By James Weiss of Queen's Capital
American International Group
American International Group (NYSE:AIG) is one of the largest insurance operators in the United States, and internationally. The company suffered from poor decision making during the financial crisis. The results of its non-core derivative transactions trumped the underlying strength in insurance operations. Since then the company has significantly reduced their exposure to derivative transactions; and management has refocused their attention to core operations. The company's primary lines of business are property and casualty insurance, life, retirement, and annuity sales. The company produces approximately $60 billion in annual revenue form both premiums and investment income. The investment portfolio of the company totals around $320 billion in assets. The company is highly levered to the high yield bond category in its life insurance operations. The company is determined to grow book value excluding deferred tax assets and accumulated other comprehensive income, at a 10% rate on an annualized basis. On the adjusted book value basis the company wants to improve its return on equity by 50 basis points. Management's last objective is reducing net expenses at a 3%-5% rate on an annualized basis. If management is successful in achieving these objectives, the company will be leaner, and better capitalized.
Property And Casualty Operations
American International Group has made significant strides in improving their property and casualty insurance operations. The strides have been made in reducing the acquisition costs for policies, and in cutting general operating expenses. The reduction in these two costs has led to a consistently dropping combined ratio. The combined ratio of insurance operations is, a measure of the costs inherent in running the underwriting operation as a percentage of premiums generated. The company has been able to reduce their adjusted combined ratio to 93.4% of premiums generated. The adjustments to the combined ratio relate to non-operating adjustments in liabilities and assets, in addition to catastrophe reinsurance contracts. The company has put an increased focus on reducing the loss ratio; the amount as a percentage of premiums the company pays out to cover insurance liabilities. The company has reduced the loss ratio between the full year 2012 and the first quarter of 2015 from 68.9% to 64.4%. This is indicative of stronger underwriting practices over that period.
Casualty insurance accounted for 49% of the segments premiums in 2010 but has been reduced to 36% of the current premium mix. This change in premium mix has shifted the segment to higher value lines of insurance, with consistently lower combined ratios. The company has also diversified its premium pool, drawing more premiums from Asia and emerging markets. The company has shifted away from long tailed risk, and focused on finding shorter-term risk profiles. This has decreased the company's net reserves. The shorter tailed risk profile will add more consistency to underwriting performance, as long-term risk events should have a smaller impact on results far into the future. Rising interest rates should increase net investment income from the $120 billion property and casualty asset portfolio. Within the segment it appears that both investment income and underwriting income will increase into the future, the twofold growth will increase segment-operating income by magnified amounts. At the current level of operating income and a conservative 9 multiple to pre-tax operating income the segment has an intrinsic value of $46.8 billion or $34 dollars per share.
Mortgage Guaranty & Institutional Market Operations
Two specialty commercial insurance segments mortgage guaranty and institutional market account for $1.260 billion in annual pre-tax operating earnings. If you assign the same 9 multiple to these earnings it values these segments at $11.30 billion, or $8.40 a share. The mortgage guaranty business was the line that generated many losses for the company in the crisis. Now with stricter underwriting the delinquency ratio on the portfolio has dramatically decreased. With very low average core ratios and the ability to generate investment returns; this is a highly profitable business line. The average FICO score on the new business generated for the portfolio was 752, and the average loan to value ratio was 91%. The institutional markets business line covers more esoteric risks, however it contributes significant operating income to the overall company.
The consumer insurance segment of the business produces $4.5 billion in annual pre-tax operating income. At a 9 multiple to pre-tax operating income the valuation for these business operations is in the neighborhood of $40.5 billion, or equivalent to $30 per share. The consumer insurance segment includes long tailed risk, and the performance of the segment has fundamentally different dynamics than commercial insurance. The company does exceed its cost of funds in the retirement portion of its business and the group annuity portion. In these two segments the company generates a 1.95% spread for the retirement portion and 2.21% in-group annuity. This business line generates income primarily from investment returns on its portfolio. Again like with most financial business these results will improve, if interest rates rise, as their portfolio is levered to short term fixed income.
The intrinsic value of the operations based on the calculations in this article, value the core operations of the company at $72.40 a share. The company has just recently sold its stake in AerCap Holdings for approximately $2.60 per share. That brings the approximate value companies core assets to $75 per common share. The company also has $20 per share of deferred tax assets and accumulated other comprehensive income. The company is focused on increasing the book value of the core operations, and don't focus on these assets. However, the deferred tax asset will bring real economic benefit, as it will lower the average tax rate on future operating income. The accumulated other comprehensive income is also a real asset, as it was derived from revaluing of assets and liabilities. Adding up all these components you come to a valuation of $95 per share. Profits derived from the core operations will increase book value over time, and the share price will adjust accordingly. Management has been buying back a considerable amount of the company's float through share repurchases. Buying the shares well below their net intrinsic value is delivering considerable value to shareholders.
Link to company presentations, information was sourced from the most recent presentations.
Link to company quarterly filings, graphs sourced from information.