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After hedge funds reduced their position in Apple (NASDAQ:AAPL), American International Group (NYSE:AIG) became a hedge fund favorite. 80 funds held AIG as a top-10 position by the end of 2012. 73 funds held Google (NASDAQ:GOOG) as a top 10 holding, followed by 67 for Apple.

A notable hedge fund holding the insurance company is Third Point. Third Point started buying AIG at around $29 in March 2012, after recognizing the forced selling by Treasury created a discount to intrinsic value. Reorganization-related activities would unlock value in the company. By December, the monetization of its Asian life insurance worth $6.5 billion would further support a higher share price for AIG.

With AIG trading recently at $37.77, shares remain well-below Third Point's tangible book value calculation of $65 per share. AIG said in its fourth quarter conference call that the company has a book value of $57.87. This calculation accounts for the $4.4 billion loss from the sale of ILFC (International Lease Finance Corporation) in the quarter.

Analysts upgraded AIG in recent days. Investment firm Sandler O'Neill thinks AIG is worth 65% of its book value, or $44. Deutsche Bank believes AIG shares will be $47. Now that the sale of all AIG shares by the Department of Treasury is completed, there remain 4 catalysts that would help close the gap between the current share price and the intrinsic value of AIG.

1) Rate Increases

AIG benefited from an 8.6% rate increase for U.S. commercial insurance. Workers compensation rates increased 12.4%, while property compensation rates improved by 14.6%. In the Asia-Pacific region, premiums increased 15%, while in Latin America, AIG experienced 13% compared to the previous year. In future quarters, AIG will generate sales of non-life insurance products in Turkey and France, through its agreement with HSBC (HBC).

2) Hedge Against Rising Interest Rates

Earnings growth was constrained for AIG as a result of low interest rates. If interest rates were to rise unexpectedly, AIG would benefit. For fiscal 2012, AIG managed to generate $4.2 billion in operating income. This was helped with improved net investment spreads.

3) High Variable Annuity Sales

Variable annuity ("VA") sales rose 42% in 2012 to $4.6 billion, compared to the previous year. $1.2 billion of it was made in the fourth quarter. AIG is a small player in VA. Even though the company said it's growth in 2013 is not likely to match the growth rate reached in 2012, AIG could report higher sales as more products are offered and priced appropriately.

4) Higher Efficiency

AIG merged six operating entities into a single entity, American General Life Insurance Company. In doing so, the company is better-structured in selling multiple products, in addition to operating more efficiently. Last year, Fairholme Capital outlined AIG had price-leadership for its product, which would help its insurance business. The restructuring should help AIG improve sales in the future quarters.

Risks

Lower rates meant reinvesting yield-dependent portfolios at lower rates for AIG. In the fourth quarter, the base yield for AIG's Life and Retirement portfolio dropped to 5.33%. Last year, the base yield was 5.44%. Total yield improved to 6.09% from 5.33% in 2011, but investors could anticipate low yields to persist.

The combined loss ratio target and the ROE target will vary with the interest rate environment.

Conclusion

The discount from book value for shares in AIG will shrink as the company continues to improve its coverage ratio, which in turn would improve AIG's rating. AIG also has a goal of being investment-grade in 2015. Such a goal will support the view that AIG shares will keep rising. Resuming a share buyback and initiating a dividend would signal management confidence in AIG's interest coverage ratio. This in turn would attract more buyers for AIG shares.

Source: 4 Catalysts That Will Drive AIG Shares Higher