Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)’s National Indemnity insurance company agreed on Friday to take long-term risks dealt with the American International Group (AIG, Financial) in relation to the latter’s U.S. commercial insurance policies.
According to Reuters, Berkshire was to receive $10.2 billion and will take on 80% of net losses exceeding the first $25 billion AIG was to have in the policies and had a maximum liability of $20 billion.
As a result, the transaction reduces the risk for AIG and frees up capital for share buybacks.
AIG shares reacted flat with 0.38% change by market close.
Trading at a price-book (P/B) value of 0.79 times, compared to its peers of 1.2 times, reviewing AIG’s financials should be worthwhile.
Earnings performance
AIG reported its third-quarter fiscal 2016 results on Nov. 2, 2016. In its nine months of operations, the $68.4 billion diversified insurance company reported negative 11.5% change in its overall sales down to $39.4 billion from $44.5 billion the year prior.
The insurance firm also delivered a negative 45.7% change in its profits, down to $2.19 billion from $4.04 billion. AIG share price went down by 4% the following day while the broader Standard & Poor 500 index had -0.4% change.
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“We continue to execute on the strategic initiatives announced in January. The strategic divestitures that we announced this quarter, our portfolio management decisions, actions to run off the legacy portfolio and capital allocation all exemplify our guiding principle of building economic value. We are successfully shaping and sculpting our company to be a leaner and more focused insurer. We remain committed to our 2017 financial targets, are ahead of plan in expense management, and continue to target a six-point reduction in our commercial accident year loss ratio, as adjusted, despite volatile quarterly results.” – Peter D. Hancock, AIG president and CEO
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AIG is set to report its next quarterly on Feb. 14, according to Nasdaq.
Valuations
Aside from its discounted book value multiple, AIG had a trailing price-earnings (P/E) ratio of 114.6 times (industry median 13) and a price-sales (P/S) ratio of 1.45 times (industry median 1) according to GuruFocus data.
Performance
According to Morningstar data, AIG had one- and five-year total returns of 23% and 22% compared to the Standard & Poor's 500 index’s 24.9% and 14%.
American International Group
American International Group was founded almost a century ago in 1919. The insurance giant provides a wide range of property casualty insurance, life insurance, retirement products, mortgage insurance and other financial services to customers in more than 100 countries and jurisdictions.
In fiscal 2015, AIG derived 72.6%, or $42.4 billion, of its sales from the U.S., 10.2% from the Asia Pacific and 17.2% from the remaining geographic locations.
AIG’s diverse offerings include products and services that help businesses and individuals protect their assets, manage risks and provide for retirement security.
AIG has two reportable segments: commercial insurance and consumer insurance as well as corporate and other.
(10-K and 10-Q Filings, AIG)
Commercial Insurance
According to AIG, its commercial insurance can further be dissected in three operating segments: property casualty, mortgage guaranty and institutional markets. Together, AIG’s commercial business serves the largest multinational corporations to local businesses and individuals.
Property Casualty
Property casualty conducts its business primarily through AIG’s nonlife insurance companies, which involve commercial automobile liability products, aerospace insurance and professional liability products among others.
In fiscal 2015, AIG’s property casualty segment had a negative 6.2% change and contributed 41%, or $23.6 billion – largest among all of AIG’s segments – to total sales including eliminations. The segment also had a pretax operating margin of 3%, compared to 17% the year prior (3).
(Screen grab found on page 80 of AIG’s 2015 10-K filing; red highlight by me)
The significant drop in pretax operating margin was secondary to a $3 billion underwriting loss logged by AIG in the property casualty segment.
Mortgage Guaranty
Mortgage guaranty conducts its business primarily through United Guaranty Residential Insurance Co. AIG’s mortgage insurance protects mortgage lenders and investors against the increased risk of borrower default related to high loan-to-value mortgages.
In fiscal 2015, mortgage guaranty business grew 0.9% and contributed 2%, or $1.05 billion, in total AIG sales. The segment delivered a pretax margin of 61%Â –Â highest margin among AIG’s segments.
Institutional Markets
Institutional Markets conducts its business primarily through AIG’s life insurance companies. Products include structured settlement and terminal funding annuities and high net worth products among others.
In fiscal 2015, institutional markets grew the strongest with 36.6% change while contributing 6%, or $3.5 billion, in total AIG sales and having a pretax operating margin of 12%, compared to 26% the year prior.
Together, AIG’s commercial business had a negative 2.1% change in total sales in fiscal 2015 and had a pretax margin of 6%.
Nine months into fiscal 2016, AIG’s commercial business still had negative growth in its overall sales with -9% down to $16.4 billion from $18 billion the year prior while having a pretax operating margin of 14%.
Consumer Insurance
AIG’s consumer insurance also has three operating segments: retirement, life, and personal insurance. The retirement and life operating segments conduct their business primarily through AIG’s life insurance companies.
Retirement
AIG’s retirement products include fixed annuities, retirement income solutions, group retirement and retail mutual funds.
In fiscal 2015, AIG’s retirement business had a negative 5% change and contributed 16%, or $9.3 billion – third largest among all of AIG’s segments – in total sales. The retirement business also had a pretax operating margin of 31% – second highest in all of AIG’s segments.
Nine months into fiscal 2016, the retirement business still delivered weak results with a negative 9% change down to $6.4 billion from $7.06 billion the year prior with an operating margin of 36%.
Life
AIG’s life insurance products include term life and universal life insurances. These insurances are distributed through financial advisers and also through employers and sponsored organizations.
In fiscal 2015, AIG’s life business grew 1.1% and contributed 11%, or $6.4 billion, in total sales. The life segment had a margin of 7%, compared to 9% the year prior.
Nine months into fiscal 2016, the life segment grew 2.6% and delivered a margin of 8%.
Personal
The personal insurance operating segment conducts its business primarily through AIG’s nonlife insurance companies. Products associated with personal insurance include accident and health (also travel) and personal (automobile, homeowners, identity theft among others) insurances.
In fiscal 2015, AIG’s personal insurance business delivered a negative 8% change, down to $11.4 billion or 20% – second highest contributor in AIG total sales – from $12.4 billion the year prior. The personal business also had a 1% pretax operating margin.
Nine months into fiscal 2016, personal insurance grew 1.3% and delivered a margin of 7%.
(10-K and 10-Q Filings, AIG)
Corporate and other
AIG’s Corporate and Other segment include AIG Parent as well as certain legacy assets and runoff insurance businesses (2). As shown in the graph above, the segment represents expenses in relation to AIG operations among other things.
Overall, AIG had five-year sales, profit growth and operating margin averages of -5.48%, -22.36% and 7.64%.
Cash, debt and book value
As of September, AIG had $13.2 billion in cash and short-term investments and $32.3 billion in long-term debt with the debt-equity ratio of 0.36 times, compared to 31 times in the year prior. AIG appeared not to have goodwill nor intangibles and had a book value of $89.2 billion compared to $99 billion the year prior.
Cash flow
(10-Q)
Nine months into fiscal 2016, AIG had a -21.5% adjustment in its cash flow from operations to $1.75 billion from $2.23 billion the year prior. In addition to its lower profits for the period, AIG also had more cash flow going out related to its sales on securities and other assets and divested businesses.
No figures for capital expenditures were noted (1).
Meanwhile, AIG allocated 545%, or $9.56 billion, of its cash flow from operations for shareholder payouts such as share buybacks ($8.5 billion) and dividends ($1.05 billion). On average, AIG paid out 178% of its cash flow to its shareholders over the recent three years.
(10-K and 10-Q Filings, AIG)
As observed, AIG has allocated way more than what its cash flow from operations can provide in shareholder payouts, especially share buybacks in both fiscal 2015 and its recent nine months of operations in fiscal 2016.
AIG also allocated the good amount of cash in investment purchases, which in total was $53.39 billion, and in return gathered almost equivalently $53.34 billion in proceeds from sales and maturities from such investment purchases.
AIG also had a net $3.6 billion in policyholder contract deposits. The firm also issued $11.4 billion in debt while repaying $7.68 billion in the period.
Conclusion
Despite AIG’s admirable balance and cash flow figures, the company demonstrates an overall slowdown in its insurance business in recent years.
AIG has been able to greatly reduced its leverage over the years since the financial crisis –with debts soaring as high as $193.2 billion in 2008 down to $32.3 billion in September, according to Morningstar data.
It would be good to see if AIG could make its property, casualty, and retirement business have positive growth figures again as these are the main revenue generators of AIG in previous years. AIG has shown progress in turning its personal insurance business to positive sales growth territory again after the poor performance in prior years.
AIG’s shareholder payouts have been relatively out of charts in recent years. In particular, share buybacks grew tremendously compared to historical figures – with exception of 2013’s $13 billion an allocation for repurchases.
This month, Credit Suisse raised its rating on AIG shares to outperform from neutral while it set a price target of $60 a share back in October. For AIG to be trading at book value, the current share price should appreciate by 27% to $84 a share.
(AIG share price at $66.5 a share with a P/B ratio of 0.8 times, GuruFocus data)
This price target would indicate that AIG share price would reach new heights since the financial crisis.
In summary, AIG would be a cautious buy with a target price of at least $75 a share.
Notes
(1) Capital expenditures were not reflected on AIG’s consolidated statements of cash flows on the company’s recent 10-K and 10-Q filings. Both Morningstar and GuruFocus data also did not reflect capital expenditures figures since 2011.
(2) 10-K: Corporate and Other consists of assets and income from assets held by AIG Parent and other corporate subsidiaries, general operating expenses not attributable to specific reportable segments and interest expense. It also includes runoff lines of insurance business, including excess workers’ compensation, asbestos and environmental (1986 and prior), certain environmental liability businesses, certain health care coverage, certain casualty and specialty coverages reported in Eaglestone Reinsurance Company, and certain long-duration business, primarily in Japan and the U.S.
(3) 10-K: Property Casualty 2015 from 2014 performance
Pretax operating income decreased in 2015 compared to 2014 primarily due to an increase in net adverse prior year loss reserve development and lower net investment income.
Net adverse prior year loss reserve development, including related premium adjustments, was $3.5 billion in 2015 compared to $550 million in 2014. The increase in net adverse prior year loss reserve development primarily reflected the loss reserve strengthening of $3.0 billion in the fourth quarter of 2015, in classes of business with long reporting tails, primarily excess and primary casualty and financial lines. Premium adjustments consisted of return premiums of $49 million in 2015 compared to additional premiums of $105 million in 2014. See Insurance Reserves – Non-Life Insurance Companies – Net Loss Development for further discussion. Current accident year loss ratio, as adjusted, increased due to higher casualty and severe losses, which were mostly offset by an improvement in attritional losses in Property and Specialty. The net loss reserve discount benefit was $68 million in 2015 compared to a net loss reserve discount charge of $71 million in 2014. See Insurance Reserves — Non-Life Insurance Companies – Discounting of Reserves for further discussion. Catastrophe losses were $581 million in 2015 compared to $602 million in 2014.
Disclosure: I have shares in Berkshire Hathaway Class B.
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