Good day, everyone, and welcome to the AIG Strategy Update conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Liz Werner. Please go ahead.
Good morning, everyone. Before we get started, I'd like to remind you that today's presentation contains certain forward-looking statements, which are based on management's current expectations and are subject to uncertainty and changes in circumstances. Any forward-looking statements are not guarantees of future performance or events. Actual performance and events may differ, possibly materially, from such forward-looking statements. Factors that could cause this include completion of the year-end audit process and the factors described in our first, second, and third quarter 2015 Form 10-Q and our 2014 Form 10-K under management's discussion and analysis of financial condition and results of operations and under risk factors. AIG is not under any obligation and expressly disclaims any obligation to update any forward-looking statements, whether as a result of new information, future events, or otherwise. Today's presentation may contain non-GAAP financial measures.
The reconciliation of such measures to the most comparable GAAP figures is included in the investor presentation. Nothing in today's presentation or in oral remarks made in connection with this presentation is intended to constitute, nor shall it be deemed to constitute any offer of any securities for sale or the solicitation of an offer to purchase any securities in any jurisdiction. This morning's Q&A format will be slightly different than in our past earnings calls. In an effort to answer more questions, we're asking that you limit your question asking period to one minute. We're also asking you to limit yourselves to one question and one follow-up. If you have more questions, please get back in the queue, and in the event you go over one minute or attempt to ask more than one question and one follow-up, we will move on to the next person in the queue.
I want to apologize in advance to anyone who may get cut off in this process, and again, I ask you, please do get in the queue. In the room this morning, we have Peter Hancock, our CEO; David Herzog, our CFO; and Sid Sankaran, our incoming CFO; Kevin Hogan, our Head of Consumer; and Rob Schimek, our Head of Commercial. With that, I'd like to turn the call over to Peter to begin our prepared remarks.
Thank you, Liz. Good morning, everybody. I'm happy to have an opportunity to speak in this webcast to all our stakeholders. Of course, to our shareholders, but also to our many customers, distribution partners, regulators, and our employees, all of whom are very interested to hear this update on AIG strategy. In this discussion, I want to give you a sense of what we're doing to accelerate a number of initiatives over the next two years, and what we're doing to be more transparent about our intentions and commit to a greater degree of openness about our progress and setbacks towards our goals. This company is where it is today, I believe, because in our recovery from the crisis, we recognized the importance of all our stakeholders if we were going to realize the full franchise value of this company.
All stakeholders are important and inform my views about these strategic actions. The pace, nature, and sequencing will reflect all stakeholders as we return a very substantial amount of capital. Let's now turn to slide four. The specific actions that we're taking, they fall into three categories: strategic actions, organizational changes, and operating improvements. On the strategic actions, the headline is that we're returning at least an additional $25 billion of capital to shareholders over the next two years, on top of the $12 billion in capital returned in 2015. Secondly, we're announcing the IPO of a piece of UGC and are announcing the signing of the sale of our advisor group to Lightyear Capital and PSP Investments. On the organizational front, we've created a segregated legacy portfolio of around 28% of the company's total equity.
Legacy consists of actively managed runoff businesses or non-core assets and liabilities that we'll target for maximum value. We're also on a path to exceed a 10% ROE in our operating businesses by 2017. In our operating businesses, we're committed to a process of what we call modularity, breaking down the broad businesses into nine components with a full allocation of expenses and capital so that we can hold individual leaders of these businesses accountable for end-to-end profitability, return on equity, and so on. This would also facilitate divestitures, should that be the appropriate value-maximizing step. On the operating improvements, we are announcing that we have specific plans to deliver on the upper end of the cost-saving targets that we provided a year ago. We will eliminate a further $1.6 billion of annual total expenses in 2016 and 2017.
Finally, we recognize that we have significant opportunities to improve performance in the commercial property casualty sector and expect the accident year loss ratio to improve by 6 full points over the next two years, with some major changes in our underwriting customer strategy and distribution strategy. Now please turn to slide five. This is the layout of the various steps we're taking to return that $25 billion of capital over the next two years. We believe that there are opportunities to exceed this target, and we'll certainly do our best to exceed the $25 billion. Should that make good economic sense? You should know that the target of $25 billion incorporates the significant reserve strengthening that was taken in the fourth quarter across a number of lines. Sid Sankaran will describe the reserve action at greater length following my comments and prior to the Q&A session.
I'd like to turn to slide six. I want to reiterate what I've said before, that as far as divestitures are concerned, there are no sacred cows. We look at all our businesses through the lens of would they create more value if they were in the hands of somebody other than ourselves. If so, what is the most efficient way to make that divestiture, weighing the significant tax implications and potential strategies for maximizing our $16.7 billion deferred tax asset, which we describe on page 23 and 24 of the deck. As we consider divestitures, we also weigh the exceptional value of diversification of between $5 billion and $10 billion in capital that we discuss in detail on page 22 in the appendix. We said, we have a plan to list 19.9% of UGC by the middle of this year.
UGC is the leading mortgage insurer in this sector, a position that we've taken it to from number five to number one when it was up for a fire sale back in 2010. On the Advisor Group sale, we expect that to close in the second quarter of 2016. It's a business we are not the best owner of, particularly in the light of potential United States Department of Labor rules. Let's turn to page seven. I want to reiterate that we're on track for the upper end of the range of our three-year cost saves by this further $1.6 billion of general operating expense reductions that we intend to execute over the next two years. We accomplished a 3% reduction in 2015 when adjusting for foreign exchange. It would have been much more if you'd included foreign exchange, almost 10%.
We certainly don't want to give ourselves credit for the foreign exchange movements. Over the three-year period, we expect a total gross expense save of $2.2 billion. This is going to be a very important contributor dealing with many of the stranded cost issues that would inhibit the ability to divest businesses without damaging ROE. Getting our fixed costs down and creating a more variable cost structure is a key strategic objective. Let's turn to page eight. I really want to talk about the specific actions we're taking to improve Property and Casualty loss ratio. Recent investments in systems and analytical tools will allow us to execute these actions. The business led by Rob Schimek has focused on a number of steps that will accelerate use of alternative capital, including reinsurance, both quota share and treaty.
This represents an aggressive shift away from monoline and dual line clients, where the cost and profitability just simply make it an unattractive proposition. We'll arm underwriters with tools that apply more data more quickly. Already, we've successfully deployed similar tools to claims adjusters over the last two years with great results. With every expectation that we'll get similar good results as underwriters take advantage of these tools. Let's turn to page nine. I want to elaborate on several important changes to the organizational design. Maximum transparency is our goal. Only after seeing how much equity is tied up in the legacy activities, can you evaluate whether our ROE targets are sufficiently ambitious. That is the column on the right.
It shows $22 billion out of nearly $80 billion of adjusted capital, earning about a 5% return, and that number is going to come down to closer to 3% in 2017. This is separate and distinct from our operating portfolio that has an ROE today of about 7.5% with every expectation it will grow. We are sub-segmenting our operating portfolio over the course of this year in a way that will allow you to judge whether the parts are earning their keep, which ones need to improve faster, and which are no longer welcome. You'll see about nine sub-segments to get a sense of how they're doing. Now let's turn to page 10. Our financial targets are clear and achievable. In the operating portfolio, we expect to have well over 200 basis points improvement in ROE by 2017.
A nine and a half ROE in 2016 and approaching an 11% ROE in 2017. This would lead to a consolidated ROE by our estimation of just over 9%, which is just above the initial forecast we gave you a year ago and reflects the accelerated nature of this new plan. On the legacy portfolio, we think that the right metric for success is how quickly we can extract capital by either divestitures, reinsurance, or other efficient runoff methods without giving away too much of our book value. It's a trade-off between releasing trapped capital so that we can reinvest it or return it to you without destroying too much book value. You will recall that one of our three financial targets is 10% in annual book value growth ex-AOCI and DTA, which we are reaffirming today. Now let's turn to slide 11.
We're taking actions today that are really designed to maximize value for shareholders while bearing in mind the impact on all our stakeholders. We're absolutely open to additional divestitures beyond what we've talked about, even of our largest units. You don't make a decision of that scale without thinking very hard about the impact on tax and on our financial strength. If the most recent reserve action says anything, it's a reminder that we have a very sizable legacy casualty portfolio, which as a standalone monoline business, would be harder to capitalize than as part of a diversified group. We're committed to accelerating the pace of these changes. We'll watch very carefully the developments of the emerging rules that come with being a SIFI.
To date, they have provided little to no additional expense, roughly $100 million-$150 million per annum, and it has not prevented the return of capital to you. Should that change in the future, of course, we would consider an exit ramp. If you'll notice from appendix on page 26, we're extremely well-positioned relative to the other non-bank SIFIs in our industry, Met and Prudential. We, in many ways, have already executed the de-risking that's necessary, that they are announcing plans to do in the future that would make an exit possible. Worrying about a SIFI designation today is a distraction from the important actions we've just announced. Our strategic actions will return significant capital to you, our valued shareholders. Our organizational changes will provide more transparency so you can judge how quickly we are moving.
Finally, our operating improvements are clear, decisive steps to improve profitability. With that, I'd like to hand it over to our incoming CFO, Sid Sankaran.
Thank you, Peter. As you saw, we announced a strengthening of our non-life reserves this quarter. The $3.6 billion pre-tax prior year development impacted our view of the profitability of accident years 2005 through 2014. We did our review of over half of our non-life reserves this quarter, comprised of our most complex lines. The strengthening was the result of new information, updated assumptions, the trajectory of our historical development, and our decision to respond more quickly to what we learned in the quarter. After applying enhanced methods and assumptions, we believe our actions will help mitigate the risk of future quarterly reserve volatility around the selected best estimate reserve. On slide 19, you can see that the strengthening is concentrated in long-tail lines of business, including primary and excess casualty in the U.S. and Canada, international casualty, financial lines, and our run-off lines.
As a result of fourth quarter detailed valuation reviews, we strengthened excess casualty by $1.2 billion. There were two underlying drivers. First, we saw the severity trends emerging throughout the year impact higher layers in general liability and umbrella commercial auto. Second, certain class action claims on high-limit policies with complex coverages moved closer to settlement, impacting our general view of. Adjusted our tail factors to reflect this information. In primary casualty, $540 million of adverse development was due to certain risk-sharing programs in auto, general liability, and workers' compensation. Our international casualty portfolio, which tends to have a shorter tail than the U.S. portfolio, was impacted by several individual product liability claims much larger than historically experienced. International casualty remains above our current profitability targets despite the reserve strengthening.
In the case of financial lines, we updated our development assumptions for more recent accident years based on claims activity in the 2006 through 2010 accident years. We note that financial lines also remains above our current profitability targets. Development in run-off lines was driven by the results in our detailed quarterly reviews across the multiple portfolios. The aggregation of these reviews accounts for $267 million of the $541 million strengthening in run-off lines. We believe that our action is slightly more responsive than our prior practice and is an important step to take, given our recent history of prior year development. It is consistent with our view to reserve to our best estimate. Again, this action should help to mitigate the risk of future quarterly reserve volatility.
Turning to slide 20, we show that we've been taking actions to reduce our U.S. casualty exposures. We will aggressively accelerate exits from underperforming business or remediate those lines this year. The long-tailed nature of these exposures is a key driver of the uncertainty in the held loss reserves. Aside from reducing the overall size of the portfolio and improving the performance, we have actively sought to reduce future reserve development through proactive claims handling strategies, particularly in workers' compensation. Providing seasoned claims adjusters and run-off professionals advanced data analytics has allowed us to identify claims more likely to develop adversely and ensure active claims management, affecting settlements and commutations within our run-off portfolio. On slide 21, you can see that our historical actions since 2011 drove improvement in the accident year loss ratio adjusted for prior year development, excluding CATs for commercial.
You will note that the impact of the fourth quarter reserve strengthening only slightly impacts the trajectory of the improvement since 2011. However, after the early gains, progress has slowed. Future improvements in accident year loss ratios will require effective execution of the strategies outlined on page 14. At this time, I'd like to turn it back to Liz for Q&A.
Thank you. Jennifer, could we open up the lines now for Q&A?
Yes, absolutely. Thank you. If you would like to ask a question, please signal by pressing star one 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. Please allow yourself one question and then one follow-up question. Then we ask that you please queue back up in order to ask any further follow-up questions. Please do limit your question to one minute. Again, please press star one at this time if you would like to come into the question queue. We'll pause for just a moment. Our first question will come from Jay Gelb with Barclays.
Thanks and good morning. As you've gone through this strategic process, I'm just trying to get a better perspective on how much you're leaving the door open for jettisoning, selling, or otherwise separating from major units, with regard to the activist pressure. That's my first question. My second question is on the reserve charge. Clearly, the significant reserve charge, $3.6 billion pre-tax in the fourth quarter, should address some ongoing legacy issues. I'm sure we'd like to see some confidence that this will address the issues on an ongoing basis, and we won't be suffering adverse reserve development going forward. Thank you.
Thank you, Jay, for both questions. I'll try and answer them briefly. On the first, we say that there are no sacred cows, and we mean that. We also mention that there are important tax and diversification reasons that would preclude major divestitures in the short term. The DTA, and in particular, the foreign tax credit element of the DTA, makes any short-term divestitures of life-related holdings very unattractive from a tax perspective. To give you a sense of the scale, each year we have about $1.3 billion of benefit by keeping the life and P&C together, and that will persist for the next three years. Just to keep that in perspective, that's roughly 10x our annual cost of being a SIFI. There's no guarantee if you were to split the two that we would no longer be a SIFI.
I don't see any short-term imperative to divest large elements of the company. There are no sacred cows, and we will hold each of the modular business units accountable to earning their cost of capital and sharing their progress of improving their operating performance with you so that you can hold us to that promise that we will ensure all of the pieces contribute. Hopefully that's useful. On the reserves, I think that Sid's comments speak for themselves.
Next, we will hear from Michael Nannizzi with Goldman Sachs.
Thanks. One question on the legacy portfolio within P&C. What percentage of premiums do the legacy businesses represent there? Can you just give us some insight into what is actually in there and what are the businesses that you're looking to potentially divest or run off other than obviously UGC? Thanks.
On page nine, we have a list of the businesses that are in the legacy portfolio. In terms of P&C, you've got the Eaglestone runoff, which is pretty well disclosed in the past and is a separate legal entity. We also have activities that are in both the holding company and in the life business. The life settlements are the holding company, and the structured settlements are in the life side of things. We single out the pre 2012 for the important reason is that they have low coupon assets against those liabilities because if you remember, we had expiring capital loss carry forwards at the end of 2014, and we had to sell all the high coupon bonds that were defeasing those liabilities. Replacing those high coupon bonds with current coupon bonds made the ROE on that legacy block very unattractive.
It added to E and lowered R. Most importantly, the cumulative total of that tax capital gains harvesting saved you, our shareholders, roughly $8 billion in taxes. We think it was the right economic thing to do. For anybody who's just looking at ROE progression, we thought it was important to carve that block of business out and put it in legacy
There's a full listing there. In terms of any other details you have on the premium number, Sid.
Well, a large bulk of the property casualty portfolios here are in runoff. To give you some context, the most important number I'd say is there are approximately $25 billion of insurance liabilities that are in this legacy portfolio comprising of the P&C and life portfolios that Peter alluded to.
Okay. We will move to our next question, which will come from Josh Stirling with Sanford Bernstein.
Hi. Good morning. Thank you for holding the call and taking the question. I know everyone appreciates the explicit commitment to buybacks and selling some of these businesses seems to be a good start. I wanted to talk about your operating initiatives. We've always obviously wanted to believe in the opportunity to fix P&C, but this whole situation has come about because you've missed your goals so many times on the loss ratio and expenses. After assuring us for three or four years now that reserves in P&C were adequate, you're now shifting the focus by putting something about a third of your assets into legacy, adding another huge reserve charge to build up the reserve base, a large amount of it from recent years, and promising that this time you'll deliver. These seem like positive moves.
I think the market should like this, what seems to be missing in all of this is kind of an honest and internal analysis of why the firm has failed to deliver, and why investors should believe that this time you've got the right strategy and that you have the right team in place to lead the turnaround and that you really do have the capability to fix this company.
Josh, do you have a question or is that just a statement?
I'd love you to walk us through what you've learned over the past three or four years running the P&C business that's led you to the conclusion that you've missed your goals and you're now going to be able to do it something differently.
I think that we have met some of our goals and some of our goals we have fallen short. I think that on the expense side, we feel proud of the progress we've made in this last year. We've made a significant step towards improving the efficiency of the company. We've reduced the accident year loss ratio by 10 full points from where I was given the good fortune to take over the P&C business. I think the team has done a remarkable job of cutting back on the troublesome casualty lines. To give you a sense of the scale of that, from 2009 to today, there's been a 60% reduction in the NPE of the casualty lines and roughly half of that over the last four years. As you know well, the casualty lines in the U.S. have very long tails.
There's little you can do in the short run to deal with the legacy of that. We've done reserve strengthening and put significant resources to improve our actuarial estimates and have increased the certainty that we have about the reserves, and this most recent reserve strengthening reflects a great deal of bottom-up study that demonstrates that we have reserve adequacy. We feel very confident the next phase of our improvement, which is micro segmentation, and much more aggressive narrowing of our focus around the clients that value us most will be important. I think the person who can do most to give you confidence that we will execute on these goals over the next few years is Rob Schimek, who has the responsibility to make it happen. Rob, why don't you add your thoughts?
Sure. Thank you. Josh, thanks for your question. I think clearly improvement is needed in particularly two areas of commercial, and that's U.S. casualty and portions of our global property. Again, as Peter said, from 2011 through 2015, I think clearly we've made significant progress in reducing our writings by about 30% in that book, shifting our mix towards shorter tail. We've also achieved an aggregate rate change over that period of positive 20%. With that said, I agree that the pace of our progress has been disappointing to us, and we need to take some further action. I would also say with respect to global property, we've made a lot of changes in global property. In the period from 2011 through 2015, we've hired over 500 engineers to provide our clients with risk mitigation services to help avoid a loss from happening in the first place.
We've made some very important strategic investments, including our strategic investment with Clemson University to establish a Risk Engineering and systems analytics center to deepen the skill sets and the capabilities of our risk engineers. Our plan for the commercial actions is outlined on page eight as well as on page 14 in a little bit more depth in the deck. I think what's really important here is that there is always a question of what's really inside of your control. If I summarized it, I would say to you, there are the two biggest pieces of our plan, which include narrowing our focus as well as the use of reinsurance and other loss mitigation tools. It's completely within our control. Let me just clarify that for a moment.
With respect to narrowing our focus, we have the ability to decide that we will exit a line of business. There are some troublesome lines of business that despite the great efforts that we've gone through since Peter arrived and even before that, the truth is, we think that we should actually just exit the line. In addition to that, there are places where we've outlined in the deck where we have client focus that really could change the trajectory of where we're moving. For example, as I show on page 14 of this deck, about 78% of our clients who buy one or more U.S. casualty products buy only one U.S. casualty product. That's the only thing they buy from us. Our ability to change our relationship with that buyer is pretty straightforward.
It does not create market disruption, and it continues to be consistent with our expressed vision, which is we want to be our client's most valued insurer. You have to take a step back and ask yourself the question of, am I really on the path to achieving that when I have one product with a client and that product is not a product that's actually a successful relationship between AIG and the client? I think that's completely within our control, just like I think deciding to exit something is completely within our control. Then I would also say with respect to what we do geographically, we operate in over 90 countries where we've got an AIG franchise, and the truth is that what we do in those 90 countries is also completely within our control.
The most important thing to this organization is that we grow and maintain our very valuable multinational platform, we will do that. With that said, we could narrow our focus in many of these countries where the truth is we really don't have a long-term strategic ability to drive value for our stakeholders. I guess the other thing that I would say outside of narrowing the focus that's within our control is our use of reinsurance and loss mitigation. I would say more recently, we've deployed our own capital and then used reinsurance in a way that would protect against catastrophic loss.
The truth of the matter is that we have the ability to use reinsurance and other alternative risk management tools that are available in the marketplace to manage our capital simply more effectively to reduce the level of volatility in the results and ultimately drive an improved return on equity to our shareholders. I think those things are pretty clear, and I think those are also within the control of our organization.
Okay. We will hear next from Jay Cohen with Bank of America Merrill Lynch.
Yes, thank you. You didn't talk too much about the Advisor Group that's being sold. Can you talk about the annual earnings that you've been able to generate from that business that will be lost? Secondly, when you think about UGC, what is your expected kind of net financial benefit from selling that business, potentially all of it, and obviously using that capital to buy back shares and other things?
The simple answer on the Advisor Group is that most recently it was earning about $40 million. It consumed a disproportionate amount of our compliance costs. It greatly simplifies our governance, and obviously with the new DOL rules, that was a big factor in thinking whether this was better owned by somebody independent of us. In terms of UGC, we look very much at this issue, whether it's worth more in our hands or somebody else's, and the issue of simplifying. A flotation of a minority stake is a first step to full divestiture. We don't view this as a matter of extreme urgency, and we're very price sensitive.
We have an existing reinsurance contract with UGC, which extends through 2017. We have, obviously, the option to either modify that or extend that, which is a very useful, flexible way to ensure that any buyer, if there was a strategic buyer rather than a public flotation, could take a greater interest in the in-force book than the new business. The prices paid for either is different. We have a very clear idea of the value of the in-force book and would not want to part ways in a way that was a fire sale. As you know, we have monetized many assets that were non-core over the last six years, including ILFC, with a very patient approach and structures that optimize the return of capital to you, our shareholders, bearing in mind the appropriate capital structure of the entity once it goes forth.
We certainly don't view this as something which is essential in order to reach our $25 billion capital return. It's nice to have, but it's not essential. We certainly want to dispose of it in a very thoughtful way on a timescale that makes sense for you, our shareholders.
Okay, we'll now move to a question from Josh Shanker with Deutsche Bank.
Yes, thank you very much. My first question is probably just numbers oriented. If we flip to slide nine, it says you're targeting a 7.5% ROE this year for the operating portfolio and 5% for the legacy portfolio. I'm guessing that excludes the reserve charge because I'm struggling to come up with those kind of numbers myself. The second question, Peter, in the past you've said, look, AIG has a huge P&C legacy reserve portfolio. It's AIG's goal to get the numbers right, not to overestimate, not to underestimate. Now you're taking a $3.6 billion charge. Has the philosophy around reserves changed? Is there any reason to be more confident that AIG's goals are going to be just to get the numbers right? Is there a greater conservatism in the new math?
First of all, the 7.5% is our forecast for last year and is a normalized number because we have been using normalization to filter out the big extraordinary items like CATs. We had a very light CAT year last year. We had a very negative experience in hedge funds and other partnership income. Then obviously the big PYD charge and a bunch of charges for severance. There were ins and outs. We have a reconciliation to the GAAP numbers in the back of the deck that helps you get to the 7.5. In terms of philosophy on the reserves we have been putting more and more resources to really deeply understanding not only the central estimate, but the uncertainty bands around them. When you talk about conservatism, that's a very sort of qualitative comment.
Today, for the very first time, we actually have quantitative ranges around the reserves line by line, accident year by accident year, and that has helped inform the thinking behind this number. I would say that we're making this reserve strengthening with much better data around the uncertainties, and that is validated by a number of third party that have looked at it. It is a bottom-up process that has an auditable process to estimate that degree of conservatism. I feel very good about this decision as we go forward. Obviously with long-tail reserves, there are changes in the economy, random court outcomes, tort temperature, things that are impossible to predict with perfect certainty. We just want to make sure that we are as transparent as possible and give you more and more disclosure so that you know what you're buying.
There is a bull case if you get tort reform in this country. We probably have the most upside leverage to tort reform. You have a two-sided risk here. Let's not forget that we have a total of $58 billion of reserves. Getting that right is very important for understanding the book value of the company that you're starting with.
Okay. We'll now hear from Randy Binner with FBR.
Hey, great. Thanks so much. I had a question on, I guess it's on slide 21. You mentioned the 6 percentage points kind of aspirationally here of accident year loss ratio improvement. Just a two-part question. One, I want to clarify, you're talking about 6% improvement from that current level. Are you talking about getting to 60%, 60 % on the accident year loss ratio? If that is the case, jumping back to that slide 14, there's some pretty good growth, I think assumption here, the green bar there. What kind of assumption are you making on the overall market? Because the P&C market is obviously softening and competition's ramping up.
The answer is yes, it's six points off that 66.1. We are not making any heroic assumptions on pricing. Perhaps you'd like to elaborate on your plans, Rob.
Yes, Randy, it's Rob Schimek. Just to clarify, yes, the answer to it is that on page 21, our intention is to take the 66.1 down six points to 60. Very important for you to know that that's an ex CATs number. If you add back in our average annual loss expectation, it's an additional five points. It would be five points on top of the 60. You say 65, including our average annual loss expectation.
Yeah, with CAT, I guess just by kind of comparison, like the underlying for Travelers we run on a forward basis is 62. Maybe I'm being too conservative there. It just seems like when you say you didn't make a heroic expectations, are you assuming that you're going to get positive price action across the book? I'd just like to fill that out. It's a big goal. It's a worthy goal. It seems like it'd be hard to execute, I guess.
I think it's very important to remember how different Travelers book is to ours. If you just take one event like Superstorm Sandy, our claims for that was $2.5 billion, roughly four times the claims that Travelers had. The kinds of accounts that we write, MTA, New Jersey Transit, Con Ed, Verizon, the fundamental infrastructure in this vicinity and in other parts of the United States. Now take that internationally. We do the same thing all over the world. It's a really different franchise where we're operating at different towers in different geographies.
I think that the direct mapping to a competitor like Travelers just really misses the opportunities we have by shifting our mix of business and emphasizing where we have dominance, like in D&O and other places, and scaling back where we are frankly not a major player and not earning our cost of capital. We're making much more decisive portfolio shifts by product, by geography, and by client segment like we have never done before. I'm very confident that Rob has the courage to execute that wisely.
Randy, one other thing I would add is, we do operate in over 90 countries, and it's very important to understand that outside of the U.S., our loss ratio, generally speaking, does perform currently well below the level that we're talking about. As we continue, we do expect that the proportion of our international book to our U.S. book will continue to grow. There's a lot of nuances to the equation here.
Okay. We'll now move on to a question from Tom Gallagher with Credit Suisse.
Good morning. Question on sort of the lost overall revenues we should be thinking about, then expense saves. If I look at your plan for capital return, it looks like half of it's going to come from divestitures and then also life reinsurance. I also just wanted to know on the life reinsurance side, what you're reinsuring there to free up that $4 billion-$5 billion of capital. If I marry that with the fact that you're planning on shrinking the P&C business, it does look like there will be considerable lost revenues here. How much of the $1.4 billion of net expense saves are actually going to hit the bottom line when you factor in what's going on from a revenue standpoint here?
Thanks for the question. I think that, let's just be clear, the divestitures at $5 billion-$7 billion is a fraction of the $25 billion, not half, and that the largest piece of the $25 billion is operating subsidiary dividends and tax-sharing payments, which have been a consistent source of recurring cash. Given our DTA, we're not paying tax at the holding company, which gives rise to significant available free cash flow. The life reinsurance transactions are an efficient way to deal with the redundant reserves. You can think about it almost as an efficient financing tool with a modest amount of risk transfer that allows us to tax efficiently upstream cash flow to the holding company to give us more buyback capacity.
The other component piece is a slight increase in our target financial leverage as our fixed charge coverage ratio improves because of the improved operating margins. The asset allocation shift we're referring to here is a significant reduction and reallocation of our hedge fund portfolio, which will lead to a much better return on risk and especially return on capital, in that part of our portfolio. In terms of how much of the cost save drops to the bottom line, we actually put in a couple of slides, the improvement in pre-tax operating income that we anticipate. Maybe Rob and Kevin, you want to give a bit of color on that?
I'll comment first. It's Rob Schimek. One of the important changes to the organizational design that Peter has put in place is the ability for a leader like myself sitting in the seat for commercial insurance to have greater end-to-end accountability and responsibility for what happens. Historically, the way we were organized, a different leader had responsibility for distribution, a separate leader had responsibility for underwriting, and yet a separate leader had responsibility for claims and operations. The ability to rejoin those pieces enables me to have a clearer view of end-to-end efficiency and the right trade-offs to make so that we can drive efficiency into the organization.
I do think outside of the loss ratio changes that we described, a really important commitment that's coming out of the businesses, especially I'll speak for commercial in particular, is the ability to continue to make sure that any decrease in our revenue is also addressed in a corresponding way with a decrease in the expenses. I'll also mention that one of the tools I described, which was the use of reinsurance, will give us the opportunity on an expected basis, I believe, to generate ceding commissions that would be at least equal to my cost, if not in excess of the cost to produce the business in the first place.
Tom, in terms of revenue impact on the consumer side, the life reinsurance transactions have no impact on revenue. In fact, the way that we anticipate constructing them, we will maintain an upside on improved mortality performance. We continue to focus on growing the retirement businesses, which are well-positioned, and we will invest past the Department of Labor initiatives and continue to participate in those parts of the value chain which are most attractive, depending on what the outcome of that DOL initiative is. In terms of the personal insurance portfolios, clearly Japan continues to be an area where we're investing. We've achieved growth in the automobile portfolio for the first time this year in almost 15 years, as Peter mentioned. We will see through the investments necessary to the transformation of Japan.
There are two things that are masking the underlying performance in Japan right now. The first is the fast growth in the life business, where we've made the decision to grow that business and consume what otherwise it would earn as part of its cash-
capital. Also the underlying performance of the Japan business, we believe is already at a low double-digit ROE if we remove the effect of the investments that we're making associated with the merger and transformation. The biggest impact on revenues would be the footprint activities as we focus on the world's largest markets, those growing the fastest in nominal terms in a handful of places where AIG has had a unique operating success. The reality is, as we downsize our footprint, in fact, this should improve our returns because these territories are places where we have vestiges of former consumer operations that were closely attached to our life businesses and no longer essentially make economic sense as standalone businesses.
As you know, with the new modular unit reporting structure, Japan will be one of those units, making it much easier for you to follow progress in the Japan transformation and to see how that ROE progression in Japan is realized.
Okay. We'll move now to a question from Meyer Shields with KBW.
Thank you. Good morning. I guess two questions. The first is, can you give us a sense of how much of your total either P&C premium or commercial P&C premium is actually moving to run-off, or it's not going to be renewed? The slide on 14 is a little bit unclear. Second, when I look at the criteria shown on slide six for businesses that will be kept or sold, I can't see which of those United Guaranty has a no for. I was hoping you could take us through that thought process.
Has what? A no.
Page six.
You want to start on the sale and then do that.
Do you want to take the premium point?
Sure. I would say at this point in time, I'm not going to say how much of our premium would move into run-off. I think that you see on the presentation, one of the things that I comment about that I think is very important is that the way we will exit sometimes will be to literally pick up and pull out of a line of business, and sometimes the way we will exit is the way we will price ourselves in the marketplace. It's very important to us to be a very reliable, stable part of the commercial insurance business. We have to consider the impact on our brokers, the impact on our clients. I am very careful here about pre-announcing changes without having spoken to our trading partners about what impact it'll have on our broader client base.
That's the reason I'm not giving you greater details this time.
I'll take the question, Meyer, on UGC. It's Sid Sankaran here. In UGC, we evaluated against the criteria very clearly laid out on page six. I think as we went through in the analysis, there was certainly a yes on the questions of helping us meet or exceed our cost of capital and maximizing the value of our deferred tax asset. However, when we look to the diversification benefit, competitive advantage, ability to serve clients and optimizing free cash flow, we had no's on those scores. Peter alluded to a structure of how we'll evaluate thinking about UGC, which is we're going to continue to evaluate how we structure potential capital support. Obviously, to his point, it's not something that we'll evaluate all our options as times come due in terms of when we would potentially divest of the whole thing.
At a 1999 IPO, just a reminder, we do get to maintain some of those tax benefits, though, that I alluded to. All of that went into our thinking on the question.
Okay. We'll now hear from John Nadel with Piper Jaffray.
Thank you. Good morning, everybody.
Morning, John.
I got a question on slide five. If I look at the first bar there, the $7 billion-$10 billion, if I think back over the last couple of years, I think we were all sort of expecting in your own targets were $4 billion-$5 billion of annual subsidiary dividends and maybe another one and a half to two, maybe, of tax-sharing payments annually. It looks like when I look out to the two-year period of 2016 and 2017 versus what we've been seeing, we're losing something like $3 billion or $4 billion versus what we used to be accustomed to. The offset clearly is coming in one or more of the other bars.
I'm wondering why, particularly given an expectation for significant loss ratio improvement, upper end or better on the expense saves, et cetera, I'm wondering why the bar, that seven to 10 is lower than we would have otherwise expected it to be.
I t's Sid here. First simple answer is this is net of the capital contribution that we announced for the property casualty companies today, and it's obviously also net of our interest expense and parent expense. Those are the two quick answers to your question.
The reserve strengthening.
The reserve strengthening had a capital contribution of approximately $3 billion.
Okay. We will hear now from Brian Meredith with UBS.
Yeah, thanks. The first question is, I am just curious, what is your assumption for alternative investment returns in your ROE targets, and what impact on ongoing investment income would the asset allocation shift have? My second question, with respect to the $1 billion of reduced compensation expenses, how do you manage the loss of institutional knowledge and client relationships that can have an adverse impact on your loss ratios and revenues?
On the normalization of the alternative investment returns, it has historically depended on which funds. We had private equity, we had hedge funds in the life companies, hedge funds in the P&C companies with really different mix of investment strategies. The assumed returns were between 8% and 10% historically. Obviously the realized returns over the last three or four years have been greatly disappointing compared to that. We are, as I said, reducing our allocation to hedge funds, and so our dependence on that assumption going forward is going to be significantly reduced. On the second question, which was?
Your employees.
Oh, yes, on employees. Institutional knowledge. We've been going through a very thorough talent analysis over the course of the last four years. One of the great things that my predecessor, Robert Benmosche, put in place was rigorous performance evaluation. We have a really good idea of the relative strengths and weaknesses of all of our people. As we have narrowed our focus on the geographies, products, and client segments that we're targeting, we were able to make a very well-informed view of what was the right blend of institutional knowledge, client relationships, geographic knowledge, as well as knowledge of some of the new techniques, data analytics and so on, that would give you the best blend of new thinking and relationships and institutional knowledge in the claims and the underwriting and all the other important functions.
We think that these savings come from a very well thought through and planned optimization of our human capital. Any transition will have short-term collateral damage. We know that. There's going to be some lost accounts here and there, some frustrated clients here and there. The feedback that we're getting from our clients, and that's who we care about most, is that the changes we're making here is a much more valuable proposition to them than the AIG of old that was more fragmented and not as coordinated and integrated in the way in which we solved their most important problems. I think that we're delivering a more integrated value proposition with a team of veterans as well as new thinkers delivering the best that we have.
I judge whether we're getting that right very much by listening to our clients, and the testimonials and the feedback I'm getting from them is very reassuring that we're on the right track.
Okay. We'll now hear from Paul Newsome with Sandler O'Neill.
Good morning. I want to make sure that I am interpreting some of these structural changes correctly. It should be a fairly simple question. It looks like you're moving from a functional structure to a business unit structure, and it looks like you're moving from mixing P&C and life to not doing that. Is that just an absolute oversimplification, or is that a fair assessment that those are structural changes that you're actually implementing throughout the business lines?
I think your first part is a good assessment. Yes, moving away from a functional structure to a business unit structure, albeit while retaining very important firm-wide shared services where they make sense. A consistent global data architecture, consistent technology architecture, shared R&D in the science team, shared asset management capabilities, shared cybersecurity. There's a whole bunch of things which you absolutely wouldn't want to replicate at a business unit level. However, there is tremendous scope by decentralizing decision-making. It's getting the right balance between centralized governance and delegated authority to speed up decision making and be more responsive to clients. Your first part, absolutely right. The second part, I think that the broad brush distinction between property casualty and life is not a helpful one.
I think you need to just click down a level of detail within those areas, this level of modularity is just blurring that distinction because we're looking at these business units around client segments and needs retirement, longevity risk. We have longevity risk in our retirement products. We have it in our life products. We have it in our workers' comp. When we have settled on the annual medical cost of our injured workers, what remains is their longevity expectations. We have over $20 billion of reserves in the P&C side of the shop that's highly dependent on longevity assumptions. I'm not sure these broad brush distinctions in life and P&C are very helpful. We're basically giving you more granular understanding of where we're allocating our capital, where we're making our money, and which customer segments and geographies we're targeting.
I do think that the life P&C distinction has some important significance from a tax perspective. There's certain tax rules that ring-fence the tax treatment of life income Which is one of the important reasons why the FTC issue is so peculiar. These are the peculiarities of the U.S. tax code that I've had to become, not an expert, but at least a bit better at over the last few years.
Okay. We'll now move to Larry Greenberg with Janney Montgomery Scott.
Morning, thanks for taking the question. Just a bit of a point of clarification on this modularity breakdown. Will we get full transparency on the allocated capital levels and the returns with each of these breakouts that you've provided for us? If in the future you were to decide to go down the road to maybe separate one of these units, has everything been done today from a capital standpoint to enable separation, or are there other moves that will be made over time to possibly allow that to happen?
That's a great question. The answer is that, yes, we will give you that level of transparency, including a push down of debt so that you can really get a sense of the capital structure that belongs with each of these units. Over time, I think that it's really important that when we report these, that these are numbers that would fully stand scrutiny under Sarbox standards and so on. I'm not promising it to you in our earnings call in a couple of weeks. Certainly during the course of this year, we will be giving you that level of disclosure for the nine initially identified modules. There are more to come. We will be adding other components over time to give you even greater transparency.
I think that this will make it easier for you to evaluate, but also for anybody that might want to acquire one of these to evaluate. As of this moment we do not have something that is easily separable. For all of the reasons I mentioned earlier, tax and diversification, we think the next two years a modest pace of divestitures is what makes sense.
Thanks.
Okay. Moving on to Charles Sebaski with BMO Capital Markets.
Good morning. Thank you. I guess I have a couple of follow-ups on the reserves and the reserve charge in the quarter. I think you said earlier that you're now reserving with new or better data and using quantitative ranges. Compared to what? I guess on reserve analysis and actuarial, how was that ever done without quantitative basis? Second, regarding the charge and the most of it coming from the most recent accident years 2011-2014, how does that compile with the already reduction in U.S. casualty over that 2011 period? What was going on with the underwriting then? You were already contracting that book. The charge seems rather outsized relative to that. I appreciate it.
The first point when I was referring to a quantitative method, I was specifically talking to the ranges. We've always used quantitative methods of course, to come up with a midpoint estimate. I think that traditional actuarial methods were not that easy to flex to give you a consistently calculated set of confidence intervals at the micro level of individual lines and individual accident years, and then aggregate that to the total level of uncertainty for the entire reserves. The uncertainty ranges were typically what's the difference between our estimate, our auditor's estimate, and the estimate of outside consultant actuaries? That is not in my view, a quantitative way of estimating ranges.
What we've instituted over the last few years and finalized in the last quarter is a more bottom-up method for estimating uncertainty at the micro level and then aggregating that to the macro level, which gives us much greater confidence of where we are in the range. That's what I was meaning by putting quantitative methods on the estimation ranges. Implications. What have we learned from the fact that we've had to strengthen recent accident years? I pass that over to Rob and say, how is that altering your strategy?
I guess the first thing I would say about what we've learned is that even though we've made significant actions in U.S. casualty, it's a highlight of the fact that there are still places in U.S. casualty that are particularly problematic. Some of those lines have informed my plan regarding what is it that we will exit, or what is it that we will simply reprice to our targeted return. Again, as I said earlier, I'm hesitant to get into the details of each of those lines without having shared that information with our clients and our brokers, where I think that's really important in the marketplace. To put it into context, it drives a further reduction in the premiums written for commercial moving forward in the vicinity of another billion and a half dollars between 2015 and 2016. It's a combination of reinsurance.
It's a combination of the management actions that we will take. Just to give you a basic idea of the relative size not just inside of casualty, but across commercial. It's important to understand that the comments I just made reflect what we think the change will be in our net written premium. Again, a piece of that will be our use of reinsurance as one of the tools to address our appetite for risk in that area.
Of course, some of the adverse development, as Sid mentioned earlier, was in very profitable lines like financial lines, which just turned out after the recent reserve strengthening to be slightly less profitable, but still well above any kind of target ROE. I think it doesn't change our strategy in any material way.
Okay, we'll now move to Gary Ransom with Dowling & Partners.
Thank you. Good morning. Most of my questions have been answered. I had a question on DTA utilization. In particular, are there any strategies available to accelerate that process? I see you say 6 to 7 years at this point. Among those strategies, are there any businesses or modules where the tax basis is different from the potential value where a realized gain in a divestiture could be used against the DTA?
The DTA breaks down into these two important parts, the foreign tax credit piece and the NOL. It's the foreign tax credit piece that has a much shorter fuse in terms of utilization. Yes, we are using and have already used a number of techniques to accelerate that. When we evaluate divestitures, we absolutely look at the tax basis, some of which is above and some of which is below the book value. It's an important consideration that we look at as we consider the pros and cons of a divestiture. I don't know whether you want to add any to that, Sid.
No, just that, Peter, I thought that was well said. We evaluate consistently and tested in our strategic process against the categories on page six a wide range of potential divestiture options and assess the tax implications in the context of that framework.
Yeah. I would say that one of the particular businesses with the lowest tax basis also has the largest diversification benefit. You have this tension between the two, and we just weigh up how one offsets the other. It's a multidimensional issue that you have to think through quite carefully.
Okay, we'll hear next from Scott Frost with Bank of America Merrill Lynch.
Okay, thanks for taking my call. From the credit side, just to summarize, you're not going to break up now, but you may consider it in the future, maybe at the end of this plan based on the use of DTAs and whether operations improved, which would include a take-up in leverage that's consistent with your peers. A full breakup is unlikely unless it occurs in a manner that it seems to preserve quantitative and qualitative metrics that are consistent with mid to high single A financial strength ratings at OpCos and mid to high triple B ratings at HoldCos. If I said that, does that sound like an accurate description of the plan?
I'd say you're understating our ratings aspirations because our clients depend on us to make large long-term promises. The moment they think that we're taking short-term actions to maximize temporary gains for shareholders as opposed to long-term sustainable gains is the moment that we start to lose the core of our franchise. We have to balance all stakeholders. That's why we made it very clear in the opening slide that that's the way we think about this company. That we're trying to build sustainable value. We care very much to clarify that point. We think that working with the rating agencies, they see the progress we're making in putting the legacy issues behind us, getting our cost structure down, delivering repeatable earnings that give us more financial flexibility, the ability to reshape the mix of business around what's most valuable.
Some people have pointed out that some of the compensation of myself and the leadership is linked to credit spreads. We think that's an important signal to our policy holders that we are serious about the financial strength of our balance sheet. To keep it in perspective, it's roughly 16% of my incentives is laid out on page 28 and 13% of the broader leadership group. It's a significant signal, but not a dominant one. We do recognize we're a shareholder-owned company. We have to be responsive to shareholders. We also want to be mindful of all stakeholders.
Next, we'll go to Josh Stirling with Sanford Bernstein.
Thank you for letting me re-queue. This has been a really helpful call. We appreciate the movement to pursue modularity and look to divest some of these businesses. If I step back and you sort of have more of a philosophical high-level conversation, the one thing I really don't get is why you don't want to take advantage of the window that's open or that seems to be open right now to pursue a plan in de-SIFI. As outsiders, all we really know is that practically every large cap financial complains about being named systemically risky due to cost, complexity, and capital. Over the past year, both Met and GE have pulled the rip cord to break up. I heard your comment about the actual cost that you've identified as due to being a SIFI.
When I think about what you need to do, you need to get to peer returns at maybe mid-teens ROE. I think that requires releveraging the firm. Earlier in the call, you said that you hold more capital today to satisfy the Fed and sort of the anticipation of future de-risking that will be required. How are we wrong in thinking that the tax of the Fed most meaningfully is the capital that you're holding? If that's right, how do you ever actually achieve your goals on page one of the present and item number one on the presentation, which is to get the top quartile shareholder returns if you have to hold more of the capital than all your peers?
Josh, first of all, we have delivered top quartile returns to shareholders, both in the last 12 months and the last three years. We absolutely do not hold more capital because of the Fed. I've stated that several times. We hold capital based on a combination of our own sense of what's required to satisfy our customers in terms of financial strength and the rating agencies that validate that view. The Fed has not been a binding constraint to date, nor do we anticipate it being a binding constraint over the next two years. If two years down the road, SIFI regulations become extremely onerous. If you look at the chart that we put in the appendix that compares our leverage to MetLife and Prudential, we think we're exceptionally well-prepared already.
We took actions long ago, back in 2011, to de-lever the company, eliminate the derivative exposures, get rid of the short-term funding risk that still plagues the balance sheets of the other SIFIs. The bank SIFIs still have trillions of dollars of derivatives that have not been cleared, so of course, they are concerned about the SIFI rules. We had to deal up front with these issues in order to unlock the Fed backstop at the end of 2010. We managed to get a jump on the whole process of shaping up our balance sheet for sustainability in this new regulatory environment. Let's not forget, you exit SIFI, you still got the European regulators that require a global enterprise-wide regulator if you want to operate in the EU.
We have all of the states, and so we have a multidimensional and highly regulated industry, and we care about all the regulators. Right now, the Fed is a complete red herring. I think that using the SIFI issue as a driver of strategic decisions when we have all of these other important strategic factors, it's maybe issue number 15 on a long list of important things we need to add value to our shareholders. We are committed to continuing to deliver top quartile total share return. Next return. Next question.
Okay. We'll hear next from John Heagerty with Atlantic Equities.
Thanks very much. I just want to follow up on the questions from Randy and Meyer around the commercial P&C business. You've pointed to the six percentage point improvement in the accident year loss ratio, which does look very ambitious in light of commercial rate movements going on at the moment. Just wanted to clarify, how much of that is actually pure improvement in the loss ratio versus some of it just shifting some of the underperforming businesses into the legacy portfolio?
Well, a couple of things. First of all, the plan that I outlined identifies key levers, including simply exiting business, reducing our involvement where clients have only one or two products with us. Again, that would be an exit of that client's relationship. Repricing the business but continuing to stay in the game. If we're unable to achieve our targeted return, accepting the fact that we're not able to retain that premium. It's not so much a shifting of the business into legacy, meaning that it's run off and we're not doing the business anymore. There will be narrow elements of our sub-segments of our portfolio that will go into legacy. The truth is, a combination of the reinsurance efforts and a narrowing of the focus that I just described will achieve four points of that in 2016 and two additional points in 2017.
Okay. We'll move to a question from Jay Gelb with Barclays.
Thanks. I had two quick follow-up questions. The first is, I think it would be helpful if you can give us the GAAP book value for the mortgage insurance business. I believe the statutory book value is around $2.1 billion, GAAP book value would be helpful. Second, with regard to the capital return plan, which is significant, and then also adding additional leverage, can you give us your perspective on how those conversations went with the rating agencies, particularly S&P and AM Best on financial strength, and whether you discussed this decision in advance with the Fed? Thank you.
We are in continuous conversations with the rating agencies, with the important state regulators and the foreign regulators that care about us. Just to remind you of who they are, obviously we got the rating agencies, we got New York State, we got Pennsylvania, we got Missouri, we got Texas, we got Delaware, and then we got the U.K., we got Japan, Singapore. These are the most important regulators. I hope I haven't left anybody out. We're in continuous dialogue with them, and we did give them advance notice of what we were doing here and incorporated their feedback in giving us the confidence that we have that we can accomplish these plans. You don't get explicit approval or disapproval from regulators
We make these plans knowing how they feel about our commitment to not only delivering to shareholders but maintaining financial strength so that we can serve our policyholders and deliver on our promises. I think that, put it this way, we have gone into this with our eyes open and knowing all of the multiple constraints that we operate under.
Jay, Sid here, just to follow up on your question on UGC, the GAAP equity is approximately $3.5 billion.
Okay. We'll move to Josh Shanker with Deutsche Bank.
Yeah. Thank you again for taking more questions today. My first question might be for Kevin, although certainly Peter can chime in. If we take an assumption that the 10-year isn't going to move significantly beyond 3%, and we note that there's a lot of competition in the U.S. life and retirement business, and you're doing divestitures of certain blocks, what's the potential way we should think about growth for life and retirement income in the United States going forward as part of this plan? The second part of my plan, you can just say, "We're not going to answer it right now," but I'm wondering if you can give us a little bit of a preview of thought into maybe fourth quarter and first half 2016 hedge fund and private equity results.
Kevin.
Sure. Thanks, Josh. I think a projection of the 10-year being north of three is not necessarily consistent with our own expectations. We will maintain our strategy of balanced growth between our variable annuity business and our fixed annuity business, depending upon market conditions. In terms of expectations of earnings, we're still seeing some continuing spread compression. At the earnings call, I think we will provide our usual update in terms of what we believe the impact of that to be. I think that covers the sort of inherent base yields in the portfolios. There will be an impact of the de-risking of certain of the alternative investments over time on the portfolio that also we will need to factor in, but it'll reduce the volatility in the portfolio and improve its ultimate returns.
Okay. We'll hear from Michael Nannizzi with Goldman Sachs.
Thanks. Just a couple of quick ones here. Peter, the expense commentary around $1 billion-$1.5 billion. You mentioned in your script further expense reductions, I think that you guys laid out that sort of same range the last time. Is there something incremental because you had the additional management reductions following that guidance? I'm just trying to square those two things. Just one follow-up if I can. Thanks.
Sure. What we're announcing today is over 2016 and 2017, a net reduction of $1.6 billion of general operating expense. That's on top of the 3% reduction that we accomplished in 2015. It's the upper end of the range that we put in my shareholder letter a year ago and an accelerating pace. The reductions in headcount of senior personnel that we announced in November hit the run rate January 1 this year. It's front-loaded, as you can see in the slide on expenses in the appendix, you can see the trajectory that we expect quarter by quarter for this year, giving you a guidance on how we expect that to continue because we're not done yet. We're continuing to implement the simplification of the operations of the company.
In a sense, an acceleration of what we announced a year ago, and far more transparency on the timing and nature of it, and with an increased focus on switching from fixed to variable cost because the strategic flexibility to divest and reshape the company is greatly assisted by a more modular support structure. Our use of outsourced providers, as well as using our shared services where it makes sense, gives us more ability to have costs that are linked to volumes of transactions rather than a fixed cost, which drives us to do more volume regardless of margin. We want to have more flexibility to flex up and flex down our volumes based on the cyclicality of the different markets we operate in so that we can maintain margins after cost rather than feeling any fixed cost pressure to grow.
I think that while the absolute amount of expense reduction we'll be delivering is at the upper end of the range, it's not fundamentally different in scale from what we've said. I just think the certainty that we have that we will get there and that we have a path on the timing, and then the composition between fixed and variable is increasing as we progress through the execution of it.
Okay. We'll hear from John Nadel with Piper Jaffray.
Thank you for extending the call and taking the follow-up. I just had two more quick ones on slide five. One was just to confirm, I think in response to my original question, I think you had mentioned that the $3 billion capital contribution into the P&C operations was already knitted into that $7 billion-$10 billion first bar. Can you just confirm that? Then the second one is where on slide five would we see You know what I believe would probably be a few billion dollars of capital that should be freed up from DIB and GCM over this couple of year period as the liabilities mature?
Hey, John, it's Sid here. Yes, just to confirm your first question, that seven to 10 is netted, so you are correct. On the second question, DIB and GCM would be in legacy assets in the five to seven bar. Any monetization of legacy assets is in that bar. Just a quick data point, because we've been working on this for some period of time, we have monetized about a third of that bar, that five to seven already via monetizations of some legacy assets in the fourth quarter.
Got it. Thank you very much. That's helpful.
We'll now move to Paul Newsome with Sandler O'Neill.
Thanks again. I'm wondering about the hurdle rate, if there is one in particular for the divestitures, and if that hurdle rate has changed with the higher expectation for ROE in the next two years.
That's a great question. I think that the whole topic of the hurdle rate has been integral over the last five years as we've implemented the concept of risk-adjusted profitability that looks at ROE minus a hurdle rate. As we've mentioned many times, we have differential hurdle rates by geography and line of business based on our perception of the cost of capital. With persistent quantitative easing, we had made the assumption that shareholders would rather have a more modest ROEs that were rock solid than more aspirational ROEs that were highly cyclical and subject to risk. I think that we've heard from our shareholders loud and clear that they like to have a minimum return on equity. We have certainly refined our hurdle rate to have a minimum that's higher than we've been using to date.
The consequence is that we have to narrow our focus a little bit more than we had in the past. We have to rein in some of our very long-term ambitions in certain emerging countries where the payback period really was out year 10 to 15. That's not to say we're abandoning all long-term projects. It's just rationing the amount of capital that we can deploy to longer payback opportunities. We think that by delivering on our short-term financial goals to you, we earn the right to invest a slightly larger amount of capital to longer time horizon opportunities. That's a process of communication with you, our shareholders.
When even a company like Google goes to Alphabet and goes to modularity so that they can separate out their longer term bets from their cash cow in the search business, surely AIG, with a longer history, has the obligation to give you clarity on that, which is why we're showing you ROE by module going forward to give you confidence that we're managing your capital to a decent hurdle rate. Hopefully that gives you a sense of the direction. We're raising the hurdle rate for sure, and we're giving you more transparency around these trade-offs of mature businesses that are cash generators with excellent margin improvement but not as growth, while we're also making some longer term bets on growth opportunities.
To give you a sense of excitement, we got our cyber insurance business where we're a market leader growing at about 35% with excellent loss ratios and very good client response, but it's a very small business compared to our more mature businesses. The last thing I want to indicate is that we're in a growth industry. We're in a mature industry. We're managing it to margin, sensible risk profile, and with pockets of growth.
Okay, we'll go to Meyer Shields with KBW.
Thanks. One quick question. You've quantified the capital diversification benefit on slide 22. I was wondering if you could give us analogous ballparks for the capital charges relating to adverse reserve development and P&C loss ratio underperformance.
I think that the way in which we calculate our own internal estimates of economic capital and diversification benefits is a broader topic than we have chosen to talk about here. It's certainly embedded in that five to 10. I think that you correctly identify the potential for adverse reserve development as one of the big risks you need to think about, just like perhaps some of the other non-bank SIFIs have to think about their very large VA books as their sort of long pole in the tent. It's the right way to think about this. We have stable cash flows from our life and retirement businesses helping to balance the possibility of future reserve development on a very large casualty book. We have not publicly disclosed the precise math behind that.
At the end of the day, the math will only take you so far. We have great respect for quantitative methods, but we think that human judgment is also an important qualitative overlay. In discussions with the rating agencies, they certainly feel that the five to 10 is a minimum number and that there's a qualitative additional amount. They take great comfort from our scale and diversity. The cost benefit of over or underestimating that diversification benefit clearly leans towards being respectful of the diversification because of the uncertainties that we have understanding probabilities and correlations of events far in the future, whether it's future reserve development on lines that will have 10, 20, 30, even 40-year tails, and policyholder behavior on VAs and other life products that will go far out into the future.
These things can be quantified, but we know that models can only take you so far.
We'll now move to Scott Frost with Bank of America Merrill Lynch.
I think you touched on this a bit, but in the presentation, you talk about the push-down of parent debt. How does that work? What does that mean?
When we're comparing ROEs of the business modules, the units, it's important if you're comparing them with external comparables that have holding company debt, that you have a leverage that is proportionate to the risk profile of that underlying unit. It's not a pro-rata push-down of debt. It's a debt push-down based on the expected capacity of that business unit to support debt if it was a standalone entity so that you can get comparable leveraged ROEs when you look at comparisons. It's really an allocation for reporting purposes as opposed to an actual issuance of debt at that subsidiary level, because in some cases, these modules aren't separate legal entities.
Got it. Okay.
They are trusted legal entities.
Okay. Just as a follow-up on the NRSRO questions, did you incorporate the reserve charge discussion into your discussions with them? If you did, how would you characterize their reaction to it?
Yes.
Operator, I think we should go to the next question.
Okay. We'll hear from Tom Gallagher with Credit Suisse.
Thanks. Peter, just a question on the $5 billion-$10 billion diversification benefit from having the multi-line model. Doesn't that effectively really raise the bar when you consider what businesses are modular, the price at which it makes sense to accept a price, because you'd clearly lose some of the diversification benefit if you considered selling some of the chunkier businesses you had. How do you factor that in?
As we talk about in the diversification slide, you've really got three ways to deal with risk. At the end of the day, we're in the risk business. How do we manage the aggregation of the risk that we have from all of our customers? Diversification is our first method, the second is reinsurance, and the third is having a conservative capital and reserve structure. As we look at the relative cost of those, if you were to divest a major subsidiary that was providing diversification, you've got to either dial up the amount of reinsurance that you buy on the piece that's remaining or run it at a much more conservative capital structure. You're absolutely right, it raises the bar, and the question is, how much does it raise the bar? That's all about the price of reinsurance.
Given the scale of some of our legacy exposures, for us to reinsure all of our legacy right up to a high attachment point would be pretty costly and would test, to some extent, the capacity of the reinsurers who have balance sheets, in many cases, much smaller than ours. It's not a trivial question. It's not a theoretical exercise. It's a very practical exercise of getting market discovery, price discovery on what people would be willing to pay for a subsidiary, what it would cost us to offset the lost diversification benefit. We're all about doing the right thing for shareholders with a rational economic framework and not trying to make short-term moves.
Okay, thanks. Can I ask
I apologize. We will take our last question from Jay Cohen with Bank of America Merrill Lynch.
Yes, thanks. Just two follow-ups. First, I guess for Rob. You're going to be obviously shrinking premiums. You're going to be reducing expenses and using reinsurance differently. Net net, do you think your expense ratio actually comes down over the next two years?
Yes. The answer to that is absolutely. I expect that our expense ratio will come down through a combination of things, including the broader efforts that we have to simplify the organization. I think it's an important part of the plan. We've expressed it, my discussion, really on the basis of what will it do to loss ratio. The truth of the matter is expenses is a broader AIG-wide effort, and as you know from the actions we took in November and in December, it's already well underway.
Got it. Thank you. Separately, Peter, when you were talking about some of the parties you had discussions with earlier, rating agencies, state regulators, you didn't mention the Fed. I'm assuming they were ahead of time, well aware of this plan. I don't know if you can talk about what the dialogue was like with specifically the Fed before you made this announcement.
I thought I included the Fed, so my apologies if I excluded. That's the New York Federal Reserve Bank as well as the Washington, D.C. Fed. We have a continuous discussion with them. It's a very iterative and interactive dialogue. We don't disclose the specific reactions of any specific regulators. I think that we have made these public pronouncements around our goals for the next two years cognizant of the likely reactions of all of our stakeholders including the Fed and the rating agencies and the state regulators. We wouldn't comment on any specific reactions of any one of them. I'd leave it at that.
Operator, I think we're going to wrap it up at this time.
Okay.
Thank you everyone for joining us. I'm happy to say we got to everybody's questions at least once. If anybody has a second or third follow-up, you should not hesitate to reach out to me and we will certainly answer all your questions. Thank you.
Thank you. That does conclude today's conference call. We do thank you all for your participation.