American International Group Inc. (NYSE:AIG)
UBS Global Technology Conference Call
May 20, 2014; 11:00 a.m. ET
David Herzog - Executive Vice President, Chief Financial Officer
Brian Meredith - UBS
Great. We’re getting started with the next presentation here. I’m Brian Meredith. I am the Senior Property/Casualty Insurance Analyst here for UBS and we are incredibly pleased to have David Herzog, AIG’s Executive Vice President, Chief Financial Officer with us today.
Now David’s been AIG’s CFO since October 2008 and has been instrumental in leading the company through the transformation it’s gone through, from the depths of the financial crisis in 2008. David’s going to give us a presentation and then we are going to open it up to questions-and-answers.
And with that I’m going to turn it over to David.
Thank you, Brian. Good afternoon everyone and welcome. Brian, thank you to you and your colleagues for inviting AIG to participate in your program. It’s a pleasure to be here.
I’m going to start with just a quick overview of our core businesses. So we’re going to talk a little bit about the core businesses and then some of the important levers that we are focused on to help drive shareholder value for AIG.
So this slide really summarizes our core business, Property Casualty, Life and Retirement and our Mortgage Guaranty business and what we’ve set out here are some of the core strategies that we’ve been undertaking. And I’ve got a couple of slides later on that drill down into a little bit of the couple of core strategies inside of Property Casualty, where we are looking to grow the high value lines, we are looking to continue the business mix shift, both from some of the less than profitable lines of business, growing our international consumer lines and spending a lot of time and energy and focus on building out some of the technical underwriting capabilities and the claims management systems and I’ll talk a little bit more about that in a minute.
Our Life and Retirement business is a very stable and steady business. It is been quite profitable; it’s been a steady producer of operating earnings and most importantly a very strong contributor in terms of cash flow to the holding company and I’ll talk a little bit about that as a core tenant of how we think about capital management.
And then finally our Mortgage Guarantee business. United Guaranty is a business that has been remade, both the front end and the backend. On the backend the claims management capabilities and discipline have been completely remade since the 2008 era. As a matter of fact, the team that accomplished that is now the team that’s in charge of the Property Casualty Global Claims management.
So they did a fantastic job at United Guaranty, both backend and front end and I’ll talk a little bit about that as well. So this is a business that’s really focused on maintaining its discipline around underwriting and around risk selection and having competitive product, but it really is about getting the right risk for the right price.
So we really start with building from a position of strength, maybe a little context around our $103 billion worth of shareholders equity. 2008 and prior we had $1 trillion in assets and $100 billion in equity and today AIG after the restructuring has about $550 billion in assets and $100 billion in equity. So as we start now on this journey of building and growing, we’re building from a position of strength, of capital strength.
Another core tenant of our capital and how we think about capital is about fungibility and about capital flows inside the company. Because its one thing to have adequate capital and sufficient capital, but its even more important to have it in the right place at the right time and in the right currency. And so the combination of generating capital, building fungibility into how you manage it, those things are the bedrock or the cornerstone to them taking action, and here’s a selection of some of the actions we’ve taken of recent times with the dividend.
We put a dividend on the stock in the third quarter of 2013; we raised that modestly in February. We’ve deployed – we’ve gotten two different authorizations, $1 billion authorizations and we’ve deployed a good piece of those through the first quarter.
One of the ways I think about capital management is to really think about it in terms of a steady, orderly cadence that we’ll talk a little bit about more in the Q&A, but to be measured in how we go about this, because this really is a marathon, not a sprint, and we want to be thoughtful in how we execute against capital management.
Our capital and ratings are again is a strong position. Our capital structure is really pretty straightforward; we have equity and we have debt and some of the hybrid securities that are one-time may have gotten some equity credited somewhere along the line from an agency or the like. They are really just a function of debt, so our capital is very strong and straightforward.
Our leverage as you can see is really pretty low. With the financial debt and hybrids under 17% and the financial debt, just straight up financial debt is under 13%, so very low. But we remain focused on coverage ratio and you’ll say, well those two things are sort of, that may not make a lot of sense.
The point is, about 40% of the debt that’s on the books today comes from 2007 and 2008, so it was issued in that era and some of that is pretty expensive, and so therefore it provides an opportunity for us to think opportunistically about how to manage the cost of our debt to capital to a more sensible level.
The recent events of the sale of ILFC to AerCap no doubt will be credit ratings positive. Just how positive, we’ll have to see how that all plays out. But clearly gaining $25 billion plus of liabilities of the books is an important step for our company. And again, our book value continues to grow nicely about 10% year-over-year and that’s a function of earnings and certainly of capital management.
With respect to the ROE levers, we remain committed to sustainable ROE improvements, it’s a clear focus of our management team and we certainly aim to meet or exceed our cost of capital and that’s imbedded in our value metrics that we pursue inside the company, and so these are just a couple of levers that I’ll talk a little bit more about.
This really has been the how. How do you do this? How do you continue to drive ROE and certainly in our property casualty business, the focus is on improving the underlying profitability. That manifests itself in accident year loss ratio. I’ve got a slide on that in a minute. But that really is driven by a combination of some of the key strategic levers, whether its business mix shift, whether its standardizing our claims practices, whether its making ourselves more operationally efficient by taking out the redundancies and the like or streamlining the legal entity, so it’s a combination of all of those.
We are undertaking a project in our Japan business, we have three very large businesses there. We have scale, but now it’s about harnessing scale economies and that work will take some time to do, but the payback will be well worth it. And of course we took a severance charge in the fourth quarter and we are going to continue to rationalize the expense base in the firm.
With respect to capital management, we’ve done about $20 billion of capital management since 2011. That’s some equity share buyback, some debt buyback. This excludes anything we’ve done with the direct investment book. I’ll talk about that in a minute, but really some of the cash funded debt that we’ve retired early and so that’s an important step, but we’ve got more to do, and there’s more out in front of us and I’ll talk a little bit about the opportunity there.
So again, the key to me is continuing to generate deployable capital and then finding the most optimal way to in fact deploy it and some of the sources of how we generate deployable capital obviously is in some of the future liquidity that we’ve set forth here; the monetization of our differed tax asset, and I’ve got a slide on that in a minute.
But keeping in mind the earnings that we report, our after tax operating earnings, we impute a statutory tax rate on those earnings. So even though we do that, we impute a tax, we don’t actually, not yet while we have the NOLs, we are not yet paying tax to the U.S. government.
We monetize that through, the monetize the DTA through tax sharing agreements that run from the holding company down to the operating company and so we charge the operating companies tax and they pay the tax up to the holding company and then the holding company when we file a consolidated tax return doesn’t pay that tax on to the U.S. government, because we’re utilizing the NOL. That’s just simply how it works, that the tax law. That’s not anything unusual and special, it’s just the way it works, but it’s an important sources of cash flow to the holding company.
And then finally with the respect of the direct investment book as it continues wind down in a very orderly way and I’ve got a slide on that in a minute. But what that will do is it frees up the $7.9 billion of net equity that we have dedicated or allocated to that book.
With respect to our Property Casualty, again some of the strategic focus that we have again, we do business with about 97% of the Fortune 500, a little over 90% of the Fortune Global 500 and so there is no single lever, there is no easy path to improving the performance of a business that is this large and global.
So it’s just a lot of very detailed execution blocking and tackling if you will. And so these are the core tenants of the strategy that Peter Hancock and our P&C team have been pursuing. The business mix shift again, focusing on the higher return, higher more RAP positive. RAP stands for Risk Adjusted Profitability, focusing on the higher profitable lines.
With terms of underlining excellence, we have an enormous amount of data, that we have at our fingertips and the key is to be able to leverage that data and turn that data into more informed decisions, be it underwriting decisions, pricing decisions, to help guide what markets we peruse, what business no longer meets our return characteristics and it gives us the courage to walk away from business that we might not once have done. But it really is about focusing on the profitability of the underlying business.
With respect to claims servicing, again as I mentioned earlier, we’ve asked that the team that was instrumental in rebuilding the United Guaranty team and that business to run the global claims for our property casualty, we pay something in the order of 5.5 million claims a year, and we now have about half of the claim cost running through a common platform or one claim system. So the team’s done a remarkable job in rolling that out. There’s more to do, there’s more benefits to be added, but the teams well on its way.
Bringing all of these strategic initiatives together really is build on or bound together by that risk adjusted profitability framework and that cascades down throughout the organization. So instead of talking about premium volumes, which premiums are important, grow is important, it doesn’t mean its not, but it’s the right growth is what the team is targeting.
So looking through a lens of risk adjusted profitability where we take the underwriting profit and we attribute an amount of capital and then ascribe a cost of capital to that and we look then at the underlying profitability of the business, plus an allocation of investment income and then compare it to the cost of capital and if you are positive that’s fine, if you are negative then it’s, okay, now what do you do about it? Which levers do you pull?
So it really changed the whole dialog and the whole focus inside the company, the focus on profitability and then importantly where we weren’t meeting return requirements and what do you do about it and what action do you take.
The metric that I look to, to assess whether or not we are continuing to make progress is in the commercial space, in particular the accident year loss ratio and so this really to me is the hardest of the measures to sustainably improve over time, because again it’s a large book as I mentioned earlier.
The business is complex and some of its longer tail, and so what we’ve done and we’ve said its not going to be a straight line down, but Peter Hancock and John Doyle who runs commercial business have by executing on those strategic initiatives, continues to believe this ratio will continue to drop by 200 to 300 basis points a year over time for the near term and that’s what you’re seeing here. It’s the benefit of having in some cases elevated expenses that are needed to fix the claims. Sometimes it’s around building out underwriting expertise and data management etc.
So overtime we still expect to see this ratio continue to fall. Sometimes you have – in our business we do have what we disclosed as severe losses and those are going to happen from time to time and particularly in the property space. So again, we haven’t seen any underlying trends that would cause us some concern either in the underwriting or the pricing, so we continue to pursue the strategies that are kind of laid out.
And finally with respect to the property causality reserves, I think the important point here is that over 50% of the reserves are now from business that’s been largely re-underwritten since 2011 and we have continued to enhance our processes over time. We make extensive use of third part experts, not just actuarial firms, but experts as it relates to the underlying drivers of a particular class of business or product line.
We look at 100% of what I would call the longer tail, more complex lines which represents about 45 billion or so of the 65 billion of reserves that we have and we further enhanced our internal checks and balances. So there is a great deal of transparency and review and consultation that goes on as we set the reserves, which represent our best estimate each quarter.
Turning now to the Life and Retirement, our second major segment of the business. This business is really very well positioned. Its top five across the fixed and variable annuity markets as well as 403b business. Again, these businesses have generated very stable earnings and importantly very stable dividend flows to the holding company.
The product portfolios are in very good shape. The distribution is under common leadership and so what we had done a couple of years ago was bring the distribution organization together under one leader. We then separating manufacturing from distribution and the distribution team now focuses on bringing multiple products through the various distribution channels and that strategy and more importantly the execution of that under the very able leadership of Jay Wintrob and our distribution team, the execution of that’s worked exceeding well.
The focus here also is on a value-based measure. We look at value of a new business, where again the focus in on meeting or exceeding your cost of capital at it relates to a particular product line.
One of the opportunities for us really is in the individual variable annuity business and this really is a unique opportunity for us, because we’ve stayed the course. You can see by the graph on the right, we’ve de-risked a very substantial portion of those liabilities and those by de-risking meaning we index the fees to the vics. We have volatility control fund requirements and we have mandatory levels that have to be put in asset allocation of fixed income accounts.
So again, it’s a very stable product line for us and we stayed the course and we’ve reenergized distribution around us and as a result we’ve actually been able to grow that business exceeding well. Again, it’s the right growth, its profitable growth, it’s meeting or exceeding its cost of capital.
Another important measure we look at obviously in the retirement savings business, that investment spread is a major source of earnings and so we’ve tracked very closely our base yield, cost of funds for a net spread. And so we’ve been very disciplined about the asset allocation, opportunistic about adding some higher yielding assets at appropriate risk adjusted return levels and again, very disciplined around AUM.
Jay and the team have been very disciplined around crediting rate management. We’ve got about 72% of the book on the fixed annuities. I believe now down around the guaranteed minimums and those guaranteed minimums are at a level that give us some headroom in the event of rising interest rates, so that part of the book is in very good shape. But again, the team’s been very consistent in how we’ve managed the crediting rate. So the net result of that then are very stable or even improving spreads. And again, that’s the key to continued stable profitable earnings in that business.
Now I’m going to turn to a couple of the non-core activities or the non-core parts of our business. With respect to the direct investment book, this was a book of term debt and structured assets that in part was in our yield rundown or runoff of the financial products group, the AIGFP and the management investment program that was done at the holding company. 100% of liabilities of the AIGFP are guaranteed by the parent companies, so essentially those two things were the same.
So we put them together; common leadership, common management team, common disciplines around how to mange the wind down of this activity. As you can see, this wind down is on pace to occur between now and 2018 and about 80% of those liabilities will be matured by then. Again, there’s essentially no optionality in these liabilities. This is the runoff pattern; this is the maturity pattern of that book. And then as these liabilities run off, then that frees up the $7.9 billion worth of net equity that we have allocated to this book.
So while its not an exact pattern of how that’s going to occur, essentially between now and 2018, about 90% of that $7.9 billion will be released out of the direct investment and over to the parent and again some of that maybe cash, some of it maybe structured securities, some of it maybe other kinds of securities. But again, the key is to get it out of the direct investment book and up to the holding company for maximum fungibility.
We did complete the sale recently of IFLC to AerCap and we ended up getting $3 billion in cash net after we net out the inter company’s netted to $2.4 billion in cash and net cash sits at the holding company and its unencumbered. So in other words its not pledged to anything. Its just sitting at the holding company unencumbered.
We also have got about $4.6 billion worth of AerCap stock. $4.6 billion was the value that we recorded at in the second quarter. We’ll end up recording a bond of little over $2 billion gain on the closing of the sale, because we have marked ILFC to about $5.4 billion when we announced the AerCap transaction and I think the math you can kind of understand that for yourselves.
The 46% of the stock, again that too will sit at the holding company unencumbered and we will elect the equity method of accounting for that, so you won’t see the mark-to-market volatility of that stock and our balance sheet will record our 46% share of the newly combined company’s earnings and you’ll see that in our operating results going forward.
But I think very important was the deconsolidation of about $26 billion from the liabilities, that investing you know, I think it goes without saying, the investment grade companies don’t let their subsidiaries fail or don’t let their subsidiaries default on obligations, so we stood behind the company and the like. So it’s an important credit event for AIG. It just lowers the operating leverage on our platform.
The last of the non-core activities or the non-core assets I’ll talk about is really our differed tax asset and the schedule is, we use the schedule from the investor deck in our financial supplement and this just lays out the sources of what we call the U.S. tax attributes DTA. Well even after this DTA gets monetized, the $17.8 billion, even after that gets monetized, we’ll likely always have some DTA, DTL, just given the timing differences.
So this really is what I focus on in terms of monetization to the holding company and what I’ve said publicly already is that that asset will monetize over the course, between here and 2021, $750 million to $1 billion this year, $2 billion in ’15 roughly. I mean these aren’t precise calculations or estimates, but it gives you a sense of the monetization pattern and then at $2 billion to $3 billion, a year between here and 2020 or 2021, I would expect by that point 2020, ’21 that we will be a tax payer again.
So that again gives you a sense of the source of capital flows and the way we have defined in our capital planning and capital policies that are under construction is we think about typical payout rates.
So we look at after tax operating earnings and there’s a percentage that we will look to consider deployable and then plus the monetization of the DTA. Because again, if we’re working off of an after tax number, then its appropriate since we’re not paying tax, since we have this tax shield, to consider that also for deployment and then in addition to that the monetization of non-core assets, while ILFC for the year kept stock over some period of time and we haven’t decided yet what, when, etcetera, how we’re going to think about that investment. We’re quite pleased to be a 46% shareholder of a terrific company. But again, it’s the monetization of those, again non-core, including the direct investment book. So as that $7.9 billion frees up, that will be up for consideration of capital management.
So you can see, there’s a tremendous amount of capital generation to the holding company and we again spent a lot of time focusing on fungibility, because that’s important.
So in summary, we’re focusing on improving our profitability and our property casualty company continuing to focus on generating deployable capital, to then be able to generate and support capital management that is prudent and is balanced, has a sensible cadence to it that keeps all the various stake holders that we deal with in favor with us. So those are all important aspects to how we think about capital management.
So with that Brian, I’ll turn it over to you to open it up for Q&A.
Brian Meredith - UBS
Yes, thank you David. I’m going to start off the first question and open it up to the audience here. So on the topic of capital management, I guess kind of a two-part question here. So with the closing of ILFC you’ve got some net cash proceeds coming through that you received. What do you intend to do with that cash proceeds in the near term? Can we see a pick up in share repurchase activity potentially and then as an addendum to that, how do the pending non-bank SIFI rules play into your decision making process when your thinking about capital management.
Yes, it’s a good question. Well first of all the non-bank SIFI rules have not yet been written. So it’s hard to comment on them that they haven’t been written. We are as a firm trying to engage constructively with the policy makers that will actually be writing the rules, but we don’t have a – I don’t have a line of sight in terms of when we can expect those rules to be written.
When they are written we will obviously plan accordingly, but we do run our own CCAR like – CCAR is the fed framework for stress testing. We run ours as though we were a subject to those requirements. We run them twice a year and so like others do, using the feds assumptions and then looking at our own idiosyncratic, our operational risk or insurance related risk to add on to that. So I mean we do run that. That’s part of the getting ready for ultimate non-bank SIFI requirements.
With respect to how we’re thinking about capital management at this point in time, the first step was to actually close the ILFC transaction. That’s pivotal because in dealing with how you interact with and at least in my view, how you interact with the fed and our capital plan is the capital plan is based upon things that have happened.
In other words you don’t put capital actions in on contingent funding sources that is inconsistent with I believe how the fed looks at what is a prudent capital plan, because then when you stress it, you run the risk of contingent actions being thrown out and your capital position being looked at as though the actions were taken and those again are, that’s not an appropriate way to develop a capital plan or capital planning framework. So first thing was get the transaction closed now. What could happen now did happen. So now you’re dealing with a fact.
We’re updating our stress test, which I mentioned a minute ago, so we’re running through the normal protocol of going through that now, so that’s happening literally as we speak. We will update our capital plan now for what did happen to close the transaction and so we’ll have a normal process that we’ll go through.
We’ll obviously review – we have an ongoing dialogue with the rating agencies. Before we take any action, we don’t like to take an operational risk as it relates to our ratings, but I wouldn’t foresee any difficulties. The fact is we respect the process and we respect people, the rating agency’s point of view and we’ll take that into consideration. We obviously then will bring management’s recommendation to our Board of Directors and that will be another round of conversation and obviously we’ll have a conversation with our representatives from the feds, so they are fully informed about what we’re doing.
So all of that’s in motion in one form or another. Again, we take the high priority for this management team. Capital management is an important value creation lever and so we’ve been planning for this moment and so we’re now executing according to our plan.
Brian Meredith - UBS
Okay, thanks for answering. Any questions from the audience?
(Inaudible) Does the mortgage guarantee business benefit from being part of the AIG family or do you think you can generate better returns as a stand-alone business through a spend or potentially sales of royalty expense?
I think the business itself is very sound. That United Guaranty has done a terrific job. Again, looking at a multi variant front end and risk selection pricing discipline around various markets and so I think the size and the scale that United Guaranty is able to accomplish clearly are being part of AIG as helpful in terms of the strength to know we’re there as part of a larger balance sheet, a larger organization, both from a talent and from a technology and certainly from a capital standpoint.
From our standpoint, from AIG standpoint, I think the point is ILFC is growing at a very acceptable pace. Its meeting or exceeding its cost of capital on new business and so I believe its somewhere around, lives around 60% I think of the earned premium today. It’s been written since 2009 under the new model, under the new underwriting model with the multi variant pricing, so again it continues to grow and the new business continues to be an even more significant part of the earnings.
So it’s growing, producing earnings and importantly producing deployable capital. Its paid its first dividend since 2010 and I believe over time that that business will continue to grow and I think the other insight that it gives us is what’s really happening in the U.S. housing market and so we’ve been able to undertake a program, albeit slow at first, but we’re taking.
From time-to-time we’ll provide the actual mortgages that we’re underwriting and we do that through a program we’ve put in place, growing at a very appropriate pace, but its another way to leverage the strategic capabilities of that very good business and so I think its got a very welcome place at the table, its earning growth, its dividend capabilities and the insights it gives us to a very important asset class in the U.S.
Hi, over here. Two questions; number one, as far as the capital management story, is there an option or have you considered this as an option when you exchange your AerCap Stock for AIG stock in some type of exchange or tender, that’s my first question.
Hi, the short answer is that the stock is under a lock up for the next 15 months. So I think it’s a bit of an academic question at this point, an appropriate one, but we’re subject to a lock up. I think this is the way I’d answer that.
I recognize that, but something you could do down the road?
There are lots of different alternatives that we would think about, but again we haven’t made any decisions about the timing or the scale or the pace. Again, the stock is a terrific combination. I think the markets did the evaluation of the sales.
The second question is, the bearer case on your capital return story would be that you have this regulator, the fed that would be impediment to that and to hit an ROE target that would equal the cost of capital, a lot of people talked about your need to have to buyback a lot of your shares. If we weren’t able to overcome or buyback as much stock as you thought about, is there a Plan B where you guys could – do you see a potential to reinvest that capital in your existing businesses, perhaps in the mortgage business or in the right business to where that capital could be put to work, to where you could get a great return, a return that’s greater than the cost of capital.
Well, I think the way we think about the framework it’s a bit of a hypothetical, but we will look to meet or exceed our cost of capital and one of the dimensions obviously will be how much capital management, the pace and the scale and the size that we’ll be able to do and we will have to take that into consideration.
But again, we continue to reinvest in our business and I’d always rather invest in our business than buying back stock. But buying back stock today is a very attractive proposition, given that we’re trading at a discount to book. So that whole dynamic will of course be evaluated over a period of time when the rules are written and when we have a sense of what it means to be a non-bank SIFI.
Brian Meredith - UBS
Great. Well, I think that’s all the time we have. David, thank you for the presentation.
My pleasure and its great. Thank you.
Brian Meredith - UBS
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