Good day. Welcome to American International Group's third quarter financial results conference call. Today's conference is being recorded. I would like to turn the conference over to Ms. Liz Werner, Head of Investor Relations. Please go ahead, ma'am.
Thank you. Good morning, everyone. Before we get started, I would like to remind you that today's presentation may contain 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 and events may differ, possibly materially, from such forward-looking statements. Factors that could cause this include the factors described in our 2010 10-K and subsequent 10-Qs under Management's Discussion and Analysis 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.
With that, let's begin our call today. Now I'm going to turn it over to Bob Benmosche, our CEO.
Okay, thanks, Liz. For our company, we're operating as if the Federal Reserve will be our regulator. We don't know what will happen, but it's important we operate as if the Fed will be our regulator. As part of that, we have to do stress testing. We constantly look at our company, what the issues are, and we said, "What would happen? What would happen if the equity markets fell apart? What would happen if, significantly, on the S&P, what would happen if the spreads blew out?" Serious issues in the fixed income markets, especially mortgages. We said, "What would happen if currencies started to create issues for us?" Throw on top of that a big hurricane, maybe in the Northeast, and what would happen if you have some typhoons running around Asia. That's how we did our stress test.
We update it all the time. We had the opportunity in the third quarter to see what happens when our stress test becomes somewhat of a reality. There's a question about AIG, our strength, and how we would handle that kind of perfect storm, which is what we've just come through. I can assure you that we're in very good shape. Our liquidity now is sitting at $15.3 billion, up from the last quarter. Big concern we've gotten during the roadshow and from many of you over time is what's going to happen to FP Remco, and the assets, I should say, not Remco. What would happen under these scenarios? Clearly, our collateral calls were basically flat. There was no issue whatsoever in terms of cash demand. We're in pretty good shape.
Let's talk about the $4.8 billion of non-cash losses of three items. I'm going to start with Maiden Lane III. Maiden Lane III, we're down $1 billion, but the cash flows continue to be strong. This is just the anomalies of the market at this point in time. Keep in mind, we've gone from $45 billion in the beginning. The Fed's balance is down to $18 billion. It's paying down cash flows of about $5-plus billion a year for Maiden Lane III and Maiden Lane II combined. This is Maiden Lane II and III combined in these numbers. We see 2014 still as a year in which AIG will begin to receive back its $6 billion investment before we begin to split the upside with the Fed after that period of time.
Maiden Lane III does cause some noise in the numbers, no question, but economically, we see that as continuing to be strong. Also, AIA. We took a $2.3 billion drop in the book in the carrying value of AIA, marking it to market. Keep in mind, as it relates to AIA, the SPV that we have from the AIA/ALICO SPV is now down to $8.3 billion. The collateral against the $8.3 billion is Maiden Lane III, ILFC, and AIA. We also have about $1.5 billion in cash sitting in the SPV from the sale of ALICO to MetLife, and that cash again will come out of escrow over the next year. Another $1 billion, I believe, and then the rest of it in 2013. Leaves us $6.8 billion left on the SPV.
We are taking our time to look at that $6.8 billion, and we're deciding what is the best way to handle paying that down such that we maximize value for the AIG shareholders. Whether it's to sell AIA now or later, whether it's to wait for the IPO of ILFC, if it works out in the markets in the future. As you know, ILFC is not core. We're looking to monetize that at the right time for the right values. We're going to take our time, and I guess that's the only way I want to continually stress it, time to make sure that we're maximizing value for the AIG shareholders. When it comes to ILFC, again, $1.5 billion was taken as part of our normal routine to look at what's happening in the manufacturing space. Some new announcements were made on new aircraft.
That puts pressure on some of our older planes. As part of our annual review, we've decided to take a charge of about $1.5 billion to deal with that issue within the legacy aircraft, which we've been talking to you about. That's a problem we need to resolve and work on. We know it's a drag, but I think this resolves a good part of that drag. Let me come to capital management real quickly. You saw we raised $2 billion in the quarter. That's really to make sure that our debt maturities are matching to what it is we have in terms of cash on hand. That deals with some future payments we're going to have to make. You also saw from a capital management point of view that we're going to be buying back shares.
Let me be very clear that until we were able to do the re-IPO of the company, we could not do any share repurchase while we had Schedule G here at the company. Being able to launch the re-IPO, to be able to terminate Schedule G and close that out, that allowed us to begin to think about how do we want to handle capital management going forward. Our priority, and it's important that you understand, our priority is to be able to work with the U.S. Treasury so that we can continue to be buying back shares from their shares, which represents overhang on the stock. That is our priority.
On the other hand, if we see in the marketplace that there's certain anomalies with our stock, and we feel it's an opportunity to take advantage of what the market has done, then the board of directors has approved a $1 billion share repurchase so that in these markets, if we choose to go out and buy in the open market, we're able to do that and take advantage of where the markets are today. That doesn't change our priority. Our priority is still to begin to think about capital management in the context of the U.S. Treasury shares and what we can do to facilitate taking that overhang off the table. As we think about our results for the quarter, David's going to bring you up to date on it.
I just want to make a few comments that clearly, if you look at what's happening after that $4.8 billion, clearly we had some storms hit us in the quarter. Chartis is continuing to make great progress. They're continuing to focus on how we get a better return for the risk we're taking and making sure that our combined ratios start to come down as we promised in terms of our aspirational goals. They're making very good progress on that. SunAmerica continues to do well. They're continuing to see client retention strong. Sales continue to be strong. Keep in mind, we're down somewhat, which you'd expect with this low interest rate environment in our fixed annuity business, but still strong. UGC continues to perform well on new business. We got that under control.
However, there's still going to be a little pressure yet as we work out some of the legacy book and some of the legacy issues and foreclosures and so on. Last but not least, ILFC continues to do well on an operating basis. We did deal with the write-down, but they continue to get pretty good releasing of the planes that we have available. I'd rather wait for some of your questions to rather get into any more detail, but let me turn it over to David on what the issues are specifically in the numbers.
Great, Bob. Thanks, and good morning, everyone. Let's turn to slide seven, and we'll step through the slides and make sure we have plenty of time for Q&A. Third quarter loss, as Bob said, is $4.1 billion. That compares to a loss of two and a half billion a year ago. Our operating income, which is our principal non-GAAP measure, was a loss of $3 billion for the quarter versus $114 million a year ago. Slide eight is the highlights of what Bob really covered with the AIA share price decline, the ILFC impairments, the spread widening and some lower interest rates. The lower LIBOR rate drove some of the loss on ML3 and obviously cat losses. We'll move past that. I think Bob covered that. On slide nine is the ILFC impairment highlight. Again, we conduct this review annually.
We typically do that in the third quarter. Much like we did in the fourth quarter, management's judgments were informed by current market events. As a result of the review, we determined that 95 aircraft were impaired from an accounting standpoint, and we took a non-cash charge of a billion and a half dollars. Again, there were a number of economic events, aircraft technology announcements, idiosyncratic counterparty issues, and other announcements that informed our judgment. Turning to slide 10 for our consolidated performance. Chartis reported pre-tax operating income of $442 million affected by cat losses of a little over $570 million, in large part due from Hurricane Irene, which totaled a little over $370 million for the quarter, as well as Tropical Storm Lee and typhoons in Japan. Interestingly, that compares to an unusually low level of cats a year ago, which was about $72 million.
Turning to SunAmerica, which posted $444 million of operating income for the third quarter. The results include the $43 million mark-to-model, mark-to-fair value for our Maiden Lane 2 investment, again, due largely to spread widening and the underlying non-agency RMBS securities. The third quarter of 2010 actually had income from Maiden Lane 2 of $156 million. You can see the dramatic swing that that had. Also due to the decline in equity markets, we increased our provision for guaranteed minimum death benefits in our variable annuity business, and we had higher DAC amortization as a result thereof as well, though together they were a little over $180 million for the quarter.
The equity market performance in the third quarter of 2010 was actually quite strong, as a result, we had positive effects on operating income of about $100 million from our variable annuity business last year. Again, fairly dramatic swings. As Bob mentioned, United Guaranty, our mortgage guaranty business reported an operating loss of $96 million versus a loss of $124 million same quarter a year ago. Overall financial results for United Guaranty were unfavorably affected by continued weakness in the U.S. housing market, as well as sustained high unemployment rates. Increased delinquencies and the severity of loss costs on some of the older vintages was only partially offset by rescissions. In addition, this third quarter, overturns of previously declined or rescinded claims continued at a somewhat elevated rate.
Our other reporting unit reported a loss of a billion and a half dollars versus income of a little over $400 million a year ago, due in large part to the mark-to-model loss of roughly a billion on Maiden Lane III, and also to a much lesser extent, the wind down AIG FP portfolio. Cash flows on Maiden Lane III remain quite strong. Our global capital markets had a loss of $174 million, primarily from credit valuation losses, or what we call CVA, on counterparty derivative balances and interest rate hedges. The super senior credit derivative portfolio withstood wider credit spreads and was flat essentially for the quarter. At the end of the third quarter, we had about $26 billion worth of notional in the CDS portfolio, of which $20 billion doesn't require active trading management.
The remaining multi-sector book is down to about $5.7 billion in notional, for which we hold a GAAP liability of roughly $3.1 billion, most of which we've already posted collateral against. We continue to believe that the actual settlements under these contracts will be less than the GAAP liability and the collateral postings we have, thus giving rise to intrinsic gains. Also during the third quarter, AIG and counterparty spreads widened substantially, those have requisite effects on the mark to market, mark to model instruments we have in the derivative portfolio. Our direct investment book had earnings of $119 million. The increase in that from a year ago was driven by net increases in the value of the formerly AIG FP asset book. Finally, we've talked about the AIA mark to market, which has already recovered somewhat in the fourth quarter thus far.
Turning to page 11, which shows our after-tax operating income reconciliation. The only comment I'd make is with respect to taxes. We apply a pro forma tax rate to our operating income or operating loss for the quarter. We show the benefit in operating, in this case, the benefit in the operating loss, we essentially reverse that out for the reconciliation to GAAP net income. On page 12 is our capital structure. Our leverage is currently in the low end of our longer-term range, we still assume a 20%-25% debt to total capital in our aspirational goals. We continue to actively manage our capital structure and cost of capital. Most recently, we issued debt to refinance some of our matched investment program notes, we launched an exchange offer for a portion of our hybrid securities.
Turning to page 14 for a word or two on Chartis. The financial results of Chartis are now reported in accordance with the recent reorganization in the global commercial and global consumer businesses. Progress continues to be made toward improving our risk-adjusted profitability and changing the mix of our business. Some highlights are as follows. Net premiums were up about just shy of 1% from a year ago when excluding the impact of foreign exchange and restructured loss sensitive programs, and exiting selected workers' compensation business net premiums were flat for the quarter. Adverse prior year development was a benign $55 million after considering related additional loss sensitive premiums. We review a portion of the reserves each quarter throughout the year, and importantly, the accident year loss ratio was 68.4% versus 67.7% in the second quarter and 68.5% a year ago.
The expense ratio was 30.8%, up from 28.2% a year ago. Last year's quarter included the benefits of negative VOBA amortization related to the acquisition of Fuji Fire and Marine. Fuji DAC amortization this year is higher from new deferrals since the time of acquisition. Excluding the FX and the DAC expenses, the ratio was up about 1%. Chartis premiums are on page 15. Chartis continues to execute on its strategy to grow higher margin, less capital intensive business in implementing corrective actions on underperforming business lines. Excluding FX, consumer insurance premiums were down about 1%, driven by personal lines, which was a management action to deal with a certain unprofitable warranty program. We see the results of our focus on the growth in higher margin lines.
Turning to commercial insurance premiums, excluding FX, we're down about 2%, driven by, again, a focus on capital management and continued discipline in certain challenging markets. I think it's important to note that in the U.S. commercial line, we're seeing rate increase overall of about 4.1% on renewal business, with rate increases led by over 8% in our property line. The trend is accelerating from prior periods. Our international business is now about 50% of our net premiums, and that's up from about 45% a year ago. Chartis investment results are on slide 16. Net investment income for Chartis was $1 billion in 2011, basically flat from a year ago. Chartis continued to reduce its muni bond portfolio, which is now about 27% of its invested assets, and that's down from over 35% a year ago. Turning to SunAmerica on page 18.
SunAmerica's operating income was $444 million for the quarter versus $1 billion a year ago. The decline in operating income reflects much of the market volatility that we've talked about with respect to ML2, some partnership investments, as well as the higher guarantee minimum death benefits, DAC amortization in our VA business. Premium deposits and other considerations totaled $5.7 billion for the quarter. That's up nearly 30% over a year ago. Net flows were positive for the third consecutive quarter at just shy of $550 million. It's interesting to note that year-to-date, it's positive $2.1 billion year-to-date versus a negative $1.6 billion a year ago year-to-date. SunAmerica's business remains diverse, strong, good momentum in sales deposits, and good, strong customer retention. Previous deposits, other considerations are on page 19, and I commented on PDOC overall.
Life sales, I would comment, were up 14%, driven by strong retail life sales. Let's turn to slide 20 for SunAmerica's investment income. Net investment income was $2.3 billion, down a little over $350 million from a year ago. As I mentioned, ML2 affected this quarter by a negative $43 million, due mainly to the spread widening. Partnership income was muted this quarter due to the private equity and hedge fund investments, which I would remind everybody are reported on a one quarter lag. There was also a $97 million impairment on equity method investments in trusts that hold leased commercial aircraft. The same factors that gave rise to the ILFC impairment affected these aircraft as well. Excluding ML2 and partnership and impairments, the investment income was essentially flat. Importantly, we've redeployed the excess cash we had coming into the year.
You can see that in our base yields that are set forth in the financial supplement. Page 21 has some information about the SunAmerica spreads. Base spreads, excluding the impact of partnerships and other enhancements, increased again as we've redeployed the excess cash from the beginning of the year. Looking ahead, if we continue to take capital gains to realize the economic value of our substantial capital loss carryforwards, again, I would just remind everybody that the spreads themselves, the reported spreads, could come under some pressure. Now for a few words on our income taxes on page 23. As more fully described in our third quarter 10-Q, we apply a framework for establishing a valuation allowance. Among other factors, AIG has emerged from its recent cumulative loss, and now we need to demonstrate a level of sustained profitability.
At the end of the second quarter, we described that framework for evaluating the reversal of a substantial portion of that valuation allowance as early as the fourth quarter of this year. If the framework is met, the valuation allowance for our net operating loss carryforward, the non-life capital loss carryforward, and the foreign tax credits could be released again as early as the fourth quarter. If the framework isn't met, obviously the release would be delayed. Realized capital loss carryforwards remains more challenging to us as we've talked about in the past, and that portion of the valuation allowance will be released as the carryforwards are realized. We still expect an effective tax rate of roughly 25%-30% for the rest of the year on our operating income, driven by our substantial investment in tax-free muni bonds.
From time to time, other discrete items will affect that rate as well. A couple of other comments before we turn it over to Q&A. A word or two about the new accounting standard on DAC, which is going to be adopted January 1st of 2012. We will adopt a standard, and there are specific categories of acquisition costs that are no longer deferrable under the new standard. If we adopt the standard retrospectively, this will reduce our DAC balance by approximately one-third, so that's about $4.5 billion-$5 billion. It'll reduce our GAAP shareholders' equity by about 3%, but it'll have no effect at all on our statutory surplus. Also, during the quarter, the parent company received dividends, distribution, and other intercompany payments from the operating companies of about $1.6 billion, bringing the year-to-date total to $2.5 billion.
That's consistent with our capital management goals and aspirations. That remains on track. Again, looking ahead, we would expect some continued choppiness in the equity markets with respect to partnership incomes. We will in fact have some losses on the Thailand floods, we're not prepared to quantify that at this time. Lastly, we remain committed to our long-term aspirational goals that we set forth in our first quarter 10-Q. Bob, now back to you.
Okay, Liz?
At this time operator, we'd like to open the call up for any questions.
Yes, thank you. If you would like to ask a question, please signal by pressing the star key, followed by the digit 1 on your telephone keypad. If you are using a speakerphone, please be sure your mute function is turned off to allow your signal to reach our equipment. Once again, that is star 1 to ask a question. We'll pause for just a moment. Our first question will come from Jay Cohen with Bank of America, Merrill Lynch.
Thank you. A couple questions. I guess first on the share repurchase. You mentioned the priority is to buy back from the Treasury. It seems that there's a situation where they don't want to sell below a certain price. Is it possible they might sell to you below that price versus selling to the public? Or should we just assume that until the price gets up $27, $28, that you won't be buying back from them?
I can't speak for the U.S. Treasury. I can only say that if they want to sell it to us below that price, we'd be happy to buy it. I think they have their view of what the company is and what the company will be. Their goal, and our goal, is to make sure that the American taxpayer gets back all their money plus a profit. That's their goal as well. I think that's clearly up to them. People say, "Gee, with the U.S. Treasury, isn't that a problem?" As far as we're concerned, they have allowed us to run the company the way we need to run the company. They're a very effective shareholder for us, and their goal is to sell where they can get a profit for the American taxpayer. They're not trying to time the market.
They're just wanting to make sure that they get out with a profit, and time is not of the essence for the U.S. Treasury. They just want to achieve that goal. I think if they chose to sell less than that, they could. That's not what their interest is.
Great. Ed Spehar is here too. He's going to ask a question.
Thanks. Just a couple quick ones. Could you give us some sense of what you think the free cash flow is for both Chartis and SunAmerica? And it kind of normalized to the basis. Then just a couple questions on top line. The VALIC deposits were very strong this quarter, and you mentioned rollovers. Is that something that is sustainable, and if so, why? Then on the Western National, was the weakness in sales because others didn't lower crediting rates as fast as you did? Or is it just that you're not interested in putting out a lot of fixed business when rates are at such very low levels, considering the risk of shock lapses if rates start to go up?
Okay. I'll have David start. Then I think when it comes to VALIC and in terms of the ongoing rollover program, so it's not a one-time thing. Jay can talk about the ongoing rollover program they've been successful at, and also the pricing strategy within Western that deals with making sure that we have the right combination of commissions and price, and that's really up to the bank and how they want to deal with that in this low rate environment. I'll let Jay handle those two. David, why don't you start?
Yeah, sure. Thanks, Ed. I would first start by saying we are reaffirming the capital flow in our long-term aspirational goal. While the markets are somewhat volatile, again, our expectations are that those dividend flows and capital flows from the operating companies to the holding company, we would reaffirm those expectations. We had in the quarter about $1.6 billion overall of flows. Again, the flows come in a number of different shapes and sizes in terms of outright dividends. We have some surplus notes between the holding company and some of the operating companies in SunAmerica. So we're paying interest plus principal on that. We've got the tax payments. While we're not going to quantify a "free cash flow," I would just say that our risk-based capital levels remain very strong.
The earnings of the operating companies continue to be strong, and therefore, the dividend flows are in line with our previously discussed expectations. Again, we got about $1.6 billion this quarter. Again, it'll bounce around a little bit, but you can't take that and annualize it. Again, I would point you back to our longer-term aspirational goals that we set out.
Jay, you want to pick up the other two?
Yes. Good morning. On the VALIC question, Ed, we did have very strong quarter on individual rollovers. I think that will continue. Exact numbers and such, obviously can't predict. I think the reasons for that are probably threefold. We've had an increased emphasis on focusing on rollover sales for some time in our recruitment of financial advisors, in our focus on doing more financial plans for prospective customers. Secondly, we have rolled out a series of new products more focused on that market. Something we call PD Advantage, which is for people rolling over from our core Portfolio Director product at the end of their service. We've added a new contemporary guaranteed living benefit rider called Income Lock Plus that's available for non-flowing customers. Finally, we also rolled out a new variable annuity for the rollover market we call Equity Director.
Those have all been picking up momentum and share starting this quarter. The last thing I would say is, in addition to our core VALIC field of financial advisors, we do have a growing independent distribution organization that is licensed with VALIC, and a large part of their sales have been focused on the rollover market. I think that you'll see continued progress here, and it continues to be a point of emphasis in VALIC. In Western, I'd say the reasons for the decline sequentially in fixed annuity sales, and I think we still had an increase year-over-year, kind of three different reasons there. First, on the positive front, we are now back in Wells Fargo, which had historically been our largest distributor. That just came online in June. We're also back in SunTrust. That just came online in August.
We continue to get reinstatements, and we'll be building back our presence in those organizations in the quarters to come. In the last quarter, with the absolute level of interest rates declining, that was a meaningful contributor to our reduction in sales sequentially. We did see a few new competitors come into our market. We've seen that over the years. That's fine. Didn't want to compete in a couple of cases. The fact is we've got, I think, something like 21 proprietary arrangements now going through our banks where we are trading off crediting rate to the customer for lower commissions. We feel like we're very well positioned. The last thing I'd say is that in the last quarter, the second quarter, we hit our highest market share of the fixed annuities through banks that we had ever hit.
I think north of 40% as reported by CARRA or LIMRA. I'm expecting this quarter we'll be back in what is our more typical market share, which is not what we target, but just where we end up, probably somewhere between 25% and 30% of the market, and still far and away the largest. Those would be three reasons for the sequential change in Western National and our fixed annuity sales through banks.
Jay, just one quick follow-up. Do you worry at all, even if you're getting your spread today, do you worry at all about the risk of writing business with rates this low and kind of shock lapses if rates start to go up at some point?
We do worry about that. We worry about it in all environments, the major mitigant there is very careful matching of our assets and liabilities. Our pricing is very disciplined. Our guaranteed minimum rates are now down to 1% on all products, have been for some time. The yield curve is still reasonably steep, we're still able to price and get reasonable spreads. The main thing will be the continued matching of our asset and liability durations, not only initially at purchase, but monitoring that very closely on a regular basis. Yes, we worry about that in the sense that we've got to constantly match those durations.
Keep in mind that what you have here and the way they've designed a product, in many cases, there's been trade-off of commission to rate. When you look at dis intermediation, it's what you got left that you haven't amortized. If you have left to amortize, the shock lapse aren't as onerous as you might have on a more traditional fixed annuity commission product. There's a lot of contributing factors to make this. We're watching it, and Jay's watching it very carefully, but it's not as bad as you might think if you think just normal fixed annuities.
Thank you.
Okay. Next we will hear from Jimmy Bhullar with J.P. Morgan.
Good morning. I had a few questions. The first one for Bob, you mentioned that you'd be open or you'd prefer to buy stock back from the Treasury, but also would consider buying it in the open market if the Treasury doesn't want to. Maybe if you could give us some sense of the timing of completion of your share repurchase plan. Second, you mentioned that ILFC was non-core. Wondering if you can share with us what your thoughts are as it relates to AIA. Then finally for Peter on in the P&C business, just talk a little bit more about pricing. You mentioned commercial property lines getting a little bit better, but maybe more details on the casualty side and personal lines. Related to that frequency severity trends, the Chartis obviously results were affected by high CAT losses this quarter.
If you look at the combined ratio ex CATs and development, it still went up from third quarter last year from the second quarter of this year. What you're seeing there and your comfort level with your long-term combined ratio targets.
Let me start with the timing of the buyback. We've got the authorization. The team will take a look at what the opportunities are. We'll begin to do what we think makes the most sense based upon where the markets are. I don't have a goal to say we're going to be done in a month, two months, or three months. We're just going to be prudent and see what makes the most sense. That's the only way I can give you that answer. We'll know it when it's over. As far as ILFC not being core, what about AIA? AIA gives us a third interest in Asia. The question becomes looking at the value of that position over time and where the markets are and what the opportunity we would have if we were to monetize that and sell it.
The question is, what would we do with the cash? Obviously, you'd say, "Well, how about buying back AIG shares?" We would look at that as one of the capital management opportunities. There could be others. Whatever we do would take a look at what the market says that property is worth. What else we could do with the money that would give us a better return over time, and it's just a consideration we have to make as we go forward. Right now we're going to stand pat from what we see, but that doesn't mean that won't change over time. I would then turn it over to, I think that covered my piece of it.
Yeah.
You want to turn it over to Peter, and you can go through that, Peter, if you would.
Jimmy, in terms of pricing, I think we are seeing some hardening as David already mentioned, both in the property and in the casualty space. He mentioned specifically, overall in the U.S., over 4% year-on-year rate increase. This is a trend that really started for us as early as the first quarter of this year. It's just a progression of year-on-year rate increase since then. I think that we are leading the industry by about a quarter in terms of rate. On the casualty side, our workers' comp year-on-year in the quarter is up about 6.3%. Again, that's a trend that actually was initiated earlier than the property, and really as early as the middle of last year. We feel good about the pricing trends on the U.S. side.
On the international and on the consumer lines, the news really is Japan, which is a vast bulk of our consumer business. The fact that since the beginning of this year, we got relief from the regulatory block on incremental rate increases that had been in existence for three years until January of this year. It was not just us, it was across the whole industry. Each quarter we've seen incremental pricing improvement in Japan, which we expect to continue and has been matched with increased flows as well. We feel good about trends in Japan, although they're obviously somewhat distorted by events in the first quarter, both in terms of losses from the tsunami and the earthquake, but also the disruption to new business flows in the second quarter. Rate and demand in Japan is looking good.
Just your views on your margins.
Your point on the combined. As we laid out in the roadshow, last year's combined on an accident year basis is 103.6. We set out a target to get that number to 90 to 95 by 2015. That's a roughly two-point improvement per annum. If you look at the projection for this year on a normalized basis, normalizing out the extraordinary cats, we are right on track for that two point per annum improvement in accident year combined. We're feeling very good about our long-term aspirational plans on improving the combined.
Lastly, does the loss in the third quarter hurt your ability to reduce the valuation allowance against the DTA, or could you still do it if the earnings bounce back in the fourth quarter?
Jimmy, it's David. You point to what happened in the third quarter. It's a factor, but there's still very real possibility that we can hit our framework, and that we can still release the allowance in the fourth quarter. That will be determined by the performance of the company. One of the critical factors was the falling away of the three-year cumulative loss. That's done. We'll just evaluate the facts and circumstances in the fourth quarter, particularly as they relate, or solely as they relate to the U.S. member taxable income for the U.S. member company. Again, I think there's still a possibility, a very real possibility of that happening in the fourth quarter.
Thanks.
It's very complex. There's a lot of judgment, and we want to make sure that everybody who oversees these kinds of activities as regulating entities all understand what they are. It's not simply saying, "Well, we look like we're going to be profitable in the future, let's just do it." There's a lot of rules and regulations around how this works and a lot of complexity and a lot of judgment. It's not quite so simple to generalize what it means. We are going through all of those steps very carefully to make sure that what we do is we're not in a hurry. We just want to make sure when we do it, we want to make sure it's right, and it's got to be very clearly right and something that's very great.
Obviously what you do on the balance sheet doesn't affect the economics of how you use it, right?
That's correct.
Yeah. Okay, thanks.
We'll now hear from Thomas Gallagher with Credit Suisse.
Good morning. I guess the first one is just for Bob or David. In terms of the little bit less than $7 billion that's owed on the SPV, is there a fuse on that? Meaning, would you have to make a decision to monetize either AIA, ILFC, or come up with the cash in another way by a certain point in time?
One, the fuse is you got to make sure you do what's right for the shareholders. There's one shareholder that has 77% of the stock, and they want to make sure we maximize their value. That's the fuse. If, for example, we were pushed to pay it down, we've already developed a strategy and a plan of what we would do if we chose not to sell any of the assets that are collateralized right now so we could free up the collateral. At this stage of the game, our primary shareholder has said, "Look, maximize our value. That's what we want, and make sure that we can sell as soon as possible." That's the only constraint we have.
Got it. Okay. Then can you talk a little bit, I guess this would be for David, can you talk a bit about your overall capital position today? I see you have north of $15 billion of liquidity resources at the holding company. But can you talk a bit about, aside from the stakes in AIA and ILFC, which I realize are, at least I think about them as residual asset values that could be monetized into capital. But as it relates to capital levels at the insurance companies, is there any excess? And I guess the other side question I had for that is the $11.6 billion of cash and short term at the holding company. There was a footnote in your 10-Q that said $8.7 billion in reverse repos is used to reduce unsecured exposures. I'm just not sure what that means, if you could elaborate. Thanks.
Sure. I'll cover parts of it, I'll ask Brian Schreiber, our treasurer, to comment on your last part there with respect to the reverse repos and the strategy behind that and the use of those. How we think about the capital management, you're right, we grew our cash and short-term and financial resources, the holding company, to just north of $15 billion in the quarter. Again, we renewed the bank facility, had a terrific stable of banks participating. We were very pleased with that participation. We also announced that we put in place an additional contingent capital facility, again, building up contingent capital and contingent resources in order to, again, allow us the greatest degree of financial flexibility. I think we've talked quite a bit about historically the capital maintenance agreements that we put in place with all of our operating companies.
Those agreements, I would say, continue to operate as designed, that the capital flows are coming to the holding company in accordance with what our expectations were with those capital levels. We don't report or haven't reported yet the RBC levels of the companies. Suffice it to say, our domestic life retirement savings companies remain very strong and in line with where they were at year-end, which was upwards of 500% RBC. The capital maintenance agreements levels were in the 350% range and would expect Chartis likewise to be at or above its capital maintenance agreement threshold. Again, the underlying capital positions of our operating companies remains very strong. Again, I won't quantify a, quote, "excess capital," but you can get a feel for that where we are there. Brian, you want to comment on the short-term investments and the use of the reverse repos?
Sure. A key component of our capital and liquidity plan has been to reduce contingent liquidity risk at AIG. As you know, AIG in the past had issued debt in foreign currencies and swapped that debt back to dollars. That exposed us to contingent liquidity risk from a strengthening dollar. We have net assets or we're long capital in many of the currencies in which we've issued the debt. We've been able to unwind the swaps, eliminate the contingent liquidity risk, and effectively invest short term in those currencies to defease that debt. We are economically hedged, and we've eliminated the contingent liquidity risk. We've chosen to go in reverse repos because it offered the best sort of risk-adjusted returns for the company from a short-term investment standpoint. I hope that addresses your question.
It does. Just to follow up, Brian, should I be thinking about $8.7 billion still available, fully utilizable by your holdco? Is there some level of, are those funds encumbered in some way, shape, or form? I just want to understand how to think about. I hear the technical explanation, I just want to know, practically speaking, are those funds there for you, or is there some level of that those are encumbered?
The cash at parent is not encumbered. It is a fungible asset that can be utilized how the parent company sees fit.
Okay, thanks.
We'll now hear from Joshua Shanker with Deutsche Bank.
Yeah, good morning, everyone. I wanted just to follow up a little bit on the CDS book. Back at the time of the roadshow, the maximum capital call was about $1.6 billion. I realize mark-to-markets are not capital calls, but you've had $1.6 billion in marks over the past two quarters. I'm wondering if your outlook has changed on that at all in terms of the maximum capital call you could have from that book at this time.
No. In fact, we continue to wind down the portfolio and reduce our exposure to contingent liquidity. As you saw, we've further reduced the impact of a downgrade to AIG. Our ATE risk has gone down. Every quarter, that contingent liquidity risk is being brought down. I hope that we don't disclose a specific number for the overall contingent liquidity risk, but again, it remains on trajectory downward.
And-
No-
Yeah, go ahead, Bob.
Just let me make a comment on it. Keep in mind that we have, at the holding company, a lot more latitude in focusing on economic value instead of just mark to the market and the consequences to capital ratios and so on. We feel pretty confident that while you're looking at various market anomalies, that we're focusing on the economic value when this stuff comes due. I think that's what you'll see, that we're not worried. It's a matter of what do we think is intrinsic, and when are we going to achieve intrinsic?
That's right.
Brian, I think maybe also comment the effects of what happened in the quarter with respect to capital calls and the like, and on the wind down book.
Yeah. Essentially, as Bob mentioned earlier, with the volatility we've seen in rates, spreads, equity markets, and FX, we've had effectively zero postings in the quarter. Again, it's a result of actions that we've taken over the last year plus again, to reduce our exposure, be it by terminating trades, by intermediating trades, and as I just described on the last question about, again, taking off swaps where we are effectively economically hedged.
Then on the upside, you made this comment back at the roadshow that you can't predict the future, but you thought there was probably $1.2 billion in upside from that book.
Yeah.
Now we've got 1.6 of downside. Does that mean you still think there's $2.8 billion, or has the current market changed your outlook for the value of the upside associated with it?
No. We believe the intrinsic value of those assets remains, and we still believe there's a significant amount of upside consistent with what we've articulated earlier.
Trouble is, nobody will sell us this stuff at this price.
Yeah.
I understand.
Yeah. That's right. That's why we're all sitting, waiting. We can afford to wait.
Thank you.
We'll now go to Michael Nannizzi with Goldman Sachs.
Thanks. I'm just trying to square a couple of things. Rates were up 4% on average. It sounded like U.S. commercial, premiums were down 8%. Obviously, you had some actions you took that impacted premiums. Excluding those actions, can you help us understand what happened to exposures there?
Yeah. This is Peter speaking. To look at the top line, first thing you got to do is strip out foreign exchange, and that's about a 4.2% adjustment. If you look at the top line adjusted for foreign exchange, it's down 3.5%. The biggest driver of that reduction, which was about 3.4%, was caused by us changing the policy form of certain policies in the U.S. along the lines that David alluded to. The loss-sensitive business is just simply rebooked in a way that reduces the top line, has zero impact on the bottom line. It's actually slightly positive because it reduces the premium tax. It's really dramatic effect on the use of statutory capital.
Right.
One example of where our focus on risk-adjusted return and capital efficiency is motivating our behavior as opposed to targeting top line per se. That being said, we're absolutely committed to a strategy of profitable growth. We are shifting the mix of business to activities that have long-term sustainable growth. In our roadshow, we talked about top-line growth expectations of 3% to 6% over the five-year period. We still expect that. In any given quarter, you'll see some top-line reductions as a result of exiting certain areas. One other area was the excess workers' comp, which contributed about 0.3% of the reduction of the top line, and that's something which we've talked about before as a business that we have exited completely.
Right. Now, I guess I'm just focusing specifically on U.S. commercial, where premiums were down 8%. U.S. commercial only. I imagine there shouldn't be a lot of FX in there. You had said, I think Bob had said in prepared or maybe David said in comments up front, that rates were up 4% in U.S. commercial. I'm just trying to understand just U.S. commercial, what happened. I get that it's about $300 million from the change in form that you had mentioned, but I'm just trying to understand what's happening to exposures in the U.S. Are they down relative to rate, and that's why premiums look to be about flat? That's what I'm trying to get to.
Yeah. First of all, I was talking about aggregate total top line commercial consumer and global.
As you know, roughly 50% of our business is international, and roughly 60% of it is commercial.
Secondly, I've made it very clear in all of our discussions that we are seeking to grow international faster than domestic and to grow consumer faster than commercial. The math works out that we are shrinking U.S. commercial, where we feel we're not getting adequately rewarded. The reductions there are quite substantial in order to get that net number on a global basis. That's as far as I'd go to comment on that.
Okay. Can you talk about, again, in U.S. commercial, can you talk about pricing versus loss trend or how pricing is tracking to your expectations at the beginning of the year? Can you talk about that?
I'll ask John Doyle to comment on that.
Hey, Michael, it's John.
Hey, John.
I would add to Peter, to the response to your last question, that we continue to reduce our exposure in the U.S. to cat property, to work comp. Peter mentioned excess comp, but also to primary guarantee cost comp and to excess casualty. Rates continue to trend more favorably. They are slightly ahead of what our expectations were in the beginning of the year. We did increase our loss picks for some U.S. commercial lines at the beginning of the year. That accounts for some of the year-over-year change in the loss ratio. Obviously, we had planned for that when we went out on the road in the second quarter. The pricing trends are a bit ahead of what we expected. I would add that September pricing was better than August, and August was better than July.
While we still have some work to do to get where we want to go, trends continue to move in the right direction.
Any difference between large case and small case? Maybe if you could touch a little bit on professional lines, in particular D&O and kind of what you're seeing there. Thanks.
Yeah. Our rates in professional liability were down about a half a point in the third quarter. That's better than where we were in the first and second quarter. The business there continues to run off very well. We're certainly confident in our portfolio there. I've certainly read about lots of other markets talking about the competition there. I would say that we're primarily a lead writer in that market, and I think it can get a bit more competitive as you move up above the lead layer. We continue to be confident in where we're headed there.
I want Rob to just clarify something. Did you mention that you thought that our commercial was down 8%?
Well, if I look at U.S. commercial, in your supplement, you break out commercial lines by geography. I was looking at, I guess it's $3.8-$3.5, roughly, in net written premiums from 3Q10 to 3Q11. I think that's about 8%. As I understand, about $300 million of that, maybe a decent chunk of that is the rate actions you took in the third quarter.
Yes.
I guess.
That's principally explained by what I talked about.
Yeah
The loss-sensitive business.
That we have changed the policy form of.
Right. Still, if rates are up 4%, even if premiums are flat, that would mean, I guess, that exposures are down 4%. I mean, is that how we should be thinking about it?
Exposures are down in comp, in excess casualty, and in property, they're down more than 4% in that area. We've written less new business year-over-year, quarter-to-quarter, because new business pricing isn't as attractive as we'd like it to be.
Great. Thank you. That helps a lot. Thanks.
Unfortunately, we're out of time. To those of you we didn't able to get to, I apologize for that. Give us a call and we'll do what we can to answer your questions. I want to close on a very important statement, and that is the fact that We have shown the strength and our resilience, in this organization going forward. As it relates to AIA, I want to repeat again, because I know there's been a lot of speculation, and sometimes people say I'm not clear, I'm working on my clarity skills. The lockup has allowed us to sell the shares, our timing and our decisions have nothing to do with the lockup. It has to do with making sure we do the right thing for the shareholders of AIG and at the right time.
On that note, I thank you all and look forward to hearing from you all next quarter.
Thank you. That does conclude today's teleconference. We do thank you all for your participation.