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Morningstar | Catastrophes Ding AIG’s 3Q; Other Factors Are Mixed

Catastrophe losses pushed American International Group to a loss in the third quarter, but underlying trends were somewhat mixed. In our view, the current market price, which equates to 0.6 times book value, implies a long period of meaningful value destruction, which to us looks more like a worst case. We think now that AIG has a management team with a history of underwriting success, it is reasonable to expect underwriting results to start to move toward peers and that even mediocre results in commercial property and casualty lines would allow the company to earn an adequate return. We will maintain our $76 fair value estimate and no-moat rating.

CEO Brian Duperreault has committed to generating a P&C underwriting profit in 2019, and we believe the lack of progression toward this goal in previous quarters has been a source of frustration for the market. We think investors should consider AIG’s size and the inherent delay in improving underwriting results, and that his timeline is reasonable. That said, we think a positive trend is necessary to inspire confidence and that this is the key issue management needs to solve in order to stop destroying value. On that front, indications in the quarter were a bit mixed. In commercial lines, AIG saw some improvement, with the underlying combined ratio (which excludes catastrophes and reserve development) coming in at 100.9% compared with 102.1% last year and 106.1% last quarter. This was partially offset by personal lines, which saw the underlying combined ratio increase to 97.0% compared with 95.0% last year and 94.8% last quarter. We see commercial lines as the key issue and are therefore more encouraged by the progress there, although the company still has a ways to go to meet Duperreault’s target. Overall underwriting results were negatively affected by a higher expense ratio, driven by mix and a more active use of reinsurance, and we think the company should have some levers to bring this back down over time.

During the quarter, AIG saw adverse reserve development of $170 million. In our view, given its history, AIG needs to string together a number of quarters of favorable development to restore confidence that its reserves are adequate. However, the amount of development in the quarter was relatively modest, and $148 million of it related primarily to higher loss estimates for the 2017 California wildfires, which strikes us something of a one-time event. Further, year-to-date reserve development remains marginally positive. AIG did also see material adverse development in excess casualty, but the bulk of this is covered under its reinsurance agreement with Berkshire Hathaway.

AIG had previously announced that it expected to record significant catastrophe losses for the quarter, and the $1.6 billion was in the middle of the previously stated range. The bulk of these losses relate to multiple typhoons in Japan during the quarter, representing the worst typhoon season in 25 years, but Hurricane Florence and California mudslides also contributed. Meanwhile, the company’s estimate for losses related to Hurricane Michael, which will be included in fourth-quarter results, is $300 million to $500 million. Occasional large catastrophe losses are inherent to the industry’s operations and don’t affect our long-term view. Still, it is a bit discouraging to see the company take such a large hit, given that Duperreault has attempted to more actively use reinsurance to limit the company’s catastrophe exposure. To that end, though, AIG did note that, after Hurricane Michael, it will be close to exhausting its North American catastrophe retention, so its programs do appear to have potentially put a bit of a cap on domestic losses this year.

One ongoing bright spot for AIG remains its life insurance operations, which generated an 11% adjusted annualized ROE for the quarter. While we don’t see life insurance as a structurally attractive business and believe the company should shed these operations once there are no material tax implications, we are impressed with the company’s ability to improve and sustain returns in this area.

For more details on our view of AIG, please see our Select presentation “Outlining AIG’s Path to Mediocrity.”