How Shifting Bond Yields Affect AIG’s Stock

Markets have started pricing in the potential that the U.S. may attack Syria following the latter’s use of chemical weapons. Oil prices are expected to soar should the U.S. invade Syria, leading to higher gas prices and inflation and potentially delaying the much anticipated tapering of the Federal Reserve’s Quantitative Easing program. Already the Brent crude index has spiked to $116 per barrel. ^[1]

While oil prices are expected to be directly affected by the incursion, it is the impact on the timeline of the Fed tapering that is the main driver for financial companies like AIG (NYSE:AIG). The program involves purchasing assets like long term treasuries and mortgage-backed securities from commercial banks and other financial institutions, thereby increasing liquidity and lowering long term interest rates. The 10-year Treasury bond yield, which can be used as a benchmark for bond yields, was around 5% before the financial crisis but fell to around 1.5% in 2012. ^[2]

With improvements in the U.S. economy, especially the job market, the Fed was expected to start tapering the $85 billion monthly bond repurchase program following the Federal Reserve’s September 17 meet.

Nearly 80% of AIG’s assets are invested in fixed maturity securities like government and corporate bonds, the yield from which has been affected by the Fed’s liquidity program. AIG’s yield from fixed maturity securities was around 5.3% before the financial crisis of 2008, but subsequently fell to around 4.3% in 2012 as the Fed kept interest rates artificially low. The company earns nearly 35% of its revenues from investment income, but it is even more important for the insurer’s margins.

Check out our complete coverage of AIG here

The Fed has indicated a threshold of 6.5% unemployment rate as a target for the economic recovery before it might start increasing interest rates. ^[3] With the unemployment rate dropping to a four-year low of 7.4% in July, it was widely expected that the Fed would begin the end of its QE program in September. ^[4] As a result of this speculation, the 10-year Treasury bond yield climbed from 1.6% in May to 2.8% at the end of August. ^[2] However, the attack on Syria is expected to delay the tapering, which might send bond yields down again. ^[5]

All This Is Good, But How Is AIG Affected?

AIG’s insurance operations can be divided into AIG property and casualty, and AIG life and retirement. Each of these divisions account for roughly half of the company’s insurance income. The premiums collected by the insurer from policyholders are invested by the company to generate returns whilst and reserves for future claims. The investment income from these assets is primarily responsible for AIG’s margins.

For the P&C division, the company has maintained a combined ratio (expenses to premiums) of 108% for the last four years (with the exception of 2010 where exceptionally high claims led to a combined ratio of 117%). Claims and related expenses have varied from 75% to 80% of premium while underwriting expenses have been around 30% to 35% of premiums. This means that if AIG was not earning investment income from the premiums, it would actually be running at a loss. However, due to investment income, which has been around 15% of premiums, the company’s operating margin has been around 13%. However, the yield from invested assets, as stated before, has been low since 2009, and was around 3.7% in 2012. Our current forecast is based on the Fed cutting back on its monthly bond repurchase program next year with a gradual rise in net yield to about 4.5% by the end of the decade. We expect combined ratio to remain around 108%.

However, in case the increase in interest rates be faster than anticipated with the 10-year Treasury bond yield reaching pre-recession levels as early as next year, AIG could see a rapid risein its investment yield. Our forecast AIG’s P&C pre-tax income could increase by as much as 25%, should the company’s yield from investments reach 4.5% by 2014 with a long-term increase to 5%. There is a 15% upside to our price estimate for AIG in this scenario. You can modify the interactive charts in this article to visualize the impact from various other situations regarding premiums, investment yields and operating margins.

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1. Energy & Oil Prices, Bloomberg [↩]
2. Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury [↩] [↩]
3. Bernanke Offers Possible Timetable for Tapering [↩]
4. U.S. Department of Labor, Labor Force Statistics from the Current Population Survey [↩]
5. Analysis: Syria, debt ceiling worry has markets questioning Fed taper, Reuters [↩]