Monday, November 30, 2009

American International Group (NYSE:AIG): AIG Reserves Deficient - Sanford Bernstein

Sanford Bernstein is out with pretty negative comments on American International Group (NYSE:AIG) lowering their target to $12 from $20 after loss reserve analysis. Firm maintains their Undeperform rating on the stock.

Firm notes they conducted a segmented industry loss reserve analysis to see if it revealed any possible competitive issues that could emerge in the coming years. The main result is a letdown for the possibility of near-term pricing improvement. Every company subgroup—large publics, mutuals, reinsurance & international, and small privates—shows strong and relatively comparable loss reserve adequacy to the other segments. This means that no subgroup is more likely than another to outlast the soft market.

− In particular, average industry reserve adequacy of about 8 points of 2008 earned premium ($26bn dollar adequacy) ranged 4-14% across 4 industry subgroups they looked at. For the large US public companies in their coverage (excluding AIG), the average adequacy is about 11 points, concentrated in commercial lines and specialty businesses.

But they did reveal a very unexpected result that could have major ramifications in coming year. It appears that AIG's loss reserves are significantly deficient again, much sooner that they would have forecast 2 years ago.

− Sanford's estimate is about $11bn deficient, +/- a $4bn standard deviation and equal to about 24 points of total 2008 earned premium (35 points for US only). This equals about $10 per fully diluted share after-tax. The majority of the deficiency ($10bn) is concentrated in 3 long-tailed casualty lines: Work Comp ($1.8bn), General Liability ($5.6bn), and Professional Liability ($2.6bn).

− Because this result was so unexpected to them, they conducted numerous independent reasonableness checks on the AIG analysis. In each case, looking at paid/incurred ratios, implied real price adequacy, and empirical loss development factors, it appears at a minimum that AIG's results are worse than its other large peers, and directionally worse than its booked reserves.

− These results give some credence to long-held views that AIG simply has always been a more aggressive competitor. There is even some support to the idea that discipline was lost after former CEO "Hank" Greenberg left the company. But a more solid analytical reason that may explain the recent deterioration is that AIG's reinsurance usage has been cut nearly in half since the late 1990s, from 43% cessions in 1999 to 22% in 2008. This fact supports both the idea that AIG's underwriters never adjusted to the greater need for more "net line" underwriting, as well as the possibility that AIG's reserves will have a "thicker" tail without so much reinsurance usage.

Investment Conclusion
Sanford Bernstein cuts their AIG target price to $12 from $20 to reflect the reserve deficiency. There is now 64% potential downside to their target from AIG's most recent close. Firm continues to rate AIG Underperform. The results of this study were a big surprise to the firm. The original purpose of the analysis is rather anticlimatic, as current loss reserve adequacy seems rather evenly distributed by company subgroup, which suggests that the industry could continue competing with itself for quite some time. This lends support to our view that a balance sheet driven hard market, of the type seen in 1985 and 2001, is likely 2-3 years off. The potential implications of this result for AIG are quite significant. If their analysis is even directionally correct, it implies that AIG shareholders and the Federal Government face considerably more uncertainty than they may have anticipated. At a minimum, if these results are reasonable, AIG would likely have to take some kind of reserve charge before it could sell or IPO its Chartis unit, which would probably greatly increase the difficulty of implementing such a deal in the first place. There is also the possibility for even greater Government scrutiny and penalties, although they have no insight as to what this might be at this point.

But this may also lead to a result that was widely anticipated earlier this year but for the wrong reason, namely continued loss of AIG market share. It was viewed by many that AIG's weakened state would compel clients and brokers to want to move business. Sanford notes they were skeptical of this view because they felt that clients would instead stay put and wait for the uncertainty to pass before making a major decision. So far, their view is what appears to be playing out. But now, with this loss reserve result, they have a more analytical case to make that AIG may face client flight in the future, driven by fear over its potentially weakened claims-paying ability. That factor seems much more likely to matter to risk managers than what is happening in AIG's Financial Products unit. It is very difficult to determine if and when any reserving problems will be manifest in AIG's results, and so if and when competitors will be able to capitalize. But at this point, they now think it is more likely that companies like TRV, CB, ACE, and even CNA will eventually be able to capitalize on the likely uncertainty this will create in AIG's client base.

Notablecalls: AIG appears to be vulnerable here. I don't think people were ready for what Sanford Bernstein has to say this morning. If AIG's loss reserves are significantly deficient again, some odd $2 billion asset sales (as reported today by Financial Times) ain't going to help much.

This is negative for the whole financial system, I believe.

I expect AIG to trade down today. Could trade to $32 or possibly even lower.


notablecalls said...

Underestimated that one for sure.

Sam said...

Yep, got crushed today. Nice call.