What’s hidden behind AIG’s $6.1bn 2017 loss

The losses published for 2017 follow a net loss of $849 million in 2016 and a net income of $2.20 billion in 2015.

The 2017 results were primarily impacted by a negative $7.53 billion tax effect, driven by the US tax reform. The Tax Cut and Jobs Act of 2017 (US Tax Reform) was enacted on December 22, 2017, reducing the statutory federal income tax rate from 35 percent to 21 percent, effective Jan. 1, 2018. As a negative side effect of the lower tax rate, insurers have seen a decline in their capitalization due to the write-down of their deferred tax assets (DTA) in line with the new tax regime.

Reserves and expenses improvements

Excluding this tax charge, AIG’s net income increased $1.5 billion in 2017, driven, among others, by lower losses from general insurance operations. The company registered $1.0 billion of pre-tax unfavourable prior year loss reserve development in 2017 compared to $5.4 billion in 2016.

“In general insurance, I'm pleased with the stability of our reserves and the outcome of our fourth quarter reserve review,” Duperreault said during the fourth quarter results conference call.

“We took decisive actions where needed, which were mostly in Europe. Importantly, our efforts to stabilize and improve our US commercial business are reflected in the fourth quarter accident year underwriting improvement,” Duperreault added.

The operating results in 2017 also benefited from lower expenses. General operating and other expenses have been falling in the past three years. Expenses shrank from $12.69 billion in 2015 to $9.11 billion in 2017. This development was driven by lower employee-related expenses and professional fee reductions related to an ongoing efficiency programme and divestitures of businesses, including United Guaranty, AIG Advisor Group, Fuji Life and NSM Insurance Group LLC (NSM), as well as a favourable foreign exchange impact of $63 million.

“With respect to expenses, while our overall expenses (in general insurance) declined 12 percent for the year, our expense ratio has remained flat as we've continued to reduce premiums as part of our remediation efforts,” said general insurance CEO Peter Zaffino. “In 2018, we've identified additional opportunities to improve efficiency as we transition to a more decentralized model, while we further invest in talent within general insurance,” Zaffino noted.

AIG wants to continue to execute initiatives focused on organizational simplification, operational efficiency, and business rationalization, according to the annual report.

“While the company has made a lot of progress on reducing expenses over the last couple of years, an organization of our size and scale needs to be a top-quartile performer in both underwriting and expense management,” Duperreault said. “We are committed to continuing to make meaningful progress in that direction in a prudent and thoughtful manner.”

In addition, in 2017 AIG benefited from higher net investment income, driven by alternative investments and higher appreciation on assets, helping to lift operating results, according to the annual report.

Challenges remain

Nevertheless, AIG continues facing challenges including long-tail commercial lines exposures that create added tests to pricing and risk management. In addition, overcapacity in certain lines of business is creating downward market pressure on pricing and claims volatility arising from natural and man-made catastrophes, according to the annual report.

But Duperreault stressed the positive side. “Despite full-year CAT losses of $4.2 billion, our highest ever, AIG delivered $3.2 billion on adjusted pre-tax operating income,” he noted.

Overall, the general insurance operations delivered an underwriting loss of $4.48 billion in 2017, an improvement compared to a loss of $5.61 billion in 2016, but at the same time, a deterioration compared to a loss of $3.12 billion in 2015. The combined ratio improved slightly to 117.3 percent in 2017 from 118.9 percent in 2016, but deteriorated compared to 110.1 percent in 2015.

Low interest rates are impacting the long-tail casualty line of business in the general insurance segment. While AIG expects limited impact on its existing long-tail casualty business as the duration of the assets is slightly longer than that of the liabilities, the firm does expect sustained low interest rates to impact new and renewal business for the long-tail casualty line as it may not be able to adjust future pricing consistent with profitability objectives to fully offset the impact of investing at lower rates.

In addition, for the general insurance segment and general insurance run-off lines reported within the legacy portfolio, sustained low interest rates may unfavourably affect the net loss reserve discount for workers’ compensation.

Adapting reinsurance cover

AIG is changing the structure of its reinsurance protection in order to reduce volatility.

“My philosophy on reinsurance is that it is an important tool for AIG to best manage its portfolio of risks," Duperreault said. "It provides another set of eyes on our underwriting, helps to manage volatility and control loss exposure. Going forward, you can expect us to be a predictable buyer of reinsurance,” he noted.

Peter Zaffino, general insurance CEO, added: “Going forward, you can expect us to more thoughtfully manage frequency and severity of CAT exposure through our reinsurance strategy and the management of our gross exposures.”

“We stated that one of our main priorities is to take a more strategic approach to reinsurance, building long-term relationships with our partners to manage future volatility. Our reinsurance philosophy is to take smaller net lines in property and casualty, reduce volatility and be a consistent buyer of reinsurance," Zaffino said.

During the January 1 reinsurance renewals, AIG has started to execute on this strategy by reducing severity and frequency exposures to North American CAT and net retention on its property per risk while also obtaining a new catastrophe cover for international CAT.

“We expect these enhancements and anticipated changes for the remainder of the year will substantially reduce our risk of future volatility,” Zaffino said.

“We've restructured the CAT reinsurance to include more aggregate cover. The attachment point dropped from $1.5 billion to $750 million with a corridor deductible."

AIG is also reorganizing its quota share programmes. "We're taking a full-year look at all of our reinsurance placements and so we've begun with property at 1/1," Zaffino said. "We are not going to continue with quota share in the US. We're going to look at a variety of different alternatives in terms of how we want to structure reinsurance in our international portfolio in casualty as well as in North America. So, we'll continue to give you updates as we revisit all of our reinsurance placements throughout the year.”

“In light of our reinsurance strategy and actions to manage the overall portfolio, we expect 2018 premium volume to be relatively flat with 2017 levels.”

Rates are improving

The general insurance operations in North America continue to face challenging market conditions in commercial lines, with excess capacity negatively impacting the rate environment and suppressing margins. Even so, AIG was able to achieve positive rate increases across a number of lines and sub-segments.

AIG anticipates a positive impact on market pricing for property following recent catastrophe activity, and observed progressive rate improvements throughout the fourth quarter of 2017.

“We are getting rate across multiple lines of business and US property is showing the greatest improvement,” Zaffino said. “The fourth quarter is seasonally our lowest quarter for US property and the rate increases have varied based on exposure, geography and the impact of recent events.

“Our primary objectives are to partner with our clients, provide solutions at renewal and offer alternatives for our new clients. As a result, recent retention has improved year-over-year,” Zaffino noted.

“Moving to other parts of the portfolio, in US Casualty, we observed rate increases in the mid-single digits, which had a wide range depending on line of business, attachment point and experience. We are maintaining a view on loss cost trends and taking rate to be responsive to our observations,” he said.

In casualty lines, rates are rising particularly in auto on a primary and excess basis. At the same time, AIG continues to observe higher loss cost trends in casualty, in particular excess casualty.

“We want to make sure that we're spending a lot of time thinking through loss cost trends for the casualty lines," Zaffino said.

“While the general insurance underlying accident year loss ratio improved year on year, we still have work that needs to be done across the commercial lines.”

“Last year, you saw the greatest impact from our remediation efforts in the North America Commercial, where accident year loss ratios began improving. In addition, in aggregate, fourth quarter North America Commercial claim trends have been favourable relative to our expectations,” Zaffino said.

The more profitable segments of commercial lines remain highly competitive, but AIG noted that it was able to achieve growth in several of its high margin businesses. Personal insurance growth prospects are supported by the need for full life cycle products and coverage, increases in personal wealth accumulation, and awareness of insurance protection and risk management. To compete in the high net worth market, accident and health insurance, travel insurance, and warranty services AIG wants to expand its innovative products and services to distribution partners and clients.

For its general insurance international operations, AIG expects the demand for multinational cross-border coverage and services to increase due to the internationalization of customers.

The commercial lines market is highly competitive particularly in Europe and the Asia Pacific region where pressure on rates is increasing due to rising market capacity, according to the annual report. Despite this, AIG continues to grow its most profitable segments across all regions. AIG is actively remediating its underperforming segments, maintaining underwriting discipline and continuing its risk selection strategy to maintain profitability.

“Our European Commercial business was impacted by reserve strengthening, adverse loss emergence and certain catch-up adjustments in the fourth quarter,” Zaffino said. “We took underwriting actions in late-2016 and the 2017 accident year has seen an early improvement in trend, but rate and risk selection is still required in these portfolios. We continue to work on remediating our book,” he added.

Internationally, in personal insurance, AIG focuses on individual customers, as well as group and corporate clients. Although market competition within personal insurance has increased, AIG continues to benefit from the low volatility of the short-tailed risk in the business. AIG expects its newly formed entity in Japan – AIG Sonpo – to provide the necessary scale and platform to compete more efficiently in the Japanese market. Outside of Japan, personal insurance continues to invest selectively in international markets, which AIG believes have higher potential for sustainable profitability.

Taking action

In February 2018, AIG closed a series of affiliated reinsurance transactions affecting the legacy portfolio. These transactions were designed to consolidate the bulk of the legacy insurance run-off lines into a single legal entity, Bermuda-based DSA Reinsurance Company.

“We formed a Bermuda-domiciled legal entity, named DSA Reinsurance Company Limited or DSA Re, to re-insure our legacy life and non-life runoff lines,” said AIG chief financial officer Sid Sankaran. “By combining these runoff lines into a single well-capitalized legal entity, we were able to achieve operating synergies and strong diversification in assets. Legacy remains non-core and will be managed by a team with extensive runoff expertise,” Sankaran added.

“Our objective with respect to DSA Re remains to efficiently manage our legacy liabilities, honour our policy and service obligations and maximize AIG's financial flexibility. The formation of this entity will allow us to accelerate these objectives,” Sankaran explained.

The composite run-off reinsurer is 100 percent owned by AIG. The transactions include the cession of approximately $32 billion of reserves from the legacy life and retirement run-off lines and approximately $5 billion of reserves from the legacy general insurance run-off lines relating to business written by multiple AIG legal entities. This represented over 80 percent of the insurance reserves in the legacy portfolio as of Dec. 31, 2017.

DSA Re will have approximately $40 billion of invested assets, managed by AIG Investments and will become AIG’s main run-off reinsurer with its own dedicated management team.

Following the close of the DSA Re transactions, Eaglestone Reinsurance Company will continue to reinsure the AIG property casualty pool companies for their asbestos liabilities and benefit from the retroactive reinsurance agreement entered into with NICO in 2011.

At the same time, Duperrault has started to transform AIG. On Jan. 21, 2018, AIG unveiled its plan to purchase Bermuda-based re/insurer Validus Holdings for approximately $5.6 billion in cash. The transaction enhances AIG’s general insurance business, adding a reinsurance platform, an insurance-linked securities (ILS) asset manager, a presence at Lloyd’s and complementary capabilities in the US crop and excess and surplus (E&S) markets.

Duperreault described the acquisition as “a significant step forward in our strategy to deliver profitable growth” as the company's business mix includes “well-positioned companies providing new sources of growth for AIG.”