Dan Kitwood
American International Group (NYSE:AIG) continues to show vastly improved performance in insurance underwriting, which is paving the way for a healthier and more durable franchise. The stock trades at a material discount to its peers, but there seems like a clear path for a higher valuation as AIG improves its return on equity over the next year or so. CEO Peter Zaffino and his team are delivering, with 16 straight quarters of underwriting improvement, along with major efficiency gains. The investment markets have been difficult this year, which has hurt earnings, masking the underlying improvement, but that situation will get better, and higher rates should provide a nice tailwind for the insurer. AIG trades too cheaply and could be a really nice play to benefit from higher interest rates, and possibly a shift towards value investing.
One could easily write a book about the downfall of AIG that culminated in a government-assisted reorganization in 2008. The company is different for both better and worse but is certainly more simplistic to understand. At its core, AIG has a large and diverse P&C business, along with a solidly profitable Life and Retirement franchise. Over the last 15 years, until Brian Duperreault and then Peter Zaffino took over, the P&C business was an atrocious underwriter. The unit was still profitable due to its large investment portfolio, but the combined ratio was consistently above 100, while problems from prior years kept developing, which is often a great sign of aggressive loss reserving policies. This was the major focus of management, which did the arduous work of refining the lines of business the company underwrites, deploying reinsurance, reducing concentration risk, improving surveillance and customer service, etc.
Life and Retirement has been a great and consistent source of profits, despite the low interest rate environment, which had hurt fixed annuity sales up until recently. With the planned IPO of Life and Retirement, AIG’s future will predominantly lie with the P&C business, which is why I put a major emphasis on underwriting results in my analysis of the company. Ultimately, a combined ratio below 100% creates a free investment float, which great investors and operators such as Warren Buffett, Tom Gaynor, and Prem Watsa have relied on for decades. If AIG’s progress continues, an ROE above 10% should warrant a valuation of at least adjusted book value, which would mark a very nice increase in stock price.
Three years ago, management implemented AIG 200, with a goal to deliver $1B of exit run rate savings with a cost to achieve of $1.3B. This was achieved in Q2, six months earlier than expected, and the company is continuing to pursue additional efficiencies. The company modernized its IT platform, including moving 80% of its infrastructure to the public cloud. AIG now has a global standard commercial underwriting platform that streamlines processes and allows over 3000 underwriters to make real time risk management decisions. Improving the expense ratio plays a big part in lowering the combined ratio, so it is exciting to see these results, which will continue to earnout over the next few quarters and years.
On August 8th, AIG reported strong 2nd quarter financial results. Adjusted after-tax income per diluted common share was $1.19, down from $1.52 in the prior year quarter, as 73% improvement in General Insurance underwriting income was offset by lower alternative investment income. GAAP net income per diluted common share was $3.78, bolstered by an increase in net realized gains on the Fortitude Re funds withheld embedded derivative, and the improved underwriting results. Pre-tax income from continuing operations was up $147MM YoY to $4.3B. Total consolidated NII for Q2 was $2.6B, down 29% YoY, mostly due to lower alternative investment income. The adjusted ROCE was 7%, down from 10.5% in Q2 of 2021, mostly due to the decline in investment income.
General Insurance pretax income was $1.26B, bolstered by 73% growth to $799MM of underwriting income, helping to offset weaker investment results. The General Insurance combined ratio of 87.4%, improved by 5.1 points YoY, and was the first sub-90% combined ratio in over fifteen years, speaking to the massive improvement in underwriting that has occurred within AIG. The adjusted accident year combined ratio was 88.5%, improving by 2.6% YoY. Gross premiums written increased by 5% on an FX-adjusted basis to $9.6B. Global Commercial Lines adjusted accident year combined ratio improved by 4 points to 85.3% YoY, while net premiums written grew by 5%, or 8% on a constant currency basis. It’s hard to overemphasize how impressive this transformation has been for AIG’s underwriting, from its days of consistently posting combined ratios over 100% just a few years back. Management has created a major profit engine in underwriting profits, with a way lower risk profile than the company had before, when it took way bigger concentration risks. Management has pruned unprofitable lines, built a reliable reinsurance program, leaving a much more durable and consistent P&C business. Catastrophe losses were only $121MM in the quarter, or 1.8% of the combined ratio. AIG Re has significantly reduced its property catastrophe writings and exposure, especially in the Southeast region of the United States, where hurricanes, tornadoes and flooding have presented such big issues.
Life and Retirement reported its second straight quarter with over $1.3B in fixed annuity deposits and positive net flows. The core business produced strong sales with fixed annuities up 48% to $1.4B, and flat indexed annuities sales of $1.5B. In Group Retirement, contributions grew 1%, nonrecurring deposits grew 4%, and enrollments were up 11%. Q2 deposits were $1.8B with base net investment spread growing 4 basis points due to higher interest rate environment. In the 2nd quarter, adjusted pretax income was $563MM, decreasing YoY due to lower NII, as reduced alternative investment income, accelerated DAC amortization and an increase in SOP reserves impacted results. Higher interest rates and market volatility has many investors craving reliable retirement income to the unit’s benefit. Life and Retirement is also starting to see a positive impact from higher rates and wider spreads, as its base portfolio net investment income is expanding, boding well for future results. The Life and Retirement balance sheet and capital position is in good shape with an RBC ratio of 415-425%, which is above the target range.
Management has elected to delay the IPO of Corebridge due to the horrendous market conditions over the last two quarters, but the company still is planning on the IPO when capital markets are more accommodating. I believe this was a smart decision, as Life and Retirement has been a good profitable business for AIG, and absolutely should not be sold at too low of a price. I’d rather just completely ditch the IPO idea (although I don’t expect it) rather than sell at too big of a discount to the intrinsic value of the enterprise. AIG issued $6.5B in Corebridge Financial debt and subsequently redeemed $7.6B of AIG debt. Management estimates that recent expense saving initiatives implemented are already on track to save $200 to $300MM but are more likely to generate closer to $400MM of savings over the next 3 years, with the majority of the run rate saving achieved in the next 24 months. Corebridge has strategic partnerships with both Blackstone who owns 9.9% of Corebridge, and BlackRock, with Blackrock taking over a large chunk of the assets under management, pursuant to an arrangement announced in late March. Corebridge is expected to pay an annual dividend of $600MM post-IPO, which will be a payout ratio of 60-65%. The return on equity is slated to be 12-14% over the next 24 months, so this is definitely a decent business and management was prudent to be patient.
Like many other insurance and financial stocks, AIG’s book value per share took a hit in Q2, declining by 16% from Q1, and 27% from December 31, 2021, to $58.16. This was due to a reduction in AOCI as a result of higher interest rates, but adjusted book value per share increased by 2% sequentially to $72.23, and up 5% from year-end. Adjusted tangible book value per common share was $66.06, up 2% sequentially, and up 5% from year-end.
AIG repurchased $1.7B of common stock and paid out $256MM of dividends, while ending the quarter with $5.6B of parent company liquidity. AIG’s total debt and preferred stock to capital ratio was 31.1% at the end of Q2, up from 27.8% in Q1, due to the impact of higher rates on AOCI. Management expects to buy another $1B of common stock in the 3rd quarter and has $5.8B remaining on its authorization.
Management fully expects to achieve a return on common equity at or above 10%, post deconsolidation of the Life and Retirement business. Keys to achieving this success will be continued momentum on strong underwriting results, including more consistency and less volatility. Expense reduction will continue to be a part of the plan with the remaining $390MM of savings that AIG expects to earn in the next 12 to 18 months stemming from AIG 200. In addition, roughly $300MM of the AIG corporate expenses will move to Life and Retirement upon deconsolidation. The company has accelerated its share repurchase program and should be able to ramp that up as it obtains the proceeds from the Corebridge IPO in the future. AIG expects to reduce its share count to between 600MM to 650MM, while maintaining leverage in the 20% to 25% level. Additionally, yield enhancements from the higher rate environment should provide a boost to earnings power over time, but the plan for a 10% ROCE isn’t dependent on them. Management believes it has a clear line of sight to a minimum of 300 to 400 basis points of ROCE improvement, which could ultimately lead to a much higher valuation for AIG’s stock.
I believe AIG could be a $70 stock in the next 24 months, which is about 30% upside, plus a 2.4% dividend. As someone that has invested in the stock many times over the last 13 years, I believe the underlying businesses are healthier than they have been over that time horizon by a far margin. Capital and investment markets will improve, which combined with the immense improvement in underwriting results should get the company to that double-digit ROE goal on a consistent basis. The stock currently trades at just around 10x times forward earnings and 81% of adjusted tangible book value per share. The current market environment reminds me a lot of the early 2000s when the Tech Bubble imploded, and value investing had one of its best runs ever. AIG is a value stock, levered to benefit from higher interest rates, and I think long-term investors would be wise to buy it before transformation is evident to everyone.
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