an industry where most of the costs of goods sold (claims) is not known for potentially many years, which provides incentives for companies to sacrifice long-term profitability in order to boost near-term growth.

We think property-casualty lines are a bit more attractive than other areas of insurance, and we believe higher-quality P&C operations do benefit from economic moats. We focus on underwriting income (earnings from insurance operations without the benefit of investments or capital gains) in determining P&C insurance moats, and historically, AIG has failed this test. Since 2005, AIG's P&C operations have managed to produce positive underwriting income in only two years. Over that timeframe, insurance expense was about 4% greater than the total of premiums earned on policies issued. However, AIG's leadership is changing the business mix to boost underwriting income. It has made progress over the past few years, and we think the worst is probably behind the company. But AIG still has challenges ahead to achieve even average performance, and we see few structural reasons to believe it will be able to perform materially better than its peers over the long run.

Life insurance and related spread-based products, on the other hand, are essentially the same from one company to the next, and even innovative new products are quickly copied. This leads to price-taking, which hampers profits. What's more, products in this segment are priced based on long-dated future assumptions. Spread-based products like annuities that contain guarantees of minimum payout benefits carry high uncertainty, in our view, as providers of these products make promises at the time of issuance based on unknown future market dynamics. About 65% of AIG's life and retirement services operating income over the past four years came from spread-based products. On the other hand, if AIG can manage the risk, this segment can produce acceptable returns.

We think AIG will have to continue to focus and execute on operational improvements in order to earn an economic moat. Some of this has already taken place as the new management team and board of directors brought in following the government bailout have taken actions to solidify core operations. AIG has sold many of its businesses in order to concentrate its resources on fewer segments. Some of the businesses, like its insurance investments in China, had the potential to add value. But others, like ILFC, its aircraft leasing business, which is under contract to close in the second quarter, were a distraction that added no value and were a drag on resources. Most important, AIG paid off the U.S. government loans last year, an action we applaud. These actions resulted in a change in our fair value uncertainty rating to high from very high. AIG has said it intends to concentrate on improving the performance of core operations, which we think is a good start. However, it still has a long way to go before it can earn a moat, in our view.

AIG's P&C Insurance Lines Can Add Value if the Business Mix Changes
When determining the value a P&C insurer creates, we think the combined ratio (expenses directly related to the insurance business divided by earned premium) is key. Insurers with combined ratios in excess of 100% rely solely on investment income, which puts even more pressure on management to engage in risky investment and underwriting behavior. We think subpar returns on insurance operations is likely one of the reasons that prior management decided years ago to rely on the noncore businesses that eventually led to AIG's downfall.

Despite a relatively soft market, most P&C insurers have had decent results over the past few years, but AIG has lagged. Positive reserve development--the re-estimation of reserves on older policies--has boosted underwriting margins at most P&C insurers, but not AIG. Most of AIG's issues have been the result of environmental and asbestos insurance coverage issued many years ago. At times, the adverse development of losses from the past has been extremely large, as in the fourth quarter of 2010 when AIG boosted reserves over $4 billion.

Catastrophe claims have been the other factor weighing on AIG's P&C underwriting income. As a global insurer, AIG has suffered from numerous weather-related catastrophes, which have become more frequent and costly in the past three years. Part of the problem is that AIG has a much larger presence in the global commercial property market. But in some instances, like Hurricane Sandy, even personal lines have borne the brunt of increased losses. From Hurricane Sandy alone, AIG incurred $2 billion in anticipated losses.

Factoring out the adverse reserve development and catastrophe claims, AIG P&C lines would have performed significantly better. From 2005 through last year, the combined ratio  averaged 104% with adverse development and catastrophes included. After adjustment for these items, the combined ratio drops to 95%, a huge improvement that would represent a significant underwriting profit. While catastrophes will always be part of the equation, the company's performance could materially improve if it can avoid replicating this level of adverse reserve developments and catastrophe losses.

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Aside from the reserve development and catastrophe issues, the segments that AIG has targeted have also contributed to weak underwriting performance. AIG has a much greater presence in more risky and erratic commercial lines than in the relatively more stable consumer lines. Although an argument can be made that being globally diversified minimizes commercial claims, it also means that AIG gets a piece of every global event loss. Commercial insurance is not necessarily a bad segment of the market, but it is one in which insurers have to specialize in to maximize underwriting income. AIG appears to have had more of a shotgun approach in the past as opposed to a targeted one, and its size makes specialization a difficult strategy.

Commercial line losses, particularly in North America, have been inordinately high, although catastrophe losses in pan-Asian geographies also took their toll in 2011. Consumer lines have had far fewer losses in both North America and in foreign markets. North American consumer insurance had positive underwriting income in three out of four years, as did international consumer insurance, while international commercial insurance had only one positive year and North American commercial insurance had none.

AIG management has said it intends to pursue a more favorable business mix that focuses on consumer and higher-value commercial segments as well as in high-growth, developing economies. In the short run, we expect the firm will incur additional costs as it did in 2012, when marketing and related costs increased the combined ratio by 3 percentage points. However, the evidence is clear that the targeted consumer segments are more profitable. Over time, this strategic shift should have a positive impact on the overall combined ratio.

In our forecasts we have incorporated the shift and also allowed for the increased expense and time to effect the change in strategy. Consequently, our projections on the P&C combined ratio remain elevated this year and next to account for the increased expense. We have also assumed that the adverse reserve development will wane, particularly since AIG reinsured most of its known environmental and asbestos risk to National Indemnity, a subsidiary of Berkshire Hathaway, in spring 2011. We have added in one year of extreme catastrophe loss. The result is that we forecast a 100%-plus combined ratio over the next two years gradually decreasing over the seven years of our explicit forecast to 97%. In our view, the most realistic expectation is that AIG's P&C segment will improve from being below average relative to its peers to becoming average over the next seven years as the firm adjusts its business mix. We think the firm benefits from having a strong global footprint, but size is also a concern as it becomes difficult to specialize in specific lines of business.

If firm outperforms our expectations, this could have a sizable impact on our fair value estimate of $51. Because P&C is the largest segment of the total AIG insurance operations, small changes in underwriting income can have a significant effect on our valuation. Avoiding the occasional large catastrophe can also have a positive impact. Even modest improvements above our base-case assumptions have a meaningful impact on the fair value estimate. The company's combined ratio has averaged 104% over the past seven years, while long-term industry averages for all P&C insurers are about 101%. Our base case essentially assumes the company moves to the industry average over a cycle.

Conversely, if P&C operations fail to improve and the combined ratio rises over the course of our explicit forecast, our fair value estimate will fall in lockstep. Management's actions create some confidence that results should improve. However, it is conceivable that P&C results return to historical levels. If the company holds to its historical average, our fair value estimate drops to $43.

Life Insurance and Retirement Services Can Affect Downside More Than Upside
As part of the price of the government bailout, AIG sold some of its life insurance investments in high-growth markets. Today, AIG is a U.S.-based provider of life insurance and retirement products. Our main issue with life insurance and retirement services is the commoditylike nature of the business. Competition is intense and there is little differentiation among participants; any new innovation can be quickly matched by competitors. This has historically kept a lid on industry returns. Life insurance operations and related products are much more exposed to interest rates and capital markets than P&C operations and are considerably more difficult to project as a result.

AIG has performed at least as well as most of its peers. But like its peers, AIG's life and retirement segment is suffering the effects of low interest rates decreasing investment income. Most of the segment's revenue is sourced from investment income that the firm must accumulate to make good on future obligations. Many of the products offered provide minimum benefits on death or retirement, pressuring firms to reach investment hurdles that may not always be available in the market without taking on substantial investment risk.

On the other hand, the United States has an aging population, creating a growing market for retirement income and life insurance. AIG's retirement services business, in particular, has generated increases in operating income over the past four years.

We think operating income can continue to grow at about 4% per year during our explicit forecast. Because of the sensitivity to interest rates and capital markets, there are scenarios that could allow operating income to rise at a lower or higher rate. Part of the growth could come from increased product sales, but we think the majority will have to come from managing expenses and a strict adherence to hedging against promises made for future benefits.

Because margins are tight in life insurance and its corresponding spread-based business, significant growth in operating income results in fairly minor changes to our fair value estimate. However, zero or minus growth does have a larger effect due to the payout obligations.

Life insurance and retirement services can contribute with increased growth, but only marginally so. The greater risk is if interest rates remain low or if AIG misjudges the size of its future obligations. Either of these occurrences would weigh on the value of the franchise.

Mortgage Insurance Is a Volatile Business, but Not a Key Driver of AIG's Value
Mortgage insurance is one of the riskiest lines in the insurance industry. In good times, it can produce some of the highest margins but--as has happened twice since 1980--it can deteriorate rapidly. In boom times, mortgage insurers have produced some of the highest margins in the insurance industry only to collapse and force major participants into runoff when mortgage defaults skyrocket. AIG's mortgage insurance subsidiary, United Guaranty, had results similar to industry leaders MGIC and Radian over the past 12 years. In the early 2000s, MGIC and Radian reported returns on equity above 20% until the financial crisis nearly bankrupted them. United Guaranty had marginally better returns but still tested the limits of its reserves beginning in 2007.

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We think the mortgage insurance industry is vital to the future of housing in the U.S., which creates an opportunity for its survivors. What's more, new entrants have emerged to take the place of three major mortgage insurers that went into runoff from excessive mortgage foreclosures. While more competitors might inhibit profitability, we think it also validates the importance of the product. Moreover, mortgage loans insured since 2009 for homebuyers with less than 20% to put down on a home have been subject to severe mortgage underwriting requirements, which should dramatically lower the default rate for many years to come. The mortgage insurance industry was highly profitable for 17 years beginning in 1990, and we think the lessons learned from the downturn will keep underwriting requirements high well into the future.

We think United Guaranty will not be profitable until sometime in late 2014, although a better economy could bring it forward earlier. United Guaranty is still working through a substantial inventory of claims, but a gradual recovery in housing should allow it to return to more normalized underwriting income in the later years of our explicit forecast.

United Guaranty is such a small portion of AIG that even the most optimistic assumptions barely move the needle on our fair value estimate. However, if AIG were to increase its presence in the industry through a major acquisition, we think it could add to the firm's value.

On the downside, if mortgage insurance operations reverse course and follow the path of others into runoff, there are consequences to AIG. At 2012 year-end, United Guaranty had $2.3 billion in equity, just over 2% of total common equity at AIG. Failure of the unit would decrease the company's book value per share by about $1.25 per share.

Interest Rates and Investment Income Also Play a Role in AIG's Future
A major component of every insurance company's profitability is the investment income earned from premiums collected in advance of paying out on insured losses. In fact, over a long period, most insurers break even on underwriting and rely solely on the float to generate profits. Consequently, today's low interest rate environment has hurt profits in the insurance industry, and AIG is no exception. Interest rate changes can have a dramatic effect on our fair value estimate. Our base case assumes interest rates will rise as the economic recovery strengthens, but if they rise beyond expectations, our fair value estimate could increase significantly.

One caveat is that increases in yield typically have a corresponding negative effect on insurance pricing. Before quantitative easing, which brought interest rates down to record-low levels, insurers had an abundance of capital that kept them from increasing prices. If yields were to rise in the current environment of excess capital, this could damp or even curtail price increases, particularly in P&C operations.

Market Price Assumes a Fairly Pessimistic Scenario
Of the four main drivers of AIG's business, only three have the ability to effect meaningful changes in our fair value estimate. P&C, life and retirement, and investment results can all have impact to varying degrees. Investment income must be considered in relation to insurance pricing, however, especially in these times of surplus capital at insurance companies. Because insurers have excess capital today, there would be no reason to raise prices if it were not for the extremely low investment yields that are necessary components of income for most insurers. Therefore, it is assumed that while rising interest rates could provide a short-term benefit to the net income of insurers, over the long run competitive factors are likely to offset increasing investment income by limiting price increases, at least until capital becomes strained.

On the downside, a falloff in the life business, combined with no improvement from historical results in P&C, results in a $35 fair value estimate, just below the current trading price. This would seem to suggest that the market doesn't put much faith in the ability of management to improve the firm's prospects. On the upside, a $65 fair value estimate assumes substantial improvement in both lines. P&C would have to average a 96% combined ratio over the next seven years and life operating income would have to grow at 9%--very optimistic assumptions, in our view. Even an improvement to just average performance going forward would represent significant upside.

There's More Upside Than Downside at the Current Market Price
While we do not consider AIG a moaty company, we do think it is undervalued. What's more, we think the existing management team, which was brought in during the financial crisis, is committed to increasing profitability through operational improvements and a shift in business mix. AIG lost its way by relying on extremely risky financial bets that obfuscated weak performance in core operations, and current management has put an end to those activities.

We think AIG has the potential to increase shareholder value even more if it can increase underwriting margins, particularly in P&C, beyond our fairly modest expectations. We also think the firm will benefit, as all insurers will, from rising interest rates, which will eventually take hold.

On the downside, AIG has no moat, nor is it likely to have one at any time in the near future. Uncertainty is also a concern, especially in the life insurance and retirement services segment. Spread-based businesses that promise payouts in the future based on erroneous shifting assumptions can negate progress in other lines quickly. That said, we think AIG is offers value to long-term investors willing to tolerate a reasonable amount of risk.