- In CEO Robert Benmosche's final quarter, AIG reported excellent results and it remains a buy after his departure.
- Reflecting tighter underwriting standards, AIG's PC unit had a combined ratio of 98.2%, and this quarter is hopefully a return to consistent underwriting profits.
- AIG's life unit continues to grow deposits and assets, and this unit will drive significant growth as rates gradually rise.
- With improving results and an aggressive buyback, AIG should trade closer to book value or $67; I would continue to buy AIG here.
After the bell on Monday, the American International Group (NYSE:AIG) reported its second quarter results. These results have significant symbolic implications because this is the final full quarter under the watch of CEO Robert Benmosche. After five years on the job, Benmosche will turn the job over to Peter Hancock, the current head of AIG's Property Casualty unit, on September 1. Benmosche took over AIG after the insurer received a $180 billion government bailout, sold assets, and amazingly returned the company back to profitability in a remarkably short period of time. Now, AIG is well capitalized, taking less risk, and is consistently turning a profit. Fittingly, Benmosche hit a homerun in his final quarter at the helm, and I would continue to be a buyer of AIG stock.
In the quarter, AIG earned $1.25 on revenue of $8.53 billion compared to expectations for $1.05 on sales of $8.13 billion (all financial and operating data available here). EPS was up 11% year over year while revenue was 2% higher. Excluding its gain related to the sale of its aircraft leasing unit, AIG generated $1.8 billion in operating income compared to $1.7 billion in operating income. There was strength across the board in these results.
Traditionally, Property Casualty has been the main driver of AIG's results. Since the financial crisis, Benmosche has been working to tighten underwriting standards to improve the unit's combined ratio. This ratio measures the operating margin on underwriting. A combined ratio of 100% means underwriting is breaking even. In this quarter, the combined ratio was a strong 98.8 compared to 102.6 last year, meaning that AIG earned 1.2% on underwriting, which is a fantastic result. After all, the majority of earnings come from investment income. In this quarter, investment income was $1.254 billion. An underwriting profit helps to juice these investment gains. I am hopeful this quarter represents a turning point, and AIG will start to consistently make money on underwriting. Thanks to better underwriting, pre-tax operating income soared 25% to $1.355 billion.
While Property and Casualty is improving, life insurance will likely be the major growth driver for AIG going forward. Premiums and deposits jumped 9% year over year to $7.36 billion. As a consequence of higher deposits, assets under management jumped 13% to $332.8 billion. Now, net investment income did fall 3% to $2.56 billion, but this was mainly driven by lower investment returns from alternative investments, which should be transitory. Base portfolio yield was 5.17% compared to 5.35% a year ago. AIG has been aggressively investing in its life business to grow premiums and assets, and we are seeing solid growth as a result. This strategy makes tons of financial sense.
Life insurance is the ultimate bet on rising interests. Customers pay premiums to AIG every month for years, and when they die many years down the road, their beneficiaries can make a claim. This future claim is a liability. As rates rise, the present value of these claims falls. At the same time, AIG can invest the cash premiums in long-term bonds, meaning income increases as interest rates rise. Rising rates increase investment income, while cutting the present value of liabilities. This is a double benefit that makes life insurance a great business to get into as rates are about to rise.
Now, over the past few months, the 10 years' yield has stayed surprisingly low, even with the Federal Reserve tapering its bond purchases. While I cannot say when rates will rise, I do believe that an increase in yields is inevitable as the Fed steps away. With some inflation and positive growth, the 10-year yield and eventually even the Fed funds rate have to increase. This increase in yields is not just a short-term benefit, but a long-term theme that will increase AIG's earnings power over several years. A 1% increase in the Fed funds rate will gradually increase AIG's EPS by around $1.50. Over time, life insurance will push AIG shares appreciably higher.
With life and PC performing well, AIG's valuation is amazingly attractive. Excluding AOCI, book value rose 10% to $67.65. At the very least, AIG should trade 90% of book value and over time should reach book value, giving shares over 15% of upside over the next twelve months. AIG's management clearly recognizes AIG stock is undervalued because it repurchased $1.1 billion in stock during the quarter. The board also authorized an additional $2 billion in repurchases. Buying back stock is very accretive with shares below book value as it increases the book value per remaining share while also accelerating EPS growth. As AIG monetizes its stake in AerCap, I expect further share buybacks.
Simply put, the AIG bull thesis is fully intact. PC underwriting is improving while life insurance continues to grow and will benefit from higher rates. With $18 billion in liquidity, AIG can continue to opportunistically repurchase shares, helping to push book value per share even higher. I expect shares to trade past $60 within 12 months and perhaps hit $67 by the end of 2015. While I am sad to see Benmosche go, AIG is in able hands in Mr. Hancock who has turned PC around. AIG is a conviction buy here.