We have recently started a long position in AIG. We are approaching a time that will represent an opportunity that does not come around very often. Of course there are many negative connotations that are involved with AIG in the present day, and will probably persist into the foreseeable future. We currently own 40 dollar calls that expire in January 2015.
It is not a secret that AIG was deviating from their core business of insurance and became a multi-faceted company that was one of the most levered companies in history. Their bets that turned sour could have taken out our financial system. Fortunately the government came in and bailed them out. The government owned 92% of shares, and was helping the company stay in business to unwind these trades. Since 2007 AIG has worked to get back to its core as an insurance company. They have sold the majority of their non core businesses and have been focusing more on guaranteed profits. As an insurance company, they have consistently been able to generate solid earnings with little risk. This is why we are buying AIG – as an insurance company they present an opportunity we have never seen.
AIG, as controversial as it may be, is in a wonderful spot. They are currently trading at 32.40, an extreme discount to their book value. If you are not familiar with insurance companies, their book value is never this deeply discounted. AIG ex AOCI book value currently stand at 61.49. This is up a whopping 9.6% since last quarter’s reported earnings. With this huge jump in book value, the market is still highlighting the negatives. Although we think it is important to note the negatives: their ROE is trailing industry peers, their combined ratio has been higher than recent street expectations, a low interest rate environment will hurt earnings power, recent hurricane Sandy will be a large hit to cash, and the government still owns 15% of shares outstanding.
We think that the majority of these negatives actually reinforce our bullish case. ROE is trailing peers because the company has been trying to get back to the basics with insurance. To aggressively price insurance your premiums received are going to be lower until you are able to compete better with your peers. This is a natural cycle of supply and demand. To increase demand you need to lower the price paid up front by the consumer. Once they are able to increase NWP(net written premium), they will have a larger revenue stream in the future. This is why they have trailed peers with their ROE. They were also subject to large losses that were not classified as a catastrophe within the last year. These losses were very unusual as far as insurers are concerned, but not large enough to be categorized as a catastrophe. This is why their P&C earnings were light. The low interest rate environment will affect everyone equally, so each firm will struggle to make a decent profit on their annuity products. Hurricane Sandy exposure is currently less than 1% of book. Other industry peers have already announced related losses and they have not been worse than expectations. One of the last hurdles for AIG is that the government still has a 15% stake. This has diminished with increasing velocity, with the last lock up expiring on November 9. Now the company is free to buy out the rest of the stake and start to return cash back to shareholders.
We are in a slow economic recovery, but the majority of AIG’s risk assets have been sold for a gain and their focus has been getting back to insurance. There are risks that remain with AIG, but does not currently carry any more risk than its peers. Their huge increase in book value recently gives them more earnings power than any one else in their industry. As low interest rates persist, they will be able to buy back shares at a 50% discount. Every share they buy back is immediately accretive. This makes AIG a very unique case. We think the company’s main focus will be to buy back shares and this makes owning long dated calls extremely attractive, as you get exposure to extraordinary upside without having to tie up much capital. The longer AIG stays in the low $30 range, the more we will be accumulating.