Good day, everyone, and welcome to the American International Group second quarter financial results conference call. This call is being recorded. Now, I'd like to turn the conference over to Ms. Elizabeth Werner, Head of Investor Relations. Please go ahead.
Thank you, and good morning, everyone. Before we get started, I'd 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 factors described in our 10-Q under Management's Discussion and Analysis, and in our 2010 10-K and subsequent 10-Qs 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.
At this time, I'd like to turn our call over to Robert Benmosche, our CEO. Bob?
Thanks, Liz, and good morning to everybody. We have a lot to cover, so I want to be pretty brief, then I'll turn it over to David. The key for this quarter, though, and I do want to comment and stress it, is that we completed the last hurdle for this company for the conditions of closing for our restructuring. By issuing 100 million shares and raising that equity capital, it allowed the Treasury to terminate the Series G preferred. Therefore, in my mind, AIG's crisis is over. We no longer have any direct obligation that we have to be concerned about vis-a-vis the government. Whatever is owed to the government for what they gave us in the beginning is all covered by collateralized partnerships or the common shares that we issued to them back in January.
Today, we are independent of government support, which is very important for our employees and our clients as we go forward. There's clarity. AIG is here. We're an investment-grade company. If you look at our results for the quarter, our top line is strong, our retention of clients is strong, our retention of people is strong. All of the fundamentals of running this company are moving in the right direction. You could see in Chartis, for example, that the combined is now 97.7% for this quarter, working its way down, and you know that's a huge book of business, so it takes time to do that. You also will see in SunAmerica the strong top line in terms of those products that they sell. That's a good story because they were back in all of the distribution systems.
UGC has a good control over its mortgage business. In fact, they're now leading in market share in terms of that business and have a very strong performance in terms of losses relative to their competitors. That's going well. Of course, as you saw in ILFC, we've been able to deal with our legacy aircraft with the announcement of this acquisition from AeroTurbine. That will give us more options in the late cycle of the life of those airplanes, which we did not have before. When you look overall, we're in good shape. I also should mention that Nan Shan looks like it will close. That will finally get done. That's another $2.1 billion-$2.2 billion we'll be able to bring in-house and deal with paying down the SPV with the U.S. Treasury. That's another good sign. Overall, we're in great shape.
We can look forward and focus on operating results, which we have over the last four or five quarters in particular. You can see it in our performance. Then I'll have David now take you through the details of that so you can reconcile what we reported and some of the nuances in those numbers. David?
Thanks, Bob, good morning, everybody. Let's turn to slide seven for the earnings highlights. Second quarter net income was $1.8 billion, up from a loss of $2.7 billion a year ago. Importantly, our after-tax operating income attributable to AIG, which is our principal non-GAAP measure, was $1.3 billion versus $800 million a year ago. On a per-share basis, after-tax operating income was $0.69 for the quarter versus $1.18 a year ago. Book value per share was $49.18, up 2% sequentially. Adjusted ROE was 6.3% for the quarter, 8.3% year to date. Let's turn to slide eight. Chartis reported pre-tax operating income of $789 million, down $166 million from a year ago due to an extraordinary level of natural catastrophe losses. Cat losses in the second quarter this year were $539 million, largely from U.S. tornadoes and storms versus $300 million a year ago.
SunAmerica posted $743 million in operating income in the second quarter, down $115 million from a year ago. The SunAmerica results included a $176 million decrease in the value of our Maiden Lane II investment due mainly to spread widening on the underlying non-agency RMBS securities. We also increased our reserve for IBNR by $100.6 million as a result of enhancing our death claim practices. ILFC operating income was $86 million for the quarter compared to $182 million a year ago. ILFC had $60 million of interest and other costs associated with their debt issuance and the subsequent tender offer for bonds and took an impairment charge of about $42 million on a handful of aircraft that we're either going to sell or put into part-out. As you might have read, again, as Bob mentioned, we announced the acquisition of AeroTurbine, the part-out business.
This will provide new opportunities and options for us to manage the older aircraft in our fleet. Turning to United Guaranty, our mortgage guaranty business reported $13 million of operating income versus income of $226 million a year ago. Last year's income benefited from $232 million of favorable prior year development, while this quarter included $25 million of unfavorable prior year loss development. To put this in context, United Guaranty has roughly $3 billion in net loss reserves. In addition, the second quarter included a $40-odd million favorable settlement with a former underwriting customer. Newly reported delinquent loans continued to decline, yet overturned for previously declined or rescinded claims increased. Domestic first lien reserves per delinquency remain steady at about $29,000 per delinquency.
Turning to our other reporting unit, this reported a loss of $984 million in the quarter versus $135 million a year ago, due largely to the mark-to-model loss of $667 million on our Maiden Lane III investment and, to a lesser extent, our capital markets wind down portfolio. As you know, Maiden Lane III is a special purpose vehicle that holds multi-sector CDOs purchased in the fall of 2008, in which we own a subordinated tranche plus a one-third residual interest. As of June 30, the value of our share of Maiden Lane III was $6.4 billion, down 10% sequentially, but importantly up 28% from our initial investment. We essentially gave back the $744 million gain in the first quarter. Prior to the second quarter, we reported eight consecutive quarters of gains.
In the second quarter, credit spread widening and the corresponding impact on fair value model discount rate assumptions were the key drivers in the Maiden Lane III value. Cash flows within the underlying CDOs remain steady, we still anticipate receiving payouts beginning in 2014. The Maiden Lane III cash flows to date have paid down $12 billion to the Federal Reserve Bank of New York, or about half of their senior loans. Asset Management, which is included in other, had income of $92 million for the quarter, down from $303 million a year ago, due largely to the tightening of credit spreads in the asset book from a year ago. Capital markets had a loss of roughly $160 million due to the unrealized mark-to-market loss on the super senior credit derivative portfolio versus a gain last quarter.
The loss was driven by a decline in values of the multi-sector CDS book. The wind down, it continues to progress very significantly. This book had 7 quarters of favorable marks before the 2Q, and our view of intrinsic value hasn't changed. Remaining in the multi-sector book is about $6 billion of notional, for which we hold liabilities of roughly $3.2 billion, most of which we've already posted collateral against. Independent views support our belief that the actual settlements under these contracts will be less than the GAAP liability and the collateral postings we have, thus giving rise to the potential intrinsic gains we believe are worth the GAAP P&L volatility that we are required to report. As previously disclosed, the 2Q marked the end of the active wind down of AIG FP.
The remaining derivative portfolio of the capital markets are predominantly non-complex market derivatives entered into to manage the risks of AIG and its affiliates or our hedges on those positions. At the end of the 2Q, approximately $29 billion of notional remains in the CDS portfolio, of which $22 billion does not require active trading management. The remaining $8 billion CDS, which is being actively managed, has over $1 billion of upside, we believe, against a modest contingent liquidity need going forward. During the 2Q, AIG FP agreed to terminate 2 super senior regulatory capital transactions with a combined net notional of over $24 billion, that notional as of March 31, and those had previously been subject to possible additional collateral postings. Finally, our remaining investment in AIA appreciated by about a billion and a half in the quarter.
Turning to slide nine, which shows the after-tax income reconciliation. Reconciling items have declined meaningfully as most of the restructuring activities are behind us. We adjust for taxes since we apply a pro forma tax rate to our operating earnings. The taxes are added back here to get the GAAP net income, since we aren't paying much tax, and we currently have a full valuation allowance. Jumping to slide 11, our capital structure. This reflects the January 2011 recapitalization and a reduced leverage. Our leverage is currently in the low end of the range of our long-term target, and we still assume a 20%-25% debt to total capital as part of our aspirational goals. Turning to slide 13, Chartis. I would note that Chartis reorganization into global commercial and consumer business is beginning to develop some positive momentum.
Net premiums written, excluding Fuji and the impact of foreign exchange, increased about 2.4%. Prior year development was insignificant for the quarter after considering related loss sensitive premiums. The 4 business lines with the largest reserve strengthening at year-end 2010, saw little activity in the quarter. The combined ratio on an accident year basis, excluding cats, was 97.7%. The expense ratio remained essentially flat. We're intensely focused on reducing general operating expenses in a thoughtful and deliberate way, we will continue to make strategic investments in projects that better position Chartis for the future. Turning to slide 14. Net premiums written benefited, as I said a minute ago, from our Fuji acquisition, otherwise were around 2.4% up for the quarter. Pricing is trending positively overall. In particular, in the U.S. market, we're experiencing low single-digit increases on average, led by our commercial property and workers' compensation lines.
Customer retention, as Bob mentioned, is also strong. Turning to slide 15, Chartis investments. Net investment income for Chartis was $1.14 billion in this quarter, up 2.6% from a year ago. The primary driver of the increase is improved interest in dividends and the effects of the consolidation of Fuji. Chartis continued to reduce its muni bond position, which was 28% of Chartis investment invested assets in the quarter, down from 31% last quarter. On slide 17, turning to SunAmerica Financial Group. SunAmerica's operating income was $743 million in the quarter, down $115 million from a year ago. As you can see, SunAmerica's operating income has been relatively stable for the last five quarters. This quarter's volatility relates to market volatility for RMBS, and in particular in its effects on the value of Maiden Lane II, which is included in the SunAmerica Group.
We also increased our reserve for IBNR by roughly $100.6 million, as I mentioned earlier. Our business remains diverse, strong, good momentum in sales and deposits, customer retention, and importantly, net flows. Turning to slide 18, premiums, deposits, and other considerations. Life insurance CPTE sales increased 29% sequentially, largely driven by retail sales. Western National, while continuing to maintain its pricing discipline, again achieved sales of over $2 billion in the quarter due largely to certain bank partners negotiating lower commissions in exchange for higher crediting rates for our customers. All in, total net flows for retirement services of $726 million were positive for the second consecutive quarter. Turning to slide 19 for SunAmerica Investments. Net investment income was $2.46 billion, down $167 million from a year ago. As I mentioned, Maiden Lane II negatively affected this quarter by $176 million versus a positive $120 million a year ago.
Partnership income was strong again this quarter due to performance of our private equity and hedge fund investments, which are reported on a one quarter and one-month lag, respectively. Excluding Maiden Lane II, investment income increased by 5% on increased interest in dividends and partnership income. Most importantly, our base yields increased sequentially as we redeploy cash. More on that in a minute from Bill Dooley. Turning to SunAmerica spreads on page 20. Reported spreads declined despite the redeployment of cash. Declines in other enhancements, which is mainly Maiden Lane II, more than offset the growth and interest in dividends. Looking ahead, as we continue to take capital gains to realize the economic value of our substantial capital loss carry-forward deferred tax asset, reported spreads could be pressured. We're choosing economics over a reported GAAP measure. Now, a few words on income taxes on page 22 and 23.
As more fully described in our second quarter 10-Q, we apply a framework for evaluating the need for valuation allowances. Among other factors, AIG must emerge from its recent cumulative loss position, demonstrate a level of sustainable profitability. AIG's U.S. consolidated income tax group has reported taxable income over the first half of 2011 and is currently projecting taxable income for the full year of 2011. In addition, the group expects to emerge from the cumulative loss in recent years in the second half of 2011. If these factors are met, the valuation allowance for the net operating loss, the non-life capital loss carry-forward, and the foreign tax credits could be released during the fourth quarter. Realization of the life capital loss carry-forwards remains more challenging, and that portion of the valuation allowance will be released as the carry-forwards 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 munis. Other discrete items in any given quarter will impact the rate as well. This quarter, among other things, we settled disputes previously reserved for, the effect was favorable on the quarter. Finally, a word on our outlook. Consistent with the next steps of our company and our increasing focus on long-term operating results, we outlined a number of long-term aspirational goals in our first quarter 10-Q, which we affirm again this quarter. We expect to continue to execute on the operating and capital management actions to achieve these goals. At this time, I'd like to turn it over to Bill for a few comments on the cash redeployment. Bill?
Thank you, David. As we entered 2011, we had high investable cash balances in the insurance companies. Over the course of the first half of the year, we invested those cash proceeds in various asset classes to give the various durations necessary for the insurance companies. In the first half of the year, we invested just under $50 billion, and the average yield across the board on those investments were roughly between 4.5%-6%. When we entered the third quarter, we were fully invested with all the cash that was available at the beginning of the year.
Okay.
Okay, operator. At this time, we'd like to turn the conference call over to Q&A. We'd like to try and take one question, one follow-up from all the analysts, then hopefully we'll have time to do more, and they can get into queue.
Thank you. At this time, we will start the question and answer portion of the call. If you have a question, please press star then one to signal. To allow everyone an opportunity to ask their question within our allotted time, please limit yourself to one question with one single follow-up question. If you have additional questions, you may re-queue. Again, that's star then one to signal. We'll hear first from Joshua Shanker with Deutsche Bank.
Good morning, everyone. My question, and I'll give them upfront, and they're not related, but they're similar. I'm trying to understand the $100 million reserve charge in SunAmerica for incurred but not reported deaths. Two, it seems for two quarters in a row, we've taken charges on a revision on the outlook on cash flows for life settlement contracts. Given about 6,000 contracts, it seems like a pretty significant charge over two quarters. I wanted to talk about whether that will moderate and what your outlook is there.
We'll have Jay just briefly give you an update on what the process changes were, and then we'll have Peter talk about the life settlements. Jay?
Good morning, Josh. It's Jay Wintrob. The increase of $100.6 million in the IBNR was in response to industry-wide regulatory inquiries, which we were in receipt of regarding our life insurance claim settlement practices and compliance with the unclaimed property laws. Our practices in that area are currently and have been completely consistent with all the applicable legal requirements and all of the historical industry standards. Having said that, we use this as an opportunity to enhance our practices. We voluntarily initiated a review using, for example, the Social Security Administration's death master file. As a result of that review, we chose to post the IBNR of $100.6 million. That's the background on that.
Is it most certainly non-recurring in nature?
Right now, most certainly, this is now part of our claims practices going forward. We will continue to use this and other information as this develops. Again, the inquiry was industry-wide, not specific towards American General or SunAmerica Financial Group.
The answer to the question is, I believe that the process change that Jay talked about, it's more about a process change. There's a question about what practices are, we looked at our practices and said, we think we should do it a different way. On the basis of what we've changed our practice to be, the team believes that they got this worked out in this IBNR, this puts the problem behind us. On a go-forward basis, it would be part of the normal operating procedure. You would see that it's just part of our numbers. I think this closes it out from what we can see right now. Let me turn it over to Peter.
On the life settlements impairment charge, I'd like to just put it in the context of the overall life settlements portfolio, which totals a carrying value of $4 billion. We have instituted increased scrutiny of the longevity assumptions with updated medical information on individual lives. This is a book which has fairly large insured values per life. As a result of those updated actuarial assumptions, which were validated by third-party scrutiny in this quarter as well, we have added the impairment charge. On the other hand, as I said, it's fairly lumpy in terms of individual lives. When we take an impairment, it's an asymmetrical charge when any single contract is impaired. You don't take positive news when it comes in, so there's an asymmetrical aspect of it.
When we take an impairment, we basically look at current yields on similar contracts to mark down the position.
In the queue, you described it as an enhanced process change. You had $60 million of charges in 1Q, and here $180 million here. Is the process change fully in effect so that we don't expect this to recur as sort of a change in the outlook, or just be mark-to-market from here on out?
It's not mark-to-market. It's effectively cost accounting. You're basically looking for impairments of individual lives. If you've got evidence that your assumption there is too aggressive, then you mark that to market, you don't mark up
The opposite lies where you have information that suggests that you have it valued too low. The enhanced process is just increased scrutiny on this book with additional third-party scrutiny to validate our own assumptions. That's what's changed, I would not expect charges of this magnitude going forward. On the other hand, I would not expect it to be zero either. There will be some volatility, and it's asymmetrical because the positive news comes in the form of a higher expected yield over the approximately 10-year duration of these contracts.
We also have completed a very deep strategic review of what we're doing here. We're going to think about how we modify it, this is not an area that we're going to be emphasizing going forward. We're just thinking about how to deal with it. Over time, we're studying this as an asset class, we don't think it's something we're going to be growing.
Okay, thank you for the color.
We'll hear next from Donna Halverstadt with Goldman Sachs.
Good morning. I had a question about a business that's a small slice of your business mix pie, but I'm just not clear how you think about it. I wanted to understand philosophically or strategically how you're viewing United Guaranty, whether it's core or non-core, or just merely a placeholder until some future point in time when we know if there's going to be a more robust future demand function for private MI. As a follow-up to that, the pace of flux in the MI industry is picking up rapidly, and I was curious whether or not you'd be interested in participating in any restructuring of the current industry makeup.
We see UGC has really done a dramatic turnaround of that business. I feel they have employed excellent technology now behind their claims process. They've got themselves very much under control for the legacy book. They've done a wonderful job of reinventing how they underwrite mortgages. They have a model now that works very effectively on new business. The experience that we've been seeing over the last, started in 2009, you look at 2009, 2010, and 2011 so far, that experience is exceptional relative to our history as well as the industry. We are pricing for the right risks, and we're getting the risks that make sense for us as a company. We're not competitive in those risks, which we obviously are concerned about. Having said that, our market share has grown dramatically, and with that performance.
We don't see any need to help anyone else out. For now, the business we operate that, as well as ILFC, is do no harm to the core franchises of the company. Unlike ILFC, we feel that UGC does provide us a tremendous insight into a major aspect of our investment, which is residential mortgages and so on. We also believe that as the government begins to pull back in some way out of the mortgage guaranty business, there may be a better market for us in here. This may grow. For now, it's running very well. It's enhancing whatever we do here, not only from a small amount of earnings but also by the intelligence it provides us of what's going out in the economy. For now, we see it as a keeper.
Great. That's helpful. Thank you.
Our next question comes from Jay Cohen of Bank of America Merrill Lynch.
I've got one question, then Ed Spehar is going to have a question as well on the life side. My question on the property casualty side, I'm wondering if you could talk about some of the claims trends you're seeing. Obviously, with the review last year, there were some negative surprises in claims trends in various businesses. As you've entered now 2011, I'm wondering if you can update us on the claims trends, particularly in places like excess casualty and excess comp.
Hey, Jay, it's Rob Schimek speaking. I think you can see from our quarterly review of our carried reserves that we did not experience any significant deviation from our expectation during the quarter with respect to claims trends. That's one of the things we focus on each quarter. We have an expectation based off of our carried reserves of what should happen during the quarter, and we compare that to what actually did happen during the quarter. I think we, generally speaking right now, it's a class of business by class of business distinction here. Generally speaking, we're seeing rate change in line with loss cost trends, in particular, for example, with respect to workers' compensation, where you're seeing rate increases. It is line of business by line of business specific. I think the overall point is that the actual results are trending in line with our expectations.
The other is it's important to stress that they've enhanced their process as well. What you're seeing us do is enhancing a lot of process because we really want to tighten this place up and really improve the quality of our performance. About $10 billion of our reserves this quarter were looked at by a third-party actuary. We're going through it quarter by quarter, and they validated that our reserves are, if anything, just slightly above what they saw as their central estimate. I think it's $10 billion, as we go through it, we're seeing everything coming in line that the reserves continue to be what we said, very strong.
This is Ed Spehar. I have a question for David Herzog. Can you give us any thought on how much of this life capital loss carry forward, this $23 billion of gross attributes, how much you think you might be able to realize?
Yeah, sure. As we said earlier, we've got about $7.5 billion of net DTA related to the life capital loss carry-forward. As we look at the life portfolio, it has about, I think, about $8 billion or so of gross gains. If you tax-effect the gains, that sort of gives you a sense of how to think about the real opportunity right now, because that's the inventory of gains that we have. The question is: how do we go about achieving that? In part, we are realizing capital gains in the life companies themselves, actually selling the securities. There are other strategies involved where we have other opportunities to realize, at least for tax purposes, the gains. We are in the process of evaluating it.
My sense is, Ed, as we've said, maybe up to 25% of that number, of the $7.5 billion we would expect to get because the expiry dates run between 2013 and 2014. Time is very different than on the NOLs, which run out till 2028. The fourth quarter evaluation, as I was commenting on, will be around the NOLs, which we expect to realize fully, the foreign tax credits we expect to realize fully, and the non-life capital loss carry-forward we expect to realize fully. Hope that's helpful.
David, yeah, it's helpful. If you expect it to maybe up to 25% of the $7.5 billion, that would suggest about $3 billion of gains harvested in the portfolio, right?
Well, no, I think of it differently. If there's about $2 billion to $2.5 billion of DTA, and the DTA is effectively 35% of the actual gain. You need gains of if we were to realize all $8 billion worth of gains.
No, I got it. All right. I had the math backwards. I guess the question though, if you had $6 billion of gains, wouldn't that be probably given up maybe around $700 million of annual investment income?
Yeah. That's why I say we're balancing economics here against a GAAP-reported number and a GAAP-reported spread. We're sensitive to that's why there are other ways to realize those gains other than just straight-out harvesting.
Yeah, Ed, I think what we're doing right now is we're assembling a world-class team in my mind because there may be some maybe as good, there'll be nobody better that have put their minds around how we begin to deal with this and how we can do things in a way such that we trigger a taxable gain on what it is we have here. Sometimes you don't actually have to sell it, that you get caught with a taxable gain. There's all kinds of theories and strategies we're putting together, we're going to do everything we can to maximize this number. However, we're also mindful that we don't want to do it to the extent that it would harm Jay's business. We're being mindful of the NII there. That's the challenge.
We have a team to do it, that's why David is going to be conservative come the fourth quarter as to what he thinks can be realized of this number.
Thanks. We vote for economics if you care.
The jobs number was pretty good.
What was it?
154.
Listen, I have to wait. My boss just said.
Ed, thanks for the endorsement of the economics versus GAAP. Appreciate that.
Michael Nannizzi of Goldman Sachs has our next question.
Thanks. Just a couple of questions here. I'm trying to reconcile the development. We've got a 98% ex cat combined ratio Chartis, 97.7 ex cat in prior year development. The development shows as being zero, 91 adverse, and then 91 in return premiums. In the Q, it looks like about $100 million in additional adverse development from the first quarter. That's page 125 of the Q. Just trying to reconcile those if I could. One follow-up. Thanks.
Well, hey, Mike, it's Rob Schimek.
Yep.
Let me just provide clarity here.
Sure.
First of all, I think you generally said this correct. Prior year development for the second quarter is adverse, we write loss-sensitive business, and on the loss-sensitive business, we have accrued premiums. The net of those two items in the second quarter are largely offset. The way that it works in the combined ratio itself, though, is that the prior year development affects the numerator.
The accrued premium or the loss-sensitive premium affects the denominator. It's not an exact zero-sum game in the combined ratio itself. I think we talked about in the first quarter, one of the significant drivers
On our development in Q1
was the fact that we had a settlement of a historical issue associated with one particular line of business. It's disclosed, I think, reasonably clearly in the 10-Q.
It was that item that really drove prior year development all in the first quarter of 2011.
Okay. In the second quarter, it looks like you had about the adverse. Just on that adverse versus the loss-sensitive. Is that the same business? You had adverse and then in addition, you had additional premiums related to that adverse development because it was business you'd written on a loss-sensitive basis, or are they two separate items?
You said it exactly, Mike. We have adverse development on business that was written years ago, and the premium accrual is on that same business. If you recall, just remember the way that this actually works.
is we do our analysis across the entire portfolio, maybe in excess of 1,000 different cohorts of data that we're analyzing. The adverse development is the sum of all of those ins and outs.
All of the accrued premiums on the loss-sensitive business, 100% of it relates to business that's also being included in, and it is the driver of the net adverse development that we experienced for the quarter. The answer to your question is absolutely, positively, these are directly and specifically interrelated. There's an exact match between adverse development and the premium accrual on the loss-sensitive business. I'm just saying to you, there's thousands of different ways that we slice this data, there are other pieces of increases in prior year development and other places where there's decreases in prior year development. The primary driver of why you have adverse development is related to those premiums that we also accrued on loss-sensitive business.
Okay. I'll follow up after on that one. Just had another math question. If I could, just wanted to understand what happened again, Chartis U.S. Consumer lines, it sounded like from the Q, you discontinued a couple programs, otherwise saw some growth there. Commercial lines, you had a big E&O policy. It sounded like higher rates in commercial, decline in specialty comp. Just trying to understand what got you to the plus 4.6%. Is it a combination of those items, or is it underlying that got you there? The expense ratio that was about a 200 basis point decline sequential. Just trying to understand how to think about those as well. Thank you very much.
Well, I think the first thing is that as we have looked at all of our lines of business, all of our individual relationships through the scrutiny of whether they meet our risk-adjusted profitability targets, certain programs just didn't make the cut. The particular consumer example you cite was one that, whatever way you look at it didn't make sense going forward. We terminated that program. In terms of the overall trend, we saw an increase in ratable exposure, which helped the general positive trend. Hopefully, the economy continues its recovery and that trend doesn't reverse itself, but we're not holding our breath. In terms of other favorable rate trends, property is probably the most promising, especially property cat and especially outside of the U.S. In the U.S., we're also seeing a slight hardening.
The expense ratio.
Well, I'm sorry. One other thing that I would mention for you there, Mike.
In the second quarter of last year, we did our first cat bond.
The prior year premium associated with commercial property is reduced by the amount of premium that we ceded on that cat bond, which was approximately $100 million. We're higher in the 2011 quarter simply because we did not cede premium again on a new cat bond. I just wanted to add that.
Very fair. Thank you. Real quick on the expense ratio, just if that's okay. About 200 basis point decline. Just trying to understand. You're clearly making some changes, cutting some specialty comp lines. I imagine there's still some outstanding claims on those. Just trying to get a handle on how the expense ratio goes down. Is that where we think it's going to be, or is that just kind of a dip here in the second quarter?
Let me start with an overall comment on the expense ratio. Then I'll hand it over to Rob. The expense ratio is not something we target. It's an outcome of things that we do target, which is improvement in our costs, regardless of whether they appear in the expense ratio or the loss ratio. I think that we're very conscious of the importance of reducing our fixed costs and then focusing on unit costs associated with claims management. As we do that has an effect on the expense ratio. Secondly, as our business mix shifts from high to very low frequency to higher frequency, low severity businesses then the expense element goes up. The amount of capital intensity goes down. As we factor in capital costs, that again is another important shift.
As we shift towards these lower risk consumer lines then we expect the expense ratio to go down.
The acquisition cost is obviously higher as well in those lines. It's an outcome of our strategic shift towards lower risk businesses with better repeatable earnings characteristics. We're very focused on expenses, however they're categorized. As far as the specific shift, maybe, Rob, why don't you explain that shift?
I'll just give you a couple more things to keep in mind, especially here in 2011, and I think certainly for the first part of 2012. We have embarked on a number of very important strategic, fundamental investments in our platform, including, for example, work we're doing on Solvency II in Europe, and we're also undergoing a very significant finance transformation effort inside of the Chartis finance organization to put us all into one single common financial platform around the world. Each of those items, among others, are investments that we think very important to the long-term sort of viability of our platform. Those will cause our expenses to go up as we go across the next year or so. However, you will see us also continuing to demonstrate progress on the items that we've been targeting as an overall reduction of GOE.
One thing you will see from us is, as we now have a full year of Fuji consolidated into our operations, Fuji carries a higher expense ratio, and you should expect that will also have an impact on us as we move forward in the rest of the year. We do a lot of work on a quarterly basis to make sure that we've got an appropriate evaluation of bad debt, whether it's on premiums or whether it's just on any receivables that we have on the books. One of the things that benefited us in the current quarter was a reduction in bad debt expense also, and that will be lumpy on a quarter-to-quarter basis, really just based off of the facts and circumstances of that analysis.
Very helpful, Rob and Peter. Thank you very much.
We'll hear next from J.P. Morgan's Jimmy Bhullar.
Hi, good morning. I had a question on capital flexibility. Obviously, you had to raise equity earlier this year to replace the Series G preferred, and maybe you have to hold that as a question. You sold Nan Shan since. What do you believe your current excess capital position is on the balance sheet? Also, how much free cash flow you expect to generate this year, given the high cat losses, and then any comments on potential uses of this capital?
The one comment, I'm going to turn it over to David, I want to stress that raising the $100 million, selling the $100 million shares, was a condition of closing to demonstrate we could. Remember, for us to be allowed to be where we are today, completely independent of government support, that we had to prove we can get unsecured debt all the way through de-risking FP and our credit ratings, and also raising equity capital. The G was put in as a stopgap until we demonstrated that. That's really about bringing us to that level at this point in time. We've also told you that we want to over-solve for liquidity during this period of time, so that the rating agencies can absorb where we are and see how we operate throughout 2011. That's what we did.
Again, keep in mind that we had to demonstrate our strength, having given up $30 billion of committed government support, plus the implied support above that. That was all part of that condition of closing and maintaining strong investment-grade ratings on a standalone basis. Having said that, David can now talk about what we're going to do with the proceeds.
Yeah. Jimmy, good morning. The Nan Shan proceeds will be used to repay, or pay down the AIA SPV balance. There's about $11.5 billion of obligation that the SPV has to the U.S. Treasury. The Nan Shan proceeds, the nearly $2.2 billion, will be used to reduce that balance. Again, which is a great outcome for all the stakeholders. That's where those proceeds are going to go. I would point you to our 10-Q disclosure, page 142. We talk about the capital liquidity availability at the holding company, the nearly $13.1 billion. As we discussed earlier, it's not so much about excess capital today as much as it is about the generation of distributable available capital as we continue to execute on our business.
Again, we reaffirm our aspirational goals, which we set forth in the first quarter Q, that the $25 billion-$30 billion of capital management activities over the course of the next several years, we believe are still very achievable, particularly in light of the continued progress that we're making. Again, we'll continue to try to optimize the capital structure of the company. We're building sufficient liquidity at the holding company. Again, the final determination of whether or not we are designated a SIFI will ultimately be determined sometime later this year, we expect. Again, all of those will play into when and how much and to what degree we commence our capital management. At this time, it's about building the pool of available capital.
By the way, we have done a lot of sensitivity testing around SIFI, and we're very confident that SIFI will not cause us to go up, but we are well above wherever even SIFI is at, so that we don't see it getting in the way of our flexibility and our thoughts at this stage of the game from what we've studied.
Okay. Any comments on free cash flow that you expect to generate this year?
Well, we have, as we laid out as part of our earlier equity markets discussions, capital dividend capacity at our operating companies, those expectations have not changed. We will continue to expect to receive dividends from our operating companies to bolster the $13.1 billion we have.
Lastly, on AIA, you have restrictions on selling that. I think you can sell some of that beginning in October. How do you view that asset? Obviously, it gives you exposure to the international markets to the extent you continue to own it. Do you think you're going to hold onto it or is it more going to be opportunistic?
I think we're going to study it. When we get to October, we'll know what the markets are. We'll know where we are. As we talk about the SPV that it's collateralizing, as David just said, we're at 11.3. We've got about $2.6 billion of cash that's sitting there in support of contingencies for MetLife because of the sale of the MetLife stock and the deal with Alico. When you take that out, we're down to about $6.5 billion if the Nan Shan comes in. That's collateralized, for example, by ILFC as well as AIA. There's a huge amount of money. We're going to be taking a look at strategically where we are, what we need to do, what makes the most sense come October.
The team will do that which we believe will give us the best shareholder value for the company going forward. It's all about how to create shareholder value for you into the fourth quarter as quickly as we possibly can.
Thank you.
Andrew Kligerman of UBS has our next question.
Good morning. Going back to the SunAmerica question for Jay. $8.4 billion in cash and short-term investments were deployed during the quarter. You go from a base yield of 5% up to 5.36%, but you also harvested, I think it read $3.4 billion of gains. Now we're at 5.36. If nothing were done going forward in terms of harvesting that $8 billion of gains that you have left, where does the base yield go? The other part of it is, if you're willing to discuss how much of that gain you want to harvest, what kind of impact would it have negatively?
This is Bill Dooley. Let me just make a comment on with the base yield increases on future cash flows, a lot has to determine on obviously where the market goes in that period of time. That's a harder question to answer. When we're taking the gains on the SunAmerica portfolio, we're doing it in a deliberate way so we can kind of close the gap between the give up and what we're getting. The other thing we don't want to do is to create another large cash balance at the life company level. I'm looking for offsetting assets that are basically the same type of assets, even though there's going to be a yield difference because of the movement of the marketplace. Everything's being done in a very deliberate way.
You want to minimize the impact, and it won't be too-
We're trying to minimize the impact, but at the same time, pick up the gains.
Got it. With the $8.4 billion that you deployed, shouldn't that yield of 536 go up next quarter, barring taking gains on the other stuff?
Well, as the sales take place, the gains are coming in. I'm redeploying those funds at lower yield levels just because of the movement in the marketplace.
Right.
Economically, as David was saying, for the consolidated entity, we're much better off by taking those gains and having a smaller yield on the underlying assets in the insurance company.
Yeah. Andrew, it's David. Just to make sure we've got our facts right. I think we've taken about $350 million of gains thus far this year in that ZIP code, not $3.5 billion.
I'm sorry. That was what you sold $3.5 billion to get that amount of gains, right?
Okay. That's fine. Good. Just want to make sure you understand where.
Yeah, no, I do.
Good. Thank you.
If I could just add to what Bill and David said, a couple things, Andrew. One is, some of the cash was redeployed rather late in the quarter, so I don't think we've seen the full impact of that yet in the base rate. All subject, as Bill mentioned, is to reinvesting new cash flow in this quarter. Again, that's one point. The other thing is that in terms of being deliberate, we are still in a negative IMR position in our life company. 100% of these gains are going also to increase our statutory capital at this point as opposed to increasing our IMR reserve. That's the kind of thing we're taking into account as we do this in a deliberate way.
Got it. That's good, Jay. There is some interest income pickup as we go into the third quarter. Nothing you could kind of give us a sense of to model for?
Yeah. I'm not comfortable with that only because there's still this third quarter to go. We know that all of the activity in the second quarter is not reflected in the base yield.
Okay. Then just while I got you, the discipline around Western National in terms of, there was a big pickup in deposits. Maybe just give a little clarity on what was so disciplined there.
We continue to target approximately 12%-12.5% after-tax internal rate of returns. We're getting our pricing. We're closely coordinated with our asset management group on the investment side. Bill, we are back reinstated in all of the distribution that we were in prior to the fourth quarter of 2008. I believe we have going now the most we've ever had, I think 12 separate rate for compensation trade-off programs across all of our different banks, large, medium, and small. That's been a big driver of the activity where banks are trading off commission compensation in order to offer the customers moderately higher crediting rates. That's a win-win for everybody. We feel good about what's happening at Western and in our fixed annuity business. The absolute level of interest rates historically has had an impact on that. Higher is somewhat better.
On the other hand, we see our customers more and more interested in guaranteed returns for some meaningful part of their portfolio. The pricing is solid, and the sales activity has remained solid. I think Western and everyone there is doing an excellent job with it.
Great. Thanks a lot.
The other thing, Andrew, the one thing to keep in mind, and for everybody to keep in mind, is Western has a product chassis that is unique to the industry. Think about it, as today, I think they priced maybe 230 different combinations and permutations of different capabilities so that they, "Here's how much money we have, and how do you want to slice and dice it?" As Jay just said, several very large banks have decided to finally see what happens when you cut commissions and go ahead and see if you can get the volume to do better. We've seen huge volumes in these institutions that are very large. This is a competitive advantage because of the way and the uniqueness of that front end.
You add to it a very, very strong, low-cost operation that comes out of Amarillo, Texas, for now, which is a very high-quality group. You put that together, it gives them the opportunity to get this kind of price with this kind of volume. It really is unique, and it's very hard for competitors to get to this overnight because you got to build that model and then get people comfortable in using that model. It really is an incredible capability.
Great. Thanks, Bob.
We'll move on to Thomas Gallagher with Credit Suisse.
Good morning. First, Bob, I just had a follow-up on the comment about the Treasury SPV in terms of the $6.5 billion that would be left and potential assets or sources to repay that. You had cited AIA and ILFC. Any thoughts on Maiden Lane III? Your Maiden Lane III stake, $6.5 billion. Should we assume that that's not on the table because it's fully in control of the Fed? Or is there a chance that you can monetize that, say, within the next couple of years? That's my first question.
You guys got some extra money? We can talk. I don't know how anybody's going to buy our interest. It's totally under the control of the Fed. All I can say is that the cash flows, remember, in the two years or so, it's gone from $24 billion to $12 billion. It's doing about $350 million a month in cash flow. The cash flows are strong regardless of the pricing that's going on here. We're all trying to figure the pricing out better to reflect the real value here. There's no question Maiden Lane III has a tremendous amount of value for us down the road. We would think if you do the numbers, that sometime during 2014, it depends on how strong they stay, that our $6.5 billion-$7 billion that's sitting in there will start to flow in here.
You just have to take that out of the equation. It's just something coming down the road, just like Maiden Lane II. We could hope to take the volatility out of Jay's earnings. That didn't succeed. Again, that's another one that has a lot of economic value over time, they'll flow in. The only properties, and remember, those are collateralized. In order to free up the collateral, you're going to have to pay it down. Those are two major properties that are there supporting it. I think Maiden Lane III is there, that's just an extra safety valve down the road. The cash coming in, Treasury wants first priority on that cash because that's the deal. As we monetize these assets, we don't get to leave them with Maiden Lane III and an SPV taking it 5%. They want their cash.
That's what we're negotiating when the time comes as to how we exit from that SPV.
That's all the time we have for questions. I'll turn the call back to our speakers for any closing or additional remarks.
I'd like to thank everyone for joining us this morning and let you know that we are available to follow up with you on all questions. Please feel free to give us a call, and we will get back to you if you are still in queue. Thank you.
Thank you all very much.
Again, that does conclude our conference. Thank you all for your participation.