Good day, ladies and gentlemen. Welcome to today's American International Group's first quarter financial results conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ms. Elizabeth Werner, Head of Investor Relations. Please go ahead.
Thank you. Before we get started this morning, I'd like to remind you that today's presentation may contain certain forward-looking statements, which are based on management's current expectations and are subject to uncertainty and changes in circumstances. Any forward-looking statements are not guarantees of future performance or events. Actual performance events may differ, possibly materially, from such forward-looking statements. Factors that could cause this include the factors described in our first quarter 2012 10-Q and 2011 10-K under Management's Discussion and Analysis and under Risk Factors. AIG is not under any obligation and expressly disclaims any obligation to update any forward-looking statements, whether as a result of new information, future events, or otherwise. Today's presentation may contain non-GAAP financial measures. The reconciliations of such measures to the most comparable GAAP figures are included in our financial supplement, which is available on AIG's website, www.aig.com.
Before we go through the results, I want to remind you that we adopted the new DAC standard on a retroactive basis. Therefore, all prior period numbers in the 10-Q and financial supplement have been revised. In addition, we plan on filing a Form 8-K to recast our 2011 Form 10-K later today, also to reflect these changes. Now I'd like to turn our call over to our CEO, Robert Benmosche.
Thanks, Liz, good morning, everybody. I want to be brief because I want to leave time for David, Peter, and Jay as they go through their parts of the report. The most important message I think that comes out of the first quarter of 2012 is the strong organic growth of this company and the strength of our insurance businesses. I think you can see with that performance alone that we're well on our way to achieve our aspirational goals. We're gaining more and more confidence that we can continue to grow effectively, and grow profitably. However, there's some other things that happened in this quarter, which I think are monumental. First is the fact of our ability to monetize non-core assets. As you saw, we sold another $6 billion of AIA as well as our Blackstone interest.
This is important because it allowed us to do a lot of things in the first quarter that gives us financial flexibility as we look to the future. For example, we were able to buy $3 billion of our shares when the Treasury made their offer in March. That's significant in my mind because one of the debates we have is the overhang and what effect the overhang has on our company. Conventional wisdom has been as long as Treasury has a large position, $29 is probably the ceiling for the stock. We believe that our performance, and we keep growing this company the right way, we believe that earnings will actually be what determines the value of this stock. I think our performance since then has demonstrated that, at least the market has shown that.
In addition to that, confidence in our company is growing when you look at our CDS spreads and where we are today, in fact, in the 190s. That's all part of how the market is reacting to what we did in March. Also, we were able to pay down the SPV of $8.6 billion. Now we are free to deal with other non-core assets as we go forward. We still have AIA's position. We are still looking to find the right time to do an IPO for ILFC. You can see that the Federal Reserve has started to sell down the Maiden Lane III portfolio. Beyond capital management, which is important, but it's the core results of this company which is more important.
If you look at Chartis, we see loss ratios improving, we see rate coming in, we see a better mix of our business. Keep in mind that, we sometimes forget it, when it comes to the insurance business, it takes time to see these improvements emerge in our financials. We had lower CATs, which is good for the quarter. More importantly, as you see our reserves continue to have modest movement, where the movement this quarter was about one tenth of 1%. When you consider the size of those reserves, that's nominal. We really have had five quarters now of very good performance there.
I know some people are still concerned about the reserves, that's why we're doing everything we can to provide you as much information as we can so you can see in a transparent way what we have and what we're dealing with. Sun America continues to do well. You see the investment results are stronger as we invested that cash and keep reinvesting cash effectively. More importantly, you see positive cash flows again in their various products. Variable annuity sales are up. The good news is we have a very well-positioned product. It's not aggressive in any one feature, we're very balanced in the features that we sell. We feel confident we're going to continue to see good growth, and Jay will talk about that.
Of course, as you look at just the delinquency ratios and so on down the line, you see at UGC, those are improving as well as our new business is growing, and we're growing with our new Performance Premium algorithm, which means that we're putting very good business on the books as we grow that. In fact, they made a profit in the first quarter of this year, so that's a good business for us. Overall, all of our businesses are profitable. We're continuing to grow. We see growth improving over time, and our performance will improve over time. What I'd like to do now is turn it over to David, who will take you through the numbers.
Thanks, Bob, good morning, everyone. In summarizing the quarter, the key theme that I would like to highlight is our continued execution around the drivers of value creation for our various stakeholders. We continue to execute on the core insurance growth opportunities across the franchise, just a few examples I would cite include
Chartis, as it continues to successfully grow the consumer business, which was 41% of net premiums in the quarter, up from 37% a year ago. Chartis continues to drive for rate, particularly in the commercial line. SunAmerica is benefiting from a more favorable variable annuity market that Bob referenced, they also continue to be very disciplined in spread management. United Guaranty continues to grow faster than the industry and pricing targets on their new business in excess of 20% return on their equity. We continue to execute on capital management, as Bob referred to, including our share repurchase, sales of non-core assets, a $2 billion debt offering. We paid the SPV, which unencumbered, importantly, several billion dollars worth of non-core assets that enhance our financial flexibility. Lastly, we continue to execute on preparing for Fed readiness and for Fed oversight.
Consistent with our comments last quarter, we still estimate that our Tier 1 common equity ratio under the Fed stress test is still close to 8%. We have a very large team of people focused on preparing for Fed oversight, including several subject matter experts. We're preparing as though AIG will likely be designated SIFI and held to a standard that can differentiate us and provide additional security to our many stakeholders, including our policyholders, our bondholders, and our shareholders. Now what I'd like to do is just step through the next couple of pages very quickly. If we turn to page four, you can see that our after-tax operating earnings were $3.1 billion, up almost 48%, or $1.65 per share, which was up 23% from last year's $1.34. Average shares outstanding a year ago reflect the recap that we completed in mid-January.
Book value per share grew 30% to $57.68 or $53.85 ex-AOCI. Contributing to that was the DTA valuation allowance that we released in the fourth quarter. We had share repurchases and again, our continued strong earnings growth. We had earnings in our investment in AIA and ML3, which I will comment on more in a minute. We also had our spreads narrowed by some 275 basis points in the quarter, which drove a mark-to-market or fair value CVA adjustment on the debt that we marked to market of about $580 million. In the quarter, we also, on a GAAP net income basis, had a DTA valuation allowance release of about $180 million related to utilization of SunAmerica capital loss carryforwards that resulted from some capital gains. Let's turn to page five.
Chartis operating earnings were over $1 billion and included catastrophe losses of about $80 million versus $1.7 billion a year ago. SunAmerica's $1.3 billion of operating earnings reflected favorable investment spread and importantly had a very strong spread management effects. United Guaranty was profitable in the quarter and saw a further decline in delinquency rates to 11.4% and also importantly, average gross reserves per delinquency is still around $29,000. Non-core assets remain a compelling source of value for AIG. ILFC had pre-tax income of about $119 million in the quarter, relatively flat from a year ago. ILFC raised over $2 billion in the quarter, proceeds of which were used to reduce interest costs, eliminate a bank facility that had change of control provisions, and to improve their liquidity.
AIA earnings included about a $580 million gain on the sale of the shares that we actually sold and another $1.2 billion in unrealized appreciation. Maiden Lane III had about a $1.3 billion increase in fair value as a result of credit spreads. Our first quarter effective tax rate was around 25%. That's a little lower than usual. It also was lower than the 35% statutory rate, in part because of the tax-exempt interest and the valuation allowance on the DTA on capital gains. Our first quarter operating income effective tax rate was about 30.8%, up from a little over 24% a year ago, in part due to a higher level of income on things like AIA or ML3, which attract an operating tax rate of 35%. That compares to more modest levels of tax-exempt interest on our munis. Let's turn to slide six.
Our approach to capital management is fairly simple: be ready. We are opportunistic in our sales of AIA and Blackstone in the quarter. We believe that it's absolutely critical to be ready when market opportunities present themselves. We have a solid foundation to build upon. Our leverage ratios remain strong at 18.7% of debt and hybrids to total capital. Let's turn to slide seven. You can see the carrying values of the remaining non-core assets aggregate in excess of $20 billion that enhance our overall financial flexibility. We note that the potential gains would be offset by our NOLs, thus utilizing or realizing the cash benefits of our DTAs. Let's turn to slide eight. You can see that the parent company liquidity exceeded $12 billion. That reflected the $3 billion in share buybacks in the quarter.
In the first quarter, SunAmerica's dividends and note repayments to the parent totaled some $1.6 billion, that contributed to the SPV paydown. Chartis contributed over $1 billion to the parent as well in the quarter. Ratings remained stable and our year-end RBC ratios exceeded our CMA requirements of 350% for Chartis and 435% for SunAmerica. In the aggregate, across Chartis U.S. and the SunAmerica companies, the amount of capital AIG is required to hold in the operating companies to meet the regulatory and rating agency requirements has not changed materially from 2011. AIG's expected annual dividends from our operating companies is still in the $4 billion to $5 billion per year.
In conclusion, again, I just want to highlight the theme of continued execution in our results, both capital management, operating improvements, and our march towards our aspirational goals of a 10% ROE by 2015, which we remain committed to. At this point, I'd like to turn the call over to Peter for comments on Chartis.
Thanks, David, and good morning, everybody. I got some slides on Chartis, but I want to just give you an overall view of the quarter. First quarter results reflect meaningful progress towards increasing the intrinsic value of our business. I'm pleased to report that we're very much on track with regards to our five-year plan. The current accident year loss ratio improved by several points from the effects of more profitable portfolio mix, stronger pricing, and enhanced risk selection. For the fifth consecutive quarter, reserve development was equal to or less than 0.1% of Chartis' total reserves, which were $67 billion as of quarter end. Catastrophe losses were immaterial at about $80 million in the quarter. The expense ratio increased, but that was consistent with our expectations as we grow higher value, less capital-intensive businesses, which cost more to acquire.
As we make strategic investments in talent and infrastructure. These investments are necessary to strengthen our competitive position and are expected to ultimately yield significant savings in the future. Turning to slide nine of the presentation, it details Chartis' underwriting results and pre-tax operating income for the quarter. Chartis' accident year combined ratio, excluding catastrophes, was 100.4%, reflecting lower underlying loss ratios offset by the increased expenses. Pre-tax operating income benefited from $1.2 billion in net investment income, a 4% increase compared to the prior year, that's primarily due to higher interest income on fixed income securities driven by redeployment of excess cash and short-term investments into higher yielding securities.
This was partially offset by a decrease in partnership income due to equity market performance and a decrease in mutual fund income as a result of a lower level of mutual fund holdings as part of Chartis' strategic asset allocation strategy. The accident year loss ratio, excluding catastrophes, improved by 3.1 points compared to the first quarter of 2011 and 2.4 points from full year 2011 results. This result largely reflects meaningful progress in initiatives to shift the portfolio to higher value products and geographies to improve business with marginal returns and to use data and analytics more intelligently in the risk selection process. During the first quarter, we brought together the global claims and operations and systems functions to create greater efficiency and reduce claims related costs. The global claims initiative and the implementation of our proprietary claims system signify steps we've taken towards improving claims handling.
We're developing a much broader target operating model that will streamline processes and capabilities to deliver further loss ratio improvement and superior customer service in the future. Consumer insurance represented 41% of total net premiums in the quarter, compared to 37% in the first quarter of 2011. 56% of total premiums were generated outside of the U.S., up from 55% in the first quarter of 2011. We continue to expand in growth economy nations, which represented 11% of total first quarter 2012 net premiums, up from 10% in the first quarter of 2011. That represents an 8.5% annual growth rate. We maintained our focus on driving improvement in pricing and terms and conditions. Rate changes in the U.S. and Canada increased approximately 5% across Chartis' diverse book of business. U.S. property and workers' comp experienced the most notable increases at approximately 11% and 7% respectively.
While we're generally experiencing positive rate change across most products and regions, some markets continue to lag. Customer retention remains strong, but in line with expectations given our business mix shift and improved risk selection initiatives. Slide 10 summarizes top-line results. Chartis' net premiums declined approximately 4.5% over the prior year period when adjusted for foreign exchange effects. The continued restructuring of our loss-sensitive business in casualty, which reduces premiums written but improves capital efficiency, accounted for 1.6% of that overall decline. An additional 1.6% of the variance was due to a large multi-year financial line policy written in the first quarter of 2011, which did not recur in the current year. The remainder of the decrease reflected our effort to improve underperforming lines, continue adherence to rate discipline, and management of catastrophe-exposed business, specifically within commercial.
This is consistent with Chartis' strategy to improve the loss ratio and to shed business that does not meet internal performance standards. Net prior year adverse reserve development was $66 million, driven by loss emergence in casualty and increased activity from multi-year environmental liability policies written in older accident years. This was also favorable development on prior natural catastrophes, mainly the Japan earthquake. Expense trends were consistent with our desired mix of business changes, particularly in consumer lines, which offer lower, more stable loss ratios, increased acquisition costs from growing the consumer business, and the change in mix in the commercial business, as well as investments related to international growth, which accounted for two points of the expense ratio increase in the quarter.
Approximately 1.9 points of the increase related to non-recurring items, including an increase in bad debt expense and a reduction in the PGAAP benefits for the Fuji acquisition. We continue to make strategic investments in systems, processes, and talent, which we expect will yield greater savings and a stronger franchise in the years ahead. We're transforming Chartis' business to be a more profitable and inherently a more sustainable value portfolio. As a result, the expense ratio will be under pressure in the near term, but we expect it will be offset by improvements in the loss ratio. That pressure will abate as we start to see infrastructure investments in 2012 and 2013 yield savings in the following years. These actions will help us achieve a combined ratio in the mid-90s and a double-digit ROE by 2015.
In the first quarter, Chartis continued to execute its capital management initiatives, making a billion-dollar dividend payment, which exceeded plan to AIG. Our capital adequacy levels are strong and in line with rating agency expectations. Significantly, AM Best upgraded Chartis' outlook to stable from negative in the first quarter, which is in line with the views of S&P and Moody's. We made very good progress optimizing our reinsurance program in the quarter. We now define our risk appetite from a global perspective rather than locally, and we continue to rely on intercompany reinsurance to help maximize capital fungibility. Chartis' catastrophe exposure management is enabling us to reduce externally ceded reinsurance, generating cost savings. As we've discussed in prior quarters, Chartis continues to grow its consumer insurance business in key regions, as well as the portion derived from the direct marketing channel outside of the U.S.
In the first quarter, we had considerable success in consumer. All lines exhibited growth and direct marketing spend helped generate profitable returns. The accident and health business benefited from the implementation of its group benefit strategy from American General. Personal lines results reflect growth in warranty and personal property, and importantly, Chartis closed on the Service Net acquisition in the quarter, significantly expanding our warranty customer acquisition and service platform. Chartis continues to measure and refine the risk-adjusted profitability of all its businesses, and we're directing capital and resources to optimize profitability where we see opportunities. Our goal is to be the most valued insurance company in the world. The transformation underway in Chartis today and the progress we're seeing against our strategies gives me great confidence that we're going to succeed. Now let's turn it over to Jay.
Thanks a lot, Peter, and good morning, everybody. Turning first to slide 11. SunAmerica delivered a solid first quarter with $1.3 billion in pre-tax operating income, strong sales across most product lines, positive net flows, and improved base investment spreads. As David mentioned earlier, SunAmerica distributed $1.6 billion to AIG as a result of the ML2 liquidation. In the quarter, we recognized income of $245 million on the ML2 investment, essentially flat with the first quarter of 2011. Going forward, SunAmerica's results will no longer include gains or losses from ML2. We saw strong sales growth in all of our product lines with the exception of fixed annuities. As expected, our fixed annuity sales declined during the quarter due to the low interest rate environment, and we expect full year fixed annuity sales to remain below last year's levels.
Variable annuity sales were a highlight in the quarter and were up 38% as sales exceeded $1 billion in the quarter, a first since the financial crisis. The sales increase was driven by expanded distribution, increased wholesaler productivity, and our competitive de-risked product offerings. Last year, we were the first in the industry to index our living benefit fees to market volatility as measured by the VIX index, reducing our exposure to changes in volatility. During the first quarter of this year, we launched a new product offering with a volatility control fund that further reduces the risk related to market volatility while offering a competitive benefit. The impact of strong equity markets in the first quarter decreased DAC amortization and guaranteed benefits expense by $52 million versus the first quarter of last year. Our variable annuity business is a relatively small piece of our balanced book of business.
Separate account reserves were $50.7 billion at March 31 out of total reserves and mutual funds of $230 billion, of which $20 billion of reserves or less than 9% include living benefit guarantees. We have the capacity, distribution capability, risk controls, and financial discipline to capitalize on the growing demand in this market as some of our competitors are pulling back. Sales of group retirement products increased 8%, driven by individual rollover deposits in the quarter. We expect rollover deposits to slow in the near term due to the impact of low interest rates. Retail life sales increased 7% in the quarter, principally due to growth in term life sales through independent distribution and our affiliated direct-to-consumer platform, Matrix Direct. Mutual fund sales continue to accelerate as a favorable equity market and strong product performance drove new deposits.
As Bob mentioned, despite a $1.5 billion year-over-year decline in fixed annuity sales, our total net flows were positive for the fifth consecutive quarter, which highlights the advantages of our diversified product portfolio. On April 12th, we announced a reorganized structure designed to better serve the needs of our clients and promote accelerated profitable sales growth. Key aspects of the new structure are distinct product divisions, shared annuity and life operations platforms, and a unified all-channel distribution organization with access to all SunAmerica products. We believe this organization structure will allow us to better leverage our competitive strengths, our diverse product manufacturing capabilities, our broad and strong distribution relationships, and our experienced and talented leadership team.
On slide 12, we show the general improvement in base investment yields and base net investment spreads over the past four quarters for Western National, our leading fixed annuity writer, and VALIC, our group retirement company. Base investment yield represents our investment yield, excluding the impact of alternative investment income, call and prepayment fee income, and ML2 fair value income. Base yields in the first quarter were up significantly over the prior year quarter due to the redeployment of cash during 2011. Base yields were also up sequentially, as this quarter we invested approximately $7.4 billion at a yield of 5.3% across all of SunAmerica, including a 15% allocation to non-agency residential mortgage-backed securities. We continue to be opportunistic with our investments in structured securities in order to improve yields, increase net investment income, and help offset the impact of the lower interest rate environment.
Base net investment spreads were helped by the improvement in base yields and our ongoing active management of new and renewal crediting rates. With respect to renewal rates at VALIC, we reset rates on a $16 billion block of business at the beginning of this year, which contributed to the sequential increase in base spreads of 24 basis points. Approximately 51% of SunAmerica's annuity and universal life account values are now at minimum guarantees, up from 45% at the end of the fourth quarter. Nearly 70% of total annuity and universal life account values have minimum guaranteed crediting rates of 3% or lower. Last quarter, we provided information on the potential impact of a continued low interest rate environment on our operating earnings.
We indicated then that we would expect a negative pre-tax earnings impact of less than $10 million this year at $65 million-$80 million next year. Given our current new money rates, our disciplined approach to pricing, and active managing of crediting rates, our view on the potential impact remains unchanged. With that, I'll turn it back over to David to wrap us up.
Thank you, Jay. Before I go over to Liz to kick off Q&A, I would remind everybody on page 13 are the highlights of United Guaranty, the highlights of which I covered in my opening remarks. Liz, back to you.
Operator, can we open the lines for Q&A at this time?
Absolutely. Ladies and gentlemen, if you'd like to ask a question at this time, please press star and then one. If you happen to be using a speakerphone today, please pick up the handset or depress the mute function so the signal can reach our equipment. Again, that is star and then one if you have a question at this time. We'll take our first question from Andy Dinnhaupt from Franklin Mutual.
I had two questions on ML3. The first is on page 15, where you break out the composition. Could you just tell us where the MAX CDO that was recently sold, which category that fell into? Secondly, in your 10-Q, you disclosed that the ML3 assets were pledged against the direct investment book. Does that hinder your ability to execute further sales in the ML3 assets? Thanks.
I'm going to turn it over to Bill Dooley. First of all, ML3 is being sold by the Federal Reserve, and they go through the positions as they see fit, and it's up to the Federal Reserve to decide how they want to liquidate it.
Max was the biggest one in the portfolio and the most complex from our point of view. In our view, it was a very successful sale. As we think about those sales, we can also be a buyer. For the insurance companies, we saw some value in the sale of Max. In fact, we bought $600 million of the positions in the insurance companies as part of our investment portfolio. We don't see anything here at AIG that would represent a constraint on the Federal Reserve to sell ML3 assets. To the extent we can get the price we think makes sense, we would be a buyer. Bill, you want to talk about the pledge and the fact that as this occurs, how that flows through in terms of cash?
Sure. First of all, mainly through the unencumbered asset at the parent company. Once it's monetized, the substantial portion can go into the financial flexibility of the firm. That means liquidity management, leverage management, and the ongoing capital management that we're doing. As Bob just said, the flexibility is tremendous because of our opportunity to, if we like the asset, if we like the price, and we do know something about these assets, as everyone knows, that they're also eligible for the insurance companies to be bought at the same time.
I think, look, the bottom line here is that we had talked to everybody a year ago on the re-IPO that we were looking at 2014 second half as the beginning of receiving cash out of ML3. We talked about ML2, our cash wouldn't have come until 2015, possibly. You've already seen all that come in, and what this basically says is we won't have to wait till 2014 second half to begin to deal with the liquidity opportunities this would create for us. Again, that plus the paying down of the SPV a year early gives us enormous flexibility we did not think we would have until the middle to the end of next year at the earliest. We're already there.
Operator, can we go to our next question?
Yes. We'll take one from Andrew Kligerman from UBS.
Morning. Could you, having said earlier in the call that you're preparing AIG that it's likely to be a non-bank SIFI, can you address the degree of capital management that you'd like to do given that over the next year? Secondly, with regard to variable annuities, you did a strong $1 billion plus in VA deposits. You guys in that business are doing $3 billion-$5 billion plus. What's your appetite there? Do you want to get into that top three and do $3 billion-$5 billion per quarter?
I'm going to let Jay talk about his appetite because I think he needs to talk about the product design. I think the question by itself, Andrew, would not make much sense unless we talked about how we price and the ROEs and the risk management that's around our products. I'll let Jay do that. In fact, why don't you do that first, Jay, we get that one first, and then we'll talk about capital management second.
Sure. Thanks, Bob. I think the most important thing, Andrew, is that we have spent a lot of time over the past couple of years reducing the risk in our variable annuity product. First, as I mentioned, with tying the variable annuity rider fees to changes in the VIX to reduce exposure to volatility, requiring a portion of the assets to be invested in bonds or in the fixed account, or on the equity side, being invested in certain asset allocation models. Just this year, our latest component, which was the volatility control fund being a part of the product in order to obtain the living benefit feature. We continue to feel good about how the product is structured and the pricing returns we're getting.
At the same time, I think if you look at our benefit roll-up rates and our withdrawal rates and our age at which you can take withdrawals, they are not overly aggressive in any respect, and our fees remain certainly at the high end for the industry. Having said all of that, as we've been reinstated in certain distribution channels, rebuilt up our internal and external wholesaling force, and improved the productivity of our wholesalers, you've seen sales increase. We continue to have an appetite to do that, assuming we can do it with products that have terms and conditions and costs that we're comfortable with. We've also invested a lot and continue to invest in our risk management, in our hedging program, and our more general risk management.
I would say that our internal goal is to continue to build up our distribution consistent with our sales opportunities. If that moves us up in sales, so be it. We don't tend to target any ranking level. Depending on external circumstances, including how aggressive some of our competitors are, we may continue to move up in those rankings. I do continue to see our variable annuity momentum in terms of sales and flows to be strong. I hope that's helpful in response to your question.
The other piece I would add to it is that if you look at our year-over-year flows, we are concerned about fixed annuities at these low interest rate levels. We don't want to build a large book at low interest rates and then be concerned about disintermediation if and when we see an uptick in rates, and especially if there's a rapid uptick in rates. That you'll see a decline in sales, and that's one we are being very strong in terms of maintaining balance on getting our return and being careful what we put on our books. It's really about the fixed annuity more so than the variable annuity that we'd be most concerned about. Coming back to SIFI and capital, the key to being regulated by the Fed and the impact to capital management is you better have a very good, well-documented process.
You have to know what you're doing, how you're doing it, show and demonstrate that you do it. We believe we've got a team that's excellent. We're working through that, and we're pretty confident if and when the Fed arrives, that we will have the process in place that will allow them to judge whether we have any constraints on our ability to continue capital management. We won't know till they get here. We won't know till we run their systems and they verify what we've done. We feel pretty comfortable that we're in pretty good shape and that we don't see any significant impact to our ability other than to comply with their rules and regulations and time frames.
Bob, looking at the assets you've outlined, $6 billion plus worth of ML3, something on ILFC, $8 billion worth of AIA. You don't see that as constrained at all over the next 12 months?
What I'm saying is that if the Fed arrives, when they determine they're our regulator, then they will decide. We don't see the constraint, but we have to go through their stress test process and their review and their audits to make sure that we're okay. I think that the constraint might be more time in our view, but could be wrong, but we're thinking it's more about when we could do things, not if we could do things, especially when they go through the company for the very first time.
Right. In the meantime, you're moving forward with capital management.
Meantime, we see no constraint right now to our capital management. We're going to continue to look at our capital, look at our non-core assets. The selling of ILFC is not only about capital management, it's about recognizing it's a non-core business. It has a huge debt load, and it's a business that doesn't fit the insurance business. We feel that that's a business we should not be in. To the extent it provides us a lot more capital, that's great because it helps us with capital management, but it's also about de-risking the company. That's another aspect of it. It's in combination, we're doing things that makes the most sense for this company, its credit ratings and our future.
Thanks, Bob.
The next question comes from Keith Walsh from Citi.
Good morning, thanks. First question for Peter, just thinking about with respect to Chartis, can you just talk about how you think about allocation of capital to each line of business, how that's communicated down to the troops, the underwriters, and then how that's reflected in their compensation? Thanks.
Well, the first thing is that we think about capital through an economic lens first, but recognize that life in an insurance company with multiple constraints is a little bit more complex than that. We look at multiple binding constraints, whether they be rating agency view of capital or regulatory view of capital. We start with our true north, which is an economic view of risk, which drives the amount of capital needed to support that risk. Secondly, consistent with our reorganization, we think about it globally. The commercial lines run by John Doyle has, under him, individuals responsible for the global allocation of capital. George Stratts, for instance, running global property, thinks about optimal capital allocation, to where he's getting fairly compensated for the exposure we're taking.
We measure performance using risk-adjusted profitability, which is ROE minus a cost of capital, times the amount of capital deployed. That metric is still in its early stages of implementation, but we have it calculated at a fairly granular level, and it's increasingly being used as a measure of people's success. In terms of incentives, we think that the right way to incentivize people in this business is over the medium to long term. Any single period risk adjusted profit number needs to be put in a broader context. We're in particular looking at changes and improvement as opposed to the absolute number. We feel that there's been much more rapid uptake of this framework for thinking about how to properly balance growth, profitability, and risk towards growing value than I could ever have hoped. I'm very pleased with the progress.
It's something that if you looked at the compensation program here at AIG, the variable portion of the compensation for the underwriters that you're talking about is actually, unfortunately, too small. It's mostly a fixed income. You have very little variable comp. As we become much more performance-based, we're actually trying to increase that a little bit as we go forward. We don't see that as a big incentive one way or the other. It's really about the quality of the way you do your job. You don't have the kind of leverage that you're used to seeing in your own businesses.
Just 2nd question for John Doyle, if he's there. Retention rate trends in the commercial line, specifically the U.S. commercial business, if you could just talk to that a little bit. Thanks.
Sure, Keith. Retention's in line with expectations for us. After the 1st quarter, as you know, we've been shedding certain segments of underperforming business. Very low retentions in segments of our commercial casualty business. I would say client retention remains very high. We've been continuing to reduce our CAT exposures, and increasing price in property CAT pretty aggressively over the course of several quarters now. We're retaining more of those customers, but reducing exposure there. Outside of that, retention remains within historical norms. As Peter mentioned earlier, we continue to see good rate improvement and good momentum on the pricing side. Property rates in the U.S. are up double-digits. They're up more than that in parts of Southeast Asia. Casualty rates up in single-digits in the United States. Some product areas and some geographies lagging a bit, probably most notably continental Europe and Latin America.
Really even in those geographies, we've seen an improvement over where we were in the 4th quarter. You may have noted we did take down the top line in Europe in the 1st quarter. It's a big renewal cycle for continental Europe. That was some corrective underwriting action we took in primary casualty. Momentum's good. Retention's where we want it to be given the pricing environment. We took some aggressive action to improve the portfolio. It was roughly a 3.7 point improvement in the accident year loss ratio in the 1st quarter.
Okay. Thanks a lot.
Our next question comes from Michael Nannizzi from Goldman Sachs.
Thanks. Just picking up on Keith's question a little bit. I see the, I guess for John and Peter, the mix shift and the impact it had on the expense ratio. As you move along this path, given the expense investments you're making and the mix shift towards higher expense, lower loss business, when should Chartis begin to see underlying action in your profitability? I guess along those lines, Peter, you mentioned the aspirational goals were here 100-ish. Where do we have to be at year-end for you to feel confident that we're on track to get to the aspirational goals by 2015? One follow-up if I can. Thank you.
I think that there's some one-off items that make the recent short-term trend in the expense ratio inconsistent with what my longer-term trend expectation would be. I'd expect the expense ratio towards the end of the year to be between 32%-33%. To be honest, we are absolutely focused not on targeting a specific expense ratio. We're really looking at the ROE and making the right trade-off between stable loss ratio improvement and whatever it takes to spend to get that in terms of infrastructure, distribution, to get the best mix of sustainable business. The infrastructure investments that are sort of heavy in nature are going to sort of peak in mid-2013. We've talked about that consistently over the last year, the benefits from those will be long-term cost advantages, scalability of platforms through better shared services and so on.
Importantly, I look at the large amount of expense that's in claims that's classified within the loss ratio, I really want to be agnostic about whether a cost is classified as loss ratio or expense ratio. Given the huge variety of businesses that we have, benchmarking our expense ratio against others is very hard to do. The bottom line on a risk-adjusted basis is a much better way to judge whether we're making progress. We feel very good about our ability to deliver the target ROE by 2015.
Great. Thanks. Bob, if I could follow up on the non-core asset question. If AIG were to sell some part of the non-core assets that you show on slide seven, is your kind of baseline expectation that you would be able to deploy all that capital that you generate from those sales?
I think we're going to take a look at what is when we do it, what's available, what makes the most sense for our shareholders, that's what we'll do. I can't give you any more color than that.
I appreciate it.
I think if you look at what we've done so far, I think we've got a pretty good track record of putting our money where it makes the most sense.
Great. Okay. Thank you very much.
We'll take our next question from Joshua Shanker from Deutsche Bank.
Yeah. Thank you. Two questions. One, can we talk a little about the moving pieces in the direct investment book so we can think about how we should model that going forward? Second, with regard to ILFC, were there planes taken offline this quarter? It appears to be there were no charges associated. Can you talk about the value of the fleet and how you're feeling about that?
David, why don't you take the first question, and then-
Yeah. Josh, could you maybe clarify what you're interested in the direct investment book? What piece of it?
Well, obviously there was the credit-related losses this quarter. Is that related to rising interest rates? How should we think about that modeling going forward?
Yeah. Fair point. Good question. That was the CVA in when our credit spread. Again, directionally, if you look at what's happening with our credit spreads, our credit spreads came in 275 this quarter, and we had a $580 million hit in that book. Now, again, what that means is our credit spreads came in much more than the credit spreads of the assets that we've invested in. The whole book is, or that piece of the book is mark-to-market. We had a disproportionate improvement in ours, which is good news. I mean, it's terrific that our credit spreads are tightening. That's the biggest driver of it.
On an operating basis, though, without the Blackstone gain, it would have been a much more bigger hit to operating income. Is this an exceptional quarter, you think, in terms of magnitude?
You mean in terms of the CVA? I would think there's going to be volatility in that number, in that mark. I think that's the way you have to look at it and map it back.
Okay. ILFC fleet values and what happened this quarter? Something that may relate to Malév.
Yeah, let me just answer it. Just briefly, the planes have been repossessed and actually re-leased. All the accounting, everything else pretty much is done in this quarter. I think you'll see some drag in the remaining three quarters as we go through this. The team did an outstanding job of getting those planes back. Some of them were not re-leased, but they were actually put in a part-out. As you know, we bought the part-out company, which gives us an option where, if we don't think we can get a good price for planes, we don't have to be stuck with them on the ground. We have a chance to get good value out of just taking them apart and selling them through that AeroTurbine, Inc. organization.
I think, overall, a quick reaction on all the numbers are in the first quarter that you can see, other than a drag a little bit in terms of income going forward.
No negative cost from the parting out?
That's correct. Josh, it's David. I want to add on to what Bob said with respect to Malev. There was no impairment in the quarter or last quarter with respect to Malev. Those planes, we had those planes valued accordingly in anticipation of that. We did have some impairment charges this quarter, but it did not relate to Malev.
Perfect. Thank you very much.
My pleasure.
Our next question comes from Josh Stirling from Sanford C. Bernstein.
Hi, good morning. Thanks for taking the call, and thank you so much for expanding your disclosures. I'm sure you folks have been drafting for weeks, and at least I certainly appreciate it. Two questions, one, if I can, for David, and then another for Peter. The question for David, if we go back to slide seven, which is the asset values and sort of how we should think about potential future divestitures, not from a timing but from a valuation perspective. Thinking about the taxes, can you give us some guidance as to either the tax bases we should be using when we model this out ourselves? Or simplistically just say if the transactions were done at current carried values, what not the cash proceeds would be, because you told us they'd be offset by NOLs, but the actual book value impact would be.
I don't know that we can actually calculate what the DTA usage would be, given that we don't know the tax bases.
Yeah. Fair point. On ILFC, we covered this last quarter, but it's a helpful reminder that the simple example that we used last quarter is if we sold it at book value. Book value is book value, and we laid that out, basically $7.5 billion. Example is we said it has a very low tax basis. Effectively, the book tax expense that would be recorded is essentially the proceeds times the tax rate. That's the book tax, and it'll be offset with NOL. Effectively, you're accelerating the utilization of those NOLs so there's no cash out the door for that tax expense. And then the book basis, as you can see, AIA and ML3 are both fair value options, so they're on the books for what they're on the books for.
AIA is carried at this point, at the end of the quarter, was $8.2 billion, and the tax expense would be the tax expense, and then it's again, utilization of our DTAs. We will have a book tax expense when we sell these, but we will not have a cash tax expense when we sell these. Is that helpful?
That's helpful color. Is the AIA tax basis and Maiden Lane III tax basis, are these values approaching the fair value? Which is, I think, what I heard you just say.
Yeah. On AIA, we've already taken the book tax expense. I think it's.
Okay
the way to think about it. If the tax basis is less than that because of the timing of when we were filing tax returns, et cetera. It's, again, I think from a utilization standpoint, the way to model it is just think about the fair value. That's the easiest way to think about it.
That's helpful. In ML3, maybe you're probably still in a loss position.
I don't know that that's the case.
Okay.
For modeling purposes.
Okay
use the book value.
Okay, that's helpful. Just if I could follow up on Andy's good question about the changes to ML3 and its involvement with the direct investment book. Should we look at that as you guys have actually already having unencumbered other assets, which were at the holding company at year-end, which were effectively pledged to direct investment book? In some fashion, you've already sort of started to get liquidity from the ML3 by pledging it against those obligations.
Yeah, I think the way to look at it is that when we extinguish the remaining SPV preferred, we use the DIB as a vehicle to do that. For effectively $1.5 billion, we were able to add about $3.5 billion of asset value, and that's excluding the net escrow to the DIB. The asset is unencumbered. It's not in a regulated insurance company or anything like that. As it is monetized, depending on what the needs of the DIB or the parent are, we will determine how much excess value there is. It's our expectation that there will be a substantial portion of Maiden Lane III that would be available for a variety of corporate purposes, including maximizing our financial flexibility.
That's great. Very helpful. If I could just overstay my welcome and ask Peter, very much appreciate the strategic color on long-term growth strategy and mixed management, loss ratio objectives, and expenses. I'm wondering if you can give us some color from the underwriting trenches of the kind of stuff you guys are actually doing today to take away historical underperforming business to get right where you need it. So we can go to the level of understanding what you're really asking, expecting of your underwriters and where we are in the execution of this story.
I think that the first thing is that we are giving clear direction to our underwriters as to how to make the trade-off between value and volume, to do so with a view to optimizing customer relationships that we've had for decades. That means going to our customers early, really helping them work with us to use our capital in a way that is most valued by them. In the lines where we have the most distinctive capabilities. I think one good anecdote that happened in the first quarter was a long-standing manufacturing customer of ours in the U.S. that was up for a large property renewal where we were the lead, they expected contingent business interruption to be included in the language as it always had been.
With the events in Thailand and in Japan highlighting the very real risk to the supply chain, we were unwilling to do the renewal without much greater detail on their supply chain risk. We wanted to have it excluded. It was a real tipping point moment where the customer eventually backed down. We had the exclusion, importantly, we agreed to work together with them over the next year to really understand the risks of their supply chain so that we could include it next year, also charge for it, help them figure out what the right retention would be on that risk.
I think that our underwriters feel they have the empowerment from management to say no when that's the right thing to do, to use the most sophisticated analytical tools to really help the customer manage their risk in the most sustainable way possible. I'm seeing lots of nice examples where I think people are very aligned to make the right trade-offs.
Great. Thank you for the color.
I'll say this one.
We'll take our final question from Thomas Gallagher from Credit Suisse.
Good morning. I just wanted to ask a quick follow-up on the ML3 question. I guess based on the way it's worded in the queue, it's saying it's allocated to the MIP book. My question is really, is it the full $7 billion or so, and is that backing MIP debt right now, or is this somehow an equity cushion within the MIP book? I just want to understand how we should think about that. I guess my follow-up is, as the stake gets monetized over the next year, can you just give some general sense for how much you think could be used for capital management if it did occur this year in a more immediate way versus that which would have to remain for liquidity purposes within the MIP book?
Sure. First, there are no specific assets in the DIB or MIP that are specifically pledged against debt. There is a pool of assets, and those assets will generate cash flows that we believe will be more than adequate to meet the needs of the DIB. When ML3 is monetized, we will then determine, using a number of tests that we look at, what the appropriate level of capital and liquidity for the DIB is. To the extent there is excess capital in the DIB, we should be able to use that freely at parent based on whatever opportunities we feel will maximize shareholder value. It is our expectation, based on our numbers now, that a portion of the Maiden Lane III assets will remain in the DIB, but that there should be a substantial portion of excess value that we'll be able to have discretion over how we use.
That's very clear. Thank you. Then just last follow-up, I guess for David. The $8.2 billion of cash in short term at the holding company now, and in addition, you have low financial leverage. Can you talk about on a more near-term basis what your position is for ability to manage capital? Should we think about some portion of the $8 billion of cash in short term as available, and potential leverage, or can you give a little color around that?
Look, we constantly are looking at what we have and making sure that the biggest constraint we have amongst ourselves is to do what makes the most sense to continue to show strength in our credit ratings and how we use the money here. We will continue to look and examine at what we have, and we will do what is most prudent at the time. I don't know it until I know it, until everybody around this table says that that makes sense to do. That's about all I can tell you.
Okay. Thanks, Bob.
Thank you, operator. I think we're going to wrap it up for now. I appreciate everyone dialing in. Certainly, if you have any follow-up questions at all, don't hesitate to give us a call.
Thank you all.
Once again, ladies and gentlemen, that concludes today's conference. We appreciate your participation.