Insight and Intelligence on the London & International Insurance Markets 19 Feb 2018

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AIG: Another terrible year can 2018 be better?

  • Gavin Davis 13 February 2018
  • Last week, AIG reported Q4 operating earnings per share of $0.57, versus Wall Street's consensus estimate of $0.75.

    Notable items from the results included $766mn of catastrophe losses (roughly in line with prior guidance), some unfavourable reserve development from its international P&C units and the creation of a new run-off entity.

    However, in what was another annus horribilis for the company, its fourth quarter results mattered little. AIG's 2017 combined ratio of 117.3 percent marks the third consecutive year the metric has come in above 110 percent, with the firm last recording a P&C underwriting profit more than a decade ago.

    Despite the terrible results, the firm is likely to get a pass from investors to some degree, firstly because of the record level of catastrophes - which cost the firm $4.2bn over the full year - and secondly because of the transitional nature of the year due to new management.

    Nevertheless, the firm's long-suffering investors are likely to want to see positive momentum in 2018. AIG's stock has underperformed its peers over almost any relevant time period in the last five years, including the period since Brian Duperreault took over as president and CEO (see chart left).

    Looking forward, AIG's management has three key areas to address, largely focused on the firm's underperforming P&C unit: expenses, the loss ratio and capital management.

    Expense challenges continue

    Expenses continue to be a critical challenge for AIG. Despite reducing P&C operating costs by 12 percent year on year, the expense ratio remained flat at 34.1 percent in 2017, as earned premium volumes declined comparably.

    One remarkable feature of AIG's stalled turnaround is how little progress the firm has made improving its expense efficiency despite draconian cuts in dollar terms.

    AIG has reduced operating expenses across the organisation by around $3bn since 2015 - or around 25 percent of its addressable expenses. Yet the firm's P&C expense ratio has barely moved from the 34-35 percent range it has largely trended at since 2012, its first full year after its re-IPO from US government ownership.

    The firm's expense ratio continues to trend well above peer levels, which remains a point of structural disadvantage (see chart below). With the expense ratio around 4 points higher than peers, and premium leverage on attributable equity in P&C of about 1:1, this underperformance accounts for around 3 points of return on equity (RoE) at the P&C business, or around 1.5 points of RoE group-wide on adjusted book value.

    Like many of the challenges facing AIG, the firm's expense issues are a legacy of decades of under-investment. The company's once leading expense ratio in the low 20s was sustained only by years of under-investment in technology and infrastructure that the firm is still paying for today.

    Since the US government exited its stake in 2011, the firm appears to have been caught between executing two competing strategies. On the one hand, AIG has at times embraced a "shrink to greatness" philosophy. On the other hand, the company has spent liberally on investing in the technology and infrastructure it needed to catch up to the level of 21st century competitors.

    However, these strategies are at odds with one another. Shrinking to greatness requires an acceptance of a diminishing franchise and to manage the business for cash to return to investors - much as Warren Buffett shrank the original Berkshire Hathaway textile mills to redeploy the cash into better businesses.

    By simultaneously shrinking its premium volumes by around 20 percent since 2011 and redeploying so much into rebuilding its franchise through technology investments, the firm has compounded its expense ratio problems.

    The firm has returned a lot of capital, but having failed to execute on its operational initiatives, it has ended up with the worst of both worlds: a diminishing franchise and a cash-draining expense base.

    Duperreault's strategy appears to be to abandon this contradiction, and to focus on growth, emphasising that AIG's scale should give it an expense advantage over time.

    "While the company has made a lot of progress on reducing expenses over the last couple of years, an organisation of our size and scale needs to be a top-quartile performer in both underwriting and expense management. We are committed to continuing to make meaningful progress in that direction in a prudent and thoughtful manner," the CEO said on the company's Q4 earnings call.

    Underwriting: more drastic actions to improve loss ratio

    AIG's loss ratio has underperformed in just about every possible way. The firm's $4.2bn of catastrophe losses in 2017, equivalent to 16 points on the combined ratio, demonstrated its significant exposure to cat volatility, particularly to cat frequency.

    Of course, the last several years have been replete with reserve charges, with more than $10bn of adverse development since 2015. And the full-year ex-cat accident year loss ratio remains stubbornly high at 68.3 percent - well above prior stated targets, and a 1.2 percent increase year on year.

    Though part of this likely reflects an effort to re-base expectations and the new management's desire to embed conservative current loss picks, considerable improvement is still needed to buoy investor sentiment.

    However, AIG has taken drastic action to remediate its underwriting performance over the past 18 months. This year it has radically changed its reinsurance purchasing philosophy, lowering its occurrence probable maximum loss by 30 percent - or 20 percent including Validus - as well as buying aggregate covers.

    In total, the firm estimates that if 2017 cat events were to reoccur its net losses would be 40-60 percent lower.

    "One of our main priorities is to take a more strategic approach to reinsurance, building long-term relationships with our partners to manage future volatility. Our reinsurance philosophy is to take smaller net lines in property and casualty, reduce volatility and be consistent buyers of reinsurance," general insurance CEO Peter Zaffino told analysts.

    Last year the firm agreed a $25bn reserve reinsurance deal with Berkshire Hathaway to reduce volatility from a significant portion of its legacy reserves.

    The firm is also continuing to focus on re-underwriting underperforming business to improve underlying results, and noted rate increases in the mid-to-high single digits. Additionally, it is likely part of its motivation for pursuing inorganic growth is to improve the "optics" of its reported loss ratios.

    One item to watch is how the firm's shift in reinsurance purchasing strategy will impact its net business mix and therefore its reported loss ratios. Buying more cat reinsurance cover and dropping the casualty quota share could shift the mix more towards higher loss ratio lines and put pressure on the optics of the loss ratio.

    Capital management focused on growth

    Perhaps the most dramatic shift under new management has been the change in capital allocation philosophy. Previously the firm's emphasis was to deploy excess capital by repurchasing shares. However, AIG's focus is now resolutely on redeploying capital into growth, with zero buybacks registered in Q4.

    On the Q4 earnings call, Duperreault said: "To me, buybacks are a capital management tool. We'll use that management tool when we think it's appropriate. But I would rather deal with our portfolio and the fact that there are pieces of it that I'd like to fill in. We have white space there. So that would be my priority."

    This focus on investing for the long term and improving the firm's franchise essentially eschews immediate financial returns to prioritise improving its valuation over time. This aligns with the long-term compensation plans given to both Duperreault and Zaffino, which implies the board is comfortable with this emphasis.

    One instructive comment was the firm's assessment of cash returns from the Validus acquisition in the high-single digit range, inclusive of synergies, emphasising that the deal was about "accretion to franchise value". Deploying capital inorganically at adequate returns is a major risk to the firm's new strategy, given the valuations of potential targets and the need to pay a control premium.

    Another notable item in the release on capital was the announcement of a new consolidated legal entity created in Bermuda for both life and P&C legacy liabilities.

    Though the firm cited operational efficiencies as its motivation, and emphasised its commitment to its policyholders, it is very likely the decision was driven by capital efficiencies. By basing the firm offshore, the legacy blocks can be combined in one legal entity, in contrast to the US where separately capitalised P&C and life entities are required.

    The firm noted $37bn of liabilities supported by $40bn of assets, implying $3bn of equity. Without knowing the nature of the liabilities, it is impossible to properly analyse, but the implied 12:1 reserves to equity ratio is suggestive of capital efficiencies.

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