- AIG will return at least $25 billion of capital to shareholders through dividends and repurchases.
- It will pursue an active divestiture program, including initially the 19.9% IPO of its mortgage insurance operation and sale of its AIG Advisor Group.
- It will reorganize into self-contained business units to enhance transparency and accountability; it will introduce a new Legacy portfolio and highlight the progress to over 10% ROE by 2017 in its operating portfolio.
- It will reduce firm-wide general operating expenses by $1.6 billion.
- It will improve Commercial P&C accident year loss ratio by 6 points.
In our view, this action plan doesn't go far enough to satisfy Mr. Icahn or other investors. While the $25 billion return of capital to shareholders is more than we might have expected, we don't believe the plan announced will placate any shareholders.
ROE is the Key Factor
Mr. Icahn has demanded that AIG split into 3 operating units - Life, P&C, and Mortgage Insurance - to avoid the systemically important financial institution/SIFI designation, which entails greater regulatory oversight and capital requirements, as well as higher compliance costs. Other SIFI-designated firms such as General Electric GE) and MetLife (NYSE:MET), are splitting off financial units to avoid the capital constraints that come along with the designation. By requiring greater capital to be held, it is more difficult for SIFI-designated firms to achieve ROE's comparable to their peers, putting such firms at a competitive disadvantage.
Indeed, AIG's operating ROE excluding AOCI was only 6.0% for the nine-months ended September 2015, down from the 7.3% reported for nine-months 2014, and far below its peers that reported mid-teens ROE. Even if AIG's ROE is looked at excluding AOCI and deferred tax assets (DTA), the AIG figure was only 7.1% for the most recent nine-month period.
AIG has had an aspirational 10% operating ROE target in place for several years now, with management already having pushed out the target date for such achievement at least once before. While many investors assume that AIG stock is cheap because it sells at a big discount to its book value, the discount reflects the lower than average ROE. The stock will likely continue to trade at a discount until the company is able to improve its ROE and reach its aspirational 10% goal.
Core P&C Operations Need Fixing: Reserves and Staff Cuts Are a Concern
AIG's strategic plan, in our view, doesn't go far enough to address the problems within its core P&C unit. The combined ratio (99.6% in Commercial Lines and 100.9% in Personal Lines through nine-months 2015) remains stubbornly high, including both the loss and expense ratios. Most likely, expense cuts and optimal use of reinsurance, other risk mitigating strategies, along with a culling of unprofitable accounts or business segments will help results.
However, we are troubled by the announced $3.6 billion of pre-tax reserve strengthening, or 6% of its carried non-life reserves, over a third of which is attributable to accident years 2004 and prior, and 41% for years 2011-14. While it is true that AIG writes long-tailed casualty lines of business that are difficult to price, where has management been the past few years on pricing for risk? The actuaries were presumed to have reviewed reserves in depth when AIG resumed its public status after the financial crisis. With all the data scientists the firm was hiring in recent years, why was it so far off on risk pricing? If reserves were that deficient in a low inflation environment, what might we expect if inflation picks up?
Sure, AIG has changed its mix of business in recent years. But, why has AIG only now announced that it is going to exit non-performing lines and segments of business and enhance its methods and assumptions to mitigate reserves volatility? Wasn't that already being done, and if so why the pricing mismatch?
Also of concern are the dislocations likely to result from staff reductions. Headcount has grown too high at AIG, and expense cuts are in order along with more downsizing and outsourcing. However, massive staff cuts can often lead to morale problems and compromised client relationships, just at a time when AIG is trying to better understand the risk profile of its accounts to achieve more accurate pricing.
Management Argument Is Too Weak
AIG management argues that a near-term breakup would provide less capital for distribution to shareholders because of loss of diversification benefits, and loss of value from the DTA. Certainly, the rating agencies would look negatively at less diversification if AIG were to sell off its life units, and the firm might not be able to utilize those deferred tax assets if it were to split. Also, without cash distributions upstream from its life operations, it might have difficulty sustaining its current dividend and repurchase activity.
Nonetheless, in today's marketplace, there are few synergies between life and non-life operations. Life insurance does provide balance when natural catastrophes hit, but cross-selling has not worked especially well.
AIG has already sold off many of its crown jewels, most notably AIA and Alico, which gave it large international insurance presence. It should at least consider selling off all or parts of its remaining life insurance business to focus on its core P&C operations, which generate the lion's share of its revenues and profits. AIG needs to fix its core P&C unit to realize a higher ROE and thus achieve a higher stock price. The mortgage insurance unit is profitable but too small relative to the overall company to make a huge difference, especially with only a partial sale now planned for the unit.
Stay Tuned ...
Mr. Icahn has until February 13 to respond to AIG's management plan. He is expected to wage a proxy fight against AIG, which could put further pressure on CEO Peter Hancock. Stay tuned for more action, as this battle isn't over yet.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: Tickers: American International Group (NYSE-AIG), General Electric (NYSE-GE), MetLife (NYSE-MET).