Search Results for: Break up AIG

Yes, Break Up AIG!

Yes, Break Up AIG!

Posted on by David Merkel
Photo Credit: Insider Monkey || Carl never looked so good.
Picture?Credit: Insider Monkey || Carl never looked so good.

I’ve written about this topic twice before:

 

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.

I’ve written a lot about AIG over the years, including my article that was cited by the Special Inspector General of the TARP in his report on AIG. ?I’ve also written a lot about insurance investing. ?I’d like to quote from the final part of my 7-part series summarizing the topic:

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.

Now Carl Icahn is arguing the same thing — size and diversification are harming value at?AIG, as well as a high cost structure. ?I think his first argument is right, and a breakup should be pursued, but let me mention four complicating factors that he ought to consider:

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.

 

Full disclosure: long ALL

 

Break up AIG!

Break up AIG!

Posted on by David Merkel

I worked for AIG for three years of my life 1989-1992.? In general, though I learned a ton while working there, I did not like the experience.? As my boss at Provident Mutual said to me, “My greatest doubt about you was that you survived there for three years; it made me wonder about your character.”

That’s probably a bit severe, but turnover was high among employees in the first five years; after that, there were many who would “lifers.”? Turnover would be low after five years.

Now, my stylized history of AIG takes it through the glory days of the 1980s, where return on assets [ROAs] was high, and financial leverage low.? ROA is a much better way to measure insurance company performance than return on equity [ROE].? Earning a spread between assets and liabilities is tough.? Earning an underwriting profit is tough.? Borrowing money to buy back stock is easy.? From the early 90s to the present, AIG became increasingly more levered.? ROE stayed near 15%, but it was less and less ROA, and more and more leverage.

I was never a great fan of my former employer, but I convinced the hedge fund that I worked for to buy some AIG when it was cheap.? We sold around $76, on the day it went into the DJIA.? It hasn’t seen that level since.

When AIG had their big problems, and ejected Greenberg, I wrote a lot at RealMoney about the situation.? The possibilities of accounting manipulation did not surprise me; my own experience there was that we played it to the edge.? AIG has been downgraded by the ratings agencies since then, but because they were big, they delayed the downgrading.? It should have happened years earlier, but Hank intimidated the ratings agencies.

So, I’m not surprised that Hank Greenberg might have directed his employees to achieve a certain GAAP earnings result through a reinsurance treaty.? To me, that would be normal.

It also does not surprise me that Hank is going after present AIG management regarding their recent disappointing earnings.? What does surprise me is the thought that International Lease Finance wants to go its own way.? When the deal originally was done, there was some skepticism inside AIG, but the word was that the tax benefits made the deal work on its own.??? My skepticism today is that AIG will not want to let go of a successful division.? It doesn’t make sense.

Now, Hank can fight AIG management as much as he wants.? (One, two, three.)? My opinion is that poor Martin Sullivan is not capable of managing such a large enterprise, and that it would be better if AIG were broken up.? (Okay, ILFC, see if you can survive on your own.)? Create a US life company, an international life company, a US P/C insurer, one for the foreign P/C business, and one more company to hold everything else.

Hank can complain, but the problems are bigger than the current management team, or Hank, can deal with.? AIG needs to shrink– reduce leverage, focus on underwriting profitability, exit unprofitable lines, as AIG did back in the 80s.? Give up market share, shed employees, become more profitable.? Essentially, they need to undo a lot of what Hank did.? The synergies of the combined enterprise are small, so break up AIG and let new managers focus more intensely on their less diverse enterprises.

Break Up AIG!

Break Up AIG!

Posted on by David Merkel

Recently at RM, I wrote:


 David Merkel
Buy Other Insurers off of the Bad AIG News
2/12/2008 2:54 AM EST

Sometimes I think there are too many investors trading baskets of stocks, and too few doing real investing work. I have rarely been bullish on AIG… I think the last time I owned it was slightly before they added it to the DJIA, and I sold it on the day it was added. Why bearish on AIG? Isn’t it cheap? It might be; who can tell? There’s a lot buried on AIG’s balance sheet. Who can truly tell whether AIG Financial Products has its values set right? International Lease Finance? American General Finance? The long-tail casualty reserves? The value of its mortgage insurer? I’m not saying anything is wrong here, but it is a complex company, and complexity always deserves a discount.

You can read my articles from 2-3 years ago where I went through this exercise when the accounting went bad the last time, and Greenberg was shown the door. (And, judging from the scuttlebutt I hear, it has been a good thing for him. But not for AIG.)

AIG deserves to be broken up into simpler component parts that can be more easily understood and valued. Perhaps Greenberg could manage the behemoth (though I have my doubts), no one man can. There are too many disparate moving parts.

So, what would I do off of the news? Buy other insurers that have gotten hit due to senseless collateral damage (no pun intended). As I recently wrote at my blog:

If Prudential drops much further, I am buying some. With an estimated 2009 PE below 8, it would be hard to go wrong on such a high quality company. I am also hoping that Assurant drops below $53, where I will buy more. The industry fundamentals are generally favorable. Honestly, I could get juiced about Stancorp below $50, Principal, Protective, Lincoln National, Delphi Financial, Metlife… There are quality companies going on sale, and my only limit is how much I am willing to overweight the industry. Going into the energy wave in 2002, I was quadruple-weight energy. Insurance stocks are 16% of my portfolio now, which is quadruple-weight or so. This is a defensive group, with reasonable upside. I’ll keep you apprised as I make moves here.

What can I say? I like the industry’s fundamentals. These companies do not have the balance sheet issues that AIG does. I will be a buyer of some of these names on weakness.

Position: long LNC HIG AIZ

Look, back when AIG had a AAA rating, there was a reason to hold the whole thing together, because of cheap financing.? Today, AIG suffers from a conglomerate discount, because no one can understand the balance sheet.? (Can anyone inside AIG understand all the exposures that they face?)

Simpler is better.? Simple companies get better valuations, and the managers are sharper at financial controls, because they don’t have to cover as much ground.? They can focus.? So it should be for AIG, if they want to unlock value.? (Perhaps AIG is the Citigroup of the insurance industry…)

Full disclosure:? long LNC HIG AIZ

Breaking up is hard to do

Posted on by David Merkel

Photo Credit: Chris Blakeley || Always optimistic when things are growing, and in the dumps when it falls apart

Over the years, I have suggested that two firms should break up on a number of occasions: AIG & GE. Both are now in the process of completing their breakups.

The news on GE dropped today, and I was surprised that the media did not pick up on one significant question on the GE breakup. Who gets the insurance liabilities that have been a real pain to GE even after selling off Genworth. As I tweeted:

How could they miss this?

I think I first suggested that GE should break up in a comment in RealMoney’s Columnist Conversation sometime back in 2005, but that is lost in the pre-2008 RealMoney file system, and exists no more. In terms of what I can show I will quote from this old post from 2008:

5) File this under Sick Sigma, or Six Stigma — GE is finally getting closer to breaking up the enterprise.? It has always been my opinion that conglomerates don’t work because of diseconomies of scale.? As I wrote at RealMoney:

David Merkel
GE — Geriatric Elephant
4/27/2007 1:16 PM EDT

First, my personal bias. Almost every firm with a market cap greater than $100 billion should be broken up. I don’t care how clever the management team is, the diseconomies of scale become crushing in the megacaps.

Regarding GE in specific, it is likely a better buy here than it was in early 1999, when the stock first breached this price level. That said, it doesn’t own Genworth, the insurance company that it had to jettison in order to keep its undeserved AAA rating. Which company did better since the IPO of Genworth? Genworth did so much better that it is not funny. 87% total return (w/divs reinvested) for GNW vs. 28% for GE. A pity that GE IPO’ed it rather than spinning it off to shareholders…

But here’s a problem with breaking GE up. GE Capital, which still provides a lot of the profits could not be AAA as a standalone entity and have an acceptable ROE. It would be single-A rated, which would push up funding costs enough to cut into profit margins. (Note: GE capital could not be A-/A3 rated, or their commercial paper would no longer be A1/P1 which is a necessary condition for investment grade finance companies to be profitable.)

Would GE do as well without a captive finance arm (GE Capital)? It would take some adjustment, but I would think so. So, would I break up GE by selling off GE Capital? Yes, and I would give GE Capital enough excess capital to allow it to stay AAA, even if it means losing the AAA at the industrial company, and then let the new GE Capital management figure out what to do with all of the excess capital, and at what rating to operate.

Splitting up that way would force the industrial arm to become more efficient with its proportionately larger debt load, and would highlight the next round of breakups, which would have the industrial divisions go their own separate ways.

Position: none, and I have never understood the attraction to GE as a stock

Over the years, I continued to write about GE and Genworth (I grew bearish over LTC after analyzing Penn Treaty. I was always bearish on mortgage insurance). I never thought either would do well, but I never expected them to do as badly as they did. Optimistic accounting ploys from the Welch years bit into profits of Immelt, as he was forced to reset accruals higher again and again. Overly aggressive financial and insurance underwriting similarly had to be reversed, and losses realized.

After today, all but the successor firm for GE (Aviation) has a chance to do something significant, freed from the distractions of being in a conglomerate. They can focus, and maybe win. As for GE Aviation, because of the insurance liabilities they will probably receive a valuation discount. Maybe they will sacrifice and pay up, selling the liabilities to Buffett with significant overcollateralization.

American International Group

I first suggested that AIG break up back in 2008. Only M. R. Greenberg had the capability of managing the behemoth, and once he was gone, lower level managers began making decisions that Greenberg would have quashed, which led to short-term gains, and larger long-term losses. After AIG was taken over by the Fed, bit-by-bit they began selling off the pieces — Hartford Steam Boiler, ILFC, AIA, Alico (to MetLife), and more. They were left with a portion of the international P&C business, and the domestic life and P&C businesses.

They are now planning on spinning off the domestic life companies, which will leave AIG as a P&C insurer with relatively clean liabilities (They reinsured Asbestos and Environmental with Berkshire Hathaway).

Where do we go from here?

Is there a lesson here? Avoid complexity. Avoid mixing mixing industrial and financial. Avoid mixing life and P&C. (Allstate is finally splitting that.)

That said, there may be another lesson for the future. What of the extremely large companies that are monopolies? Some of them aren’t complex; they just dominate a large area of the economy as monopolies. Governments want to do one of two things with monopolies. They either want to break them up, or turn them into regulated utilities. Why?

The government doesn’t like entities that get almost as powerful as them, so they limit their size, scope, and subject them to regulation. So be aware if you hold some of the largest companies in the US or the world, because governments have their eyes on them, and want them to be subject to the government(s).

Full disclosure: long MET

Against Insurance Groups [AIG]

Posted on by David Merkel

Photo Credit: Mindy Georges || The umbrella belongs to Travelers

This is a bug in my bonnet, and I have written about this for at least 13 years, and maybe as long as 16 years, but insurance conglomerates don’t work well. After suggesting at least three times that AIG should break itself up, we are finally to the last stage of it doing so.

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.

Big companies develop a culture, and it makes them less willing to change. That was true of AIG. Hank Greenberg should have eliminated all life companies early on, and run a domestic P&C company with high underwriting standards. Then maybe it would not have had to rely on Berkshire Hathaway to reinsure them.

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.

Thoughts on MetLife and AIG

Thoughts on MetLife and AIG

Posted on by David Merkel

Photo Credit: ibusiness lines
Photo Credit: ibusiness lines

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.

Look for a moment at two victims of the?Financial Stability Oversight Council?[FSOC]… AIG and Metlife. ?I’ve argued before that the FSOC doesn’t know what it is doing with respect to insurers or asset managers. ?Financial crises come from short liabilities that can run financing illiquid assets. ?That’s not true with insurers or asset managers.

Nonetheless AIG has Carl Icahn breathing down its neck, and AIG doesn’t want to break up the company. ?They will spin off their mortgage insurer, United Guaranty. but they won’t get a lot of help from that — valuations of mortgage insurers are deservedly poor, and the mortgage insurer is small relative to AIG.

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.

AIG plans to do it through?(see pp 4-5):

  • Reducing expenses
  • 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)

AIG Was Broke

AIG Was Broke

Posted on by David Merkel

138524447_df928490da_o
Photo Credit: Ron

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.)

Spot the failure

To What Degree Were AIG?s Operating Insurance Subsidiaries Sound? (1)

To What Degree Were AIG?s Operating Insurance Subsidiaries Sound? (1)

Posted on by David Merkel

Hey, friends.? My piece on AIG is done, and I will be posting over the next few days, and resume a more normal posting schedule.? Here it is:

Summary

Aside from the mortgage insurers, the P&C subsidiaries were basically sound, though with some issues such as capital stacking, affiliated assets, etc., as mentioned below.? The non-mortgage P&C subsidiaries didn’t have a great 2008, but they would have survived as standalone entities.

The life and mortgage subsidiaries are another matter.? Without the help of the US Government, many of them would have failed.? Even now, given the levels of affiliated assets, capital stacking, deferred tax assets, etc., they are not in great shape now should there be another surprise.? Profitability is likely to be lower in the future than in the banner years of the middle of the 2000s decade.

Introduction

When the economic history books get written about the crisis at the end of the 2000s decade, the difficult analyses will involve Fannie, Freddie, Lehman, AIG, and the large banks that failed.? The degree of leverage employed, both explicit and implicit, will be quite a tale, as will the abandonment of underwriting standards.

This piece is meant to deal with the company that I view as the most complex, and the most levered – AIG. There have been many attempts to explain the problems at AIG, with most of the attention paid to AIG Financial Products.? This analysis is meant to be complementary to those analyses, because I will focus on AIG’s regulated US Life and P&C subsidiaries.? I have gone through the Statutory books for these subsidiaries, and there is an interesting tale to be told.? (A better story than how I got the Statutory data, even.)

Flashing back

Several incidents shaped my perception of AIG over the years.? Working there in the domestic life companies from 1989-92, I heard the AIG mantras:

  • 15% return on average equity is the golden rule of AIG. Subsidiaries and divisions that cannot meet that will be eliminated.
  • We exit business lines that cannot meet our return goals.
  • Keeping the AAA rating is of utmost importance.
  • Our accounting should be conservative.
  • Keep expenses low.
  • Few people make it past five years at AIG, but if you can survive that long, you will be a lifer, and you will be rewarded.
  • We didn’t take over The Equitable because we couldn’t get to the 15% target. That said, the takeover team scared them away, and into the arms of AXA (another accounting nightmare I suspect).

I took the rules seriously.? I ended up closing two lines of business that could not meet return goals, and found two centimillion-dollar reserve errors.? There were several products that never made it to market because they could not meet the 15% return goal.

But there was the rest of the story:

  • “Dealing with auditors is bloodsport.”
  • “I drop my deficiency reserves in the Atlantic Ocean.” (via reinsurance)
  • “I like the pension and annuity businesses because they give some bulk to our balance sheet.” (Reputedly M.R. Greenberg said this to a colleague of mine. We scratched our heads over that one, because it was so anti-AIG philosophy.)
  • Heavy reliance on surplus relief reinsurance in order to front statutory earnings into the present, and reduce capital needs.
  • My boss found two centimillion-dollar reserve errors also.
  • “Dealing with reinsurers is bloodsport. Never give them an even break.”
  • Clever use of transfer pricing to get money out of blocked currencies.
  • Arrogant guys at AIG Financial Products that would hardly acknowledge you as part of the same team at conferences.
  • And, a $1 billion GAAP reserve understatement at Alico Japan in 1992.

There was AIG in theory, and in practice.? I was a young actuary at the time, and relatively idealistic, but it was easy to get cynical in a highly politicized office environment, where almost everything was a fight.? Thus my view of AIG was always colored by the hidden leverage, the large losses that never seemed to derail the company as a whole, and the bare-knuckled approach to business.

I could not live with my conscience while I worked there, so I sought greener pastures from year one there – it took two long years to get the right position.? Two very hard years.

Fourteen years later, I had dinner with a well-regarded sell side analyst while visiting P&C companies with him in Ohio.? The management teams we talked with thought we were twins separated at birth.? Our views were very similar, except on AIG.? He asked me why I didn’t like AIG – it was so cheap.? I told him the story that I have told you, and one more thing: when I worked for AIG, there was virtually no debt.? By 2006, the degree of financial leverage was four times higher than when I worked there.? The 15% ROE was intact, but the return on assets had dropped like a stone, and leverage from debt made up the difference.

I told him AIG was not the great company that it once was.? It was far more leveraged, and the ratings agencies were behind on their evaluations.

To the Statutory Statements

The statutory statements record the life of an insurance operating subsidiary.? The regulators require insurance companies to publicly disclose far more data than the banks do to their regulators.

Insurance holding companies own their subsidiaries, and survive by receiving dividends from the subsidiaries, or borrowing against them.? Operating subsidiaries receive cash from holding companies when opportunities are good, and dividend back when there aren’t as many opportunities.

The ability to dividend back is controlled by statutory accounting principles, risk-based capital rules, and also by the state regulators.? This places insurance holding companies in a tough spot; they need dividends from some operating subsidiaries to survive, particularly during times when credit is not available on favorable terms, if at all.

The key question I went off to answer is to what degree were AIG’s operating subsidiaries sound? We all know that AIG Financial Products was a basket case, but perhaps the rest of the operating companies were in good shape.? The answer to this question is mixed, and I will attempt to explain where there are weaknesses and strengths.? Sneak Preview: the weaknesses outweigh the strengths.

Given my prior experience with AIG, I expected to find question marks in the area of reinsurance.? I did find some, but it wasn’t the biggest area of problems.? I’ll try to take the problems in order of importance.

What of AIG?

What of AIG?

Posted on by David Merkel

Over the past 24 hours, i have received half a dozen calls/messagesasking me what about AIG?? Before I start that, let me point to a few of my posts on AIG:

Let me say that it took this long for the price to fall below where it was when I left the firm in 1992.? For many firms with significant slack assets, they could have resisted this fall in the stock price, but AIG could not.

Why not?? It is a complex firm.? Complex firms have a hard time splitting/understanding the results of their various business units.? Management’s view of free cash flow is cloudy.

With AIG, the best thing that they can likely do is spin/sell off their US Life and P&C arms separately or together.? Those units have a relatively easy to determine value.? WIth the cash, AIG can focus on improiving the remaining units.? If they can’t do that, AIG is heading for the scrap heap.

Call me a bear here.? I have no idea how good the current management team will be, but so many are mezmerized by the past of AIG.

A New CEO at AIG

A New CEO at AIG

Posted on by David Merkel

Before I start this evening, I just want to say to new readers who are reading me because my piece, Ten Notes on Crude Oil: The Fixation made an unexpected splash, that my blog is a hodgepodge. I write about a wide variety of topics, but mostly it boils down to macroeconomics, stocks, bonds, portfolio management, value investing, insurance, speculation, real estate and mortgages, and structured products and derivatives. When I wrote more actively for RealMoney, I realized that I was probably the columnist with the widest field, including Cramer. I like to think that I am a good generalist, but I try not to push my expertise beyond its limits. Writing about energy fits into many of my posts, but it is not what I write about most of the time.

On to AIG. I write about AIG this evening, because businessweek.com cites my blog post as the source of “buzz” for breaking up AIG. (I like what I do in blogging, but my voice isn’t that big.)

Well, the dissident shareholders won. Martin Sullivan is out, Robert Willumstad is in. Whether having been part of Citigroup when it grew into a behemoth is an advantage here is questionable. He is clearly a bright guy, but so is Martin Sullivan. One thing is certain, and I wrote about it when Greenberg was shown the door in 2005, no one can replace Greenberg. He built AIG, and he is a bright guy who had his fingers on the pulse of a very complex operation. No one else can match his institutional knowledge, or the culture of fear that he ran.

This brings me to my controversial point for the evening: what if AIG did so well for so long by shading/shaving their reserves? A new CEO coming in to clean up would find a continual stream of assets marked too high, and liabilities markets too low. Martin Sullivan found that out the hard way. What then for Robert Willumstad?

If there are large holes on the balance sheet, the old mantra about eating elephants applies. How do you eat an elephant? One bite at a time. Much as the credit rating has fallen, AIG would not want to see it fall further. If I were in Mr Willumstad’s shoes, I would do a thorough scrubbing of every asset and liability on the balance sheet, and then do the following exercise:

  • If the restatement is small, take it all at once, declare victory, and make a splash to the media.
  • If the restatement is moderate, such that it would wipe out a year of earnings or so, take some writeoffs quarter by quarter, until the hole is filled.
  • If the restatement is large, such that it would wipe out 3-5 years of earnings, or wipe out a large amount of book value, I would create a plan for a turnaround, and then sit down with the rating agencies and the regulators. That would minimize the ultimate damage. The stock price would get killed when the problems are revealed, though.

I have a few other thoughts if the loss is larger still, but I will leave those to the side, because they would be too sensational. Now as to breaking up AIG, this WSJ article suggests that some units could be sold. That’s a good idea; as companies get huge, diseconomies of scale set in. It becomes more and more difficult to manage behemoth firms.

Perhaps AIG can get back to areas where they had a true sustainable competitive advantage: serving foreign markets where there is little/less competition. Maybe ILFC [International Lease Finance Corp]. Beyond that, what is truly distinctive about AIG? In my opinion, not that much.

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