Description

Opportunity

Following the downturn in the stock price due to the recent market volatility and significant global insurance catastrophe outcomes, AIG presents itself as a significant value opportunity with generous margin of safety.

Based on the current share price of $42.94, the company is trading at 77% of its adjusted BVPS (excluding AOCI and DTA) and at 64% of its BVPS (Ex. AOCI)

AIG is currently composed of a Global P&C business, a US focused Life & Retirement Business, other operations and a legacy / run-off insurance portfolio.

AIG Equity Breakdown by Business Unit

Sum of the Parts

Valuation upside mid / long term appears even larger on a sum of the parts basis as the current price is at 62% of the value.

Assumptions:

• General Insurance Comps include ACGL, AIG, ALL, AXS, CB, HIG, PGR, RE, RNR, TRV, WRB as of Nov 9th

• Life and Retirement Comps include MET, PRU as of Nov 16th.

• Legacy discounted to 0.75x BVPS

• DTA valued based on analyst estimated pre-tax income and 10% discount rate

Investor Fear - AIG underwriting weakness and questionable capital allocation

The market is discounting AIG primarily because of its severe historical underperformance in its General Insurance segment related to poor underwriting, leading to significant reserve strengthening and magnified catastrophe losses that impacted book value growth.

The historical underwriting weakness of the General Insurance is tangible as its combined ratio over the 2015-2017 period has been abysmal at 110.1, 118.9 and 117.3 respectively.

In addition, AIG capital allocation has been in doubt as cash flow was invested either to repurchase stock at high valuations ($6.3bn repurchases at $62.95 avg price in 2017) or to acquire Validus at a 1.5x BV multiple.

The main thesis of the investment idea is that these results will be mitigated going forward by: i) re-insurance completed in January 2017 with Berkshire Hathaway that covers 80% of the US commercial long tail reserve for accident years 2015 and prior; ii) Improved current and future underwriting and catastrophe risk mitigation by new management team who has extensive underwriting experience and track record; and iii) current price enables management team to focus on BVPS accretive share repurchases

1. Reduced reserve strengthening risk due to Berkshire Hathaway reinsurance

Investors are scared by the $26bn of reserve strengthening that AIG had to do between 2007 and 2016, demonstrating poor underwriting and severe under reserving of long tail risks.

In order to mitigate this investor concern, AIG completed in Jan 2017 a $10bn premium agreement with Berkshire Hathaway to re-insure away 80% of the US commercial long tail reserve exposure up to a limit of $25bn. As of Q3 2018, $17.3bn of the program has been utilized.

I believe this transaction, while impacting investment income, has significantly addressed the reserve risk for legacy underwriting.

Apart from this program, no significant reserve strengthening has happened after the new management team has come onboard (Spring of 2017). Specifically asked about the robustness of the reserves in place, CEO Duperreault and new actuaries did not take the opportunity to create extra cushion on the tab of previous management and have stated that they did not assess any major weaknesses.

2. Improved Underwriting and Catastrophe risk mitigation

General Insurance underwriting improvements following the reinsurance transaction have been impaired by the extreme catastrophe seasons of 2017 and 2018, exposing a combination of bad luck and AIG’s lack of risk mitigation.

Catastrophe Losses accounted for $4.1bn in 2017 and $2.1bn in 2018 YTD with another $300 to 500mm coming in Q4. This compares to the 2013-2016 average of $894mm.

In addition to the experience coming back to more average levels going forward, current management is highly focused on mitigating this risk by enforcing stricter underwriting and re-insurance limits in order to manage earnings volatility and avoid massive impairment of BVPS going forward. For example, these new limits enabled AIG to reach the North America 2018 exposure cap for both cat and severe losses in Q3 and should significantly reduce exposure to the recent California wildfires for Q4. While unfortunately late given the 2018 Japan exposure, management has also committed to apply risk mitigation structures for the International operations going forward.

Even accounting for the premium reductions due to the new risk mitigation measures, management believes they can realize an exit rate 2018 underlying underwriting profit (defined as accident year combined ratio including a normalized catastrophe load).

3. Capital Allocation

An additional point of investor questions has been the capital allocation framework used by new management.

While initially management has previously guided to eternal M&A as a preferred capital allocation tool and has confirmed it with the expensive $5.5bn purchase of Validus, management has hinted that share and warrant buybacks appear particularly attractive given the current price. Consequently it may postpone M&A deals to focus on BVPS accretive share buyback.

The strong cash generation potential of the company, driven by insurance subsidiary dividends and DTA realization ($4.7bn YTD in 2018), could allow for a yearly repurchase of 10%+ of the market cap at current values.

Summary

Based on current market price and the sum of the parts valuation above, General Insurance is valued at $19.86 per share or $17.6bn in total for a Global Multi-Line P&C with $26.9bn in equity ex. AOCI.

New AIG management has the challenging, but not insurmountable task of bringing back the division to just average performance.

If they can deliver, and they have the track record and the plan to back it up, the company could easily re-trade north of $70.

If they don’t, book value offers significant margin of safety to avoid losing principal.

A case of heads I win a lot, tails I lose a little that in this market environment appears attractive.

Risks

• Deeper reserve strengthening going beyond the $25bn reinsurance cap

• Poor capital allocation to expensive M&A

• Crush in capital markets, affecting life & retirement AuM and profitability

Catalyst

• Achieving General Insurance Combined ratios below 100% / absence of future reserve strengthening
• Normalized CAT outcome demonstrating run-rate profitability and cash flow
• Gradual increase in interest rates improving investment income