Analyst take: Duperreault walks the line

To take AIG’s earnings guidance at face value, the company is at an inflection point, having fixed the balance sheet and done the heavy lifting of an operational turnaround.

And there are many reasons to be optimistic. New management under CEO Brian Duperreault has recruited an extraordinarily high-calibre executive team, and has clearly done a huge amount of work overhauling the insurer’s underwriting culture, aggressively cutting capacity and limits on a gross and net basis, and looking to offset shrinkage with growth in middle-markets and via acquisitions.

However, management is also “walking the line”, maintaining a difficult balancing act between communicating the enormity of the firm’s challenges and its confidence in meeting both its near- and longer-term financial objectives.

On the one hand, the executive team spent most of Thursday’s frank call with analysts admitting the company’s problems were “deeper and more pervasive” than they thought when Duperreault first took the helm in early 2017. 

On the other, management attempted to reiterate confidence in the firm’s turnaround efforts and its earnings guidance of a double-digit return on equity within three years and a run-rate combined ratio below 100 percent in Q1 2019.

Though these statements are by no means in outright conflict, there is an inherent tension that makes them uncomfortable bedfellows at best.

Investors in the space typically assume, due to human psychological biases and lagging actuarial accounting, that bad news is serially correllated, and consider that a single emerging problem suggests others will follow.

Even vanilla turnarounds are typically thought of as “show me” stories, let alone a company like AIG that has flattered to deceive before, and proved a perennial value trap for investors for more than a decade.

And looking at the stock, it seems like only one of those messages is resonating with investors currently. The firm’s shares were down 9 percent the day after earnings, essentially wiping out the shares gain for the year following huge losses in the latter part of 2018.

Though the shares had recovered somewhat by close Friday, the shares have still underperformed the market by close to 50 percent on a total return basis since current management took over, with the valuation hanging around lows not seen since 2013, and a gap to peer valuations not seen for more than a decade.

Bad news first

One of legendary investor Warren Buffett’s rules of business is for executives to give investors the bad news first – on the principle that good news tends to take care of itself whereas bad news can often get buried until it reaches crisis levels.

In a remarkably candid and transparent call with investors on Thursday, Duperreault admirably took this reporting burden to heart, outlining the significant problems the firm had uncovered due to prior management’s “go-large” strategy on limit sizing.

The executive said he had “not appreciated the extent of the issues [large limits] created or that have been deployed throughout the company”.

“As additional industry veterans stepped into key positions and focused on fixing the fundamentals, we discovered issues and unintended consequences of prior strategies, particularly as a result of what was referred to as the go-large strategy,” he told analysts.

“This approach to the market created outsized risk and volatility for AIG. By expanding its risk appetite to encompass very large limits on a gross and net basis, AIG added significant risk to its earnings pattern and balance sheet.

“Additionally, certain of these issues were exacerbated by risks being written on a multi-year basis, record cat losses, and $30bn of stock buybacks, which reduced AIG's capital, making the outsized limits more risky,” he explained. 

The executive also claimed the prior “go-large” strategy and “the loss of underwriting discipline” were to blame for the level of adverse prior-year reserve development recorded over the past few years. 

Pointing to the firm’s prior strategy of deploying $2.5bn limits in property, Duperreault said it was “impossible to get value for that kind of additional limit”.

And rather than cornering a market by being the only company willing to write it, you risk creating an environment where you are adversely selected against. This leads to a situation where “you go large on risk you shouldn't be writing”. 

“It just exacerbates everything”, he said, adding that the challenge of reserving for this type of tail risk and volatility “is impossible”. 

“So all I know is I wouldn't have done it and I know we're not doing it. That's all I can say,” he explained. 

One area where management said it had discovered new areas of surprising risk aggregation was in the firm’s private client group, a provider of homeowners’ insurance to ultra-high-net-worth individuals. 

Management also went into great detail on the type of gross and net limit management the company has done over the past years, confirming much of what this publication first published in October.

The firm re-iterated its reduction in gross property limits from $2.5bn to $750mn and, through additional reinsurance purchases, net limits have been reduced to a range of $5mn to $50mn. 

As previously disclosed, casualty gross limits have been reduced from $250mn to $100mn, and net limits have been “reduced significantly” through the additional quota share programmes purchased. 

General insurance CEO Peter Zaffino also noted that AIG has reduced its gross limits for primary directors' and officers’ by $8bn in aggregate throughout 2018. And in the Caribbean, the insurer reduced gross limits by 50 percent and net exposure by over 75 percent. 

Good news on guidance

Reflecting on the challenges ahead, Duperreault shared that he remained positive on the progress the firm was making. 

“I have done turnaround throughout my career and remain committed to completing this one. As I said earlier, I'm more confident today than I was a year ago that AIG's on the right path.

“We continue to focus on making sustainable changes that will yield long-term profitable results, which means we are not taking shortcuts or settling on easy fixes,” he told analysts. 

“Instead, we are doing this the right way. We have the best talent in the insurance industry at AIG, we have the right strategies in place, and we will restore AIG as the leading insurance company in the world,” he added. 

But more significant than management sentiment, the firm insisted it was sticking by its guidance of a double-digit return on equity within three years and a run-rate combined ratio below 100 percent in Q1 2019.

Market scepticism

However, despite management’s professed optimism, it is apparent from the stock that the market remains sceptical the company can deliver its financial objectives to investors on management’s timeline.

Using a sum of the parts valuation approach for AIG’s other businesses, we estimate that the market is only giving credit for a 4-5 percent RoE in the firm’s P&C business. This is considerably lower than the 7-8 percent RoE implied if we project a 100 percent combined ratio in general insurance in 2019.

Notably, from a valuation perspective, this also implies a market attributed valuation to the P&C business of just 0.4x book value – under half the multiple of peer levels.

Reasons to be optimistic

As we have noted, there are many reasons to feel good about the operational changes at AIG. But even looking at the immediate expected trajectory of the firm’s financial results, there are reasons to be optimistic.

As we note in a separate article in this issue, AIG’s outsized investment losses in Q4 appear to have been due to its higher investment leverage and alternatives allocation, and therefore will likely reverse in Q1. Notably, the company seems to have pulled forward losses, giving it a cleaner slate for 2019 results.

Additionally, there are reasons to be positive on the firm’s reserve adequacy after a decade of constant headwinds. The majority of the potential losses in the US commercial lines business written prior to 2016 are covered by the adverse development reinsurance agreement with Berkshire Hathaway.

Current CFO Mark Lyons has also conducted a thorough review of the 2016 and 2017 books since he joined the company in May 2018 as chief actuary, and has expressed confidence in reserving levels.

“I have now reviewed all the worldwide general insurance loss reserves and feel that AIG is within a reasonable range, which dovetails with the opinion of our outside actuarial consultants for the group of segments that they have independently reviewed.”

While a new CEO and CFO has given opportunities to reset expectations, the firm is now at a point where management must take responsibility for the balance sheet.

Perhaps most importantly, there is a clear signal from management reaffirming commitment to its improving combined ratio as early as Q1 2019, which management must have reasonably good visibility on already.

Indeed, Q4 2018 had many aspects of a “sandbagging quarter”, and with significant cat losses and other “noise” already making for a messy year and quarter, management had every incentive to pull forward as much bad news as possible, and defer as much good news into 2019 as the accounting rules allowed.

AIG remains an industry wildcard

As we outlined in our Seven central themes for (re)insurance in 2019, we believe AIG is one of the key wildcards for 2019. However the company wants to spin it, there is no way for it to radically transform its willingness to put out significantly smaller gross and net limits without having a significant impact on some segments of the market.

As management itself points out, there are parts of the market where it is essentially the market, albeit a problematic, and adverse selection-driven market.

There is no doubt this will create at least some challenges for brokers in the coming weeks and months, and potentially some opportunity for other carriers to step in as “problem solvers”. Though just how much of a problem or opportunity there is will clearly depend on the level of supply-side response in the broader (re)insurance market as AIG re-calibrates its risk appetite.

On the other hand, the AIG has made emphatically clear that it has no intentions of shrinking to greatness. Just as it pulls back in some segments of the market, it is also redeploying its capital to other segments, including expanding in middle-market excess and surplus lines as well as bringing its monster balance sheet and slack capacity to the reinsurance, ILS and various specialty markets through its acquisition of Validus.

Given the sheer size and scale of AIG relative to the industry and the capital it can bring to markets, how these two opposing forces net out will continue to be a key factor in determining the market’s competitive landscape in the coming months and years.