At AIG in the early ’90s on the life side, some of the actuaries had a phrase “economically rational.”? When a new person would come into some position of power that we had never dealt with before, we would ask others who knew him better, “Is he economically rational?”? (“He” applies to females as well as males.)

Now economically rational could mean two things:

• He is economically rational for the company, and thinks like an owner.
• He is economically rational for himself, and thinks like a worker.

When we/I used the phrase, we meant the former, not the latter.? It implies a very different standard of behavior than merely trying to get the best for yourself — you are trying to faithfully serve the company that employs you.

Insurance is the most complex industry in accounting terms.? In simple terms, that is because when a sale is made, you have little idea what the “cost of goods sold” is.? The cost varies in time and severity.? That complexity meant that there were a lot more games that could be played with the accounting, and the games could go on for a long time.

If you were out for the good of the company, you would aim for organic growth where it made sense, but close down lines of business where it did not make sense.? Now, when you are trying to close down another person’s line of business because it does not earn enough, you might run into some opposition.? And so I did, several times on flawed business that had been, and was being written by the domestic life companies.

It may seem lousy to shut businesses down, but when the underwriting is losing large amounts of money, it is a mercy to the company and its shareholders.

I have known many people in insurance that talk a good game, but in reality, they aren’t doing much.? They may play with the accounting to make things look good.? They may cram sales out the door in the short run, but the quality is bad.? They may boast of big sales in the past, but they don’t deliver when you hire them.? They claim to be a good claims manager, and they settle a lot of claims, but then you find that all the tough cases are stagnating in their bottom left hand drawer.

But the worst is when it reaches to a CFO or a CEO.? The Peter Principle propelled him into office, and the CFO manipulates the earnings, or the CEO takes actions to make it look like he is doing something, when it is not adding to value.? Worse is when the incentives are misaligned, and they sacrifice real profitability to meet incentive targets.

That’s why I believe that pay incentives should be based on growth in book value plus dividends over 3-5 years, with book value being “old style” book, not taking in market value elements.? It has to be long enough to take in a full economic cycle.

Now the phrase “economically rational” does have utility in this respect — the first definition would mean the same thing for everyone — acting like an owner.? The second definition is every man for himself.

I ran into the same situation at companies I served before and later.? Were financials being managed for the good of the owners, of the good of the leading managers?? Sometimes it was owners, sometimes it was managers, and sometimes it was greedy managers.? I remember being disillusioned when the guy who hired me for my first job had used me to tweak earnings higher (I didn’t get it until a years later).? He had left to start something new.? I never saw him again.

I liked my work most when we were acting like owners.? It forced us to be more creative, and take prudent risks.? On imprudent risks, I remember a boss praising me for not putting the company at risk on floating rate Guaranteed Investment Contracts, when I proved it was too risky.? When several of my competitors failed shortly thereafter, I was vindicated.? But being a good businessman, I called those who would want floating rate GICs but no one was willing to lower their yield demands for the contracts.? They weren’t economically rational, and we abandoned the market.

At another company, a chief actuary who would eventually be shown the door for malfeasance, said to me, “We are losing business to these five companies.? Why can’t the investment department make money like they do!?”

I did heavy due diligence.? It was a perfect question to ask me, because my skills on both sides of the balance sheet were significant.? I came back to him and said, “Four of the companies are taking risks far beyond what anyone else in the industry is taking.? In a bear market, they will die.? The last one has a weird holding company structure that allows them to lever up more.? If you want the ask [the parent company] for a similar deal.

Within one year, two of the competitors died, and my explanation of it put me on Jim Cramer’s radar; he even posted what I wrote. Within three years, another had died, and one merged into another entity.? After seven years, the last merged into another entity.? They all were gone.

So what is the value of all this?? I think of it as training to understand managements — see if they act like owners maximizing long-term profits, or as workers aiming to maximize their pay packets.? You will earn more with companies that think like owners.

Now after all of this, it’s not so much a question of rationality but ethics.? Who will do the right thing for the one he ultimately serves?? Working for those people is a joy, and is beneficial to those that own. Doing right does well for many.

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.