American International Group AIG blew itself up during the financial crisis and was only saved by a government bailout. However, the years since the financial crisis have shown that AIG would have destroyed substantial value even if it had never written a single credit default swap, had noncore businesses it needed to shed, and had material issues in its core operations that it needed to fix. More than a decade past the crisis, AIG continues to struggle to generate an acceptable return.
We think because of the duration of AIG’s underperformance, the market has been slow to react to the underlying improvement that current management has effected. The shares trade well below our $65 fair value estimate.
Life Insurance Is Not the Problem; P&C Is
While AIG as a whole continues to struggle, its life insurance and property and casualty operations are in very different places. From a fundamental point of view, we do not view life insurance favorably. Life products are largely commodified, and we don’t believe fixed costs are sufficient to generate a scale advantage. Further, life insurance results are leveraged to capital market conditions, which are difficult to predict. Low interest rates in particular have been a consistent headwind since the financial crisis. Before COVID-19, it appeared the industry might finally see some relief from this pressure, but the pandemic renewed the headwind.
We think it is difficult for any life insurer to generate significant and sustained excess returns, given the dynamics of the industry. However, AIG’s life insurance operations have performed reasonably well, with adjusted returns essentially in line with its largest peers. As such, we do not see improving the company’s life insurance operations as a key factor in effecting a turnaround for the business as a whole.
In P&C insurance, we see essentially the opposite situation. AIG’s P&C operations contain both commercial and personal lines, but commercial operations are the largest portion, accounting for about two thirds of net written premiums in 2020.
We believe commercial P&C insurers have a potential path to an economic moat. In our view, the primary way for a P&C insurer to give itself a competitive edge is to focus on the least commodified areas of the market. Specialty line is often used in the P&C insurance industry to describe this type of line. While the term is not precisely defined, some areas, such as excess and surplus lines, are clearly specialty. Outside of Lloyd's, AIG is the largest E&S underwriter in the United States. The company does have some other potential areas of strength: It is among the largest commercial P&C underwriters, which means that it should be able to leverage its proprietary database to better price and select risks than smaller peers, and recent investments in technology should allow it to better exploit this potential advantage. AIG also has one of the widest geographic reaches, which gives it an advantage in garnering business from large multinational companies.
But historical performance shows AIG has a long way to go to exploit these potential advantages. In fact, over the past 10 years, the company has been a massive negative outlier in terms of underwriting performance. These poor results are in part due to large adverse reserve development hits the company took in long-tail lines, but underwriting results have clearly been very poor.
Mismanagement Has Been the Issue
Given that AIG has underperformed for such a long time, it would be fair to question whether better performance is even possible, and whether AIG is stuck in lines with poor competitive dynamics. However, we see no structural reason for this company to generate such poor underwriting performance. Its commercial P&C business mix is comparable with peers, and its closest peers in terms of mix and customer base is Chubb CB, which is one of the strongest underwriters in the industry. The two companies also share an international footprint.
Given the depth of its issues during the financial crisis, AIG spent years effectively under government control. Management’s focus in this period was rebuilding the balance sheet and running down or divesting noncore operations. We believe attacking operational issues in core operations took a back seat during this period.
As this phase wound down, Peter Hancock took over as CEO in September 2014, with the goal of improving returns. We believe Hancock most notably fell short when it came to improving underwriting results in commercial P&C lines. Hancock did not have an underwriting background, and his lack of experience in this area seems like the most likely reason he was unable to make positive changes in the underwriting culture at AIG.
Brian Duperreault replaced Hancock in May 2017. At the time, we saw experience managing a successful commercial P&C underwriting operation as the dominant consideration for AIG’s CEO, and Duperreault fit this mold quite well. Duperreault started his career at AIG during the heyday of the franchise. He left to take the CEO position at ACE (now Chubb) from 1994 to 2004, and then served as chair. ACE had a long history of strong underwriting results, suggesting that Duperreault has a good handle on the key factors involved in improving AIG’s underwriting culture.
We think some investors have been frustrated with the pace of improvement under Duperreault, but in hindsight it seems understandable. Duperreault’s initial actions were centered on undoing the previous “go big” strategy, pulling in the company’s risk appetite, and increasing the use of reinsurance. This had the short-term impact of increasing the underlying combined ratio, but it gave the company a more solid base to drive underwriting improvement.
In March 2021, Duperreault moved into the chair role and Peter Zaffino took over as CEO. Zaffino has been a key lieutenant in the company’s turnaround efforts (especially during the derisking phase), and we see this move as confirmation that AIG will maintain its course.
We think AIG did not have the right management in place until 2017, and it took time for its efforts to result in better underwriting results. We see the positive trend the company has demonstrated over the past two years as supporting our view that AIG’s problems are not structural and that better performance is possible.
We think the events of the past year and the impact of the pandemic have obscured the underlying progress AIG has made, as capital market movements hindered the company’s life segment and the P&C segment was hit by unusual claims arising from the pandemic.
There’s Room for Further Improvement
Improvement in underwriting profitability has been concentrated in commercial lines, which historically have been the worst performer. The more disciplined risk selection the current management team initiated appears to be resulting in better underlying loss ratios over time. While AIG has made significant progress, it has not fully closed the gap with Chubb, suggesting there is still room for improvement.
We expect further underwriting improvement to come increasingly from a lower expense ratio. The expense ratio ticked up during AIG’s derisking phase, as a more aggressive use of reinsurance lowered net premiums and deleveraged operating costs. However, the company implemented the AIG 200 program at the start of 2020, with a target of $1 billion in annual cost reductions by the end of 2022. The program will require one-time costs of $1.3 billion. Run-rate savings are expected to be on a cumulative basis $300 million, $600 million, and $1 billion in 2020 through 2022. Through the second quarter of 2021, the company had executed $550 million in cost reductions, with an annualized amount of $355 million realized within the quarter’s results.
Approximately 75% of the savings are in the P&C segment. Assuming cost reductions to date are pro rata, that implies the company expects to realize about an additional $400 million in the P&C segment. Based on our 2022 premium projections, this would reduce the combined ratio by about 160 basis points.
Management has set a target for a combined ratio below 90% by the end of 2022. This target looks very reasonable given recent performance (the underlying combined ratio was 91% in the most recent quarter) and further savings from the AIG 200 plan.
We think 5% is a reasonable estimate for average catastrophe losses. The company’s historical experience is a bit higher, with an average of 6.5% over the past 10 years. However, that average includes the unusual COVID-19 losses in 2020. The company became more diligent in pulling in limits and more aggressively using reinsurance during the derisking phase. So, we think using a lower estimate is reasonable.
Assuming no material impact from reserve development, that would suggest a reported combined ratio a bit below 95%, which would put AIG roughly in line with peers.
AIG Has a Handle on Its Reserve Development Issues
In the years following the crisis, AIG was plagued with consistent adverse reserve development and intermittently recorded large slugs of adverse development charges. The reserve development issues largely revolved around reserves on long-tail commercial lines, and it took quite some time for the company to work past this. This raised constant questions about the adequacy of its reserves. However, in the past few years, the company has appeared to turn a corner. Since 2019, the company has recorded modest amounts of favorable development, which brings it in line with what we typically see at peers. This inspires confidence that the current management team is approaching reserving with appropriate conservatism.
Better Market Conditions Will Help
We think the outlook for commercial P&C profitability is positive. The industry recently saw the largest pricing increases since 2003. To some extent, better pricing is necessary to offset lower interest rates and negative social inflation (litigation) trends. However, pricing increases appear more than sufficient to outstrip these factors. A more favorable industry backdrop should be a considerable aid in the company’s turnaround efforts.
Thanks to the work that management has done to improve the quality and stability of its book, AIG appears to be in a position to exploit this environment. AIG has been reducing the size of its book for years, but in the past two quarters, the company was able to pivot to substantial net written premium growth.
We Think the Shares Are Undervalued
Given the company’s long history of poor performance, we think the market has been slow to factor in the underlying improvement AIG has achieved and the prospect for further gains in underwriting profitability. As such, we believe the shares are currently undervalued from a long-term perspective.
In our base case using a discounted cash flow model, we project premiums to grow at a 3% compound annual rate during the next 10 years, with recent declines giving way to modest growth. While management is pivoting toward growth and industry pricing increases will be a tailwind in the near term, we think AIG’s size and the maturity of the industry will limit long-term organic opportunities. AIG took a step back in profitability in 2020 because of the impact of the coronavirus on claims and capital market conditions. However, we expect returns on equity to improve to a level consistent with our cost of equity assumption over the next few years and for core operating ROE over the next 10 years to average about 10%, excluding the impact of deferred tax assets.
We expect the combined ratio in the company’s P&C operations to improve over the next few years as adverse development rolls off and the company reduces its fixed costs. We expect significant underwriting improvement, with the combined ratio in the P&C segment reaching 95% over the next couple of years and holding roughly at this level before creeping up over time as interest rates increase. Over the full projection period, we expect the combined ratio in P&C operations to average 97%, with results moving in line with long-term historical industry averages over time, reflecting our view that AIG can ultimately bring underwriting performance in line with peers. We project results in the company’s life operations to improve modestly over time, as higher interest rates eventually lead to a more favorable operating environment.
AIG is a complicated franchise, with operations across numerous lines and geographies. Its sizable deferred tax assets present an additional valuation wrinkle. As such, we believe a sum-of-the parts analysis is useful to backstop our discounted cash flow valuation.
Using book value excluding accumulated other comprehensive income, the average multiple from the bottom third of a P&C peer group and the average multiple for AIG’s closest peers on the life side results in an implied value of $66 per share, roughly in line with our fair value estimate. Using tangible book multiples results in an implied value of $69 per share.
In a best-case scenario, using Chubb’s multiple for the P&C side results in an implied value of $93 per share.
Spinning Off Life Insurance Business
In October 2020, AIG announced its intention to spin off its life insurance business. We don’t believe a separation will necessarily unlock material shareholder value, but we do believe that allowing management to completely focus on the turnaround in the P&C business would be a positive. Further, we see no material strategic benefit from combining P&C and life operations; eliminating any noise from the life side of the business will provide a clearer look at the effectiveness of P&C turnaround efforts.
We believe AIG’s life insurance segment is not in need of any major operational fixes, as its recent returns have been good relative to peers. In our view, the differing states of the two sides of AIG’s operations is another argument in favor of separation.
In July 2021, AIG announced a deal with Blackstone that looks like the first step in spinning off its life insurance operations. Blackstone will purchase a 9.9% stake in the life insurance business for $2.2 billion. This price implies a valuation slightly above book value, which seems reasonable to us. Additionally, Blackstone will manage $50 billion of the existing life insurance investment portfolio, with this figure to almost double to $92.5 billion over the next six years.
Management has said the next step will be an initial public offering. AIG has not settled on the amount to be included in the IPO, or what the next step will be after the spin-off. But the company does believe the IPO will be completed in the first quarter of 2022.