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Recently, I received few comments on my recent American International Group (AIG) article that drew my attention towards the impact of changing interest rates environment on AIG. Therefore, in this article I will give an in-depth analysis of the impact of interest rate changes on AIG.

As the US economy recovers from the financial contraction, so does the property-casualty and life insurance industry. The slow economic growth coupled with the rock bottom interest rates had chipped away investment income and compelled carriers to increase rates to offset, while being mindful of market share loss. Things seem to be reversing now for insurance companies like American International Group as the good news of once again rising interest rates hit the market last week.

Immunized investment portfolio

The major risk that financial institutions face is the movement in their investment portfolio following the movement in interest rates. However, AIG has immunized its investment portfolio from the interest rate risk by matching a significant portion of the duration of its investment assets with the duration of its liabilities. This results in hedging away the price risk of the investments made by the company. In the current scenario of soaring interest rates where the company may witness a fall in the value of its assets, this loss is likely to be counter balanced by the decline in the market value of its equal duration liabilities. Thus, AIG remains immunized against the interest rate fever.

Analyzing the company's investment portfolio, it has mainly invested in investment grade bonds with maturities ranging in between 5 to 10 years or higher than 10 years. Under the five year duration bracket, the company has slightly higher insurance and investment contract liabilities to pay compared to its parallel investment assets which will result in a net favorable impact in the prevailing scenario of higher interest rates. However, higher duration (> 5 years) investments in fixed income securities are greater than the contract liabilities of similar duration which exposes the company to some risk. The net interest rate risk exposure is very low as equal duration liabilities serve as financial hedges in place to take out some of the sting.

Reinvestment rate: the margin driver

There are two sources of generating revenue and ultimately, profits for AIG. Underwriting premiums is the first one and investment income takes the second position. The latter factor stands to be the primary driver of margins. I can very well explain this with the help of combined ratio, a metric used in the insurance industry to gauge its underwriting activity.

Source: AIG Investor Presentation

A combined ratio of 101.6 explains that currently the underwriting business is contributing a loss of 1.6% to AIG's bottom line. Wondering where all the net profit margin of 14.37% in the third quarter of 2013 came from? Yes, it is the investment income that continues to uplift the company's bottom line. In fact, for AIG, their very survival depends on it.

The insurance business heavily depends on the reinvestment of its premiums raised to match the claims when they arise. Due to its historically low interest rates, the investing environment since the Great Recession has been a boon for borrowers and a major headache for insurer companies. But the game is turning in the favor of AIG now as the interest rates have started to move upwards. The wait is over for this company who is well-positioned to invest the premiums at a higher rate and enjoy a higher investment income in the upcoming quarters.

It is the reinvestment risk, rather than the price risk, that makes interest rates so important for the insurance carriers like AIG.

No gain from mortgages

Unlike many other industry players, AIG was unable to pocket some dollars from the recovery in the prices of mortgaged-backed securities (MBS) following the improvement in the housing market. Also, mortgages make up to only 6% of the company's current investment portfolio.

Isn't it unusual from a big insurance company like AIG to have remained largely indifferent to the favorable movement in the price of MBS? Here's the answer. During the financial crisis of 2008 and 2009, the company was compelled to sell its MBS portfolio at a significant loss to meet the immediate liquidity need. The company panicked to sell its mortgages to meet the collateral calls from banks that owned credit default swaps (CDS) written by AIG that had to be paid out when the housing market crashed.

Although the company is trying sue some of the major banks against the fraud of selling MBS to AIG right before the financial crisis was about to set in which pushed the company on the verge of bankruptcy. According to AIG, "Bank of America and the other defendants created mortgage securities backed by shoddy loans and sold the investments based on inflated credit ratings that masked their true risk."

Valuation Insight

Price to tangible book value (P/TBV) is a solid measure for analyzing an insurance company which has an active market for most of the tangible assets reported on its balance sheet. Filtering out the intangibles that may be used to window dress the financial position of a company is what makes this heuristic pure and transparent.

AIG is currently trading at a P/TBV of 0.72 compared to the industry norm of 0.99. What more can an investor ask for than a stock like AIG that upholds a bright future outlook based on its higher investment income prospects and is also available at a significant discount.

Source: American International Group Welcomes Higher Interest Rates