Despite Strong Q3 Results, AIG’s Underwriting Profitability Remains A Concern

by Trefis Team
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AIG (NYSE:AIG) reported a 17% increase in net income for the third quarter of 2013, helped by improved profitability from its property and casualty unit and strong sales from the U.S. life and retirement operations. Pre-tax income from its insurance operations was up 38%, with a 33% increase in P&C and a 38% increase in life and retirement pre-tax income. Both these units contribute an equal amount to the company’s income. This was the eighth consecutive quarter of positive income for the company, which appears to have turned the corner after the 2008 fiasco which resulted in a Federal bailout.

The main concern for AIG is underwriting profitability; its combined ratio for the P&C division was 101%, which indicates an underwriting loss. It also continued to expand in the equity-linked variable annuities market, which MetLife (NYSE:MET) believes to be a risky prospect. MetLife was once the market leader in variable annuities but is looking to reduce risks by cutting back on sales.

Check out our complete coverage of AIG here

Property And Casualty

Despite its global presence, AIG still has its feet firmly in the U.S., with more than half of its P&C premiums coming from the Americas region. Like its peers in the U.S. P&C industry, AIG has maintained a strategy of price hikes to offset the impact of low yields from investments in fixed maturities. More than 80% of the company’s assets are invested in bonds, the yields from which have dipped drastically in the last few years. 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. This decline was largely due to Fed policies. The yield has improved to 2.6% this year, but is still a long way off of pre-recession levels. [1] As a result, insurance companies have had to resort to price hikes to maintain profitability. As a result of this pricing strategy, AIG’s net premiums written in the Americas region increased 2% over the prior year.

AIG’s peers like The Hartford Financial Services Group (NYSE:HIG) and The Travelers Companies, Inc. (NYSE:TRV) have maintained price increase rates of around 8% through the last few quarters. AIG competes directly with these two companies, particularly in the commercial segment, which caters to businesses across the country. It is the market leader in the “other liabilities” line of insurance, followed by Travelers in second place. In the worker’s compensation line of insurance, AIG is in fourth place, behind Liberty Mutual Group (market share 8.7%), Travelers (market share 7.9%) and Hartford (market share 6.8%) and has a market share of 6.1%. [2] AIG reported a 2% increase in commercial premiums for the third quarter.

However, unlike AIG, Travelers and Hartford have maintained combined ratios (expenses to premiums) of under 100%. Hartford recently reported a combined ratio of 93% for the third quarter, while Travelers reported a combined ratio of 88.9%. A ratio of under 100% indicates an underwriting profit. In contrast to its competitors, AIG reported a combined ratio of 101.6% for the three months ending September. Although this is an improvement over the ratio of 105% it reported last year, the company is still operating at an underwriting loss. We believe that it can unlock significant value by improving its underwriting performance. There is a 25% upside to our price estimate should AIG’s combined ratio fall to 90%. However, its exposure to catastrophe losses across the globe make it difficult to achieve margins that its U.S. based competitors have maintained.

Asian Earnings Hurt By Currency Fluctuations

AIG has been focusing on Asian expansion to drive growth. Around 30% of AIG’s P&C premiums come from Asia, where the company has established operations in markets like Japan, China, Korea, Singapore, Vietnam, Thailand, Australia and Indonesia. It is the largest foreign property casualty insurer in Japan, [3] and also in China. [4]

Although local currency premiums from the Asia Pacific region grew 5% in local currency, foreign exchange fluctuations hurt the company as the reported net premium volume was down 10% from the prior year. However, we still expect the company to maintain long-term growth from the region. Measured in local currency, the commercial premiums from Asia grew 10% last quarter while consumer premiums increased 4%, indicating strong sales.

Life And Retirement

AIG reported a 76% surge in premiums and deposits from its U.S. life and retirement operations while assets under management grew by 10%. Strong sales of annuities and retail mutual funds helped results. Fixed annuity premiums increased 57% over the prior year, while the growth in retirement solutions and mutual funds was more than 70%. AIG is now the sixth largest seller of variable annuities in the U.S. with a market share of 7%. The company has capitalized on MetLife’s decision to exit the market. [5]  MetLife was once the biggest seller of the market linked product, but has now dropped to fifth place with a 40% decline in sales through the third quarter.  We expect strong growth in AIG’s life and retirement premiums, but due to its exposure to the equity markets, profitability will be crucial to its performance.

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Notes:
  1. Daily Treasury Yield Curve Rates, U.S. Department Of The Treasury []
  2. NAIC, Property and Casualty Insurance []
  3. http://www.seiho.or.jp/english/publication/2011/pdf/2-11.pdf)) which is the second biggest insurance market outside the U.S., ((Swiss Re’s World Insurance []
  4. Foreign Insurance Companies In China, PWC, December 2012 []
  5. U.S. Individual Annuity Sales, LIMRA []
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