AIG: Rise, Fall, and Rebirth - [Business Breakdowns, EP.187]

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1:05This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. And we are here to bring them to you. To find more episodes of Breakdowns, check out JoinColossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. hosts, podcast guests, their employers, or affiliates may maintain positions in the securities discussed in this podcast.

1:48This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Welcome back to Business Breakdowns. This is Zach Fuss. In today's conversation, we are diving into the insurance giant AIG. AIG's story is one of a remarkable turnaround, a tale of a global insurance giant emerging from near collapse during the great financial crisis. Over nearly two decades, AIG has transformed itself into a more focused and efficient property and casualty insurer. To grasp the magnitude of AIG's journey, consider this. During the financial crisis, the company required a $180 billion bailout from the U .S.

2:30government, a summit fully repaid with interest. For those unfamiliar with PNC insurance, we'll explore the fundamentals, how the businesses are insured, how risks are assessed, premiums priced, and assets invested. AIG's turnaround has been remarkable. From 2009 to 2019, the company lost over $30 billion in underwriting losses. Put simply, it was consistently paying out more in claims than it collected in premiums. Today, under Peter Zafino's leadership, AIG has refocused its underwriting efforts, returning to profitability while divesting non -core businesses, including the demerger of its life insurance arm, Corbridge.

3:13The AIG of today stands as a near pure play specialty insurer with a focus on achieving top quartile industry returns. To help tell the story of AIG's transformation and its current position, I'm joined by Austin Hawley, Portfolio Manager at Diamond Hill. We hope you enjoy this breakdown of AIG. All right, Austin, thanks for joining us to discuss the American International Group more familiarly recognizes as AIG. The company is infamous for its experience through the financial crisis. And I think finally, somewhat over a decade later, we're on the back end of the business's evolution. I thought maybe just to kick things off, it'd be super helpful for you to provide the story of AIG from pre -financial crisis to today, and then we'll jump into the details of the business from there.

4:06Great. Thanks, Zach. I'm happy to be here to join you. AIG is a fascinating story, and I've had two decades tracking essentially my whole career on the buy side involved with AIG, going back to the first days as an analyst at a business school. And I think AIG is a fascinating case today because it offers investors looking for a challenge, just about everything you could hope for. It's got that complicated, scandalous history that you referenced. There are a ton of moving pieces over the last few years from business mix changes, hidden assets on the balance sheet, just lots of complicated things.

4:49And then we throw on top of it today, and especially over the last three years, a new management team that is extremely talented, that is really repositioning the business moving forward. So I'll start with a little bit of the history of AIG. And we could spend a whole podcast talking about the history of this company because for most of its history, it is a really remarkable success story of a company that throughout the 20th century, going back to 1919 when the company was founded, grew to become the most powerful insurance company in the world for a period of time. And that growth was really focused on two areas.

5:27And the first was they were one of the first companies to build out in a meaningful way distribution outside the United States. And in fact, this company was founded in China as a managing underwriter during its early days. And then what AIG really became known for under the leadership of Hank Greenberg from the 1970s through the financial crisis or just before the financial crisis was for having a real entrepreneurial drive and appetite to underwrite complicated risks that many other people were not willing to take on. And that allowed AIG to grow very quickly, to earn good margins over time.

6:13And eventually, that growth led them to start to use their scale to diversify into some other areas. And to me, that's the tale of the downfall of AIG through the financial crisis is once they started to use that scale in their balance sheet as leverage to diversify into things like aircraft leasing, like complicated investments on the asset side of the balance sheet. And then most notably, the bond insurance business, where they were insuring hundreds of billions of dollars of mortgage -backed securities, as well as municipal bonds, into the financial crisis is what ultimately took AIG down and led them to be taken over by the government in 2008.

7:01And I'll make one final comment here, which I think is really, really important in that pre -financial crisis history is that AIG lost almost all of its value. It essentially went bankrupt and was taken over by the government. It was an asset -rich business, even throughout that period of time. If you look at the core assets that AIG had, both the international insurance businesses, the core domestic insurance businesses, they were worth a ton of money. However, they had basically used those businesses as collateral to underwrite these large bond insurance contracts in terms of notional value.

7:41And they had basically a call and a run on the bank. So they had a major liquidity crisis that led them to be taken over by the government. But in fact, it was a very, very valuable company overall, if you looked at the sum of the parts. That was proven out over the next several years as the government at this point has been fully repaid and has a nice profit on all their investments in AIG. I understand that effectively from call it 2009 to 2017, it was a period where the business was cleaning itself up. I think before we dive into the details of what AIG is today, I think it'd be helpful to perhaps zoom out and just explain at the most basic level what a PNC business and an ENS business do and how they fit into the financial institution ecosystem.

8:28So if you can just explain that from a first principles level, and then we can dive into how AIG has recreated and positioned itself for growth again. So again, the insurance industry is pretty complicated, and we could spend probably two or three podcasts on the various parts of the industry. So let me try to zoom out and give my view of the different parts of the insurance industry and the way I think about the quality of that industry overall. So if you read through Warren Buffett's shareholder letters over the years, he always has a section there on insurance. And he talks about insurance as being a business of promises.

9:08An insurance contract, an insurer is basically giving a promise to pay their customer in the event that some uncertain outcome occurs. And so when you're in the business of promises, trust is extraordinarily important. And you want to know that that counterparty is going to be willing and able to pay in the event that unfortunate event happens. And so when you think about the insurance industries, companies that have built reputations in brands that are valuable and have paid consistently over time, companies like Chubb come to mind when you think about that type of reputation, they have a real advantage over any sort of startup trying to enter the industry.

9:54So there are some modest barriers to entry for new companies and some advantages to those incumbents that are currently in the industry. But having said that, this is still a highly, highly competitive industry. And it is an industry where it is very, very difficult to price your product. You don't know the cost of goods sold when you price your product. And that leads to a cyclical industry over time. And one, again, where returns for the entire industry are not great. If anything, the industry overall earns roughly its cost of capital. And it's probably even a little bit worse than that, because for the companies that happen to underprice their product, they're likely to get adversely selected against.

10:43And what I mean by that is there are insureds who have private information about their riskiness that the insurer does not have. And they are the most likely to seek out that cheap insurance because it's most beneficial to them. So the company that misprices by a small amount in this industry is likely to have much, much worse outcomes than the median. And so when you think about this industry, again, you are unlikely to want to invest in the insurance industry if you think you're going to get the median outcome, because it's not great. The returns on capital are in the neighborhood of 8 % to 10 % typically.

11:23But what's attractive about investing in insurance are there are a group of companies, the top quartile underwriters in this industry, who earn very attractive returns on capital. And they've earned good returns in the stock market over time. And those companies tend to be persistent through time. And they're companies a lot of your listeners would have heard of. We're talking about Berkshire Hathaway. We're talking about Progressive. We're talking about Chubb. And so that's what I focus on when I think about the insurance industry is I want to focus on those companies where I think they are either a top quartile underwriter or they have a path and a clear path to get to top quartile results.

12:05And that's where I stand with AIG is I think with a very complicated history and a lot of messy things going on over the last several years, I think we're actually on a pretty clear path to get to a top quartile type of underwriting performance. That was great. And so in studying the history of AIG and preparing for this conversation, I noticed a pretty big change in the way that the business expressed itself to the street. In 2017, they brought in what I guess is recognized as a turnaround specialist. That seemed like an inflection point in the business. I guess if you take a white piece of paper and explain to the audience what they did to position the business for success, what exactly transpired, how they clean this thing up, what did they sell, what did they buy, and then we can go into why the business today is positioned to grow again.

12:56Yeah, and I think you're exactly right. The new management team that came in in 2017 was a clear inflection point in the trajectory of AIG. And I'm going to give a little bit of extra background here because I think it's relevant. If you think about AIG fully repaid the government in 2012. And so, and they, from 2012, 13 through 2017, they continued to have pretty terrible underwriting results at that company. And it was a really difficult situation because AIG had lost that reputation of being someone that people could trust. And if you are an insurer that loses trust, you're in a tough spot.

13:40You have to try to keep the business going and keeping cash coming in the door and retaining those clients. But it's hard to do without underpricing the business. And AIG was trapped in that vicious downward cycle of trying to keep those clients, keep money coming in the door, but knowing that they potentially had some really mispriced pieces of business that they'd written during those years. And so when you think about the task of a new management team coming into that situation, There's a few things you have to do right out of the gates to get people comfortable and to have the opportunity to attract new underwriting talent to the company.

14:19And the team that came in, which was Brian Dubrow, who had a long history as an executive at AIG through the 70s all the way through the early 90s and had successfully managed a turnaround at Marsh Mac, the large insurance broker in the aftermath of the Spitzer scandal in 2005. He brought in Peter Zofino as his number two, who is another executive who had helped in the turnaround of Marsh McLennan. These were gentlemen with deep, deep expertise in insurance. They spent their entire careers in insurance and were respected broadly as real leaders in the industry. And the first thing they did when they came in or near the first thing is they got an adverse development cover, which is an insurance contract that protects the balance sheet against adverse development, meaning some of the business you had written in prior years comes back.

15:13And as I discussed, you don't know the cost of goods sold. Sometimes it turns out to be much worse than what you expected. And when that happens, you have to revise your reserves, your liabilities upwards. And that had happened several times during that post -financial crisis period from 2009 through 2017. So they bought a large contract from Berkshire Hathaway to protect the balance sheet. And essentially what that did is it cut off the tail risk from those prior years. So I talked about just the problem of trying to keep money coming in the door. That had led to underpriced business. They took that risk off the table.

15:51And Berkshire Hathaway basically agreed in exchange for a very, very large premium. They agreed to ensure AIG going forward for all the business written in 2016 and earlier. So that was a huge step and took tail risk off. And for me as an investor, that was one of the things that triggered me to spend a lot more time on AIG because all of a sudden that tail risk was gone. The second thing they did, and this was very methodical, and that's the word that comes to mind for me most when I think about what's happened at AIG, the new management team was methodical in how they walked through this turnaround.

16:28Between 2018 and 2020, they essentially re -underwrote the entire book of business, meaning every year that business came up for renewal, they were repricing that business and in many cases, non -renewing that business. So what happened is they actually shrank the business in terms of the revenue and their footprint in the insurance market by around 10 % to 12 % between 2018 and 2020. That re -underwriting and shrinking of the business, that pain that they had to take was necessary in order for them to move forward a much stronger company. Once they had re -underwrote that business, the next step they took was to look at the portfolio of companies they had overall and to optimize for what they wanted in terms of a top quartile business going forward.

17:20And at that time, they still owned a large life and retirement business. They had a reinsurance company that they had bought in 2018. And they had a couple other businesses, crop insurance being one that didn't necessarily fit the model of what they wanted for the long term. And so the next step was they announced a plan to divest themselves of the life and retirement business, which is no small task because it was a $20 billion plus equity business. They sold the reinsurance and crop business. And then they sold a small personal lines business, the travel business. And they put the high net worth business, personal lines business, which was a homeowner's business in the United States.

18:03They put that into a JV and they are going to start moving that off of their balance sheet to someone else's balance Sheeth. And they are left now today after all these actions with a commercial property and casual business that is heavily focused on specialty lines of business, including excess and surplus lines in a business where they have real expertise, where their capacity matters to clients. And I think, I believe, as we look at 2025 and beyond, we have a clear path to this being a pure play with much higher returns on capital that deserves a much higher multiple than what we've seen in the past.

18:45It just strikes me in that if you're doing a transaction with an outside party, clearly someone is getting a good deal and a bad deal, and perhaps you can have a win -win situation. But if Berkshire was willing to take on the risk that AIG had underwritten, how does that type of transaction work? And Berkshire is obviously sophisticated in their business and exceptional at underwriting these types of weird and esoteric portfolios. But I'm just curious how that type of thing transpires and how you think about who's ultimately wearing the larger risk there. Yeah, it is a really interesting transaction.

19:19And one of those types of transactions you'd love to have been in the room for and listen to the discussions. But I think there's good reasons to think that this is potentially win -win for both sides. And the reason I say that is AIG knew that they had to get this off of their books in order to credibly move forward, both with their clients, but also with potential employees that they needed to recruit to the business going forward, which is a big part of turning around this business. And so they were willing to take some pain to do that. And I think that's the right economic move. Without doing it, the downside was much more severe for them.

20:01And so getting this off the table, even if it requires some near -term pain, is a positive NPV transaction for AIG. The other thing that you have to think about with this type of transaction is the unique nature of Berkshire Hathaway. Berkshire Hathaway has some real advantages over other insurers in that it has expertise on both the liability side of the balance sheet, meaning how it prices and underwrites these types of risks, but also for long duration liabilities. And these liabilities were most definitely long duration. This was a lot of casualty type business that will pay out over years, if not decades.

20:39So these liabilities are going to have a very long duration. And Berkshire Hathaway has the ability to invest on the asset side of the balance sheet in a way that generates much higher returns over the long term than many, many peers. They have broad flexibility from their regulator to invest basically all the portfolio in equities. And they have done that to some extent over time when equities have been attractive. And so Berkshire Hathaway is able to price that contract different from any other reinsurer in the world. And so I think it's a case where given the long duration nature of the liabilities, the size of those liabilities, Berkshire was very interested in taking those on because it got $10 billion of premium that it's allowed to invest upfront in whatever mix of assets it chooses.

21:29They made the decision to get into the reinsurance business and ultimately to exit that business. I'd be curious how management presented that opportunity and the decision to then exit as they've cleaned up and refocused the business today. They bought Validus very early on in Duperow's time as CEO. And I think if you ask Peter Zofino, he probably wouldn't tell you the real answer, but I think he may have made a different decision if he was pulling the trigger on that particular transaction. Now, I think at the time, the way they thought about Validus is Validus was a very highly respected reinsurer.

22:08And in particular, they had very deep knowledge of the catastrophe markets and a very talented employee base. And I think they viewed Validus as buying Validus as a way to improve their intellectual capital to develop their understanding of the catastrophe reinsurance markets and to bring in some people that could help build the business going forward. I think once Peter Zabino became CEO and fully developed what he wanted AIG to be five, 10 years from now, which is more of a primary specialty lines insurer, it no longer made as much sense to have validists there. I think the other very, very important consideration here is that in the interim years, we had a roaring hard market for property cat reinsurance, which drove up the multiples on those companies.

23:06And they were able to sell this business at a higher multiple to Renaissance Re, which is the best property cat reinsurer in the world, in my opinion, at a very attractive price. And so I think there's the combination of this being maybe not the best fit longer term, but also a reality that the market was willing to pay a multiple for validus when they sold it that was significantly higher than probably what they thought they would be able to get for it during those interim years. And then seemingly the most important transaction they've done since was the spin of the life and retirement business that's now today an independent public company that AIG is very much involved with.

23:49I think that's obviously one of the biggest changes with the business. How did that come about and how does the market and investors view that transaction today? The life and retirement spin has been discussed for nearly a decade at this point. And when Peter Hancock, who is the CEO prior to Brian Dupro, was asked about the spin many times, he waffled on this issue. And we actually had some activists involved in AIG, including Carl Icahn, who were advocating for a split up of the business at the time. There were some real constraints coming out of the financial crisis that made a split more difficult.

24:31The most notable being they had a very large deferred tax asset, and it was going to be difficult to split up the two companies and fully utilize those tax assets over time. They were also getting pretty substantial benefits from the rating agencies in terms of a diversification benefit that they were given in their ratings. And so that deferred. It was an easy excuse to not split these two companies up. But the reality is, I think lots of people recognize that there were no real synergies from having these two companies together. They are very, very different businesses in terms of underwriting expertise, in terms of distribution and how you sell, and also in terms of balance sheet.

25:15You have a much larger, more leveraged balance sheet with a life insurer than you do with a property and casualty insurance company. And the market has a hard time digesting a company that mixes those two types of balance sheets. You tend to trade at a discount to what I think a rational, some of the parts analysis would suggest. And so Peter Zafino, as he made more and more progress towards improving the underwriting on the property insurance company and getting the earnings base up to a level where they could comfortably be standalone and have ratings that were high enough, but also utilize some of those tax assets over time, it became clear that it was the right time and they could now do this transaction.

25:59It's still not an easy transaction because you have some stranded costs that were shared at the parent company. that you have to work down over time. But once again, Peter Zofino has been really methodical about cost reduction programs over the last couple of years to manage those costs down. And so where we stand today is we now have, as you point out, a publicly traded company, CoreBridge, that is the life and retirement business. It has now been deconsolidated off of AIG's balance sheet because they are now below 50 % ownership, just barely below. They have announced a transaction to sell an additional 20 % of that business to Nippon Life in early 2025 at a premium to where the market price is today.

26:47And we expect that they will sell the rest of that business down over the coming one to two years after that transaction with Nippon Life. And that will leave us as we exit 2025, most likely with a pure play property and casualty business, and then a standalone business and core bridge that's fully owned by shareholders. All right. So I think we successfully navigated the last, call it 20 years of AIG to get to a point today where it's a more focused and simpler business to understand. And I guess given our success in getting there, AIG today, how big is it? What are the core business units, geographic footprint, competition, the nuts and bolts of what AIG is today and going forward?

27:35Great. Well, I'm glad you think we successfully did that. It's not easy to cover that much time, so I'll declare victory. If you look at AIG today, AIG is you can look at an insurance company, a property and casualty insurance company on a couple of different metrics. So in terms of gross premiums, which is what the market sees, the customers, they write about $35 billion in gross premiums. Now, they share some of those premiums with reinsurers that they help protect them from certain events. And about $10 billion of those premiums go to reinsurers. So the net premiums that investors tend to focus on because it's what we earn our return on, those net premiums are about $24 billion today.

28:22If you think about the tangible book value of the property and casualty business today, it's a little over $30 billion. And that compares to a market cap for AIG that's close to $50 billion today. Now, you may look at that gap between that core tangible book value and the market value and say, well, the market's paying a pretty high price for AIG in that case. But you have to remember, they still have a $9 billion stake in Corbridge. And they also have a little over $4 billion in deferred tax assets that are going to be utilized in the next three to four years. So those are pretty close to value that what I think is a fair price for those DTA is just the face value.