To make an (perhaps poor) analogy, AIG is like a patient with a lot of pre-existing conditions. It’s overweight (expenses are too high), has high blood pressure (too much operational leverage), and eats too much processed sugar (in too many underperforming businesses).
With AIG’s recent decision to separate the P&C and life businesses, they are finally taking their health seriously. The next big decision is how exactly will they proceed with the separation.
The vagueness of the language in the release suggests AIG is open to suggestions. I’m sure the bankers are lining up to make their pitches, but I will offer some advice for free.
The Challenge
Let’s begin by discussing some of the obstacles. The first is AIG has historically used the combined balance sheet to double lever their risk. While they often call this “diversification benefit”, it’s really more of an excuse for excess risk taking.
For example, AIG has taken more cat risk than it’s stand alone P&C balance sheet suggests it should. Both sides of the business have taken more alternative investment and credit risk than one suspects they would on their own.
So, one of the first questions is whether the current life earnings are really the right starting point for an independent life co or do they need to take some risk down? My guess is it’s the latter.
The next question is do they have enough capital without the covariance benefit to support the current amount of allocated debt? This seems unlikely. This means they probably need to raise some capital to enable the transaction.
The most obvious way to raise some capital is to float a 19.9% stake rather than do a clean spin. This allows AIG to monetize part of the business and bring down leverage.
Of course, the problem with this is, at current market valuations, you’re likely selling this stake well below book value so you’re locking in the loss.
The other thing to consider is the impact of any balance sheet adjustments post separation. Presumably, a clean evaluation of DAC and other GAAP assumptions will lead to writedowns. While non-economic, there are real consequences. Namely, this lowers equity which reduces the debt capacity.
Again, a 19.9% initial sale would get around some of these issues as it could postpone the realization of these writedowns and buy time.
The Solution
Bariatric Surgery = Sell Stuff
First, AIG should sell in force books to raise additional capital. Yes, they will likely be selling below long term fair value, but there is no difference to corporate whether they sell cheap to the new shareholders or financial buyers.
Selling blocks of business raises capital in the same way that selling a 19.9% stake does. Obviously, it is worse for the new shareholders to lock in losses rather than see if valuations recover over time, but we all know nobody is looking out for the shareholders of the independent life co.
Thus, step one is to try to raise up to $5B by selling blocks of in force annuity (fixed and/or variable) as well as older mortality blocks that have crested the XXX curve and will see their capital requirements start to gradually come down.
This will help with the D/C pressure in addition to the cash raised on the spin. However, that only addresses the immediate issue. There is still the longer term issue of business model and valuation.
Just separating the businesses doesn’t create material value. For evidence, see the Met Life/Brighthouse separation. To create value, the new entity needs to restructure post separation. While selling some blocks helps and perhaps even selling a business unit like VALIC might be under consideration, the real issue is the ongoing business.
Cut Out the Carbs = Go Capital Light
Namely, nobody wants to own stock in a life and annuity company unless it is at a material discount to book value. Deploying capital in new business that the market immediately values at less than 100c on the $ is destructive. The excuse that “the market will eventually correct” lost credibility at least five years ago.
Nobody cares. Something needs to change. Lucky for AIG, I suggested a change recently. Life insurers should take advantage of the ample demand for insurance liabilities from diversified asset managers to manufacture on their behalf.
In other words, AIG Life should act primarily as an MGA. It should originate business on behalf of its balance sheet partners. This will change the perception of the business with investors and allow it to be revalued.
Arguably, AIG can do this without separation but, as I said earlier, the separation has never been about shareholders. It seems apparent new CEO Zaffino isn’t interested in running a life business, so he is happy to let it go rather than fix it himself.
Furthermore, if you are going to make a major strategic change, it is better to do so in a more focused entity where investors can bet on the execution rather than as part of a larger organization where it may not get rewarded in the same way.
The Future
So what would the new AIG look like after surgery? It would be trimmed down and better able to compete. The balance sheet would still need work but would have a clear path to improvement.
Statutory strain would plummet with the reduced new business on its own paper. This would provide plenty of dividend capacity to delever and even return to shareholders.
While $ profit would decline, return on capital would increase materially which would result in a much better valuation. Now, maybe the new management won’t care about that either and will continue to pursue market share growth and size above all, but if the new management is truly focused on maximizing wealth, reducing the size of the balance sheet is the way to go.
Bonus Content: Election Prediction
No, not that one. This is about the 2024 Election. My prediction is, if Trump loses a close race, he will be back in 2024. The idea that tomorrow is a binary event is false. If Trump loses closely, he will declare that he wants a rematch. He will be more vocal than ever as he won’t have any constraints as a private citizen.
So if you are voting for Biden because you want a return to “normalcy”, you need to hope for a big win where Trump has to leave the stage. Something like 350 electoral votes (e.g. Biden takes FL, GA, & NC).
If you think Trump will lose a close election, you can get 33-1 odds on Trump for 2024. Crazier things have happened!