AIG Management Proposal and Reserve Strengthening February 5, 2016

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1 AIG Management Proposal and Reserve Strengthening February 5, 2016 On January 26, AIG announced a series of strategic measures to create a leaner, more profitable and focused insurer. This new plan was released in conjunction with the announcement of substantial prior year reserve strengthening for its property & casualty operations, which equaled $3.6 billion (taken in the fourth quarter 2015). The announcement also included a plan to sell just under 20% of AIG s mortgage insurance operations via an initial public offering. All of this comes amid pressure to enhance shareholder value from a few activist investors, with the most discussed plan including a separation of AIG s mortgage insurance and life/annuity operations (whether through sale or spin-off), which would leave property and casualty insurance as AIG s primary business. Other more substantial proposals include a full dismemberment of AIG, selling or spinning off all the various operating units and possibly marking an end to the AIG brand altogether. AIG also stated that a full breakup in the near term would detract from, not enhance, shareholder value. Its reasoning includes the fact that current business diversification allows for less capital support than the businesses would need independently, and that a break-up would sacrifice substantial deferred tax assets. AIG management stated that their preferred actions would most efficiently leverage the company s sizeable deferred tax assets, and provide a return to shareholders of $25 billion over the next two years. The most important of the new strategic measures include: 1. Capital Return: AIG announced that it plans to return an aggregate $25 billion of capital to shareholders over the next two years. Management stated that this would be funded primarily through: o Divestitures (including the sale of AIG Advisor Group and partial IPO of its mortgage insurance operation), o Capital from subsidiaries (dividends and tax-sharing payments of an aggregate $7-$10 billion in 2016 and 2017), o o Life reinsurance transactions, Increased debt leverage (which assumes improved operating profitability and stable interest coverage levels). 2. Modular Structure: a new modular operating structure will create nine stand-alone business units, with each judged on its own merits. Further divestitures could be evaluated on results. 3. Expense Reduction: Reducing expenses by $1.6 billion within two years. 4. Improved ROE: Targeting a 9% after-tax ROE by Reallocation of Assets: Plan to monetize a significant portion of hedge fund investments, to reduce capital charges and increase projected distributions. ALIRT Insurance Research Page 1 February 5, 2016

2 This review will discuss the ability of AIG s insurance companies (both Life and P&C) to support the shareholder dividend requirements of the aforementioned capital return. I. Capital Return Management s statements allude to the potential that this strategy may be only temporary, as it qualified that any break-up would be a near term detraction from shareholder value. Management further stated that its new modular business structure would allow the company to: take public or sell units if they don t adequately contribute to financial targets, or it becomes apparent that they are worth more outside of AIG than within, or if they represent an efficient means of returning capital to shareholders. Management stated that the planned capital return to shareholders of $25 billion by the end of 2017 would be in the form of stockholder dividends and share buybacks. Per company management, the sources of AIG s projected capital return over the next two years are shown below in Exhibit 1. 1 Note that AIG returned $12 billion to shareholders (via stockholder dividends and share buybacks) in Exhibit 1: Because AIG s U.S. operating subsidiaries represent the vast majority of AIG s business operations, both in terms of assets and revenue, below we take a look at the profitability and capitalization of these subsidiaries to determine their ability to contribute dividends to the parent company over the coming years. 1 From AIG s: Strategic Actions to Maximize Shareholder Value: January 26, ALIRT Insurance Research Page 2 February 5, 2016

3 Operating Subsidiary Profitability and Excess Surplus U.S. Life & Property/Casualty AIG has streamlined (i.e., unstacked) all its U.S. insurance subsidiary structures over the past several years. These simplified groups now consist of: AIG has four (4) principal life insurers, which include American General Life, United States Life of New York, and Variable Annuity Life Ins. Co. These insurers are directly owned by AGC Life Ins. Company, an insurer that itself does not issue any insurance or annuities. AGC Life is in turn owned by AIG Life Holdings, Inc. which is directly held by AIG, Inc. The group has fourteen (14) property/casualty insurers within its commercial lines pool, though only five of these retain underwriting risk from the pool. Almost all of these insurers are subsidiaries of AIG Property Casualty U.S., Inc. which is directly owned by AIG, Inc. The mortgage insurance business comprises eight (8) mostly small insurers, almost all of which are direct subsidiaries of United Guaranty Corp., which is directly owned by AIG, Inc. Given that this group is a minor contributor to earnings and that AIG plans to sell a minority interest in this business via an initial public offering, we do not include them within this study. In the table on the following page, we show AIG s principal U.S. insurance companies for the life and P&C sectors, along with select financial information and five years of ALIRT Scores. Life Operations: The four life insurance companies, led by American General Life Insurance Company, comprise the majority of AIG s assets which is understandable given the long-tailed and leveraged nature of the life and annuity businesses. These companies also generate the majority of the group s revenues, which largely represent individual life, individual annuity, and group annuity business. AIG s four U.S. life insurers generated an aggregate $3.3 billion of statutory after-tax earnings first nine months of 2015 and paid $2.2 billion of shareholder dividends, which equaled 67% of earnings). In 2014, the AIG life insurers paid $9.6 billion of shareholder dividends (well beyond its earnings), though this was almost $5 billion above 2013 shareholder dividends. We also note the strong capitalization for the life insurers, which could allow for additional shareholder dividend payments without reducing capitalization to well below industry average. However, each insurer faces regulatory limitations on shareholder dividends from their state insurance departments. For AGC Life (the only AIG life insurer that can pay dividends directly to the parent), the regulatory limitations from the Missouri Insurance Department (AGC Life s state of domicile) limit annual shareholder dividends to the greater of 10% of prior year surplus or 100% of prior year after-tax earnings. Though insurers can petition insurance departments to pay extraordinary dividends (i.e. any amount above and beyond the regulatory limit), these petitions would have to be approved in advance by the requisite insurance commissioner. AGC Life has received approval from the Missouri Insurance Department to pay extraordinary dividends in previous years. P&C Operations: Five major U.S. property/casualty insurers generate the lion s share of AIG s property & casualty revenue, via reinsurance and an intercompany pooling arrangement for AIG s international P&C operations. Of these five insurers, the largest are American Home Assurance (AHA), Lexington Insurance Company (LIC), and National Union Fire (NUF), which are almost equal in size to each other. ALIRT Insurance Research Page 3 February 5, 2016

4 Select Statutory Data for U.S. Subsidiaries of AIG Data in $Millions - 9/30/2015 Shareholder Dividends 2014 Total ALIRT Scores NAIC Company Net Inv. Assets Total Assets Surplus Revenue A-T Earnings /2015 RBC Ratio / AGC Life Insurance Co. 14,828 15,399 8,805 2,909 1,810-4,738-9,560-2, % American General Life Ins Co.* 119, ,228 9,302 16, All Dividends Paid to AGC Life 512% U.S. Life Insurance Co. NY 22,965 28,130 2,055 2, All Dividends Paid to AGC Life 534% Variable Annuity Life Ins Co. 41,536 73,247 2,728 5, All Dividends Paid to AGC Life 601% Total Life 184, ,917 22,890 27,896 3,274-4,738-9,560-2, AIG Property Casualty Co. 4,393 4,855 1, % American Home Assr. Co. 22,121 25,577 6,437 4, , , % Commerce & Industry Ins. Co. 3,699 4,281 1,178 1, % Lexington Ins. Co. 21,492 24,674 6,002 4, ,875-1, % National Union Fire 22,589 25,948 6,373 4, ,328-1, % Non-Participation Pool Subs 2,834 5,998 2, Total P&C 74,295 85,337 21,452 16,853 2,823-8,888-3,876-3, United Guaranty Resdl Ins Co. 3,327 3,535 1, N/A Other Mortgage Insurers 1,210 1, Total Mortgage Insurers 4,537 4,810 2, Totals U.S. Life & PC (Statutory) 263, ,064 46,553 45,458 6,409-13,646-13,436-5,655 Total AIG (GAAP)** 346, ,985 99,619 44,496 4,037 % U.S. Stat/AIG GAAP 76.1% 71.1% 46.7% *In December 2012, American General Life was merged with other 7 AIG life insurers, including American General Life & Accident, Western National Life, and SunAmerica Life & Annuity. **For AIG Totals, the "Surplus" column figure = GAAP Total equity ALIRT Insurance Research Page 4 February 5, 2016

5 $ Millions 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, Over the last several years, AIG s U.S. P&C insurers paid shareholder dividends that exceeded their statutory operating earnings, though this was due in part to a substantial restructuring of AIG s P&C intercompany pooling arrangements in The following items could affect the shareholder dividend paying ability of the U.S. P&C insurers: 1. Operating earnings improved over the past several years and in the first nine months of 2015, due in part to low catastrophe losses and the positive impact of price increases especially in the period. However, our analysis of the U.S. P&C industry points to a possible plateau of profitability in the current cycle, which could lead to more competitive (i.e. flat/lower) pricing environment in coming years. Other challenges include a reversion to the mean on catastrophe losses, and the continued very low interest rate environment, which hampers investment income. Prior Year Reserve Development (5 Major AIG U.S. Commercial Line Insurers) /2015* 2. Reserve Increases: The positive earnings trend referenced above was tempered by AIG s recent announcement of substantial reserve strengthening in the fourth quarter 2015 ($3.6 billion). This is the seventh consecutive year that AIG s has strengthened reserves for its U.S. commercial lines insurance business, and as shown in the graph, the 2015 increase is the highest in the last five years. 3. Ratings: The chart below shows the current public insurance financial strength ratings for AIG s insurance companies. While S&P and Fitch did not change their ratings or outlook, Moody s downgraded its ratings for AIG s P&C insurers one notch to A2 (6 th highest, and now equal to the Moody s rating for AIG s life insurers). * Full year estimate, including the recently announced $3.6 billion charge. Most importantly, A.M. Best placed its A (3 rd highest) rating for the AIG U.S. insurers Under Review with Negative Implications. A downgrade to A- could affect AIG s ability to sell its products in certain distribution channels, which could impact its life insurance, annuity, and/or property/casualty insurance businesses. Ratings of AIG Subsidiaries - February 4, 2016 Moody's S&P Fitch A.M. Best Rating Outlook Action Rating Outlook Rating Outlook Rating Outlook Action Life Insurers A2 Stable A+ Stable A+ Stable A Under Review Negative P&C Insurers A2 Stable Downgrade A+ Stable A Stable A Under Review Negative United Gnty Residential Ins Co. Baa1 Watch Neg. A Watch Neg. N/R N/R 4. Risk-Based Capital Ratios. Both Lexington Insurance Company and National Union Fire Insurance Company had relatively low risk-based capital ratios (201% and 194% respectively) at year end 2014, while the ratio for American Home Assurance Company equaled 223%. These ratios were below the 2014 ALIRT Commercial Lines Composite RBC ratio of 282%. Management stated that it will manage its P&C insurer RBC ratios at between %, and that additional funds ($3 billion) would be infused into certain carriers in the fourth quarter 2015 to ensure this. ALIRT Insurance Research Page 5 February 5, 2016

6 5. Broker and Client Concerns: Per client commentary to us, institutional distributors and purchasers of property/casualty insurance have increasing concern about AIG, in light of the sizeable reserve increase, potential rating downgrades, and perhaps especially the uncertainty surrounding AIG s future business profile. Divestitures As noted in our introduction, AIG has announced that it plans to spin off approximately 20% of its mortgage insurance operations, United Guaranty Corp. (UGC), in an initial public offering, a first step towards the full divestiture of this business. AIG s Advisor Group will also be sold, with a target close date of the middle of this year. While these organizations are small relative to other parts of AIG, any proceeds from these transactions could aid in the upstreaming of funds to shareholders. But could there be more divestitures coming? ALIRT has witnessed a number of ownership changes in the life insurance space over the past five years 2, including Hartford Financial s exit/sale of the majority of its life and annuity operations in 2012/2013. The Hartford transaction has parallels to AIG, given that it was driven by activist investors who wanted the group to concentrate on the property/casualty insurance side of its business. The fact that some of the same activist investors are involved in discussions with AIG is not lost on us. However, no two situations are exactly alike and there are significant differences between the companies, most notably that the operational performance of the AIG/American General life insurance and annuity businesses is much stronger than that of the Hartford life and annuity operations in the years preceding their transaction in As discussed, AIG s recent announcement to divide its operating units into autonomous modules could make future business/unit sales easier to both justify and execute. Conclusion AIG s announced actions are defensible, given shareholder pressures on one hand to take dramatic action and a natural urge by existing management to move more deliberately, as well as significant deferred tax assets in place for AIG that could be jeopardized with a full separation. The good news is that AIG s life insurance and annuity companies are in relatively good financial shape. While secular pressures in the life insurance market such as the impact of volatile equity markets, low interest rates and an anemic economic recovery have impacted revenue growth and earnings and resulted in lower ALIRT Scores over the past several years, all of AIG s life insurers still outperform life industry averages. We will closely monitor the impact of AIG s strategic decisions on the operating profiles for the AIG insurance companies we follow for clients, including but not necessarily limited to future shareholder dividends paid to the parent. As for the P&C insurers, ALIRT Scores for the five principal entities remain well below the commercial lines composite average but at least are not deteriorating (with the possible exception of Lexington Insurance Company). However, the weaker financial performance (as exhibited by the lower ALIRT Scores) indicates that the P&C insurers may have less flexibility to support the group s desire to boost shareholder returns through dividends and share buy-backs. Finally, the large reserve strengthening announced could affect the P&C insurers capitalization and earnings as of year end 2015, though management has stated that it will infuse capital as necessary to keep risk-based capital ratios are reasonable ( %) for each of the major P&C companies. 2 Other instances include the sale of Sun Life s U.S. life and annuity business, Aviva U.S., Lincoln Benefit Life, and more recently MetLife s plan to separate its retail life and annuity business. ALIRT Insurance Research Page 6 February 5, 2016