After the bell on Monday, the American International Group (NYSE:AIG) reported what would be best described as a messy quarter. A bit of disappointment in the report sent shares lower by about 3%. This quarter had a plethora of positives and negatives with several moving parts that complicate the picture, but essentially, there are two key takeaways. First, AIG's post-crisis strategy to simplify the business and generate consistent profits is working well. AIG has de-risked its balance sheet and is now a consistently profitable life and property-casualty ("PC") insurer. Second, AIG's operations remain far from perfect with more cost-cutting and stricter underwriting standards needed. AIG's turnaround is clearly on the right path, but there is still room for improvement. Nonetheless with a strong management team and very attractive valuation, I would be a buyer on weakness.
AIG reported operating income of $1.21 per share compared to expectations of $1.07, but premiums earned across the various PC business lines were less than analyst expectations (financial and operating data available here). AIG also suffered a year-over-year decline in operating income, which was $1.34 last year. Essentially, AIG's income decline was less than analysts expected despite slow underwriting activity. In some ways, AIG was less bad than feared, but this was not a particularly good quarter. The weakness was mainly at the PC unit, which actually had lower pre-tax operating income ($1.159 billion) than the life insurance unit ($1.417 billion). This was because PC continues to underperform while life performs well.
At the PC unit, net premiums earned fell 4% to $8.23 billion, which led to a 26% drop in profitability. Net investment income fell 5% as the markets were a bit choppier, and foreign-exchange was a small headwind. The driver of the decline was a deterioration of underwriting profits, which swung from a gain of $232 million to a loss of $97 million. The combined ratio measures underwriting profits. A ratio of 100 is breakeven, less than 100 a profit, more than 100 a loss. In the PC business, a ratio consistently in the 94-100 area is a solid performance. The goal is to generate an underwriting profit and also generate significant investment income from the cash received from premium payments. When you can generate an underwriting profit, you essentially are borrowing money from customers at a negative interest rate, which you then can invest in interest bearing securities to make a significant amount of money.
The combined ratio was a weak 101.2, which was a sizable deterioration from last year's 97.3. Now, quarter to quarter, this ratio can be volatile based on the timing of a large payment or catastrophes. In this quarter in fact, catastrophe losses were $262 million compared to $41 million last year. If we normalized catastrophe, the combined ratio would have been 97.3 compared to a normalized 97.2 a year ago. This does make the picture a bit better. However, this was not a quarter with a shocking amount of catastrophe losses, and I would have liked AIG to at least break even on underwriting in a moderate catastrophe environment. AIG continues to write new business with stricter requirements, and I expect this to flow through to the combined ratio in the back half of the year. PC was weak, but not as weak as headline numbers suggest due to some one-time losses.
On the other hand, the performance of the life unit was unambiguously strong. Premiums and deposits were up 28% to $7.13 billion, and pre-tax income was up 2% to a record $1.42 billion. Assets under management were up 9% to $324 billion, which should power stronger investment income as rates rise. Base investment yield was 5.3%, which will increase as interest rates rise. Over the past two years, AIG has refocused on this business, and in an era of rising rates, now is the perfect time to get into life insurance. With rising rates, the present value of future claims declines, and higher rates will also increase investment income. While insurers who offered annuity and life products were slammed from 2008 to 2012, we are at an inflection point that AIG is wisely taking advantage of. No business benefits from a gradual multi-year increase in interest rates as much as the life insurance because it can reinvest maturing bonds into higher yielding ones. Over time, a 1% increase in the federal funds rate could increase AIG's EPS by over $1.50.
Therefore, AIG's PC business was a mixed bag, while life was an area of strength. AIG's strategic focus on life will also prove profitable in an era of rising rates. Importantly, AIG maintains a solid balance sheet with $103.8 billion in equity and $15.6 billion in liquidity at the parent company level. With further divestitures, AIG will have a significant amount of excess capital on its balance sheet, and it is returning it to shareholders. It currently pays a $0.125 quarterly dividend for a 1% yield. The focus instead has been on share buybacks, which totaled $867 million in the quarter.
At the present time, a focus on buybacks rather than dividends makes sense. Shares are trading at a significant discount to book value. Excluding AOCI, book value grew 10% in the quarter to $65.49. This 22% discount to book value makes a buyback very attractive and accretive. As AIG repurchases stock, the book value per share on the remaining shares increases further. Until shares hit book value, it makes sense to spend the vast majority of capital returns on buybacks. After the aggressive buying this quarter, only $537 remains under the current authorization. I expect AIG to fulfill the authorization this quarter and would expect a new authorization within the next three months. AIG can comfortably buy back $750-$1 billion in stock per quarter. After this quarter, I continue to believe AIG should trade 90-100% of book value this year, which would push shares higher by about 20%. I would be a buyer on this weakness. AIG's turnaround is real and making progress, particularly in the life division.
Disclosure: I am long AIG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.