FX Headwinds And Adverse Weather Conditions Nullify AIG’s Expansion

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American International Group

Currency fluctuations and high catastrophe-related losses took their toll on AIG’s (NYSE:AIG) earnings for the first quarter of 2014. The insurance company’s after-tax operating income fell 10% from the prior year’s level as its pre-tax operating income from insurance operations dropped 11%.

AIG’s operations consist of its global property and casualty insurance unit, its U.S. life and retirement unit and its mortgage guaranty unit. The contribution from these divisions to pre-tax operating income is 44%, 53% and 3%, respectively.  For the first quarter, P&C operating income fell 26% due to FX headwinds, particularly from the weakening of the Japanese Yen against the U.S. dollar. The life and retirement unit reported a 2% increase in pre-tax operating income.

AIG maintained its capital management strategy, with share repurchases of $867 million and declared a common stock dividend of 12.5 cents per share, payable on June 24, 2014. Our $50 price estimate for AIG’s stock is in line with the current market price.

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Property and Casualty

AIG offers property and casualty insurance in 130 countries and jurisdictions across the world. Around 45% of its P&C premiums are earned from the Americas region while the rest are evenly divided between the Asia-Pacific and EMEA regions. For the first quarter, the premiums from the Americas were unchanged while those from Asia-Pacific fell 11% and those from EMEA increased 7%. The fall in the Asia Pacific region was due to the weakening of Asia currencies against the dollar; on a local currency basis the premiums went up 2%. Japan, the second biggest insurance market in the world after the U.S., is a big source of premiums for AIG. The quarterly weighted average exchange rate for converting the Japanese Yen to U.S. dollars has increased 17%, from 88.43 Yen per dollar in March 2013 to 103.15 Yen per U.S. dollar. [1] However, the company did observe an increase in consumer insurance premiums from the country, driven by strong demand for Fuji Life products. AIG is also expanding in other markets outside Japan. We expect the company to regain momentum in the next two years.

AIG is currently the fifth largest P&C insurer in the U.S., with a market share of 4.52%. [2] Around three-quarters of its premiums in the Americas region are earned from commercial insurance, which is offered to companies. It is particularly strong in the “other liabilities” line of insurance with a market share of 11.49%. It is also the fourth largest insurer in the workers’ compensation line of insurance, with a market share of 6.14%. For the first quarter, AIG reported no change in commercial premiums, but premium rate hikes in consumer insurance led to a 1% increase in premiums from the latter.

Catastrophe Losses Affect Top Line

The global nature of its operations means that AIG is exposed to events worldwide. The combined ratio is a useful metric to gauge the profitability of its P&C business and represents the expenses incurred by the division as a percentage of the premiums earned by it. A combined ratio of less than 100% indicates that the company is able to generate underwriting profit.  However, most companies are not able to maintain this ratio; the P&C industry as a whole has run on underwriting losses for 37 of the last 45 years. [3] For the first quarter, AIG’s combined ratio worsened from 98.4% in 2013 to 101.9% as catastrophe related losses increased from $41 million to $262 million. The loss ratio increased 3.8 percentage points to 67.1%.

Claims and related expenses have fluctuated between 86% of premiums in 2010 and 67% of premiums in 2013. This metric is difficult to forecast, but we believe it will remain around the historical average of around 72% through the decade. You can modify the interactive chart below to gauge the effect a change in forecast would have on our price estimate.

Variable Annuities Help Life And Retirement

Premiums and deposits for the U.S. Life and retirement operations surged 28% as the company maintained its pricing approach with strong net inflows from the retirement income solutions sub-division. This was primarily due to a high volume of variable annuity sales and a low surrender rate. AIG has been looking to capitalize on MetLife’s (NYSE:MET) withdrawal from the variable annuity market and has overtaken the former leader into fifth position in the U.S. market. [4] The company’s assets under management increased 9% over the prior year, helped by strong inflows and appreciation in equity markets. AIG’s stable value wrap product accounted for a $13 billion increase in assets under management.

AIG’s portfolio base investment yield for life and retirement operations increased from 5.3% in the first quarter of 2013 to 5.32%, with participation income from commercial mortgage loans offsetting lower yields from new investments in fixed maturities. The company also reported depreciation in the fair value of its investment in The People’s Insurance Company (Group) of China Limited (PICC Group), which fell by $79 million in the March 2014 quarter, leading to a negative impact on the net investment income.

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Notes:
  1. AIG 10Q Filing []
  2. NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS PROPERTY AND CASUALTY INSURANCE INDUSTRY 2012 TOP 25 GROUPS AND COMPANIES BY COUNTRYWIDE PREMIUM []
  3. Berkshire Hathaway Sec filing []
  4. U.S. Individual Annuity Sales, LIMRA []