There is a saying in the industry “Life Insurance is sold, P&C Insurance is bought.” They are different markets, and there is no reason for shareholders to own a company that does both. But some companies diversify. Who does that benefit?
The main beneficiary is the management, as it gives them cover for underperformance. They can always blame transitory factors for underperformance of one division or another.
And much as Hank Greenberg blamed his successors for the failure of AIG, the main cause of longer-term underperformance stemmed from the purchases of SunAmerica and American General at high prices.
AIG was highly profitable in 1989 with its foreign and domestic P&C operations, and its foreign life operations. What should it have done with its profits?
It should have paid a higher dividend, bought back stock, and shrunk the company as many other successful insurers have done. Companies is mature industries should return capital to shareholders.
Just as GE has suffered, so has AIG. Both CEOs were lionized, then despised. The main idea to take away from this is conglomerates where businesses have different sales models don’t work.
In some ways, this is a boring time in insurance investing. ?A lot of companies seem cheap on a book and/or earnings basis, but they have a lot of capital to deploy as a group, so there aren’t a lot of opportunities to underwrite or invest wisely, at least in the US.
As I have also pointed out before AIG’s reserving was liberal, and recently AIG took a $3.6 billion charge to strengthen reserves. ?Thus I am not surprised at the rating actions of Moody’s, S&P, ?and AM Best. ?Add in the aggressive plans to use $25 billion to buy back stock and pay more dividends?over the next two years, and you could see the ratings sink further, and possibly, the stock also. ?The $25 billion requires earning considerably more than what was earned over the last four years, and more than is forecast by sell-side analysts, unless AIG can find ways to release capital and excess reserves (if any) trapped in their complex holding company structure.
Improving?the Commercial P&C accident year loss ratio by 6 points
Targeted divestitures (United Guaranty, and what else gets you to $6 billion?)
Reinsurance (mostly life)
Borrowing $3-5B (maybe more after the $3.6B writedown)
Selling off some hedge fund assets to reduce capital use. (smart, hedge funds earn less than advertised, and the capital charges are high.)
Okay, this could work, but when you are done, you will have reduced the earnings capacity of the remaining company. ?Reinsurance that provides additional surplus strips future earnings out the the company, and leaves the subsidiaries inflexible. ?Trust me, I’ve worked at too many companies that did it. ?It’s a lousy way to manage a life company.
Expense reduction can always be done, but business quality can suffer. ?Improving the Commercial lines loss ratio will mean writing less business in an already overcompetitive market — can’t see how that will help much.
I don’t think the numbers add up to $25 billion, particularly not in a competitive market like we have right now. ?This is part of what I meant when I said:
…it would pay Carl Icahn and all of the others who would be interested in breaking up AIG to hire some insurance expertise. ?Insurance is a set of complex businesses, and few understand most of them, much less all of them. ?It would be easy to naively overestimate the ability to improve profitability at AIG if you don?t know the business,? the accounting, and how free cash flow emerges, if it ever does.
They might also want to have a frank talk with Standard and Poors as to how they would structure a breakup if the operating subsidiaries were to maintain all of their current ratings. ?Icahn and his friends might be surprised at how little value could initially be released, if any.
Thus I don’t see a lot of value at AIG right now. ?I see better opportunities in MetLife.
MetLife is spinning off their domestic individual life lines, which is the core business. ?I would estimate that it is worth around 15% of the whole company. ?In the process, they will be spinning off most of their ugliest liabilities as far as life insurance goes — the various living benefits and secondary guarantees that are impossible to value in a scientific way.
The main company remaining will retain some of the most stable life liabilities, the P&C operation, and the Group Insurance, Corporate Benefit Funding, and the International operations.
I look at it this way: the company they are spinning off will retain the most capital intensive businesses, with the greatest degree of reserving uncertainty. ?The main company will be relatively clean, with free cash flow being a high percentage of earnings.
I will be interested in the main company post-spin. ?At some point, I will buy some MetLife so that I can own some of that company. ?The only tough question in my mind is what the spinoff company will trade at.? Most people don’t get insurance accounting, so they will look at the earnings and think it looks cheap, but a lot of capital and cash flow will be trapped in the insurance subsidiaries.
There is no stated date for the spinoff, but if the plan is to spin of the company, a registration statement might be filed with the SEC in six months, so, you have plenty of time to think about this.
Get MET, it pays.
One Final Note
I sometimes get asked what insurance companies I own shares in. ?Here’s the current list:
Long RGA, AIZ, NWLI (note: illiquid), ENH, BRK/B, GTS, and KCLI (note: very illiquid)
Those were back in 2008, before the financial crisis. ?I made similar comments at RealMoney earlier than that, but those are lost and gone forever, and I am dreadful sorry.
1) The first thing to realize is that diversification across insurance subindustries usually does not work.
Do not mix:
Life & P&C
Financial & Anything
Health & Anything
Maybe you can mix P&C, Mortgage & Title, after all Old Republic survived.? The main point is this.? Insurance is not uniform.? Coverages are sold and underwritten differently.? Generally, higher valuations will be obtained on ?pure play? companies? Diversification is swamped by management inability.? These are reasons for AIG and Allstate to spin off their life operations.
2) Middle-sized companies tend to do best from a valuation standpoint: the large have nowhere to grow, and the small are always questionable on their viability.? With a few exceptions, I like sticking with focused mid-cap companies with my insurance names.
Both of these concepts augur in favor of a breakup of AIG — even without the additional capital needed for being a SIFI (which no insurance firm should be, they don’t collapse together, like banks do), large firms get a valuation discount, because they can’t grow quickly.
Synergies and diversification benefits between differing types of insurance tend to be limited as well. ?Focus is worth a lot more in insurance than diversity, because managements are typically not good at multiple types of insurance. ?They have different profit models, distribution systems, capital needs, and mindsets. ?Think of it this way: if you can’t get personal lines agents to sell life insurance and annuities, why do you ever think there might be synergies? ?They are very different businesses.
1) Costs aren’t overly high at AIG, and there may not be a lot to cut. ?Greenberg ran a tight ship, and I suspect those who followed tried to imitate that. ?I would try to double-check cost levels.
2) ROEs are low at AIG likely because many life insurers have low?embedded margins and those?can’t be changed rapidly because of the long duration nature of the contracts. ?The accounting for DAC [deferred acquisition cost]?assets can be liberal at times — writedowns are not required until you are deferring losses. ?I would analyze all intangible assets, and try to estimate what they returning. ?I would also try to look at the valuation of life insurers?comparable to those at AIG, which are high complexity beasties. ?You might find that a breakup won’t release as much value as you think, at least initially.
3) Pure play mortgage insurers are fodder for the next financial crisis. ?If one of those gets spun off, it won’t come at a high valuation, particularly if you give it enough capital to maintain its credit ratings.
4) There are a variety of cross-guarantees across AIG’s subsidiaries. ?I’m assuming Icahn read about those when he looked through the statutory books of AIG. ?That is, if he did do that. ?They are mentioned in the 10K, but not in as much detail. ?Those would probably be the most difficult part of a breakup of AIG, because you would have to replace guarantees with additional capital, which reduces the benefit of breaking the companies up.
Summary
Breaking up AIG would be difficult, but I believe that focused insurance companies with specialist management teams would eventually outperform AIG as it is currently configured. ?Just don’t expect a quick or massive initial benefit from?breaking AIG up.
One final note: it would pay Carl Icahn and all of the others who would be interested in breaking up AIG to hire some insurance expertise. ?Insurance is a set of complex businesses, and few understand most of them, much less all of them. ?It would be easy to naively overestimate the ability to improve profitability at AIG if you don’t know the business,? the accounting, and how free cash flow emerges, if it ever does.
They might also want to have a frank talk with Standard and Poors as to how they would structure a breakup if the operating subsidiaries were to maintain all of their current ratings. ?Icahn and his friends might be surprised at how little value could initially be released, if any.
There’s a significant problem when you are a supremely?big and connected financial institution: your failure will have an impact on the financial system as a whole. ?Further, there is no one big enough to rescue you unless we drag out the public credit via the US Treasury, or its dedicated commercial paper financing facility, the Federal Reserve. ?You are Too Big To Fail [TBTF].
Thus, even if you don’t fit into ordinary categories of systematic risk, like a bank, the government is not going to sit around and let you “gum up” the financial system while everyone else waits for you to disburse funds that others need to pay their liabilities. ?They will take action; they may not take the best action of letting the holding company fail while bailing out only the connected and/or regulated subsidiaries, but they will take action and do a bailout.
In such a time, it does no good to say, “Just give us time. ?This is a liquidity problem; this is not a solvency problem.” ?Sorry, when you are big during a systemic crisis, liquidity problems are solvency problems, because there is no one willing to take on a large “grab bag” of illiquid asset and liquid liabilities without the Federal Government being willing to backstop the deal, at least implicitly. ?The cost of capital in a financial crisis is exceptionally high as a result — if the taxpayers are seeing their credit be used for semi-private purposes, they had better receive a very high penalty rate for the financing.
That’s why I don’t have much sympathy for M. R. Greenberg’s lawsuit regarding the bailout of AIG. ?If anything, the terms of the bailout were too soft, getting revised down once, and allowing tax breaks that other companies were not allowed. ?Without the tax breaks and with the unamended bailout terms, the bailout was not profitable, given the high cost of capital during the crisis. ?Further, though AIG Financial products was the main reason for the bailout, AIG’s domestic life subsidiaries were all insolvent, as were their mortgage insurers, and perhaps a few other smaller subsidiaries as well. ?This was no small mess, and Greenberg is dreaming if he thought he could put together financing adequate to keep AIG afloat in the midst of the crisis.
Buffett was asked to bail out AIG, and he wouldn’t touch it. ?Running a large insurer, he knew the complexity of AIG. ?Having run off much of the book of Gen Re Financial Products, he knew what a mess could be lurking in AIG Financial Products. ?He also likely knew that AIG’s P&C reserves were understated.
For more on this, look at my book review of?The AIG Story, the?book that tells Greenberg’s side of the story.
To close: it’s easy to discount the crisis after it has passed, and look at the now-solvent AIG as if it were a simple thing for them to be solvent through the crisis. ?It was no simple thing, because only the government could have provided the credit, amid a cascade of failures. ?(That the failures were in turn partially caused by bad government policies was another issue, but worthy to remember as well.)
I am biased on AIG.? It was never as good as proponents of its past have said.? But it was not as bad as current detractors allege.
AIG went through several eras, some of which are barely covered by this book.? There was the secular growth era, which existed from the beginning until the late 1980s.? It was easy to continue to grow in P&C businesses in the US until then.? After that growth would have to come from other ideas:
Life insurance in the US and abroad.
Foreign P&C insurance
Aircraft leasing
Asset management
And so, AIG moved from being primarily a US P&C insurance company to being a behemoth, big in life and P&C everywhere, as well as aircraft leasing and asset management.
Other Books on AIG
If you are reading this book, you ought to also read Fallen Giant. and Fatal Risk.? Excellent books both, but they cover different aspects of AIG.? Fallen Giant focuses more on the development of AIG by the founder Cornelius Vander Starr.? It spends relatively little time on the fast growth era which was the start of Greenberg tenure as CEO.
Fatal Risk focuses on the diversification era under Greenberg’s era, when AIG was so big in US P&C insurance that they began diversifying into risks that had more capital markets exposure — Life, annuities, derivatives, airline leasing, commodities, and asset management.
All three of the books spend disproportionate time on the failure of AIG, which is kind of a shame, because the failure was the simplest part of the story.
No risk controls because Greenberg was ousted.? That said, risk control should be institutionalized, not personalized.? That was Greenberg’s fault.? No one man should be in charge of risk for a whole company.
Too much subprime and other mortgage risk spread through the whole organization. (Investments in the life companies, securities lending, derivatives, direct lending, mortgage insurance, etc.)
True leverage was understated on the GAAP financials.
Notable Information
One aspect of AIG that The AIG Story tells is how AIG became a single company.? There were many minority interests, and when Greenberg was a new CEO he bought all of them in.? That decision allowed the company to focus, and not be concerned with minority interests.
In two breezy pages (122-123) we get Greenberg’s take on how he built his life insurance business, buying SunAmerica (1998) and American General (2001).? An aggressive company buys two more aggressive companies, overpaying in the process.? There should be no surprise why AIG’s stock price was basically flat from 1999 to 2007.? Greenberg overpaid for life insurance companies he did not understand.? He was a P&C guy, and did not get how life insurance companies worked.? He saw two aggressive companies willing to sell at exorbitant prices, and paid up.? Culturally, they fit, but buying overpriced assets always takes its toll.
Not mentioned is the debacle that was the attempt to take over The Equitable in 1991.? AIG assumed that a New York company would have a distinct advantage versus AXA, a French company that was the eventual buyer.? AIG made the following errors:
Scared Equitable’s management team into the arms of AXA, who would treat them well.? Yes, Equitable’s management team was incompetent, and needed to be shown the door, but you didn’t have to tell them that directly.
Assumed that the Real Estate portfolio would not rebound.
AIG offered to buy The Equitable for very little, while AXA offered $1 billion of funny money, surplus notes and convertible debt.? Strange, but the funny money was worth more than almost nothing.
Unlike the purchases of SunAmerica and American General, the purchase of The Equitable would have been cheap.? Very cheap.? And AIG missed it, and also under-rated the abilities of AXA.? I was there; I know.
This brings me to a significant point over what was included, and what was excluded… this is the story as Greenberg wants it to be told.? He excludes his errors, and focuses on his achievements.? He was not as good of a CEO as often credited in the 1990s.
On page 127, Greenberg talks about leaving markets where AIG could not earn an underwriting profit, but by the 1990s, AIG was so big that that flexibility was gone.
Closed Culture
AIG’s culture bound employee? fortunes to the stock price of AIG.? Options, participation in C.V. Starr, and a number of other programs created significant incentives for people to stay, and trust in the continual increase in the price of AIG shares.? That created a culture of “lifers” if if survived long enough.
Also, in the 1980s and 1990s the board of AIG had more insiders than most, but when corporate governance rules changed, by 2005, the AIG board was populated by enough incompetent businesspeople, that there was no way that they could control the risks inside AIG.? They tossed out Greenberg at the behest of Spitzer, and then could not supply the moxie that Greenberg had.
The Financial Crisis
The post-2008 Greenberg understands the financial crisis.? Let me quote:
A financial crisis was brewing due to a combination a including: (1) U.S. policy overstimulated appetites for home ownership and kept interest rates low for too long, (2) regulation of institutions was poor, as commercial banks fed the appetite for home ownership with generous mortgages while investment banks demand with complex financial products and increasing leverage; (3) rating agencies failed to analyze many financial products adequately, and the lack of trading in such products on organized markets made them difficult to value; and (4) regulators at the SEC failed to monitor the leverage of many financial institutions, whose debt levels rose to as much as 30 to 40 times capital and, in AIG’s case, regulators at the? Office of Thrift Supervision, which had authority because AIG owned a savings and loan association, simply ignored any signs of trouble.
Hindsight is 20/20… there were many mortgages insured by AIG before Greenberg left, and many mortgage bonds purchased by his life subsidiaries as well.
Greenberg tries to make out the problems of AIG as a liquidity crisis, and not a solvency crisis.? I’m sorry, but in a panic, there is no difference.? If you can’t produce cash when needed, you are insolvent.? It’s that simple.? AIG had enough incremental demands for cash in the crisis, that it should have gone into chapter 11.? Maybe the Fed should have rescued the derivatives counterparty, and charged it back to AIG, but beyond that, it should not have acted.? Much as Greenberg complains, AIG was insolvent, and should have been reorganized.? He would have gotten far less as a result.
He also takes umbrage against Ed Liddy, a good man who attempted to do what the stupid government wanted — liquidate in a hurry, but Greenberg does not recognize that he set much of this process (though not all of it) in motion himself.
Greenberg won the suits against himself.? He personally did nothing materially wrong.? But the mismanagement of AIG in the Greenberg era and the time thereafter did deserve to be punished with chapter 11, not coddled with a bailout and tax incentives.
Quibbles
The book is worth reading, but what you are getting here is court history — the history as approved by the King.? It has elements of history in it, and it is mostly true, but you have to consider the source.? A lot of true history was purposely omitted.
Who would benefit from this book: If you are an AIG buff, you can’t get the full picture without knowing what Greenberg purports.? If you want to, you can buy it here: The AIG Story.
Full disclosure: The publisher sent me a copy of the book for free.
If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.
It seems that I can’t escape AIG anymore.? I asked my kids (who are still at home) today, “Of all the jobs I had, where did I get treated the worst?”? The oldest answered “AIG.”? He was born shortly after I left AIG in 1992.
I guess I made some of the wounds obvious enough.? I don’t believe in “payback,” I believe in “Love your enemies,” and “Be honest.”? Thus I find it odd that I am being ever more sought out by reporters on any AIG news.
Granted, I’ve written on underreserving by AIG, the problems they had at their operating insurance subsidiaries during the financial crisis, which got picked up by SIGTARP.
What has prompted recent inquiries, is the sale of stock at $29/share,? at only a 1.6% discount to the prior closing price.? That price was a hodgepodge between what the market would bear, and what would give the government a “profit.”? Bad idea in my opinion; it would have been better to price the deal lower, say $28.50, where the government took a loss, but where the market might have driven the price up.? A 1.6% gap is marginal and would invite sellers. $28.50 would be over 3% and would invite buyers.
Now, some sympathy for Bruce Berkowitz — He saw book value decline by almost $1 today, from $47.32 to $46.35.? I don’t know if he was buying as the largest private shareholder of AIG, but he was certainly disappointed by the company offering shares.? Why offer shares at less than 2/3rds of book?
Easy, because AIG can’t borrow or issue any other security.? But that is a signal to what the company is worth.? I mean at worst, AIG could have procured a secured loan to? provide $3 billion, offering a valuable subsidiary as collateral.? They chose to dilute, which tells you what the stock is likely worth.
Also, with such a large fall in price after the offering the next offering should come at a larger discount to the recent market price.? Those that were burned in this offering will be less willing to step up and take immediate losses.
Now, AIG has two other ways to improve their stock price.? Improve transparency, and improve Return on Equity.? The first of those means eliminate the sense that there could be negative surprises in the future.? That means that reserves have to be modestly conservative, unlike they have been in the past.? That means taking one last reserve strengthening to do so, if needed, even if it temporarily hurts the stock price because of the loss.
But if it can be shown that the loss is likely the last of such losses, and that AIG isn’t going to use its reserves to manipulate earnings any more, the loss in the stock price should be minimal.? After all, a lot of that is buried in the discount to book anyway.
Then comes improving ROE. The CFO Peter Hancock has said, ‘?We are moving away from any kind of top-line targeting,? Hancock said in a call with analysts. ?We think that leads you to do business at the margin, which is unattractive.?’
That’s some of the best news I have heard on AIG in some time.? If AIG limits its underwriting, and focuses on profitability, it has a lot of potential for upside, but that would mean:
Reducing overhead expenses
Compensating line managers on underwriting profitability, conservatively estimated.? Tie their long-term bonuses to aggregate underwriting profits.
Eliminating marginal lines of business, including selling off lines where AIG has no sustainable competitive advantage, like investment management, consumer finance, aircraft leasing, and domestic life insurance.? The last of those is the most controversial — I would sell off the domestic life insurers to the highest bidder.? I suspect there would be willing buyers among the big players of the life insurance industry.? Use the proceeds to buy back stock from the government, or to reduce debt.
AIG would do best if it were a pure play P&C insurer.? As I have argued since long before the crisis, the size and complexity of AIG make it unmanageable.? Better management will come through creating a more focused company that does not require having a “superman” like Maurice Greenberg to manage it.
Disclosure: I don’t own any AIG, nor am I short.? The same for my clients.
I read every email sent to me, and every comment? written at my blog.? But much as I would like to, I can’t answer them all.? One comment to my last piece on this topic questioned the validity of accrual entries in insurance accounting.? I would like to say that the standards for GAAP reserve accounting are pretty good.? They need some tweaks here and there, but they do the job fairly well.
One of the things you learn as a fundamental investor is that the quality of accounting derived from accrual entries is always lower than that for cash entries.? There is an implicit assumption behind every accrual entry that someone will make good in the future to pay cash, whether the amount is fixed or estimated.
Accruals vary in quality.? Accounts Receivable are more reliable than inventories.? Who knows what fixed assets, property, plant and equipment are worth?? Pension obligations are squishy, the assumptions can be manipulated within reason.? Deferred tax assets rely on the ability to earn more money, but most companies with the deferred tax assets have lost significant money in the past.? Will the company bounce back?
And there are intangibles.? Goodwill is only worth something if a company earns cash from operations in excess of net income over the long run.? Capitalized R&D, software costs, must produce cash flows that justify capitalizing the expenses, otherwise capitalizing is merely deferring losses.
So there are tests such as normalized operating accruals that for industrial companies and utilities can flag many companies that look cheap, but may not be, because too much of their income comes from accrual entries.
With financial companies, the problem is worse, because financial companies are a bag of accruals.? What are the loans worth?? What are those weird structured securities worth?? And with insurance it gets tougher.? What level of claims do you expect to pay out and when?? Will you recover the amounts that you invested in acquiring the policies that have been written?
Tough questions, but they are what accounting rules have been designed to try to answer.? Because there is complexity, unscrupulous management teams can take advantage of the flexibility.? That does not mean the rules are wrong, though.? No human system can be both consistent and comprehensive.? There are tradeoffs between modeling the details of a company’s financials accurately, and doing the accounting consistently across corporations.? To what degree do you make accounting “cookie cutter” versus tailored?? That is the tough question that vexes those that set the accounting standards.
I would add that insurance accrual quality is subject to three factors:
Length of the accrual — longer is worse.
Uncertainty of the contingency in question — uncertainty of amount and timing?
Does the law of large numbers apply?? What is uncertain in specific, may be more predictable in aggregate.
I received another comment, and initially I said, “I can’t get that done.? Yes that would be good but….”? Here is the comment:
It would be interesting to normalize the reserve charges two ways:
1) Adverse reserve development as a % of beginning reserves.
2) The ratio in #1 above compared with the industry.
While these reserve charges were bad, long-tailed P&C insurers were taking similar reserve charges ? even the more ?responsible? ones.
Look at the results of one of AIG?s smaller competitors ? W.R. Berkley. Similar business mix and a charismatic CEO to boot. Same string of reserve charges, but the CEO is still there, and investors got a nice 20% annual rate of return from 2000. The difference? AIG was trading at 4x book value in 1999, while Berkley was trading below book.
So I went and did it, choosing eleven peer companies that were large, having long tailed liabilities.? This was the peer group:
ACE — ACE Limited
BRK — Berkshire Hathaway
CB — Chubb
CINF — Cincinnati Financial
CNA — CNA Financial
MKL — Markel
PRE — PartnerRe
TRV — Travelers
WRB — W. R. Berkley
WTM — White Mountains Insurance
XL — XL Capital Limited
I could have chosen more, but I thought these were representative of stockholder-owned insurers and reinsurers that write long-tailed P&C business.
So what did I find?? I found that AIG was among the worst of major P&C insurance companies in terms of having to strengthen reserves from 1993 to the present.? AIG had to strengthen its reserves 2.1%/yr versus my peer group average of 0.6%/year.? CNA did worse, and White Mountains (a company that talks a lot about conservative accounting) was slightly behind.
Note that the four companies that did not stretch all the way back to 1993 in terms of reported numbers likely would have looked better, because they missed some favorable underwriting years.
Here is the graph of the twelve companies, and the average:
And here is the graph of the companies that were not as good as the average:
The clear conclusion is that AIG was among a group of P&C insurers that were less conservative in reserving than most of their large competitors. CNA and White Mountains were much smaller companies — AIG was dropping a boulder into the pond.
Among all the other difficulties that AIG had, from a yield-seeking derivatives subsidiary, to life and mortgage insurance subsidiaries in trouble, this was just another facet of a company that played it fast and loose.? They under-reserved their P&C divisions, and there can be no reasonable defense on that topic.
PS — I like investing in P&C insurers and reinsurers that regularly release reserves for the business of prior years.? Conservative companies have high earnings quality, and are reasonable investments, despite all of the uncertainty.
The above graph is lovingly culled from AIG’s 10-Ks for the past 23 years.? It tells an amazing story, in my opinion, and you will get my view of AIG’s reserving.? I am somewhat biased because I worked for AIG from 1989-1992, and some of that bias is expressed in the paper I wrote on AIG’s operating insurance subsidiaries, in the first three pages.
A key figure in reviewing reserving is how much a company increases or reduces reserves due to claims from business written in prior years.? Good companies set initial reserves conservatively, and slowly adjust reserves downward as? time progresses, and claims emerge below estimates.
What’s that, you say? Doesn’t GAAP require reserves to be best estimates?? Well, yes, technically it does.? But no one, not even the actuaries internal to P&C insurers or reinsurers can be truly certain about what the best estimate is.? Thus, investors in insurance companies have to be confident that the management teams are being conservative, or at least neutral in their judgment on reserves.
But here is the reserving story on AIG: up until 2000 AIG generally released reserves for the business written in prior years.? Toward the end, they probably released more than they should have.
AIG was one of the consummate growth companies in the financial space in the 1990s.? It grew faster than most financials, and did not lose luster during the dot-com era.? Indeed, its price only peaked in early 2001, shortly after reporting their annual earnings.? After that, AIG went from being a growth stock to being a non-growth stock, and its P/E multiple fell.
Now, perhaps AIG goosed its earnings by setting reserves too low in the late 90s.? That is possible, and it may have led to the need to restate reserves higher in 2001-2002.? By 2002, all of the reserve releases of the past 15 years were wiped out.
In the investment community 2002 was a “big bath,” where AIG took significant one-time losses to reset its balance sheet and continue its growth.? But it was not enough. 2003 and 2004 had continued strengthening of reserves for past business written.
In 2005, Greenberg was shown the door, and Martin Sullivan took over.? The 2005 restatement of reserves for business written prior to 2005 was huge.? I suspect Martin Sullivan was trying to clean things up.? Maybe it worked; in 2006 and 2007, they released excess reserves.
In 2008, there was a small degree of reserve strengthening, but nothing compared to the other problems at AIG.? In 2009, strengthening was significant, possibly reflecting new efforts to clean up, or perhaps like my comment in the paper I referenced above:
Reinsurance does carry a risk, though, if the reinsurer can?t or won?t pay.? AIG?s rather sharp handling of reinsurers in the past carries with it the risk that reinsurers will be less than sympathetic to their problems.? Because of AIG?s difficulties, reinsurers will be more likely to try to deny claims while AIG is weak.? And like the parable of the unjust steward, some AIG employees might be inclined to compromise at levels fairer to the reinsurer.? After all, opportunities at AIG are ebbing, but having friends in the industry is always an aid when looking for work.
One final note on the table: 2004 and after, AIG adjusted their prior year incurred figures for foreign exchange fluctuations, and interest that needed to be accrued, because they discounted their reserves.? Those factors should not make a ton of difference to the 2003 and prior years.? Magnitudes might change but the overall story will not change.
Summary of AIG’s Behavior
There came a point in the life of AIG, in the late 90s, where management pushed reserves to be less conservative.? By 2003, the ruse was obvious, and though AIG was added to the Dow Jones Industrial Average, the stock never attained to its 2001 highs.
Possible Policy Advice
The process of P&C reserving, after reviewing the results of AIG almost begs to have a valuation actuary statute for P&C companies the way companies do, but for a different reason.? Life companies do stress tests on cash flow mismatch, credit sensitivity and more.? It’s a confidential document that the regulators can look at, but the public can’t.
For P&C companies, the actuaries would have to spell out their valuation methods down to all of the major parameters and methods by line of business, and then roll them forward from the last year in order to show the effects of parameter changes, method changes, and adverse or favorable development.
I can hear the squealing from P&C companies now.? That said, my peers in Casualty Actuarial Society would send me a box of chocolates for the new “Actuarial full employment act.” ;)? File a GAAP version confidentially at the SEC; then have the SEC hire a staff of Casualty Actuaries to review the filings in detail, and offer suggestions for dealing with egregious violators.
That’s what it would take to get reserving for P&C companies straightened away.? I could suggest it to the SEC/NAIC, but they aren’t that concerned about reserving at present because most companies seem to play fair.? AIG did not, and perhaps still does not play fair in this area in my opinion, but they were an outlier in the industry that got special treatment because of their size, complexity, and seeming success.
Final Summary
AIG was an outlier, but that does not mean it can’t teach us a few things.? First, don’t trust P&C reserving, particularly of big companies.? Second, look to see if management teams reserve conservatively — do they release reserves consistently year after year?? (Which means they set reserve high for the current year’s business.? Tough to do, because setting reserves low on the current year’s business is the easiest way to show good profits in the short run.
Third, someone paying attention to reserve strengthening would have exited AIG in 2003 or 2004, after two or three large reserve strengthenings. This brings up a subsidiary point.? M. R. Greenberg is responsible for the trouble that occurred at AIG, not Sullivan, or anyone that followed.? The huge reserve adjustments occurred under M. R. Greenberg’s watch, not anyone else.? He encouraged the growing derivatives book because it aided AIG in making its earnings numbers through seemingly free yield from writing protection.
So, no, prior to 2000, AIG was probably not underreserved.? After that, it most definitely was underreserved.? Today?? Who can tell?? Ask me in a few years.
I never thought the deal where Sam Zell bought Tribune was fair, because it relied on the savings of workers in their ESOP [employee stock ownership plan].? Here is what I wrote in the past:
Well, now Mr. Zell is getting sued by Tribune employees, and he deserves it.? Zell could not have bought out Tribune without the support of the ESOP, but his actions harmed the economic interests of the ESOP, and thus the employees.? Many will agree to anything if their job is threatened.? The semi-coercion plus failure will not work out well for Mr. Zell.
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And, speaking of not working out well, we have the NYT Op-ed on AIG.? I say good, let AIG, the Fed and the Treasury disclose what they said during the bailout.? We already know that many areas of AIG would have gone under without the bailout.? Though the Treasury Secretary has changed his tune on why AIG was bailed out, originally it was only and ostensibly for AIGFP, the derivatives subsidiary.
Let AIG and the Government reveal what they said? regarding the bailout.? The American people deserve to know it.
When Robert Benmosche was named CEO of AIG, I thought it was a good thing.? Ed Liddy, possibly tired of the abuse, wanted to move on.? Liddy was primarily skilled with personal lines P&C insurance, which was a small part of AIG, and has been sold off.? Benmosche’s skills extend to that — MetLife has a small personal lines subsidiary, but he has run the largest life insurer in the US.? AIG has grown to be as much a life insurer as a P&C insurer, having grown through the acquisitions of Sun America and American General.
Benmosche has his work cut out for him, and it may be an impossible task.? Quoting from today’s WSJ article:
As shares of American International Group Inc. continued to ascend Thursday, newly minted Chief Executive Robert Benmosche said he is taking a far more patient approach than his predecessor toward selling assets to repay the government.
He is willing to wait as long as three years, he said, to offer stakes in two multibillion-dollar foreign units that the insurer had been racing to spin off.
“It’s not a question of if, but when,” Mr. Benmosche said in an interview with The Wall Street Journal at his home here. “Once the market gives us a price that I think is fair, we can go forward. … If we sell too soon, everyone loses.”
And the money quote:
After analyzing all of AIG’s businesses, Mr. Benmosche said, he determined the company wouldn’t be able to repay the government even if it sold everything. But he suggested that if he can bolster the businesses before selling off units, the situation might improve.
“The sum of the parts are a little below the whole. The whole has to be big enough to pay back the government, and with a little hard work there will be something left called AIG,” he said.
Okay, so the value of the equity is zero, but maybe AIG can grow out of the situation with government aid, waiting for higher valuations to appear? The article continues:
In May, AIG said it planned to “accelerate” that process for one of the units, American International Assurance Co., which sells life insurance in Asia. AIG hired lead underwriters in June, and the IPO was scheduled for the first quarter of 2010; it was expected to raise more than $5 billion.
Similarly, in July, AIG said it planned to accelerate the IPO for the other unit, American Life Insurance Co., known as Alico, which also sells life insurance overseas.
It isn’t clear how much the businesses are worth, but their value has been eroded by the financial crisis and AIG’s problems. In February, AIG was said to be valuing AIA at $20 billion to $40 billion.
In the interview, Mr. Benmosche said current estimates for what the businesses would fetch were too low.
“That kind of price talk is ridiculous,” he said, without specifying what he considers a fair price. “I’ve told the government that if we have to sell them right now, we may not be able to pay back what we owe.”
Then come the following contradictory statements:
Mr. Benmosche said his primary goal is to repay as soon as possible the government support that is still allowing the company to operate.
“If the U.S. government doesn’t continue to support AIG, we will fail,” he said. “We have no right to use the government funding to make a profit; that is inappropriate.”
Yes, AIG would fail without US Government support. US Government support allows AIG to profit off of its relatively cheap funding base. Benmosche is delaying the sale of units previously slated for quick sale by the prior management, because if valuations recover significantly, there will possibly be some value to share among shareholders.
That’s a big if, though.? It is rumored, or rather, alleged by some insurance CEOs that AIG has been aggressively cutting prices in order to gain business for short-term liquidity reasons.? After all, if you were an employee of AIG, your largest incentive might be having your salary paid for a few more years, before the reserving catches up.? In the short-run, insurance reserving can be gamed.? The majority owner, the US Government, has little expertise with such matters.? Insurance is a black box to them.
What, that’s up over 400% from the nadir?? Wow.? What’s it down from the peak?
I’ll bet you don’t remember when AIG was trading over 1500.? Well, I do.? At my last firm, I sold our shares of AIG the day it entered the DJIA.? We got prices of over $75, which post the last reverse split, is over $1500 today.
This current rally is fueled by bullish comments from the new CEO, day traders who follow momentum (look at the recent rise in volume in the first graph, and short sellers buying in their positions.
Looking at the middle graph, short-covering isn’t that common yet through 8/14, but the rapid price move since then has likely had some shorts with weak balance sheets covering their trades.
This brings me to my last point regarding AIG for the evening.? Benmosche wants advice from Maurice Raymond “Hank” Greenberg.? I don’t know for sure, but I suspect that the two knew each other from their days as CEOs of NYC’s two largest insurers.? It wouldn’t surprise me if AIG offered to demutualize and buy MetLife; back in the early ’90s, we tried to do the same thing with The Equitable when it was in trouble.? AXA won because it was willing to bet on a real estate recovery, and AIG was not willing to take that chance.
Though Greenberg blames the woes of AIG on incompetent successors, I lay the blame at his feet.? If AIG was such a great company, how could it be undone in three years?? From the mid-1980s until 2005, leverage at AIG quadrupled.? ROE achieved the hallowed 15%/year target, but ROA sagged, which is a better measure for financial services firms.
My last issue here is the accounting.? It is rare for companies under financial stress to not have accounting that is liberal.? Firms with conservative accounting typically have management cultures that retreat when times are not conducive to low-risk profits.
The upshot here is simple.? AIG is a leveraged play on the financial sector.? If insurance company valuations rise far enough, AIG might have value.? AIG common is behaving like a warrant on the underlying assets.? But even at present levels, AIG common is worthless.? Sell it to the speculators, but watch your own balance sheet; even when a stock is likely to go to zero, it is difficult to manage a short position all of the way to extinction.
With that, be wary.? I still believe AIG common is still an eventual zero, but it will be very noisy between now and the end.? Complicating the matter is the asset inflation the Fed is trying to engender.? They want to bail out financial company balance sheets without creating inflation that the average person can notice.
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