American International Group: Underscoring Focus On Core Insurance Activities

| About: American International (AIG)


The insurance giant has effectively reported a positive earnings surprise in the second quarter.

The positive results were achieved on the back of improved underwriting activity and one-time gain of $1.4 billion from the sale of its aircraft-leasing unit.

Life and retirement business segment also registered an increase of 3% in the pre-tax operating income brought in by both its retail and institutional segments.

Now, the business has become more centered towards its mainstream insurance business.

The scrip is undervalued and represents an upside potential of 19.50%.

The earnings release season is at its peak and many companies continue to report the results of their efforts. Positive earnings surprise and negative earnings surprise are the most common terms being used these days. Similarly, American International Group, Inc. (NYSE:AIG) is counted among the companies that have successfully translated their prolific efforts into positive results, as that is what shareholders value. The insurance giant has effectively reported a positive earnings surprise.

Let's take a look at the details of the company's achievement and the probability of continuation of this momentum.

Source: CNBC

Underwriting Success

The positive results were achieved on the back of improved underwriting activity. The losses of $223 million in the underwriting business in the second quarter last year have finally turned into positive numbers ($101 million) for AIG in the most recent quarter for both commercial and consumer underwriting.

This can also be seen in the improved combined ratio, a performance metric used to gauge the efficiency in the insurance industry. A ratio less than 100% shows that the company is achieving underwriting profit whereas a ratio greater than 100% means that it is giving out more money in claims than it is getting from premiums. As for American International Group, the insurance company has moved into the safety zone by bringing down its combined ratio to 95.4% in the second quarter this year compared to 101.7% in the corresponding quarter last year, mainly due to lower accident year losses, favorable last year loss reserve development and lesser catastrophe losses. The company was able to benefit from its higher international presence compared to peers who have their business activities mainly centered in the US, as the worldwide disaster costs were lower this time. The company's catastrophe losses were reported to be $139 million in the second quarter of fiscal year 2014 as compared to $316 million in the corresponding period last year.

Peter Hancock, head of the company's property-casualty business, is planning to focus on higher pricing and divesting from unprofitable business areas while at the same time, also updating the company's computer infrastructure to better utilize data analytics.

Premium written, a future performance assessment metric, had plunged by a meager 0.5% this time and had clocked in at $9.2 billion. However, excluding the foreign exchange impact, the figure had actually increased on the back of 4% growth in consumer insurance, which came from various products and distribution channels. On the contrary, AIG was not able to perform that well in commercial insurance business due to lower retention of renewal business and lower new business due to intensifying competition in the market field.

Life and Retirement Segment

The company's life and retirement business segment registered an increase of 3% in the pre-tax operating income brought in by both its retail and institutional segments. Higher fee income was earned on the back of higher assets under management, i.e. $332.8 billion in the most recent quarter compared to $293.7 billion during the same period prior year, representing an increase of 13%. This segment went on to gain from the right pricing of new business, actively changing credit rates for interest rate-sensitive business and the surplus of previous business with comparatively high credit rates, counterbalancing the adverse investment results due to the prevailing low interest rate environment.

Contribution of One-off Events

The company's latest quarter results also consisted of a one-time gain of $1.4 billion from the sale of its aircraft-leasing unit to AerCap Ireland Limited. The sale was made to streamline AIG's business operations and as a result, the company is now more focused on its mainstream insurance business.

Moreover, the company has also agreed to settle the litigation by paying $960 million in cash to investors who blamed the insurer for deceiving them about its financial position just before the financial contagion set in which called for government rescue.

Overall, the net impact has been positive i.e. $0.44 billion. This uplifted the EPS by $0.30 in the quarter under discussion and was one of the main drivers of the positive earnings surprise apart from the solid improvement witnessed in the company's core operations.

Final Verdict

Apart from the improvements in the core operations, the exceptional profit growth was driven by exceptional sales gain item in the income statement. As the business becomes more centered towards its mainstream insurance business, the market has actively incorporated the growth potential that AIG upholds. This can be reconfirmed by the stock's P/E based valuation. The industry has a P/E "ttm" of 14.70 while the analysts expect its 2014 earnings per share to clock in at $4.45. This effectively translates into a fair value of $65.42. However, the stock is presently available for purchase at $52.66, which represents an upside potential of 19.50%.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.