Description

Investment Overview

We recommend establishing a long position in the equity of AIG, which is in the later stages of its exit from government assistance and making progress in improving the profitability of its core insurance franchises.  

With the sale and equity buyback announced following Q1 2012 results,USgovernment ownership fell to 61% of outstanding shares in May 2012.  We estimate that by the end of the year AIG, through disposal of non-core assets, will generate $15-$20b in cash, which it can use to repurchase significant additional shares from the Treasury.   At the current pace of share disposal by the government and repurchase by AIG, we believe AIG will be less than 50% owned by the government later this year, and completely free of Treasury ownership by end of 2013.

We believe that once Treasury ownership falls to 30%, this will remove a significant overhang on the share performance, as the market turns its attention to its de-risked and gradually improving business model.  We expect AIG to hit $40 by the end of this year.  Share repurchases in connection with government divestitures will push AIG book value per share to $75 by the end of 2013, and we expect a $50 stock price in 2013 as improvements in AIG core insurance businesses translate to a higher ROE.  If expectations are that ROEs will improve to 10-12%, then valuations should approach book value in 2014.

AIG has made great strides in extracting itself from the several forms of financial assistance which it was forced to take during its $150b+ bailout in the fall of 2008.  Specifically, in 2011 and early 2012 AIG repaid and terminated the $21b line of credit from the Federal Reserve and the $26b non-controlling interests in certain special purpose vehicles holding stakes in former subsidiaries AIA and ALICO.  This year AIG also fully paid down the $20b Maiden Lane II SPV which held distressed mortgage backed securities.  Later this year the final portion of the $24b Maiden Lane III SPV which holds CDOs, is expected to be repaid.  In the past year, the Treasury has sold 596 million of the 1,655 million shares it received in connection with the bailout (36% of its stake).  Thus, as of May 2012 the only government assistance is comprised of an approximately $30b common equity stake and a liquidating interest in Maiden Lane III.  This represents significant progress in repaying the $150b+ bailout in 2008, and within the next year, AIG should be completely free of US government assistance or ownership.  In May 2012, the GAO reported that the government expects to make over $15b profit on its bailout of AIG.

Near Term Capital Management

AIG is in the process of divesting three noncore assets which will generate over $15b in deployable cash.

1. Remaining 19% interest in AIA (American International Assurance, the Hong Kong based life insurance company spun off by AIG in 2010 and now publicly traded), worth over $8b.  These shares are subject to a lockup which expires on September 4, 2012.
2. Completion of the wind-down of Maiden Lane III is expected to generate over $6b.  Maiden Lane III is a special purpose vehicle 2/3 owned by the Federal Reserve and 1/3 by AIG.  The Federal Reserve is actively marketing assets within the SPV, with 16% of the portfolio sold in May and more put up for sale recently.  At the current pace of disposition the Maiden Lane III vehicle should be fully wound down by the end of this year. 
3. IPO of ILFC could generate additional $3-4b of cash, as early as this year.  ILFC is the aircraft leasing division of AIG, with book value of over $7.5b.  AIG has designated ILFC as a non-core business and filed an S-1, but has delayed the offering until more favorable market conditions prevail. 

AIG has used $5b total of cash to purchase shares from the Treasury simultaneous with the two most recent sales of Treasury’s stake in March and May of this year.   We expect AIG continues to purchase 50% of the stock to be sold by Treasury (currently worth approximately $33b).  The proceeds from the three assets sales set forth above, together with AIG’s $1b+ per quarter earnings power, will give AIG ample resources to effect such future buybacks.

A De-Risked and Steadily Improving Business 

AIG’s core insurance operations are comprised of three businesses:  Chartis (global property and casualty insurer), Sun America Financial Group (SAFG) (aUSlife insurance and investment services provider) and United Guaranty (Mortgage Insurance).

Chartis is one of the world’s leading providers of property and casualty insurance, offering a diverse mix of consumer (41% of premiums for MRQ) and commercial (59%) lines.  It offers insurance in US andCanada(47%) as well as Asia Pacific (primarilyJapan) (28%) and Europe, Middle East andAfrica(25%). 

Chartis’s financial performance since the financial crisis has been uneven.  Its combined ratio (loss ratio plus expense ratio) has been elevated, in part due to catastrophic losses such as the Japanese Tsunami but also due to poor product pricing in prior years.  Moreover, Chartis has had to strengthen its reserves by over $6 billion during 2009 and 2010 for certain long tail lines (excess casualty, asbestos, and workers comp).  This poor performance led to doubts about Chartis’s earnings power as well as the sufficiency of its reserves. 

Most recent data from Chartis has shown improvement in pricing (North American pricing up 5% in Q1) and business mix as Chartis is de-emphasizing its less profitable longer tail lines.  Last year, Chartis sold off its asbestos exposure to Berkshire Hathaway, further reducing its tail risk.  In the past four quarters prior year loss reserve development has been de minimis (less than 1/10 of 1% of total reserves), giving support to AIG’s claim that the reserves (at over $67b as of Q1 2012) are adequate and will not see the multibillion reserve adjustments seen in 2010 or 2009. 

Company management has set forth aspirational goals for Chartis, that by 2015 its combined ratio will be between 90 and 95 and its unlevered return on equity will be 10-12 percent.  The company repeated on its most recent earnings call that it is on track to achieving these goals, driven by the aforementioned improved pricing and tactical shift in business mix, but with combined ratio at a still elevated 102, it will take several more quarters for this improvement to flow through to the bottom line.

The current low interest rate environment is also a drag on the earnings power of Chartis, and for the P&C sector as a whole.  Low interest rates constrain the ability of Chartis to earn an attractive return on its investment portfolio, which, with a combined ratio at around 100, represents all of the profit from the division.  A higher interest rate environment would be a catalyst to Chartis more quickly hitting its aspirational ROE target, which likely cannot be met with pricing increases alone. 

SAFG sells a variety of life insurance and retirement products.  Its life insurance division American General has historically been relatively stable and slow growing, with operations focused on term and universal life.  SAFG’s retirement services offerings are sold by its VALIC, Western National and SunAmerica Retirement Markets subsidiaries.  The key drivers of profitability for SAFG are the spread on its investment portfolio, and the mortality and surrender rates versus actuarial assumptions in the life business and investment flows in the retirement services business.  A low interest rate environment has been the major headwind for the division, as this reduces the ability of SAFG to generate positive spread on its investment book, and also is a negative to investment flows in the retirement business.  Nevertheless, SAFG has been able to weather this challenging operating environment well, with relatively stable investment yield and profitability and steadily increasing AUM.  SAFG represents close to $35b in book value for AIG.

United Guaranty is AIG’s mortgage insurance guaranty business.  It covers mortgage lenders for first loss on high LTV mortgages; it previously provided insurance for second lien It represents a small (2%) portion of AIG’s book value at $2.4b and was profitable in its most recent quarter.

It should be noted that AIG has nearly completely exited the financial products business which necessitated the bailout.  In 2008, AIG had $1.8 trillion in notional derivatives exposure from over 35,000 positions, including $305b in credit derivative liabilities.  As of the end of 2011, AIG had fewer than 2,000 open derivative positions, representing a notional derivative exposure that had fallen below $200 billion, the bulk of which is fully hedged and in wind down. 

Valuation

AIG has a book value of $59 per share after the recently announced share repurchase.  Assuming AIG repurchases half of the remaining Treasury ownership of approximately 1 billion shares at an average share price of $35 (above its more recent purchase at $30.50 per share), AIG’s book value per share would be $70.   Adding in the approximately $8b in earnings AIG should generate through middle of 2013 (when we expect the Treasury divestiture and share repurchase program to be completed), AIG’s book value per share will be over $75. 

AIG’s current ROE (stripping out 1 time items) is 6%; given a 10-12% cost of equity this can support a $40 share price within the next year.  A “sum of parts” analysis of its various businesses, assigning a 0.8x multiple to the book value Chartis ($22) and a 0.7x multiple to the book value of SAFG ($14), together with its $16 billion deferred tax asset (expected value of $6), can also support a $40+ per share price (value of  noncore assets offsets debt and other liabilities, to complete the “sum of parts”).  The 0.8x multiple for Chartis represents a discount to the 1.0x P&C peer group (note that industry leader Chubb trades above 1.25x book).  The 0.7x multiple for SAFG is in line with the average of its Life Insurance peers.

However, we believe AIG is making substantial progress towards eventually achieving its aspirational goal of 10%+ ROE (in line with most large cap insurers).  Under a scenario where AIG is able to lift its ROE above 8%, a $50+ share price is clearly achievable, which we expect to occur by the end of 2013.  Note that an ROE lift will be assisted by the company’s repurchase of 25-30% of its outstanding shares at a 50%+ discount to book.  The investor paying $50 in 2013will be investing in an insurance company with a book value of $80+ per share within the year and a higher interest rate environment, supporting a further improved ROE.

Key Risks

Delayed turnaround for Chartis

• Need for additional reserves or elevated combined ratio would trigger a negative market reaction

Health of CEO Bob Benmosche

• Former CEO of Met Life, hired by AIG in 2009, age 67
• In 2010 AIG announced that Bob Benmosche had cancer (type undisclosed) and was receiving treatment
• He has remained as CEO during treatment and has announced he intends to stay on at least through 2012; he has been a steady hand and no clear successor has been identified

Persistently low interest rates

• Low interest rates present a challenge to generate positive investment returns
• Aspirational ROE targets may be delayed if rates stay low beyond the 2014 time period

Sifi status

• We expect AIG to be named a non-bank Sifi (Systemically important financial institution), which will entail oversight and stress-testing by the Federal Reserve
• While AIG is being transitioned to Federal Reserve oversight, this may limit or delay AIG’s ability to return capital to shareholders 

Catalyst