Thoughts On MetLife And AIG

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Includes: AIG, MET
by: David Merkel, CFA

In some ways, this is a boring time in insurance investing. A lot of companies seem cheap on a book and/or earnings basis, but they have a lot of capital to deploy as a group, so there aren’t a lot of opportunities to underwrite or invest wisely, at least in the US.

Look for a moment at two victims of the Financial Stability Oversight Council [FSOC]… AIG (NYSE:AIG) and Metlife (NYSE:MET). I’ve argued before that the FSOC doesn’t know what it is doing with respect to insurers or asset managers. Financial crises come from short liabilities that can run financing illiquid assets. That’s not true with insurers or asset managers.

Nonetheless AIG has Carl Icahn breathing down its neck, and AIG doesn’t want to break up the company. They will spin-off their mortgage insurer, United Guaranty. but they won’t get a lot of help from that — valuations of mortgage insurers are deservedly poor, and the mortgage insurer is small relative to AIG.

As I have also pointed out before AIG’s reserving was liberal, and recently AIG took a $3.6 billion charge to strengthen reserves. Thus I am not surprised at the rating actions of Moody’s, S&P, and AM Best. Add in the aggressive plans to use $25 billion to buy back stock and pay more dividends over the next two years, and you could see the ratings sink further, and possibly, the stock also. The $25 billion requires earning considerably more than what was earned over the last four years, and more than is forecast by sell-side analysts, unless AIG can find ways to release capital and excess reserves (if any) trapped in their complex holding company structure.

AIG plans to do it through (see pp 4-5):

  • Reducing expenses
  • Improving the Commercial P&C accident year loss ratio by 6 points
  • Targeted divestitures (United Guaranty, and what else gets you to $6 billion?)
  • Reinsurance (mostly life)
  • Borrowing $3-5B (maybe more after the $3.6B writedown)
  • Selling off some hedge fund assets to reduce capital use. (smart, hedge funds earn less than advertised, and the capital charges are high.)

Okay, this could work, but when you are done, you will have reduced the earnings capacity of the remaining company. Reinsurance that provides additional surplus strips future earnings out the company, and leaves the subsidiaries inflexible. Trust me, I’ve worked at too many companies that did it. It’s a lousy way to manage a life company.

Expense reduction can always be done, but business quality can suffer. Improving the Commercial lines loss ratio will mean writing less business in an already overcompetitive market — can’t see how that will help much.

I don’t think the numbers add up to $25 billion, particularly not in a competitive market like we have right now. This is part of what I meant when I said:

…it would pay Carl Icahn and all of the others who would be interested in breaking up AIG to hire some insurance expertise. Insurance is a set of complex businesses, and few understand most of them, much less all of them. It would be easy to naively overestimate the ability to improve profitability at AIG if you don’t know the business, the accounting, and how free cash flow emerges, if it ever does.

They might also want to have a frank talk with Standard and Poors as to how they would structure a breakup if the operating subsidiaries were to maintain all of their current ratings. Icahn and his friends might be surprised at how little value could initially be released, if any.

Thus I don’t see a lot of value at AIG right now. I see better opportunities in MetLife.

MetLife is spinning off their domestic individual life lines, which is the core business. I would estimate that it is worth around 15% of the whole company. In the process, they will be spinning off most of their ugliest liabilities as far as life insurance goes — the various living benefits and secondary guarantees that are impossible to value in a scientific way.

The main company remaining will retain some of the most stable life liabilities, the P&C operation, and the Group Insurance, Corporate Benefit Funding, and the International operations.

I look at it this way: the company they are spinning off will retain the most capital intensive businesses, with the greatest degree of reserving uncertainty. The main company will be relatively clean, with free cash flow being a high percentage of earnings.

I will be interested in the main company post-spin. At some point, I will buy some MetLife so that I can own some of that company. The only tough question in my mind is what the spinoff company will trade at. Most people don’t get insurance accounting, so they will look at the earnings and think it looks cheap, but a lot of capital and cash flow will be trapped in the insurance subsidiaries.

There is no stated date for the spinoff, but if the plan is to spin of the company, a registration statement might be filed with the SEC in six months, so, you have plenty of time to think about this.

Get MET, it pays.

One Final Note

I sometimes get asked what insurance companies I own shares in. Here’s the current list:

Long RGA, AIZ, NWLI (note: illiquid), ENH, BRK/B, GTS, and KCLI (note: very illiquid)