American International Group, Inc. (AIG) Q3 2013 Earnings Report, Transcript and Summary

Good day and welcome to this American International Group’s third quarter financial results conference call. Today’s conference is being recorded. At now at this time, I would like to turn the conference over to Ms. Liz Werner, head of investor relations. Please go ahead.

Thank you, and good morning everyone. Welcome to AIG’s discussion of third quarter 2013 results. Speaking today will be Bob Benmosche, President and CEO; David Herzog, Chief Financial Officer; Peter Hancock, CEO of AIG Property & Casualty; and Jay Wintrob, CEO of AIG Life and Retirement. Other members of senior management are also in the room and will be available for the question and answer period. Before we get started this morning, I’d like to remind you that today’s presentation may contain forward-looking statements, which are based on management’s current expectations and are subject to uncertainty and changes in circumstances. Any forward-looking statements are not guarantees of future performance or events. Actual performance and events may differ, possibly materially, from such forward-looking statements. Factors that could cause this include the factors described in our third quarter and second quarter 2013 Form 10-Qs and our 2012 Form 10-K, under management’s discussion and analysis and under risk factors. AIG is not under any obligation and expressly disclaims any obligation to update any forward-looking statements, whether as a result of new information, future events, or otherwise. Today’s presentation may contain non-GAAP financial measures. The reconciliation of such measures to the most comparable GAAP figures is included in our financial supplement, which is available on AIG’s website, www.aig.com. Now, I’d like to turn our call over to Bob.

Thanks, Liza, and good morning everybody. This is another solid quarter for AIG and we clearly have said we’re going to work on making sure that you see consistent and improving earnings of the company over time, and I think you see that in our operating numbers for the insurance companies in particular. I’d also like to welcome Kevin Hogan. As you know, we have held the position of the consumer group open under Peter Hancock. We have waited for Kevin to return. A 24-year veteran of AIG, having run much of the consumer businesses over that career, and we’re pleased to have him back. So Kevin, welcome back and we’re looking forward to you talking to our investors next quarter on the progress you’re making on the consumer side. Before we get into the numbers, first about ILFC, we continue to work with the consortium that has been working with us over the almost past year. We still feel that while they’re making slow progress, they are making progress, but this quarter accounting suggests that we have to think about whether this can continue to be a discontinued op and some other accounting rules, so we’re really thinking hard about if we can’t get this transaction closed this quarter, then we may want to commit to a path of IPO for next year and not continue to carry it the way we’re carrying it on our books. So that’s a decision we hope to make in this fourth quarter. However, we still feel that there’s a good chance this transaction can close as is. On the aspirational goal comment that I made yesterday, and we want to talk about today, clearly when we did our re-IPO in May of ’11 there was some serious concern in the marketplace, could…

Thank you, Bob, and good morning everyone. As Bob mentioned, our insurance operations delivered a solid operating earnings of about $2.2 billion and we continue to execute on our capital management plans. And our businesses continue to work towards growing their risk-adjusted returns. As we have said in the past, ILFC remains a noncore asset and is accounted for as held for sale, given our plans to monetize it through a sale or an IPO. We have already written ILFC down to a fair market value and this quarter, when ILFC files their results with the SEC, they will have completed their annual aircraft impairment review. This review resulted in a $1.1 billion impairment from older out of production aircraft, but this impairment has no effect on AIG’s carrying value of ILFC. Further to Bob’s comments on our work towards our long term goals, we’ve made good progress on deploying capital. We’ve deployed $18 billion in capital through equity buybacks, a combination of equity buybacks, debt capital management, and the reestablishment of our common stock dividend. And importantly, we remain focused on generating deployable capital with distributions from our insurance operating companies of about $4.6 billion year to date through the third quarter. We’ve made good progress on our expenses, but we’ve still got a lot to do in terms of investing in our infrastructure and our growth opportunities. We’ve also made good progress on improving our ROE and are committed to our strategies. You can see the progress we’ve made in reducing the accident year loss ratio in property-casualty, which has declined roughly 3 points annually over the last couple of years. Turning to our financials, on slide 4, net income for the quarter was $2.2 billion, and included an after-tax provision $260 million for legacy litigation matters as…

Thank you, David, and good morning everyone. Before I begin my comments on the quarter, let me echo Bob’s comments about Kevin Hogan’s return to AIG. Kevin’s the right leader to grow our market leading global consumer business, including life, and I believe they will prosper under his very strong leadership. AIG property-casualty results in the third quarter reflect our consistent focus on underwriting improvements and targeted growth. The current quarter benefited from modest catastrophe losses, our ongoing shift in business mix, increasing pricing, and enhanced risk selection, partially offset by elevated severe losses and alternative investment returns that were lower than our expectation. As we discuss the quarter’s results today, I’ll highlight our focus on balancing growth, risk, and profitably. Turning to slide eight, net premiums written grew 3% on a normalized basis. This growth is consistent with our expectations for 2013, as we continue to be disciplined in our underwriting and opportunistic in our pricing actions. The accident year loss ratio, excluding catastrophes, declined by 3 points from the year ago quarter, reflecting continued progress improving our business mix and risk selection. We’ve said in the past that there would be quarterly volatility in the accident year loss ratio, and this quarter we experienced severe losses of $211 million, which are concentrated in seven property losses largely outside of the United States. We continue to expect improvement in our underwriting results. Pre-tax operating income of over $1 billion included lower catastrophe losses of $222 million versus $261 million a year ago. Catastrophe losses related to multiple perils around the world including Colorado flooding, wildfires, and European weather events, but no major U.S. windstorms. Our reserves remain stable and net adverse development was $72 million in the quarter compared to $145 million a year ago, a benign level given…

Thank you, Peter, and good morning to everyone. I’m going to begin on slide 13, where you can see that AIG’s life and retirement delivered another strong quarter from both a top line and bottom line perspective. Operating income was $1.1 billion in the third quarter, up 38% from a year ago. The year over year comparisons were impacted by several items in each period, including a net positive unlocking of assumptions in the current quarter versus a charge in the year ago quarter, primarily related to our [GIC] portfolio and other liabilities. Even after adjusting for these items, we delivered bottom line growth in the quarter with positive comparisons across the majority of our product segments. Strong fundamental trends, including variable annuity fee income growth and continued enhancement of profitability through active spread management were key contributors to our favorable earnings comparison. The third quarter highlighted the strong cash generation capacity of our business. As David mentioned, AIG life and retirement distributed $1.2 billion to the parent this quarter, bring our year to date dividends and loan repayments to more than $3.1 billion. This reflects both our solid capital position and the strong profitability of our businesses across multiple product segments. And even after the payment of dividends, we grew shareholder’s equity, ex-OCI, by $2.2 billion since year-end 2012, ending the quarter at $33.8 billion in shareholder’s equity ex-OCI. We continue to experience strong sales momentum, and this quarter achieved our highest level of sales in life and retirement’s history. Innovation product design, favorable market conditions, and increasing effectiveness of our distribution strategy all contributed to a 118% increase in retail premiums and deposits from the year ago period. Sales increased across all retail investment products, from both the prior quarter and the year ago period. Surrender rates also…

[Operator instructions.] We will hear first from Michael Nannizzi with Goldman Sachs.

I guess one question, Bob, maybe on ILFC I guess. If it’s not resolved immediately, does that imply it could come back on the balance sheet and could that complicate the SIFI review process at all?

I don’t think it would complicate any SIFI process whatsoever. I think it’s a noncore asset. We would continue to divest and deconsolidate it, and we’ll do that in as rapid a time as it makes sense financially for the company to do it. With what the value of that company is, we know what’s been accomplished, and when you refinance almost $20 billion of debt and do it in a way that gives us a very tight match between cash flows and debt maturities and so on, I think it’s a property that we can divest of. But I’ll have David talk about the actual accounting.

There are two things, one on the balance sheet held for sale, that’s one “accounting judgment”, and then there’s another judgment we make with respect to discontinued operations. And those are two different judgments. Connected, but they’re two different judgments. And the held for sale treatment is pursuant to our plan. We have a plan, we are pursuing the plan. It includes pursuit of the jumbo transaction, but there are other interested parties as we’ve said, as well as an IPO alternative. So there’s a solid basis for the held for sale. And then the question is, on discontinued operations, depending upon the ultimate disposition path, we need to make a determination whether or not we will have significant continuing involvement. And that will be a facts and circumstances judgment that we’ll make, and we’ll continue to evaluate facts and circumstances. So it’s the held for sale. It’s not going to come back on balance sheet, and so now it’s just a matter of how we go about divesting it.

And on partnership returns, you noted in your disclosure that returns were impacted negatively by equity markets, but I’m trying to remember the lag. I think you’re either three months or one month, depending on the investments. Equity market has been very strong. I was trying to understand, even not relative to last year but just relative to sort of a run rate, the returns [unintelligible]. I’m just trying to get a better understanding for how we should think about that.

The partnerships are a quarter lag, and hedge funds are a month lag. Private equity partnerships are a quarter lag. Bill, anything to add? [William Dooley - EVP, Investments & Financial Services and CEO, Asset Management]: As far as the year’s concerned, first of all these returns aren’t linear each quarter, so they’re a little lumpy. Our goals are somewhere between 8% to 10%. And already this year we’re close to our annual goal on the return on these assets. So even though this quarter was lighter than the previous quarters this year, we’re still very confident in it, and as David said, the hedge fund part of the portfolio is in the books already. We just don’t know what it is, because we need the information flows to come in, and the hedge funds have one month to go. And there is a correlation between that and the markets, and you guys can judge from where the markets are today how the quarter’s going to line up. But I think that asset class is certainly performing the way we expect it to.

If we did that math backwards, though, I guess we wouldn’t quite get there, and I wonder is the 8% to 10% return goal against the backdrop of a market that has risen as much as equity markets have risen this year, and this could be just a wrong assumption, but that that would kind of gradate with the underlying return in the equity markets, not be sort of kind of a fixed return threshold. [William Dooley - EVP, Investments & Financial Services and CEO, Asset Management]: No, it’s not a fixed return threshold. As I said before, these returns aren’t linear, and the type of funds that we invest in depending on the volatility of the fund, the risk associated with the funds, we try to maintain 8% to 10%. And as I said, we’re in good shape through the first three quarters to attain those goals.

And now we’ll take the next question from Josh Stirling with Sanford Bernstein.

A question for Peter if I may. You’ve made a lot of progress in commercial lines in particular. I’m wondering if we could talk a bit more about consumer. When I think about these businesses, most of them are structurally more attractive in your consumer lines - the lower elasticity, lower risk, and not really as broken. But you haven’t thus far been getting a ton of margin momentum, and recognize this is partially you’re investing in growth and maybe some other is just getting the team in order. I’m wondering if you can walk us through a bit more granularity what you guys intend to do to actually drive the consumer combined ratio to a low-90s number, and sort of what the realistic trajectory of that would be to play through.

I think that the first thing to remind everybody is how much of our consumer business is in Japan. And so what’s going on there is a major merger integration effort between Fuji Fire Marine, AIU, and an integration of many capabilities which will improve the expense picture on by far the largest consumer operation we have. So that is certainly progressing well, and we expect that to improve the margins in what is a large and stable book of business. But it’s not growing that fast obviously, with the demographics in Japan as they are. The one exception there is the excitement we have about Fuji Life, and so we see good growth there as we rebuild the life business, taking advantage of the aging population in Japan. The other dimension is the investments that we’re making in building a firm foundation for scalable growth in emerging countries. And I’d say that there are three large emerging countries which we’ve been investing quite heavily in over the last year, where we have taken perhaps a little longer than expected to build the platform that we wanted and get the sales kicked off at the rate that we’d like, but we have still a high degree of confidence that those platforms will performance fairly promptly. So slightly delayed startup in three large emerging markets, which we’re investing in. And then the USA&H story, somewhat negative for a variety of reasons that are kind of one-offs, but we’ve got other quite good growth momentum on the consumer side, especially on the extended warranty side despite the short term profitability issue that we talk about in this quarter on one particular extended warranty program.

Bob, if I could switch to sort of a bigger topic, we all get that you don’t want to provide guidance, and the aspirational goals were stretch goals back in 2010, but you’ve since made a lot of progress against them. And so when you say - I think I’m getting this right - that we’re not sure we’ll get them done by 2015, investors just wonder what to expect. And recognizing you’re not going to give guidance, there were, I think, fundamentally three big pieces to the aspirational goals: driving ROE 10%, returning capital of $25 billion to $30 billion, and investing to get some growth and rebuild the franchise. I’m wondering if you could at least give us some directional sort of color on which of these big pieces you think may be at risk.

First of all, you’re assuming it’s at risk. What we’re saying is that once we get closer to the time we need to give you maybe a range around it. We’ve discussed a whole lot of things one would have to do once we get closer. Because look, if I could tell you exactly what I could be, at exactly a point in time, I think I would have problems with some of the people in Washington in the enforcement group, because you can’t run this business with that degree of accuracy, and you all know that. What’s important is we look at how we’re running it, what are our focuses on different things within this company, and we have said we’re focusing on expense and we’ve been investing a lot of money to get our expenses down, so we had to spend to eventually see the savings. We’ve talked about our investment portfolios and the things we’re doing there. We talked about making sure we understand our cost of capital for the businesses and the risks we’re taking. And we want to earn more than our cost of capital, especially in the property casualty business, [with its big focus], so that we are capital light on the things that make the most sense for us. So we’re continuing to do all of that. And it all comes together, including capital management. So it’s not a question of anything other than, as you go through all of these things, when we get closer to 2015 you’re going to ask us to be a little bit more specific and instead of an aspiration it becomes we will achieve something around this in this period of time. And that would be guidance, and that’s what we’re concerned about. So we’re focusing on all of it, and we’re proud of the progress we’ve made, and we’re putting a lot of energy into achieving all of it by 2015. But what I’m saying to you today, well in advance of that time, is we may not get there by 2015. It might be a little later. And that’s about all the comment we can make on the whole subject, but I think you need to look at our progress every quarter, look at the trends every quarter, and I think you’ll see a continually improving organization here.

And now we’ll hear from Adam Klauber, William Blair. Go ahead please.

The ramp up in some of the life and retirement products is very good to see. I guess two questions. Do you think it’s the earlier part of the ramp up? In other words, can it continue to accelerate? That’s number one. And number two, how should we think of the returns of that business today, and particularly the fixed annuity business today compared to what they’ve been more recently and historically.

First of all, in terms of the ramp up, I think that the potential demand for the products we’re selling, based on demographics, greater concern about longevity risk, outliving your savings and such, is definitely there, as well as the continued movement of money from defined benefit pension plans into defined contribution plans and ultimately to IRA accounts, where the money moves from, in effect, institutional management to retail management and more personal control. I think that primary driver though, of the kind of quarter to quarter growth, is going to have a lot to do with market conditions. The equity markets, certainly rates, the shape of the yield curve, and such. But I think the underlying demographics and the basic demand growth will continue to be there, but market conditions will have an overlay that’s going to play a big role in quarter to quarter results. You saw, for example, this quarter a very significant increase in fixed annuity sales based on rate movements. And we generally follow the 10-year Treasury, assuming credit spreads are the same quarter to quarter. And you saw the kind of movement not only for our company, where we’re able to take advantage of that, but really for the industry, as I mentioned in my comments. At the same time, the pricing continues very strong. We continue to target pricing for fixed annuities in the roughly 11-12.5% return on equity or internal IRR basis. And we continue to get that pricing [unintelligible] at the time we’re writing that business. So pricing is actually very good in this environment. Market conditions will depend a lot on rates and spreads, and I think we’ll be ready to go with our low-cost operating platform and our very strong distribution organization to take advantage of that or any other product segment that grows going forward.

To add what Jay just said, it’s a fact that people wonder about the businesses, keeping them together, and the diversity of risk and the diversity of dividends to the holding company and so on. But a startling number that just keeps hitting me is that over the next 35 years, there will be four times the number of people over 65 than there are today. So forget about percentages and numbers and all the other stuff. That is four times the number of people in that age code category. And that is the area where we do a lot of business, where we deal with protection and life and other products. So we see the opportunity not only in the U.S. market, but you have those statistics even more exaggerated in China. So this is a great growth business over time. So it’s not only quarter to quarter in the markets, but it’s also about client need.

Next we’ll hear from Greg Locraft with Morgan Stanley.

Just wanted to get a little more detail on the tax rate. The tax rate we were expecting was in the low 30s. You put up an 18%. You mentioned the credits in the commentary. Can you go into kind of the timing around that, what they were, and whether there’s any more like that coming forward?

Again, we’ll address discrete items in any particular quarter as they occur. And we’ll give you plenty of disclosure around that. And so the 31% rate that we expect going forward is really a reflection of the ongoing operations. As you know, over the last couple of years we’ve done some portfolio rebalancing in property casualty to reduce our holdings of tax-exempt securities. So that certainly affected the effective tax rate. So again, I’m not going to give you any specific guidance as to what to expect. Again, the 31% is really sort of the normalized rate, and then we’ll break out the discrete items that we do. And then we’ll let you know when those occur.

What I’m wrestling with, and I know you mentioned it earlier, is just the difference between the definition of aspirational and guidance. To me they’re the same thing. And in a quarter where the pre-tax miss was pretty sizable, why choose now to suspend guidance, effectively, going forward? And I appreciate you guys are aiming for 10%-plus, but even then I thought that the plus would have covered you. You don’t have to give decimal point accuracy, so to speak. I just don’t know why right now you would suspending guidance.

It’s very simple. We’re getting too close. You want to wait until next quarter, or the quarter after? Sooner or later we’re going to face this issue, and so the feeling is that guidance is something that I believe, from what we’ve looked at, we have a likely chance to achieve. Aspirational says we look at this company and all the things we need to do over a five-year period, we believe that we could get to this kind of target. And so the word aspirational, and why we used it, was to say to you that we don’t have a plan specifically that says you can get there. We haven’t gone through the details, but we knew that directionally, if we do a whole lot of things and it began to take hold, we could get into that ballpark. And so we’re going to get through a journey, we’re going to get to southern New York. Now you’re going to ask me, well, are you going to make it to Westchester, or are you going to make it to Putnam, or are you going to make it to Manhattan? That’s guidance.

Lastly, just for Peter maybe, on the pricing outlook in P&C, I don’t know if you’ve given a lot of color on where you think it could be, but decelerating a little on the margin. It’s great to see the gains. But how do you think this thing plays out going forward, from a pricing perspective on the commercial side?

You know, rates were up for us in the U.S., where rate is needed the most, by 5.5% in the quarter. A little down from the second quarter. Casualty rates in the U.S. remain fairly strong. The property market seems to have gotten a bit more competitive. We’ve been observing that over the course of the last several months. But I expect the same factors driving pricing improvement in casualty in the U.S. to continue in the near future.

John’s answer is very correct, but underneath that answer is something that many of you would not know, and that is the amount of analytics going into understanding what is our account quality index, thinking about the quality of clients, the quality of the risk and so on, down the line, to make sure we’ve segmented that in a much more refined way. We’re now looking at brokers and what the broker quality index is. So we know the kind of business that is being brought to us by brokers, some of them taking a shot in the dark and hoping someone at AIG will write it versus somebody who really prides their business with AIG and tends to bring us very good risk and very well field underwritten. And so when we talk about price increases, we actually look at it by these segments, and we’re going to get more refined by these segments. So we have very good retention in our best clients and very little rate increase, but we’re getting pretty good retention in some of our lower quality clients, where you need the rate because of the performance of those accounts. And so it isn’t just following the market anymore. We’re becoming much more scientific, and where in our client base or brokerage brought business do we want to begin to add rate? And that would be independent of what’s actually happened in the market. So it’s not just the old everybody’s up and down by the tide. So I’m very impressed and very optimistic about what John’s been doing in particular in the whole commercial business with Peter. So that’s a different level of detail behind that answer.

I would add that beyond the tools that we’re building to help make better judgments at the underwriters desk, we’ve made big investments in the claims side as well, in people and process and in technology, that are enabling better results for us to reduce the cost of risk once the claim hits. And so that’s an important part of the improvement as well.

Now we’ll take a question from Joshua Shanker, Deutsche Bank.

My first question is for Jay. In terms of the amortization of the DAC on the life business, interest rates were kind of stable during the quarter, but you got a benefit there. Can you talk a little bit about what went into this quarter’s change in the DAC and what we might see happen in future quarters if rates go up, and when that actually hits the P&L?

In terms of the DAC, you’re results. In terms of the fixed annuity business what we saw there were really two things: the yields on the portfolio supporting the book were better than what we had modeled, as well as Jay has talked to you about the crediting rate actions we’ve been taking and really managing the overall spreads. That benefited us in terms of the actual spreads coming through versus what we had assumed in our model. Our model, if you go back a year ago, still is anticipating continued pressure around yield and spreads, and we’ve been able to really manage through that by both the investing side and actively managing the crediting rates.

This may sound somewhat naïve, but I would have probably thought that would happen more likely in Q2, and we didn’t see it, then, in Q3.

Well, we do our annual review of the critical assumptions on an annual basis, and so we are tracking our actual experience quarterly, but we do do a detailed review. And we also want to make sure we see the patterns emerge over time. And so this was, really since last year, the first time that we did a detailed review of where the yields and spreads were coming in, and therefore adjusted in the quarter, across the whole life and retirement portfolio.

And on share repurchases, what told you you had about capacity for $200 million of repurchasing during the quarter? And I’m wondering if you were blacked out for any periods in the quarter otherwise. [Brian Schreiber - EVP, Treasurer]: We received authorization midway through the quarter in August, so we didn’t have a full quarter, and we also have a blackout date that started on September 15. So we were really only in the market for 27 days. We didn’t have $200 million of capacity. That’s how much we did. But we wanted to be just disciplined in how we were deploying the authorization.

Our capacity was $1 billion. We have the authorization for a billion. We used $190 million, and so as I said in my remarks, we’ll remain committed and disciplined around deploying that capital.

And is it reasonable to say you get about 25 days a quarter that you can be in the market?

Yes, but again, it depends on when we get the authorization, where in the quarter it is.

That’s true. This quarter you already have the authorization, so you have more days?

Right.

And now we’ll hear from Jay Cohen with Bank of America Merrill Lynch.

Two questions on the property casualty side. The first is you had some adverse development of primary casualty business, more so than we’ve seen in the past. And I’m wondering what’s going on there, what drove that. And then secondly, just explain what happened in the retail warranty business, what drove those losses? It wasn’t quite clear from the press release.

The adverse [POID] we experienced was related primarily to construction defect. And we saw some increased frequency. We accelerated a review that had been scheduled for a later period, and really impact of prior major cat events, as well as the expansion into some new states that historically hadn’t been troubling in this regard. We had historically tracked a couple of different states where [CD] had been a challenge for us. We saw, again, some increased frequency and some new states accelerated around the review. And I would also say, beyond the impact of major cats in the United States, also the impact of the credit crisis. Now we’re observing a tail that’s longer than what we had expected, and the issue moving into some other states. So again we accelerated review and dealt with it in the quarter.

On the warranty business, this is working with one or two large retailers, and in particular one. So this is a program where the profits and the risks are shared with the retailer. And there is a mechanism to true up through rate change historical profitability. So while in any given quarter you can have fluctuations, which we’ve had, we have confidence that we can recoup those adverse results within a very prompt period. So it really is a partnership with the retailer, and it’s not as much risk transfer as the numbers would suggest.

What kind of underlying products are we talking about? Is it white goods, computers?

All of the above. But in particular mobile phones in this quarter.

Operator, I think we’re at the top of the hour, and so I know we have a lot of questions in the queue. I’d like everybody to reach out. We certainly do want to respond to all your questions and make sure we get back to everybody. So thank you for joining us this morning, and we look forward to talking to you [unintelligible].