Good day everyone, and welcome to the American International Group's second quarter financial results conference call. This call is being recorded. Now I'd like to turn the conference over to Ms. Liz Werner, head of investor relations.
Thank you, and good morning everyone. Before we get started, I’d like to remind you that today's presentation may contain forward-looking statements, which are based on management's current expectations and are subject to uncertainty and changes in circumstances. Any forward looking statements are not guarantees of future performance or events. Actual performance and events may differ, possibly materially from such forward looking statements.
Factors that could cause this include factors described in our 10-Q under "Management's Discussion and Analysis" and in our 2010 10-K and subsequent 10-Qs under "Risk Factors". AIG is not under any obligation and expressly disclaims any obligation to update any forward looking statements, whether as a result of new information, future events, or otherwise.
Today's presentation may contain non-GAAP financial measures. The reconciliation of such measures to the most comparable GAAP figures are include in our financial supplement which is available on AIG's website, www.aig.com.
At this time, I'd like to turn our call over to Bob Benmosche, our CEO. Bob?
Thanks Liz, and good morning everybody. We have a lot to cover, so I want to be pretty brief, and then I'll turn it over to David.
The key for this quarter, though, and I do want to comment and stress it, is that we completed the last hurdle for this company for the conditions of closing for our restructuring, and so by issuing 100 million shares and raising that equity capital it allowed the Treasury to terminate the Series G preferred.
And so therefore, in my mind, AIG's crisis is over. We no longer have any direct obligation that we have to be concerned about vis-à-vis the government. Whatever is owed to the government for what they gave us in the beginning is all covered by collateralized partnerships or the common shares that we issued to them back in January.
So today, we are independent of government support, which is very important for our employees and our clients as we go forward. There's clarity. AIG is here. We're an investment grade company, and if you look at our results for the quarter, our top line is strong. Our retention of clients is strong. Our retention of people is strong. And so all the fundamentals of running this company are moving in the right direction.
You can see in Chartis, for example, that the combined is now 97.7% for this quarter, working its way down. And you know that's a huge book of business, so it takes time to do that. You also will see in SunAmerica, the strong top line, in terms of of those products that they sell. That's a good story, as they were [backing] all of the distribution systems.
UGC has a good control over its mortgage business. In fact, they're now leading in market share in terms of that business, and have a very strong performance in terms of losses relative to their competitors. That's going well. And of course, as you saw in ILFC, we've benefit able to deal with our legacy aircraft with the announcement of this acquisition of AeroTurbine. So that will give us more options in the late cycle of the life of those airplanes that we did not have before.
So when you look overall, we're in good shape. I also should mention that Nanshan looks like it will close. That will finally get done. That's another $2.1 billion, $2.2 billion we'll be able to bring in house and deal with paying down to SPV with the U.S. Treasury. So that's another good sign.
Overall, we're in great shape. We can look forward and focus on operating results, which we have over the last four or five quarters in particular. You can see it in our performance.
And I'll have David now take you through the details of that so you can reconcile what we reported and some of the nuances in those numbers.
David Herzog – EVP and CFO
Thanks Bob, and good morning everybody. Let's turn to slide 7 for the earnings highlights. Second quarter net income was $1.8 billion, up from a loss of $2.7 billion a year ago. Importantly, our after-tax operating income attributable to AIG, which is our principal non-GAAP measure, was $1.3 billion versus $800 million a year ago.
On a per share basis, after-tax operating income was $0.69 for the quarter versus $1.18 a year ago. Book value per share was $49.18, up 2% sequentially. Adjusted ROE was 6.3 for the quarter, 8.3 year to date.
Let's turn to slide 8. Chartis reported pre-tax operating income of $789 million, down $166 million from a year ago due to an extraordinary level of natural catastrophe losses. Cat losses in the second quarter this year were $539 million, largely from U.S. tornados and storms versus $300 million a year ago.
SunAmerica posted $743 million in operating income in the second quarter, down $115 million from a year ago. The SunAmerica results included $176 million decrease in the value of our Maiden Lane II investment due mainly to spread widening on the underlying non-agency RMBS securities. We also increased our reserve for IBNR by $100.6 million as a result of enhancing our death claim practices.
ILFC operating income we're seeing $86 million for the quarter, compared to $182 million a year ago. ILFC had $60 million of interest and other costs associated with their debt issuance and the subsequent tender offer for bonds and took an impairment charge of about $42 million on a handful of aircraft that we're either going to sell or put into part out.
As you might have read, as Bob mentioned, we announced the acquisition of AeroTurbine, the part out business, which will provide new opportunities and options for us to manage the older aircraft in our fleet.
Turning to United Guarantee, our mortgage guarantee business reported $13 million of operating income versus income of $226 million a year ago. Last year's income benefited from $232 million of favorable prior year development while this quarter included $25 million of unfavorable prior year loss development.
To put this in context, United Guarantee has roughly $3 billion in net loss reserves. In addition, the second quarter included a $40-odd million favorable settlement with a former underwriting customer. Newly reported delinquent loans continued to decline, yet overturns for progressively declined or rescinded claims increased.
Domestic first-lien reserves per delinquency remained steady at about $29,000 per delinquency. Turning to our other reporting unit, it reported a loss of $984 million in the quarter, versus $135 million a year ago, due largely to the mark-to-model loss of $667 million on our Maiden Lane III investment and to a lesser extent our capital markets wind-down portfolio.
As you know, Maiden Lane III is a special purpose vehicle that holds multi-sector CDOs purchased in the fall of 2008, and which we own a subordinated tranche plus a one-third residual interest. As of June 30, the value of our share of Maiden Lane III was $6.4 billion, down 10% sequentially but importantly up 28% from our initial investment.
We essentially gave back the $744 million gain in the first quarter. Prior to the second quarter, we reported eight consecutive quarters of gains. In the second quarter, credit spread widening and the corresponding impact on fair value model discount rate assumptions were the key drivers in the Maiden Lane III value.
Cash flows within the underlying CDOs remain steady, and we still anticipate receiving payouts beginning in 2014. The Maiden Lane III cash flows to date have paid down $12 billion to the Federal Reserve Bank of New York, or about half of their senior loan.
Asset management, which is included in other, had income of $92 million for the quarter, down from $303 million a year ago, due largely to the tightening of credit spreads in the asset book from a year ago.
Capital markets had a loss of roughly $160 million, due to the unrealized mark-to-market loss on the super senior credit derivative portfolio versus a gain last quarter. The loss was driven by a decline in values of the multisector CDS book. The wind down, again, continues to progress very significantly. This book had seven quarters of favorable marks before the second quarter, and our view of intrinsic value hasn't changed.
Remaining in the multisector book is about $6 billion of notional, for which we hold liabilities of roughly $3.2 billion, most of which we've already posted collateral against. Independent views support our belief that the actual settlements under these contracts will be less than the GAAP liability in the collateral postings we have, thus giving rise to the potential intrinsic gains we believe are worth the GAAP P&L volatility that we are required to report.
As previously disclosed, the second quarter marked the end of the active wind down of AIGFP, the remaining derivative portfolio of the capital markets, our predominantly non-complex market derivatives entered into to manage the risks of AIG and its affiliates or our hedges on those positions.
At the end of the second quarter, approximately $29 million of notional remains in the CDS portfolio, of which $22 billion does not require active trading management. The remaining $8 billion CDS, which is being actively managed, has over $1 billion of upside we believe against the modest contingent liquidity needs going forward.
Also during the second quarter, AIGFP agreed to terminate two super senior regulatory capital transactions with a combined net notional of over $24 billion - notional as of March 31 - and those had had previously been subject to possible additional collateral postings. Finally, our remaining investment in AIA appreciated by about $1.5 billion in the quarter.
Turning to slide 9, which shows the after-tax income reconciliation, reconciling items that have declined meaningfully as most of the restructuring activities are behind us. Also, we adjust for taxes since we apply a pro forma tax rate our operating earnings. The taxes are added back here to the GAAP net income to get to GAAP net income, since we aren't paying much tax and we currently have a full valuation allowance.
Jumping to slide 11, our capital structure. This reflects the January 2011 recapitalization and redundant leverage. Our leverage is currently in the low end of the range of our long term target, and we still assume a 20-25% debt to total capital as part of our aspirational goals.
Turning to slide 13, Chartis. Overall, I would note the Chartis reorganization into global commercial and consumer business is beginning to develop some positive momentum. Net premiums written, excluding Fuji and the impact of foreign exchange, increased about 2.4%.
Prior year development was insignificant for the quarter, after considering related loss-sensitive premiums. The four business lines with the largest reserve strengthening at year end 2010 saw little activity in the quarter. The combined ratio on an [accident] year basis excluding cats was 97.7%.
The expense ratio remained essentially flat. We are intensely focused on reducing general operating expenses in a thoughtful and deliberate way, but we will continue to make strategic investments in projects that better position Chartis for the future.
Turning to slide 14, net premiums written benefitted, as I said a minute ago, from our Fuji acquisition, but otherwise we're around 2.4% up for the quarter. Pricing is trending positively overall, in particular in the U.S. market. We're experiencing low single digit increase on average, led by our commercial property and worker's compensation lines. Customer retention, as Bob mentioned, is also strong.
Turning to slide 15, Chartis investments. Net investment income for Chartis was $1.14 billion in this quarter, up 2.6% from a year ago. The primary driver of the increase is improved interest and dividends and the effects of consolidation of Fuji. Chartis continued to reduce its muni bond position, which was 28% of the Chartis invested assets in the quarter, down from 31% last quarter.
On slide 17, turning to SunAmerica Financial Group, SunAmerica's operating income was $743 million in the quarter, down $115 million from a year ago. As you can see, SunAmerica's operating income has been relatively stable for the last five quarters. This quarter's volatility relates to market volatility for RMBS and in particular its effects on the value of Maiden Lane II, which is included in the SunAmerica group.
We also increased our reserve for IBNR by roughly $100.6 million, as I mentioned earlier. Our business remains diverse, strong, with good momentum in sales and deposits, customer retention, and importantly, net flows.
Turning to slide 18, premiums, deposits, and other considerations. Life insurance CPPE sales increased 29% sequentially, largely driven by retail sales. Western National, while continuing to maintain its pricing discipline, again achieved sales of over $2 billion in the quarter due largely to certain bank partners negotiating lower commissions and exchange for higher crediting rates for our customers. All in, total net flows for retirement services of $726 million were positive for the second consecutive quarter.
Turning to slide 19 for SunAmerica Investments, net investment income was $2.46 billion, down $167 million from a year ago. As I mentioned, Maiden Lane II negatively affected this quarter by $176 million versus a positive $120 million a year ago. Partnership income was strong again this quarter due to performance of our private equity and hedge fund investments, which are reported on a one-quarter and one-month lag respectively.
Excluding Maiden Lane II, investment income increased by 5% on increased interest and dividends and partnership income. Most importantly, our base yields increased sequentially as we redeploy cash. More on that in a minute from Bill Dooley.
Turning to SunAmerica spreads on page 20, reported spreads declined despite the redeployment of cash. Declines and other enhancements, which is mainly Maiden Lane II, more than offset the growth in interest and dividends. Looking ahead, as we continue to take capital gains to realized, the economic value of our substantial capital loss carry-forward deferred tax asset reported spreads could be pressured. We're choosing economics over a reported GAAP measure.
Now a few words on income taxes on page 22 and 23. As fully described in our second quarter 10-Q, we apply a framework for evaluating the need for valuation allowances. Among other factors, AIG must emerge from its recent cumulative loss position and demonstrate a level of sustainable profitably.
AIG's U.S. consolidated income tax group has reported taxable income over the first half of 2011 and is currently projecting taxable income for the full year of 2011. In addition, the group expects to emerge from the cumulative loss in recent years in the second half of 2011.
If these factors are met, the valuation allowance for the net operating loss, the non-life capital loss carry-forward, and the foreign tax credits consolidated basis released during the fourth quarter. Realization of the life capital loss carry-forwards remains more challenging, and that portion of the valuation allowance will be released as the carry-forwards are realized.
We still expect an effective tax rate of roughly 25-30% for the remainder of the year on our operating income, driven by our substantial investment in tax-free munis. Other discrete items in any given quarter will impact the rate as well. This quarter, among other things, we settled disputes previously reserved for, and the effect was favorable on the quarter.
And finally, a word on our outlook, consistent with the next steps of our company, and our increasing focus on long term operating results, we outlined a number of long term aspirational goals in our first quarter 10-Q which we affirm again this quarter. We expect to continue to execute on the operating and capital management actions to achieve these goals.
At this time, I'd like to turn it over to Bill for a few comments on the cash redeployment. Bill?
Thank you David. As we entered 2011, we had high investable cash balances in the insurance companies, and over the course of the first half of the year, we invested those cash proceeds in various asset classes to give the various durations necessary for the insurance companies. So in the first half of the year, we invested just under $50 billion, and the average yield across the board on those investments was roughly between 4.5-6%. So when we entered the third quarter, we were fully invested with all the cash that was available at the beginning of the year.
Operator, at this time we'd like to turn the conference call over to Q&A. We'd like to try and take one question and one followup from all the analysts, and then hopefully we'll have time to do more and they can get into queue.
Thank you. At this time we will start the question and answer portion of the call. [Operator instructions.]
Josh Shanker - Deutsche Bank
My questions, and I'll give them up front, and they're not related but they're similar. I'm trying to understand the $100 million reserve charge in SunAmerica for incurred but not reported debts. And two, it seems for two quarters in a row, we've taken charges on a revision of the outlook on cash flows for life settlement contracts. Given about 6,000 contracts, it seems like a pretty significant charge over two quarters. I want to talk about whether that will moderate, and what your outlook is there.
We'll have Jay just briefly give you an update on what the process changes were, and then we'll have Peter talk about the life settlements.
The increase of $100.6 million in the IBNR was in response to industry-wide regulatory inquiries, which we were in receipt of regarding our life insurance claim settlement practices and compliance with the unclaimed property laws. Our practices in that area are currently, and have been, completely consistent with all the applicable legal requirements and all of the historical industry standards. Having said that, we use this as an opportunity to enhance our practices, and we voluntarily initiated a review using, for example, the Social Security Administration's death master file and as a result of that review we chose to post the IBNR of $106 million. So that's the background on that.
Josh Shanker - Deutsche Bank
Is it most certainly nonrecurring in nature?
Most certainly this is now part of our claims practices going forward. We will continue to use this and other information as this develops. And again, the inquiry was industry-wide, not specific terms of what the American General or SunAmerica Financial Group.
But the answer to the question is, I believe, that the process change that Jay talked about - and it's more about a process change - there's a question about what practices are, but we've looked at our practices and said we think we should do it a different way. On the basis of what we've changed our practice to be, the team believes that they've got this worked out in this IBNR and this puts the problem behind us. And on a go-forward basis, it would be part of the normal operating procedures. So you would see that it's just part of our numbers. So I think this closes it out from we can see right now. Let me turn it over to Peter.
Peter D. Hancock
On the life settlements impairment charge, I'd like to just put it in the context of the overall life settlements portfolio, which totals a carrying value of $4 billion. We have instituted increased scrutiny of the longevity assumptions with updated medical information on individual lives. This is a book which has fairly large insured values per life, and as a result of those updated actuarial assumptions, which were validated by third-party scrutiny as well, we have added the impairment charge. We would not anticipate future charges, anything of that scale, but on the other hand, as I said, it's fairly lumpy in terms of individual lives. But when we take an impairment it's an asymmetrical charge when any single contract is impaired. But you don’t take positive news when it comes in. So there's an asymmetrical aspect of it. When we take an impairment we basically look at current yields on similar contracts to mark down the position.
Josh Shanker - Deutsche Bank
In the queue, you describe it as an enhanced process change. You had $60 million of charges in one quarter and here $180 million. Is the process change fully in effect, so that we don’t expect this to recur as sort of a change in the outlook? It will just be mark-to-markets from here on out?
Peter D. Hancock
It's not mark-to-market. It's effectively cost accounting, so you're basically looking for impairments of individual lives and so if you've got evidence that your assumption there is too aggressive then you mark that to market, but you don’t mark up the opposite, lives where you have information that suggests that you have it valued too low. So the enhanced process is just increased scrutiny on this book, with additional third-party scrutiny to validate our own assumptions. That's what's changed, and I would not expect charges of this magnitude going forward, but on the other hand, I would not expect it to be zero either. There will be some volatility and it's asymmetrical because the positive news comes in the form of a higher expected yield over the approximately 10-year duration of these contracts.
But we also have completed a very deep strategic review of what we're doing here. We're going to think about how we modify it, but this is not an area that we're going to be emphasizing going forward. We're just thinking about how to deal with it. So over time, we're studying this as an asset class, and we don't think it's something we're going to be growing.
We'll hear next from Donna Halverstadt with Goldman Sachs
Donna Halverstadt – Goldman Sachs
I had a question about a business that's a small slice of your business mix pie, but I'm just not clear how you think about it, and I wanted to understand philosophically or strategically how you're viewing United Guarantee, whether it's core or noncore or just merely a placeholder until some future point in time when we know if there's going to be a more robust future demand function for private MI. And as a followup to that, the pace of flux in the MI industry is picking up rapidly and I was curious whether or not you'd be interested in participating in any restructuring of the current industry makeup.
We see UGC has really done a dramatic turnaround of that business. I feel they have employed excellent technology now behind their claims process and so they've got themselves very much under control for the legacy book. They've done a wonderful job of reinventing how they underwrite mortgages, so they have a model now that works very effectively on new business.
And the experience that we've been seeing, it started in '09, so if you look at '09,'10, and '11 so far, that experience is exceptional relative to our history as well as the industry. So we are pricing for the right risks and we're getting the risk that makes sense for us as a company and we're not comparative in those risks which we obviously are concerned about.
Having said that, our market share has grown dramatically, and with that performance, we don't see any need to help anyone else out. So for now, the business, we operate that as well as ILFC, is do no harm to the core franchises of the company. But unlike IFLC, we feel that UGC does provide us a tremendous insight into a major aspect of our investment, which is residential mortgages and so on.
We also believe that as the government begins to pull back in some way out of the mortgage guarantee business there may be a better market for us and here this may grow. And so for now it's running very well and it's enhancing whatever we do here, not only from a small amount of earnings, but also by the intelligence it provides us on what's going on in the economy. So for now we see it as a keeper.
Our next question comes from Jay Cohen of Bank of America Merrill Lynch
Jay Cohen - Bank of America Merrill Lynch
Yeah, I've got one question, and then Ed Spehar's going to have question as well on the life side. My question on the property casualty side, I'm wondering if you could talk about some of the claims trends you're seeing. Obviously with the review last year there was some negative surprises in claims trends in various businesses. As you've entered now 2011, I'm wondering if you can update us on the claims trends, particularly in places like excess casualty and excess comp.
I think you can see from our quarterly review of our carried reserves that we did not experience any significant deviation from our expectations during the quarter with respect to claims trends. That's one of the things we focus on each quarter. We have an expectation based off of our carried reserves of what should happen during the quarter and we compare that to what actually did happen during the quarter. Right now, it's a class of business by class of business distinction here, but generally speaking, we're seeing rate change in line with loss cost trends, in particular, for example, with respect to worker's compensation, where you're seeing rate increases. But it is line of business by line of business specific. I think the overall point is that actual results are trending in line with our expectations.
It's important to stress that they’ve enhanced their processes. What you're seeing us do is enhancing a lot of processes, because we really want to tighten this place up and really improve the quality of our performance. And about $10 billion of our reserves this quarter were looked at by third party actuaries. We're going through it quarter by quarter and they've validated that our reserves are, if anything, just slightly above what they saw as essential estimates. So I think it's $10 billion, but as we go through it we're seeing everything coming in line, that the reserves continue to be what we said, very strong.
Ed Spehar - Bank of America Merrill Lynch
I have a question for David. Can you give us any thought on how much of this life capital loss carry-forward, this $23 billion of gross attributes, how much you think you might be able to realize?
As we said earlier, we've got about $7.5 billion of DTA, net DTA, related to the life capital loss carry-forward. And as we look at the life portfolio it has about I think $8 billion or so of gross gains. And then if you tax effect the gains, that sort of gives you a sense of how to think about the real opportunity right now, because that's the inventory of gains that we have. And then the question is how do we go about achieving that. In part we are realizing capital gains in the life cost of services themselves, actually selling the securities.
And then there are other strategies involved where we have other opportunities to realize, at least for tax purposes, the gains. And we are in the process of evaluating that. My sense is, as we said, maybe up to 25% of that number, of the $7.5 billion, we would expect to get, because the expiry dates run between 2013 and 2014. And so time is very different than on the NOLs, which run out until 2028. So the fourth quarter evaluation, as I was commenting on, will be around the NOLs, which we expect to realize fully. The foreign tax credits we expect to realize fully, and the nonlife capital loss carry-forward we expect to realize fully.
Ed Spehar - Bank of America Merrill Lynch
So if you expect maybe up to 25% of the $7.5 billion, that would suggest about $3 billion of gains harvested in the portfolio, right?
Well no. Think of it differently. If there's about $2-2.5 billion of DTA, and the DTA is effectively 35% of the actual gain. So if we were to realize all $8 billion of gains, take -
Ed Spehar - Bank of America Merrill Lynch
No, I got it. I had the math backwards. I guess the question though, if you had $6 billion of gains, wouldn't that be probably given out maybe around $700 million of annual investment income?
There's a tradeoff, and that's why I say we're balancing economics here against a GAAP-reported number, and a GAAP-reported spread. And we're sensitive to that, but that's why there are other ways to realize those gains other than just straight out harvesting.
Ed, I think what we're doing right now is we're assembling a world-class team in my mind. Because there may be some that are maybe as good, but nobody better that are quicker minds around how we begin to deal with this and how we can do things in a way such that we trigger a taxable gain on what it is we have here. Sometimes you don’t actually have to sell it that you get caught with a taxable gain. So there's all kinds of theories and strategies we're putting together, and we're going to do everything we can to maximize this number. However, we're also mindful that we don’t want to do it to the extent that it would harm Jay's business, so we're being mindful of the NII there. And that's a challenge. We have the team to do it, and that's why David is going to be conservative come to fourth quarter as to what he thinks can be realized [inaudible].
Ed Spehar - Bank of America Merrill Lynch
Thanks. We vote for economics if you care.
Mike Nannizzi of Goldman Sachs has our next question.
Mike Nannizzi - Goldman Sachs
Just a couple questions here. Trying to reconcile the development - we've got a 98% ex-cat combined ratio at Chartis, 97.7% ex-cat and prior year development. The development shows as being zero, 91 adverse and then 91 in returned premiums. And then in the Q it looks like about $100 million in additional adverse development from the first quarter. That's page 125 of the Q. So just trying to reconcile those if I could. And one followup. Thanks.
Let me just provide clarity here. First of all, I think you generally said this correct. Prior year development for the second quarter is adverse, but we write loss-sensitive business, and on the loss-sensitive business we have accrued premiums. And so the net of those two items in the second quarter are largely offset. The way that it works in the combined ratio itself, though, is that the prior year development affects the numerator, but the accrued premium or the loss-sensitive premium affects the denominator. So it's not an exact zero-sum game in the combined ratio itself.
And then as I think we talked about in the first quarter, one of the significant drivers on our development in Q1 was the fact that we had a settlement of a historical issue associated with one particular line of business. It's disclosed I think reasonably clearly in the 10-Q. But it was that item that really drove prior year development, all in the first quarter of 2011.
Mike Nannizzi - Goldman Sachs
So just on that adverse versus the loss-sensitive, is that the same business? You had adverse and then in addition you had additional premiums related to that adverse development because it was business you had written on a loss-sensitive basis? Or are they two separate items?
No, you said it exactly Mike. We have adverse development on business that was written years ago, and the premium accrual is on that same business. Just remember the way this actually works is we do our analysis across the entire portfolio, maybe in excess of a thousand different cohorts of data that we're analyzing, so the adverse development is the sum of all of those ins and outs. All of the accrued premiums on the loss-sensitive business, 100% of it relates to business that's also being included in, and is the driver of, the net adverse development that we experienced for the quarter. So the answer to the question is absolutely positively these are directly and specifically interrelated. There's an exact match between adverse development and the premium accrual in the loss-sensitive business. I'm just saying to you there's thousands of different ways that we slice this data and so there are other places of increases in prior year development and other places where there's decreases in prior year development. But the primary driver of why you have net adverse development is related to those premiums that we also accrued on loss-sensitive business.
Mike Nannizzi - Goldman Sachs
I'll follow up after on that one. I just had another math question. But if I could, I just wanted to understand what happened, again in Chartis U.S., is it consumer lines? It sounded like from the Q you discontinued a couple programs, otherwise saw some growth there. Commercial lines, you had a big E&O policy. It sounded like higher rates in comp, commercial, decline in specialty comp. Just trying to understand what got you to the plus 4.6%? Is it a combination of those items, or is it underlying that got you there? And then the expense ratio. There was about a 200 basis point decline sequential. Just trying to understand how to think about those as well. Thank you very much.
Peter D. Hancock
I think the first thing is that as we have looked at all of our lines of business, all of our individual relationships through the scrutiny of whether they meet our risk adjusted profitably targets, certain programs just didn't make the cut. And the particular consumer example you cite was one that whatever way you look at it just didn’t make sense going forward. So we terminated that program.
In terms of the overall trend, we saw an increase in ratable exposure which helped the general positive trend. Hopefully the economy continues its recovery and that trend doesn’t reverse itself, but we're not holding our breath. And in terms of other favorable rate trends, property is probably the most promising, especially outside of the U.S., but in the U.S. we're also seeing a slight hardening.
One other thing I would mention there Mike is that in the second quarter of last year, we did our first cat bond and so the prior year premium associated with commercial property is reduced by the amount of premium that we ceded on that cat bond, which was approximately $100 million. So we're higher in the 2011 simply because we did not cede premium again on a new cat bond. So just wanted to add that.
Mike Nannizzi - Goldman Sachs
Very fair. Thank you. Real quick on the expense ratio if that's okay? About a 200 basis point decline. Just trying to understand. You're clearly making some changes, cutting some specialty comp lines. I imagine there's still some outstanding claims on those. Just trying to get a handle on how the expense ratio goes down. Is that where we think it's going to be? Or is that just kind of a dip here in the second quarter?
Peter D. Hancock
Let me start with an overall comment on the expense ratio, and then I'll hand it over to Rob. The expense ratio is not something we target. It's an outcome of things that we do target, which is improvement in our costs, regardless of whether they appear in the expense ratio or the loss ratio. And I think that we're very conscious of the importance of reducing our fixed costs and then focusing on unit costs associated with claims management. And so as we do that, that has an effect on the expense ratio.
Secondly, as our business mix shifts from high to very low frequency to higher-frequency, low severity businesses, then the expense element goes up, but the amount of capital intensity goes down. So as we factor in capital costs, that, again, is another important shift. So as we shift toward these lower-risk consumer lines, then we expect the expense ratio to go down. And the acquisition costs are obviously higher as well in those lines.
So it's an outcome of our strategic shift toward lower risk businesses with better repeatable earnings characteristics, but we're very focused on expenses, however they're categorized. And so as far as the specific shift, maybe Rob, why don't you explain that shift as well.
I'll just give you a couple more things to keep in mind, especially here in 2011, and I think for the first part of 2012. We've embarked on a number of very important strategic fundamental investments in our platform including, for example, work we're doing on [inaudible] in Europe and we're also undergoing a very significant finance transformation effort inside of the chartered finance organization to put us all onto one single financial platform around the world.
Each of those items, among others, are investments that we think are very important to the long term viability of our platform and those will cause our expenses to go up as we go across the next year or so. However, you'll see us also continuing to demonstrate progress on the items that we've been targeting as an overall reduction of GOE.
One thing you will see from us is as we now have a full year of Fuji consolidated into our operations, Fuji carries a higher expense ratio and you should expect that that will also have an impact on us as we move forward into the rest of the year.
We do a lot of work on a quarterly basis to make sure that we've got an appropriate valuation of bad debt, whether it's on premiums or whether it's just on any receivables that we have on the books, and so one of the things that benefitted us in the current quarter was a reduction in bad debt expense also. And that will be lumpy on a quarter to quarter basis, really just based off of the facts and circumstances of that analysis.
We'll hear next from JP Morgan's Jimmy Bhullar.
Jimmy Bhullar - JP Morgan
I had a question on capital flexibility. Obviously you had to raise equity earlier this year to replace the Series G Preferred. And maybe I'll have to hold that as a question, but you sold [inaudible] and so what do you believe your current access capital position is on the balance sheet? Also, how much free cash flow do you expect to generate this year given the high cat losses? And then any comments on potential uses of this capital?
I'm going to turn it over to David, but I want to stress that selling the 100 million shares was a condition of closing to demonstrate we could. Remember, for us to be allowed to be where we are today, completely independent of government support, we had to prove we can get unsecured debt all the way through derisking FP and our credit ratings and also raising equity capital. So the G was put in as a stopgap until we demonstrated that, and so that's really about bringing us to that level at this point in time.
And we've also told you that we want to [inaudible] the liquidity during this period of time so that the rating agencies can absorb where we are and see how we operate throughout 2011. So that's what we did, and again keep in mind that we had to demonstrate our strength, having given up $30 billion of committed government support, plus the implied support above that. So that was all part of that condition of closing and maintaining strong investment grade ratings on a standalone basis. Having said that, David can now talk about what we're going to do with the proceeds.
The Nanshan proceeds will be used to repay or pay down the AIA SPV balance, so there's about $11.5 billion of obligation that the SPV has to the U.S. Treasury. Of the Nanshan proceeds, nearly $2.2 billion will be used to reduce that balance, which is a great outcome for all the stakeholders. So that's where those proceeds are going to go.
I would point you to our 10-Q disclosure, page 142. We talk about the capital liquidity availability at the holding company, the nearly $13.1 billion. As we discussed earlier, it's not so much about excess capital today as much as it is about the generation of distributable available capital as we continue to execute on our business.
And again, we reaffirm our aspirational goals which we set forth in the first quarter Q, that the $25-30 billion of capital management activities over the course of the next several years we believe are still very achievable, particularly in light of the continued progress that we're making.
So again, we'll continue to try to optimize the capital structure of the company. We're building sufficient liquidity at the holding company. Again, the final determination of whether or not we are designated a SIFI will ultimately be determined sometime later this year we expect. And so, again, all of those will play into when and how much and to what degree we commence our capital management. But at this time it's about building the pool of available capital.
And by the way, we have done a lot of sensitivity testing around SIFI, and we're very confident that SIFI will not cause us to go up. We are well above where even SIFI is at, so we don’t see it getting in the way of our flexibility and our thoughts at this stage of the game from what we've studied.
Jimmy Bhullar - JP Morgan
Okay. And then any comments on free cash flow that you expect to gentlemen this year?
Well, as we laid out as part of our earlier equity markets discussions, capital dividend capacity at our operating companies and those expectations have not changed. And so we will continue to expect to receive dividends from our operating companies to bolster the $13.1 billion we have.
Jimmy Bhullar - JP Morgan
And lastly, on AIA, you have restrictions on selling that. I think you can sell some of that beginning in October, but how do you view that asset? And obviously it gives you exposure to the international markets to the extent that you continue to own it, but do you think you're going to hold on to it? Or is it going to be more opportunistic?
I think we're going to study it and when with get to October we'll know what the markets are. We'll know where we are. As we talk about the SPV that it's collateralizing, as David just said, we're at [$11.3 billion]. We've got about $2.6 billion of cash that's sitting there in support of contingencies for Met Life, because of the sale of the Met Life stock, and the deal with Alico, and so when you take that out, you're down to about $6.5 billion, after Nanshan comes in.
And that's collateralized for example by ILFC as well as AIA, and so there's a huge amount of money. We're going to be taking a look at strategically where we are, what we need to do, what makes the most sense come October. And then the team will do that which we believe will give us the best shareholder value for the company going forward. It's all about how to create shareholder value moving into the fourth quarter as quickly as we possibly can.
Andrew Kligerman of UBS has our next question.
Andrew Kligerman - UBS
A SunAmerica question for Jay. So $8.4 billion in cash and short-term investments were deployed during the quarter. You go from a base yield of 5% up to 5.36%, but you also harvested, I think I read, $3.4 billion of gains. So now we're at 5.35%. If nothing were done going forward in terms of harvesting that $8 billion of gains that you have left, where does the base yield go? And then the other part of it is if you're willing to discuss how much of that gain you want to harvest, what kind of impact would it have negatively?
Let me just make a comment on the base yield increases on future cash flows. A lot is determined on obviously where the market goes in that period of time. So that's a harder question to answer. But when we're taking the gains on the SunAmerica portfolio, we're doing it in a deliberate way, so we can close the gap between the give-up and what we're getting. The other thing we don't want to do is to create another large cash balance at the life company level. So I'm looking for offsetting assets that are basically the same type of assets, even though there's going to be a yield difference because of the movement of the marketplace. So everything's being done in a very deliberate way.
Andrew Kligerman - UBS
So you want to minimize the impact?
We're trying to minimize the impact, but at the same time, pick up the gains.
Andrew Kligerman - UBS
Got it. So then with the $8.4 billion that you deployed, shouldn’t that yield, the 5.36%, go up next quarter barring any taking gains on the other stuff?
Well, as the sales take place, the gains are coming in, but I'm redeploying those funds at lower yield levels, just because of the movement in the marketplace. But economically, as David was saying, for the consolidated entity, we're much better off by taking those gains and having a smaller yield on the underlying assets in the insurance company.
If I could just add to what Bill and David said, a couple things. One is some of the cash was redeployed rather late in the quarter, so I don't think we've seen the full impact of that yet in the base rate, all subject, as Bill mentioned, to reinvesting new cash flow in this quarter. That's one point. But the other thing is that in terms of being deliberate, we are still in a negative IMR position in our life company, so 100% of these gains are going also to increase our statutory capital at this point as opposed to increasing our IMR reserve. So that's the kind of thing we're taking into account as we do this in a deliberate way.
Andrew Kligerman - UBS
So that's good. So there is some interest income pickup as we go into the third quarter. Nothing you could kind of give us a sense of to model for?
I'm not comfortable with that, only because there's still this third quarter to go. But we know that all of the activity in the second quarter is not reflected in the base yield.
Andrew Kligerman - UBS
Okay. And then just while I've got you, the discipline around Western National in terms of there was a big pickup in deposits, maybe just give us a little clarity on what was so disciplined there.
We continue to target approximately 12-12.5% after tax internal rate of returns and we're getting our pricing. We're closely coordinated with our asset management group on the investment side and [Bill]. We're back reinstated in all of the distribution that we were in prior to the fourth quarter of 2008. And I believe we have going now the most we've ever had. I think 12 separate rate for compensation tradeoff programs across all of our different banks, large medium and small, and that's been a big big driver of the activity, where banks are trading off commission compensation in order to offer the customers moderately higher [accrediting] rates. So that's a win-win for everybody. So we feel good about what's happening at Western and in our fixed annuity business. The absolute level of interest rates historically has had an impact on that. Higher is somewhat better. On the other hand, we see our customers more and more interested in guaranteed returns for some meaningful part of their portfolio. So the pricing is solid and the sales activity has remained solid. And I think Western and everyone there is doing an excellent job with it.
You know, the one thing to keep in mind, and for everybody to keep in mind, is Western has a product chassis that is unique to the industry, so think about it as today I think they price maybe 230 different combinations and permutations of different capabilities. So here's how much money we have and how do you want to slice and dice it. And as Jay just said, several very, very large banks have decided to finally see what happens when you cut commissions and go ahead and see if you can get the volume to do better. And we've seen huge volumes in these institutions that are very large.
And so this is a competitive advantage because of the uniqueness of that front end, and you add to it a very strong low-cost operation that comes out of Amarillo, Texas for now, which is a very high quality group. So you put that together and it gives them the opportunity to get this kind of price with this kind of volume. So it really is unique, and it's very hard for competitors to get to this overnight, because you've got to build that model and then get people comfortable in using that model. So it really is an incredible capability.
We'll move on to Tom Gallagher with Credit Suisse.
Tom Gallagher - Credit Suisse
First, Bob, I just had a follow up on the comment about the Treasury SPV in terms of the $6.5 billion that would be left in potential assets or sources to repay that. You had cited AIA and ILFC. Any thoughts on your Maiden Lane III stake, $6.5 billion? Should we assume that's not on the table because it's, I guess, fully in the control of the Fed? Or is there a chance that you can monetize that within the next couple of years? That's my first question.
Have you guys got some extra money, because we can talk. I don't know how anybody's going to buy our interest. It's totally under the control of the Fed. All I can say is that the cash flows - remember in the two years or so it's gone from $24 billion to $12 billion. It's doing about $350 million a month in cash flow. So the cash flows are strong regardless of the pricing that's going on here. We're all trying to figure the pricing out better to reflect the real value here, but there's no question Maiden Lane III has a tremendous amount of value for us down the road.
And so we would think if you do the numbers that sometime during 2014 - it depends on how strong they stay - that our $6.5-7 billion that's sitting there will start to flow in here. And so you just have to take that out of the equation. It's just something coming down the road just like Maiden Lane II. We had hoped to take the volatility out of Jay's earnings. That didn't succeed. But again, that's another one that has a lot of economic value over time that will flow in.
And remember those are collateralized, so in order to free up the collateral you're going to have to pay it down. Those are two major properties that are there supporting it, and I think Maiden Lane III is there, but that's just an extra safety valve down the road. But the cash coming in, Treasury wants first priority on that cash, because that's the deal. So as we monetize these assets, we don't get to leave them with Maiden Lane III and an SPV, taken at 5%. They want their cash, and that's what we're negotiating when the time comes as to how we exit from that SPV.
That's all the time we have for questions. I'll turn the call back to our speakers for any closing or additional remarks.
I'd like to thank everyone for joining us this morning and let you know that we are available to follow up with you on all questions, so please feel free to give us a call and we will get back to you if you were still in queue. Thank you.
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