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This 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.
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All opinions expressed by hosts and podcast guests are solely their own opinions.
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This 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 US government, 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 Zefino's leadership, AIG has refocused its underwriting efforts, returning to profitability while divesting non -core businesses, including the demerger of its life insurance arm, Corebridge.
The 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 enjoyed 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' 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.
Great, 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.
And 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.
And 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.
And eventually that growth led them to start to use their scale to diversify into some other areas.
And to me, that's the tail 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 ensuring 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.
And 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.
And they had basically a call in 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 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.
So 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 shareholder letters over the years, he always has a section there on insurance and he talks about insurance as being a business of promises.
An 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.
So 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 under price their product, they're likely to get adversely selected against.
And what I mean by that is there are insurers 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 missed prices 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 gonna get the median outcome because it's not great.
Returns on capital are in the neighborhood of eight to 10 % typically.
But 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 wanna 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.
And 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 express 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 did 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.
Yeah, 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 gonna 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 continue 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.
You 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.
And the team that came in, which was Brian Duperot, 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 Zafino as his number two, who was 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 and 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 under priced business.
They took that risk off the table and 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.
Between 2018 and 2020, they essentially re -underwrote the entire book of business.
Meaning every year that business came up for renewal, they were re -pricing 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 and the insurance market about 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 optimize for what they wanted in terms of a top quartile business going forward.
And at that time, they still owned a large life and retirement business.
They had a re -insurance 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 longterm.
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 re -insurance and crop business.
And then they sold a small personal lines business, the travel business, and they put the high net worth business, personalized business, which was a homeowners business in the United States.
They put that into a JV and they are going to start moving that off of their balance sheet to someone else's balance sheet.
And they are left now today after all of 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.
It 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.
And 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.
Now I think that's the right economic move.
Without doing it, the downside was much more severe for them.
And so getting this off the table, even if it requires some near -term pain, is a positive MPV 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.
So these liabilities are gonna 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 of 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 insurer 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.
They 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 cleaned up and refocused the business today.
The bond validus very early on in Duperrault's time as CEO.
And I think if you ask Peter Zafino, 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.
And 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 Zafino 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 validus 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.
And 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.
I 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 Dubrow 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.
The most notable being they had a very large deferred tax assets.
And it was gonna 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, you 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 Zappino, 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.
It'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 Zappino 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 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.
And 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 at Corebridge that's fully on 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.
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?
Great, 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.
If 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 gonna be utilized in the next three to four years.
So those are pretty close to valued at what I think is a fair price for those DTAs, just the face value.
And so if you back those out of the market value, you've got a pretty low price for AIG relative to a lot of its peers.
So when you look at the footprint and what AIG is focused on in that core PNC business, I've mentioned many times already during this first 30 minutes, the focus on specialty lines.
And what I mean by specialty lines, when I say that, this is a term that gets thrown around amongst insurance analysts all the time, usually without a lot of definition around it.
And what I think that really means and what's helpful about that term is it means lines of business that require real underwriting expertise.
They are difficult to standardize.
They often require individual structuring.
And you can think about lines like marine, like aviation, like excess and surplus lines, where several of the traditional admitted insurance markets have basically rejected that risk because they don't know how to underwrite it.
And that gets kicked into the excess and surplus lines market.
And that makes up the bulk of the commercial lines business, those specialty lines at AIG today.
AIG's commercial lines business is about 75 % of the total of that 24 billion, and it's split roughly 50 50 between international business and domestic business.
And AIG is one of a few large insurance companies that do have a true global footprint on the commercial side.
In addition to that commercial business, AIG has a couple of niche personal lines businesses.
I talked a little bit about what they are doing with their high net worth business, which is they're basically moving that to more of an excess and surplus lines business.
And they're moving it to a JV where they are taking some of that on their balance sheet today, but over time, more and more of that will move off of their balance sheet, and it'll be more of a fee business for AIG.
And then they have an accident health business internationally that is a very unique business.
And you can think of this as basically supplemental health products, think about what Aflac does in the United States.
And you have some similar types of products internationally for AIG that have been very, very successful over time.
So AIG today, again, a large insurance company with about $24 billion of premiums, about $31 billion of tangible net worth for the core PNC business.
And I expect over the next several years that that company will move from being close to a 10 % return on tangible equity business over the last year or so to something that's closer to top court by returns, which would be in the teens for returns on tangible equity.
And that's what I would expect over the next several years.
And when you look at an insurance business, obviously as an analyst, you have the ability to invest in any public company that fits the mold.
What do you look for to differentiate a business?
How do you think about comparing and contrasting these businesses?
Because we see a clean package, consolidated group of financials, but it's tough to get a better appreciation for what is actually in the portfolio.
And I'm curious how you go about doing that research.
Yes, insurance is a daunting industry for a lot of investors because the accounting is somewhat complex.
And even if you study the accounting for years and understand it backwards and forwards, you still can't get around the challenge that the largest portion of your liabilities are an estimate.
And so even on the investor side, there's this huge element of trust that goes into investing in an insurance company.
And I rely on many of the same things that I talked about that a customer would look for, or when they think about doing business with an insurance company, I look to a lot of the same things.
I look for a very long track record for insurers of having conservative balance sheet.
And then I look at the people involved more than anything else.
Insurance is an industry where managerial talent has a disproportional impact on the outcomes.
And so if you can get a company where you see a long track record of conservative behavior and a management team that you really trust, that's really more important than a lot of the accounting that you can dig into because again, at the end of the day, it is just an estimate.
So we'll look at things like the consistency reserve releases as evidence that you've been conservative over time in how you estimated your cost years earlier when they were originally underwritten.
And you can see a huge shift at AIG over the last five years to the point where we've had consistent reserve releases over the last three years at AIG every single quarter compared to that period from post -financial crisis to 2017 where we had billion -dollar charges that came up on multiple occasions.
And I would say AIG still probably has a long way to go to build up the decade type of track record that will really get the type of premium valuation in the marketplace.
But I also think you have to consider the management team.
In AIG, I think today, we have one of, if not the best management team in the industry.
And I think they have proven in terms of how they have methodically shifted the underwriting at this business.
That they are focused on the right things, which is underwriting skill over the long term.
One other point here just on how I think about as an analyst, what's important for an insurance business.
I've referenced several times that people shouldn't be too interested in owning the median company in the insurance industry because it's not a great result.
And so I think you really have to think that you have identified a top quartile business or again, a company that's gonna move to that top quartile.
And when I think about competitive advantages in the insurance industry, there's two paths you can take to having a competitive advantage that allows you to deliver that types of returns.
And there's parallels actually to the asset management industry in these two paths.
The first path is for companies that deal with more standardized risks.
Think about personal lines and auto insurance or homeowners insurance or some small commercial policies.
These are granular policies that are pretty easy to standardize.
And for those types of businesses, the competitive advantages that really dominate are scale advantages.
And it's companies like Progressive and Geico where you've been able to scale fixed expense base and go direct consumer.
And so your advertising expense is a fixed expense and as you get more and more customers, your per customer cost of acquiring goes down and down and down compared to other business models.
And that's been massively successful over the last couple of decades.
And at a smaller scale, you have companies like Hartford within small commercial have had similar success with investing in technology to make it much easier for their agents to use them.
So that's the distribution advantage, but it's a scale advantage for standardized products.
At the other end of the spectrum, you can think about companies like WR Berkeley or Berkshire Hathaway or Arch Capital.
These are top quartile, especially underwriters and they operate in sections of the market where it is very difficult to underwrite and they are either competing with people who are not as skilled or with very few other competitors because it takes real underwriting talent and database of history to
know how to underwrite these risks.
And I'm talking about marine aviation, excess and surplus lines markets.
And these are the markets where culture and managerial talent makes a huge, huge difference over time.
And it also happens to be lines where you have to have the discipline to walk away from business where it's mispriced.
And I go back for this example, Berkshire Hathaway and its 2004 annual letter, Buffett put a table in that letter that was called Portrait of a Disciplined Underwriter.
And it was a track record of National Indemnity's underwriting history over two decades.
And what you saw in that track record is National Indemnity was very, very profitable over those two decades, but their premiums, the amount of business they wrote went from tiny amounts and grew rapidly when pricing was good, but then shrunk dramatically when pricing was bad.
This is an unnatural and very difficult decision for a lot of companies to make.
And that's why you need that culture of underwriting and managerial talent.
And I would describe those competitive advantages based on culture and managerial skill as more fragile than the type of advantage that a progressive or a GEICO has, but they can also be wildly profitable during periods of time.
And so when I think about those, what I'm looking for, it's one of those types of competitive advantage.
And I think AIG is making its way to having one of those specialty advantages built on managerial talent and culture of underwriting.
And that's where they're gonna get.
Again, I think you can think about this similar to our industry, the asset management industry, where you have scale advantages for the index type players in our industry.
And then at the other end of the scale, you have the more niche players that are focused on true active management within domains where they have some expertise and you can't outperform all the time and you have to have the discipline to stick with what you do well throughout a cycle, but you can have wild
success during the right environment.
And so when you were citing some of those examples, you spoke to what is a quote unquote good pricing environment versus a bad one.
And when I reflect upon insurance in some ways, if you want to grow an insurance business, you can write more insurance.
And if it's priced poorly, you're not gonna make money, but your book will grow.
And obviously that's the wrong decision.
What is it that dictates the pricing environment and how do these companies decide whether to go forward in writing this policy or not?
Well, there's lots of things that impact it over time.
It is definitely a cyclical industry and a lot of cyclical industries, the thing that dictates the pricing environment is the supply side of the industry and the discipline in the industry around maintaining capacity at a level that's consistent with demand.
And one of the issues you get in very cyclical industries, if you think about the semiconductor industry, just as an example, you get significant inventory supply shocks or you get too much inventory in the channel and you have to wash it out of the channel.
And that leads to some discounted pricing and very cyclical results over time.
If you think about the insurance industry, it's really not that different in that you are pricing your product today, you don't know exactly what the costs are gonna be for at least a couple of years for commercial insurance.
And so as that new information comes in, you have to revise your expectations about what the right price is for your business.
And if you end up being wildly wrong on some of that business you wrote two years ago, you all of a sudden the whole industry needs to price up because you have a hole in your balance sheet that you have to recover from.
And so one way to think about that is that capacity comes out of the industry when you realize that you misprice because your equity goes down, you have to revise those liabilities up.
Tangible equity is the true capacity in this industry.
And when that comes out, you have to price up.
What's been interesting about this most recent pricing cycle and we've had very favorable commercial pricing from about 2019 through 2022.
It's faded a little bit, but still above loss cost inflation.
And one of, I think the huge catalyst for pricing getting better is the fact that AIG, who is one of the largest players in the industry, removed capacity from the industry.
AIG, one of the things that I think is less well understood about what AIG has done over the last few years is that people will see the underwriting margins and the dramatic expansion over the last few years, but that's been done while reducing the amount of limit that they offer to the market and limit
being just the amount of total coverage that they offer in the marketplace.
And AIG's reduced the limits they offer by a trillion dollars, more than a trillion dollars.
That's a massive, massive amount.
And so that is pulling capacity that was in the market out of the market.
And it's forcing everyone to price up as AIG's leading the market and pulling that capacity out.
And so I think the simplest way to think about what drives pricing is it's this lagged effect of knowing your cost of goods sold combined with fluctuating capacity that's in the market.
And that capacity is loosely related to that cost of goods sold, but in this most recent cycle has also been driven, I think notably by the discipline that AIG's had about reducing some of its limits.
We spent a lot of this conversation talking about how they underwrite policies and assess risk and taking volatility out of the business, but less so on what they do with their assets.
A lot of generalist investors tend to obsess over how insurance companies redeploy their float.
But presumably AIG takes a more basic approach here.
Is there anything important about their investment portfolio and how they redeploy that capital?
As you point out float is basically the money you get upfront from premiums that is eventually gonna get paid out as claims, but you get to hold it in the meantime and invest it.
And for insurance companies, depending on the duration of that float, how long it's gonna take to pay out those claims, receive those claims over time, they can invest that float in some combination of high -grade bonds to try to match the duration of those liabilities, or in some cases, a more exotic
type of investments.
In the case of Berkshire Hathaway, they've owned significant amounts of equities over time that have helped to drive the returns over the long -term and drive book value growth, which is a very important metric for thinking about value creation for an insurance company.
For the most part, insurers are bound by their regulator to invest largely in high -grade bonds.
And what I think is most important to know about AIG is that AIG had taken some more significant risks on the asset side of the balance sheet in the past.
One of the things they have done over the last few years is to really reduce that risk.
And they have a much more plain vanilla investment portfolio today.
It is largely outsourced to BlackRock at very, very low cost.
And this is one more example of where Peter Zofino and his management team have been very methodical in thinking about what are the activities that really drive value for AIG where we have competitive advantages, and what are the activities where we don't think we have a real advantage and where we
can outsource that at much lower cost.
And the asset side of the balance sheet is one of those places where they have increasingly tried to minimize the cost and have a plain vanilla portfolio.
And what that means in terms of the value creation is more the value creation is coming from the underwriting side of the business, the underwriting margin, and that's where you really should focus your time as an investor because that's gonna determine whether this is a real success over the long term
or not. It's not gonna come as much from the asset side of the balance sheet for AIG.
There are certainly some companies like Berkshire and Markel where the asset side can be a meaningful driver.
That is not going to be the case for AIG.
Throughout the conversation, you've mentioned some of the competitors and adjacent insurance businesses, but are there true comps from a competitive perspective that you would watch and study in order to learn more about how AIG's business is performing?
Yes, there definitely are.
I think Chubb is the most notable in that if you look at Chubb, which of course Chubb was a standalone company for decades and one of the most respected insurance businesses in the world.
It was acquired or merged into ACE, which is coincidentally run by Evan Greenberg, the son of Hank Greenberg, who was well known leader of AIG for decades.
And Chubb has a business mix that is not perfectly similar to AIG, but is a pretty good comp.
And so I would look at the property and casualty insurance business of Chubb.
They are a great insurance company, very highly respected.
Again, I don't think it's any coincidence.
Berkshire Hathaway took a pretty large position in Chubb recently.
Other companies I would look at that I think AIG is going to start to look a lot more like are WR Berkeley.
It's a smaller scale business, but WR Berkeley has had very good results in specialty insurance without the type of catastrophe volatility that you've seen from some companies and you saw from AIG historically.
And Arch Capital would be another one.
Arch Capital is a little bit more skewed towards reinsurance, but they have that same type of specialty lines discipline and underwriting focus that I think AIG is focused on for the longterm.
And so to bring it all together and take us home, we have our customary concluding question regarding lessons learned from the AIG story that you can apply to other investment areas.
And also from an operational perspective, some of the things that AIG has done that can be taken as lessons and applied to other investments.
Just curious your take on how you think about this one and what lessons are ultimately learned and watched here.
To me, the big lesson for AIG and what they've done over the last few years is a lesson about turnarounds.
And I think that maybe the most important thing to remember about turnarounds is they're not twice as hard as you think they are.
They're like 10 times as hard as you think they'll be.
And that is true for all turnarounds, but it is especially true with a financial company where you have a large balance sheet and essentially an enforced book of business that is really hard to shift on a short time scale.
And so it takes years to fully re -underwrite a book of business like AIG had.
And in order to believe that you're gonna have success with a turnaround like that, you have to be unbelievably confident in the management team and their conviction around taking short -term pain in order to get to a long -term payoff that's worthwhile.
And again, you have to frame an investment in a company in the insurance industry within the context of the overall industry and what the returns are likely to be.
And when you look at the industry, you're not likely to get a good outcome if you're just playing for a company to get up to medium in the industry.
It's just not good enough.
And it's not worth the effort and the pain that's involved with a turnaround.
You have to really deeply believe that you have the right people involved to get you to a top quartile type of performance.
And to me, the reason I've been more and more convicted in this idea is listening to and watching the actions of Peter Zaffino and his management team over the last several years.
And it's the critical factor that I think takes this from a turnaround where AIG moves from something that was a total disaster to in line with the industry.
And instead, I think we're gonna get something that's much better than that.
And it's largely because of my conviction around the management team involved in turning AIG around.
But I think ultimately this is a lesson around turnarounds.
And I've tried to, we've had some success in a couple of turnarounds, Hartford was another one.
And I think the big thing in both of those cases is that you really, really have to believe that there's a crown jewel that the management team recognizes and is going to make shine for everyone in the market over a period of years.
Well, explaining the depths of an insurance company as large and complex as AIG in less than an hour is not an easy task.
So I appreciate you in giving that a go.
This has been a fascinating story and it seems like a business that's moving in the right direction and we appreciate your time.
Thanks Zach, it was great to be on.
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