Monday, March 20, 2006

AIG Review Continued

AIG reported not once but twice on Thursday with its current 10-K for the 2005 year and its amended 10-K for 2004 which restated results for the last several years. The best news of all is that at least AIG managed to bring its filings up to date and on time for the current year despite a lot of sturm and drang.

There is some sense of relief as I went through these numbers that the good ship is back on course.

The company’s reserve additions should provide some sense of comfort rather than alarm. Bringing in an outside insurance actuarial consulting firm provides additional credibility to a management that has had an exceptionally tough year. Between hurricanes, regulatory issues with Mr. Spitzer and the NY Dept of Insurance, and the ongoing issue of Mr. Greenberg, the company has essentially remained on course.

This is a very diverse business. General insurance represents about one-third of the business of which roughly one-third is foreign general and one-third is domestic brokerage.

The Life Insurance segment is almost half of the total business of which 50% is the rapidly growing foreign life segment that includes “hot” markets of Asia

The remainder of the business includes International Lease Finance (ILFC) the aircraft leasing operation (less than 5% of total) capital markets, asset management, consumer finance, etc.

The $1.64 billion settlement with the Department of Justice, the SEC, the New York Attorney-General, went through the fourth quarter result and is now behind the company. Remember, the company neither admitted nor denied any of the DOJ charges.

Because of the higher growth aspects of its international markets (totaling about 1/3 of the total) AIG should be able to offset the inherent cyclicality of property and casualty business. The reserve strengthening also took place at a time when the operating results contained a lot of noise and consequently, should provide for much cleaner results as time goes on.

What question marks remain? There remain some lawsuits alleging conspiracy between insurance brokerage firms and insurance companies regarding contingent commissions and bidding practices. There remain some lawsuits regarding accounting treatment of non-traditional insurance product. Finally, there is the matter of Starr. Starr International is a private Panamanian firm that holds 12% of AIG's shares and has represented, at least historically, another means of providing compensation to retired AIG executives. There are suits and counter suits between AIG and Starr alleging unjust enrichment as well as breach of contract and breach of fiduciary duty. Still somewhat ugly for me to read, but more importantly, these matters are not materially dire to the company’s long term health, at least in the judgment of management.

C.V. Starr and Company appears to have sold 5 million shares of AIG earlier this month but retains some 23 million shares.

The auditor’s statement references the internal controls that were lacking in the past which allowed the former CEO and CFO to influence certain reconciliations and thereby achieve “desired accounting results.” Most of these issues have been addressed fully, but some issues remain:

“As of December 31, 2005 and as described under Remediation of Material Weaknesses in Internal Control Over Financial Reporting below, the material weaknesses relating to the control environment and controls over the evaluation of risk transfer were remediated, and the material weaknesses relating to controls over certain balance sheet reconciliations, controls over the accounting for certain derivative transactions and controls over income tax accounting remained, as they were not fully remediated.”

Overall, the company appears to be recovering from this “year from hell” and appears to much chastened in its attitude toward disclosure. A few clouds remain, but these should dissipate soon, in my opinion.

Though the valuation is not exactly rock bottom cheap at 260% of tangible book value, for its current 13% ROE, my sense is that the company should return to a more normal 17-18% return on tangible equity within the next year or two.

Buried somewhere in the noise of last year as well is a notion that the company is reviewing its capital allocation methodologies which could well result in some restructuring of the core businesses that may cause us all to re-examine the shareholder value improvement that is feasible here. This review probably awaits further clarification of the remaining legal issues as well as restoration of complete confidence in internal controls.

I, my family, and clients own a position in this security.


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