Hi. I'm now Mike. They've spent their career in insurance. Peter is one of the cutting-edge developers on derivatives as he grew through JPMorgan's role in that area. He did a couple of years at KeyBank as the CFO. Now he's closed down the financial products issues at AIG as they emerged from the financial crisis and has come into Chartis to get that business to its fighting weight. I'm going to let him do most of the talking, hopefully. Please make him feel welcome and let's get started.
Should we shut the door at the back? Let's do that. David, I have a seat for you up here. Any difficult questions go to you because you're late. David Herzog, the CFO of AIG, just walking in.
Thank you.
Hi, David. Thanks for coming today. I am, first of all, going to try not to make any forward-looking statements, but the verbiage there, the law insists on starting everything with is the usual boilerplate. I'm going to talk very briefly and then open it up for Q&A. If you go to the next slide, I wanted to just give you a sense of how AIG has changed over the last few years. As you've heard, I'm a relatively recent arrival, both in the insurance industry and at AIG. I joined AIG in February of 2010. Even in the short time I've been there's been a remarkable change in this company.
For those of you that are veterans of the industry that may have known AIG very well over the decades of its dominance in the insurance industry, if you take the time to really dig deep into the company today, you will see some important attributes that have been carried on, but some very major changes. I think giving you a sense of what has been left behind. You've got world-leading insurance franchises. It's a company that is much simpler than it was. If you can remember, at the peak, this was a company with a trillion-plus balance sheet, 2.5 trillion of derivative notionals. Companies in every activity beyond insurance, from derivatives to consumer finance to aircraft leasing, and all over the world, direct investing in real estate, and a lot of other things. Today it's a much more focused company.
Chartis, the division that I am responsible for, the property and casualty division, is today about two-thirds of the people. It's about 44,000 out of the 65,000 people. Give you a sense, at the peak, AIG had about 2.5 million employees and agents around the world. It's a much more focused and more manageable company that's complex. Second, you've got SunAmerica, which is our domestic life and retirement business, the top five of U.S. in the industry there. A nicely balanced portfolio between life, fixed annuities, and a modest-sized variable annuity business. Then we have United Guaranty, the mortgage insurance business, which like all private mortgage insurers had a pretty tough 2008, 2009. Got recapitalized by AIG. Completely new management, completely new business model, and has gone from a number 4 ranked player to the number 1 ranked player.
Has for the last three years, I think, an impeccable quality book, partly because of the nature of the business, but also in terms of risk selection. They have by far the least leverage in their sector, about 16 to 1 risk to capital ratio. A small business, but an interesting option on the future of mortgage finance in the United States as the role of the GSEs and the Federal Housing Administration change. Those are the three core operating units that are left. There's still 1 major non-core operating unit, ILFC, that is on the blocks. The S-1's been filed and updated, and that has about $35 billion worth of aircraft. Book value of about $7.5 billion. Importantly, about $25 billion of debt, which would get deconsolidated if we sell below 50%.
In terms of balance sheet, it's a lot simpler, a lot less leverage than it used to be. Debt to capital ratio. Debt and hybrids capital ratio of about 18%. Importantly, stable credit outlook from all of the major rating agencies. I think, given that when I had arrived that first year, the rating agencies basically relied entirely on the $30 billion of undrawn capacity from the Fed as a source of credit support, and they'd assumed that that would be there through 2013. We broke the news to them in the fourth quarter 2010 that, no, the Fed was going to be fully repaid in January, and that backstop would disappear, and we needed a standalone rating. An important part of the story here is that the rating agencies were forced to assign a standalone rating quicker than they had ideally wanted.
We overcapitalized, in a sense, to satisfy the credit rating agencies' lack of comfort with the newly configured AIG, because we had very recently sold off roughly 20 operating companies in the previous year and a half, and they had not had a great deal of time to familiarize themselves with our newly constituted financial statements. Where do we stand today? We have a plan to improve our return on equity as a company from about 6% to 10%-12% between 2010-2015. A very important part of that is capital management. In our launch of the re-IPO last year, we had suggested that that capital management would start towards the end of this year.
In fact, we'd be able to do this on an accelerated basis in recent equity offerings by the U.S. Treasury, the two that were done in March and a couple of weeks ago. We bought about $5 billion between those two, $3 billion in the first, $2 billion in the second. We're well ahead of expectations in terms of timing on that, and the U.S. Treasury is now down from a 92% to a 61% share of the company. We've unwound the special purpose vehicles that were set up that had AIA shares in them. It's a much, much simpler balance sheet to understand. The government exit is in sight when you look at the capacity that we would have once we've sold our non-core assets, the non-core assets being AIA shares, about $7 billion, $8 billion of AIA shares, the ILFC disposal through the IPO.
That ILFC is an interesting one because it's not just the dollar proceeds that come from the IPO, but the deconsolidation of $25 billion of debt that has an important positive feedback loop in terms of our capacity for capital management. The third is the Maiden Lane III vehicle, which is a bunch of structured assets in the last remaining special purpose vehicle with the Fed, which has accelerated the monetization of those underlying assets in a series of auctions which took place over the last four weeks. Most importantly, this morning, announced a reestablishment of that schedule after a very brief hiatus on Thursday, which seems to have shocked people that not everything goes perfectly according to plan. It was a technicality that put the thing on a one-week hold, and we're now completely back on track for Maiden Lane III monetization.
That's about a $7 billion cash proceeds to the holding company. Between all of those three things, AIA shares and ILFC monetization and Maiden Lane III, we're talking about substantial capital management flexibility of the holding company. I'm not really here to talk about AIG so much as the part of it that I am responsible for, which is Chartis. Let me talk about the story of Chartis. Chartis is, by some measures, the largest property and casualty insurer in the world. Last year, we wrote about $35 billion of premium. It's a business that is truly global. About more than 50% of our premium was outside of the U.S., and about 60% of it's commercial, 40% consumer, which is often a surprise to people who know us in the U.S., where it's predominantly a commercial operation.
In other countries, especially in Japan, where we have a very large presence, it's got a much bigger consumer component to it. Size is not the issue. It's a very large organization. We deal with 97% of the Fortune 1,000 and comparable groups in Europe and elsewhere. Scale is not the issue. Value is what we're really focused on. We're very focused on the trade-off between value and volume and getting the balance between growth, profitability, and risk right to grow intrinsic value. That's a different mix in different places. In the U.S. casualty lines, for instance, we think that we're not getting paid adequate rate, even with the rate increases that we're getting.
We think that we can rebalance our risks between U.S. and international in the property portfolio because we've historically had a much bigger risk appetite for U.S. property CAT and rather limited appetite and over purchase of reinsurance internationally. We're getting that right. We're using metrics that help us to provide people with a clear path to value creation, and we use an acronym, RAP, which is just risk-adjusted profitability. Very similar to economic profit, EVA, and similar concepts, but somewhat modified to the insurance industry and recognizing the cost of risk is not a straightforward cost to capital calculation. An important metric to complement the more traditional combined ratio and ROE numbers, because an appropriate hurdle rate for Japan is very different than a hurdle rate for Brazil, two countries we're very active in.
Given the diversity of business lines and geographies we operate in, we need a common metric that helps people understand what it takes to add substantial shareholder value. That helps align people and delegate the individual trade-offs between risk, profitability, and growth that need to be made on a customer by customer, country by country, business line by business line basis. In terms of other drivers of improvement, to give you a sense, the ROE of Chartis itself mirrors that of AIG, normalized about 6% with a normal CAT load for 2010, targeting an unlevered ROE of 10-12 in 2015, which corresponds to a combined ratio of 90-95, depending on the rate environment. How are we going to get there? In terms of underwriting excellence, we realized that as a company, we are very rich in experience.
We have underwriters, 4,500 production underwriters on the commercial side with deep product expertise and a wealth of underwriting experience. They're not equipped with state-of-the-art risk selection tools. We're investing very heavily in the science of technical underwriting and capturing the vast amounts of data that we have and analyzing it to do better risk segmentation. We created a new role in January, Chief Science Officer. Murli Buluswar joined us from Farmers by way of Progressive and Capital One in his past, and is bringing a lot of very powerful analytical individuals to complement the deep experience we have on the underwriting side. We have some great hope that that's going to really improve our loss ratio. In terms of customer experience, this is a company that was managed by profit center.
During its growth phase in the '70s, '80s, and '90s, business leaders, profit centers were given clear mandates to grow and to have a lot of autonomy to pursue their growth opportunities. That made an awful lot of sense until we became the biggest, at which point they started to cannibalize each other, overlap, undermine each other's pricing power, and of course, build a lot of duplicate infrastructure. From a customer point of view, it was not exactly easy to navigate the AIG organization. We've been consolidating these profit centers, simplifying the internal organization in a way that makes it much easier to do business with us and makes it much easier for us to allocate our capital to wherever the returns are greatest and to use our pricing power where we have it. It's also important from a management point of view.
We created global organizations, there's a Global Head of Commercial, John Doyle, Global Head of Consumer, Jeff Hayman, and then there's three regional leaders, Peter Eastwood for the Americas, Rob Schimek, who has EMEA, and then Jose Hernandez, who has Asia Pac. From three time zones, two broad product groupings, it's a fairly streamlined organization. For the first time, we can really allocate capital fluidly to where the returns are greatest. Importantly, we want to create quality of earnings, not just quantity of earnings. I think this company has historically made a bad trade-off between quantity and quality. Certainly, there's some evidence to suggest that could have been done better.
We're very careful today to add risk-adjusted earnings that we think we can sustain through the long term, and we do that by investing in talent, infrastructure that's really got long-term capacity to delight our customers and to make good risk selection over the long run. We feel very good about being on track with our program to get to the financial targets we've set. Importantly, a cultural change in the organization to emphasize, as I say, value over volume. The management is highly aligned with shareholders. We're paid largely in equity or in equity units. Our goal is very much to grow the enterprise value. The book capital of the company is over $100 billion. The market cap is about half that.
I think there's plenty of room for value creation by just reassuring people that we can earn our cost of capital and reassure our stakeholders that our capital base and our $68 billion of reserves, $67 billion of reserves, are more than adequate to satisfy the long-term claims-paying ability. Keeping our ratings stable to improving is an important other goal that we have. Finally, we think that the government, which has been an excellent partner, by the way, can be exiting from their involvement in AIG with a substantial profit in the not too distant future. The Government Accountability Office, the GAO, came out with a report as recently as 10 days ago suggesting that overall, the U.S. government should make a profit from their intervention in AIG of roughly $15 billion. That's not something that I think has really fully reached the public consciousness.
When it's done, then we'll have a chance to talk more about it. In the meantime, we just want to manage our business well and ensure that our interests are aligned with those of you that are owners and those of you, hopefully, that will become owners. With that, I'd like to open up to questions.
Josh.
Well, I have plenty of questions, but I'll look for hands first because this is really your opportunity. If there are none, then I will begin. Let's talk about RAP. To what extent when you think about current interest rates, RAP, how much of that is being computed in the amount of capital? Is it the new money rate, or is it the legacy money rate that you're earning on the portfolio? In terms of the capital being applied to the businesses, do the underwriters have more capital than they know how to use, or are they being applied the right amounts of capital and there's excess capital in the business?
When we think about ROE going forward in each individual business unit, what can we hope will both come from an investment income, from an underwriting, and how much capital is that going to require of an underwriter to put to use?
That's a great question. The first thing is on interest rates, we use new money rates. The RAP is calculated based on the risk-free rate, the U.S. Treasury rate, or the comparable in whichever country we're operating in, to the duration of the expected payout of the claims, plus a liquidity premium. The liquidity premium is dynamic and dependent on the fact that there are high-quality assets that we feel as a buy and hold investor that we can extract a liquidity premium for. It is dynamic and reflects current new money rates. Secondly, from a capital point of view, we have a concept of no orphan capital.
You can't have individual business units saying, "Well, based on my favorite quant's estimate of reserve risk and other risks, I only need this much capital." At which point you added it all up and it doesn't add up to the total capital of Chartis. That's not allowed. All of the capital gets allocated so that everybody has a very strong incentive to work collectively to make the whole entity capital efficient, and upstream as much in the way of normal as well as special dividends to the holding company so that we can use that capital in the most fungible way possible, whether it's for buybacks, dividends, acquisitions, or any other sensible use of that capital. That capital is burning a hole in the pockets of all the businesses.
In terms of how that total capital pool is allocated, it's a bit of a hybrid of economic and other binding constraints, whether they be regulatory or rating agency methodologies, because we want to make sure that we have the right, proper incentives to do that. I think that the concept of RAP is simple. The details of how it's applied business line by business line, distribution channel by distribution channel, and customer by customer is trickier. Another important dimension here is it's not just a single period measure. We have this concept of RAP-POR, risk-adjusted profitability projected over a reasonable timeframe. Simply saying that we've built relationships with customers over decades. We're not about to slam the brakes on and double their pricing just to get to a positive RAP number.
We're being very thoughtful about how do we look at profitability across multiple product lines and geographies in the multinational accounts, and making sure that we get that portfolio mix to a RAP positive number over a reasonable timeframe. Likewise, if we're correcting the pricing in a business which is monoline, we're in a hurry to get to a RAP positive number or get the heck out of that business because there's very little in the way of relationship repercussions. It's I think taken hold much faster across the organization than I expected. It's still clearly a work in progress, something we're not going to publish publicly until we've really refined the methodology and got comfortable with disclosing.
Along those lines, obviously, you're making investments in the future for the company, which are depressing ROE to some extent right now. If you think about what those investments in maybe a year or two, maybe three years before they go away given the RAP-POR sort of timeline, what's the ROE of business being written today at the company? Are we at maybe a 7% round? Where do you think you are in that timeline? Obviously, we can see the GAAP numbers say we're at a six. Are we really at a six? Are we higher than that? Where are we?
Well, I think that the ROEs are all over the map, which is the good news. The highest ROE business that's material is in a consumer line in a direct marketing. There you're north of 20%, very attractive. That's about 15% of our total consumer lines. The trouble is we don't employ much E at that high R. We'd like our direct marketing business and consumer to grow a lot faster. That's a very accretive business from an ROE point of view, at least from an economic perspective. From a GAAP point of view, not so true because of the EICF and IIG, where you're forced to expense a lot of marketing expense, which from an economic perspective rightly should be capitalized and amortized over a much longer time horizon based on the data we have over the consistency of customers. That's the one extreme.
The other extreme, you've got a bunch of businesses that are in runoff, which have a very modest ROE. You've got some businesses which are just simply not earning their keep with negative ROEs where we are either shutting them down, changing the pricing, changing the way we participate in those things. Taken as a whole, the investments are going to elevate the expenses somewhat through the middle of next year, and then you'll start to see it coming down. A lot of investment in infrastructure was well underway before I showed up and therefore is starting to reap benefits. On the loss ratio side, we're expecting benefits to offset that headwind on the expenses. On a combined, I think that there's a two-point per year improvement is a reasonable assumption to make, give or take with a few anomalies here and there.
We had a bit of an anomalous first quarter expense ratio with the one-offs that were discussed in the conference call.
One of those examples being the decrease in the reserve for bad debt. We should normalize that, feel comfortable normalizing that?
Yes.
Yep. Okay. Last year, you did have a lot of municipal securities in the portfolio, but obviously the unusual tax situation at AIG, you don't benefit from those securities like the company once did, causing a major overhaul in portfolio management. Where does that mean today the asset portfolio stands compared to the new money rates? Firstly, that yields are depressed sooner they were because we rolled everything over, but it's also meant that actually you don't have to roll over as aggressively going forward.
Well, we've turned the portfolio in the last 15 months about 40%. Chartis' portfolio is about $120 billion, to put it in perspective, of general account assets. SunAmerica is about $180 billion. It's about a $300 billion portfolio between the two. Strategic asset allocation in both SunAmerica and Chartis is a big opportunity for improvement. Historically, obviously, these portfolios were in the context of an overall balance sheet of $1 trillion. Secondly, the asset management group was incentivized to manage third-party assets more than general account assets. Now, that group has been spun out and that was part of the simplification. We have an asset management group today that's 100% focused on managing the general account assets.
In doing so with a reduced size, $300 billion than $1 trillion, there's opportunities to continue to optimize, not simply for the tax reasons that you suggest. To give you a sense of the scale of that, Chartis' holdings of tax-exempt munis came from a peak of $65 billion to close to $30 billion today. A new money rate is around 4%, reflecting our shift to some illiquid assets that we've been able to acquire that we feel very good about, but are still a relatively modest share of our total very liquid asset base. Where have those munis been reinvested? Largely in investment-grade corporates, but also in some private label RMBS and some CMBS assets. We're also stepping up some other asset classes where we think that we've got some real comparative advantage.
The capital regime that applies to us is almost the opposite of what applies to banks in terms of banks being increasingly penalized for illiquidity while we get rewarded. Secondly, from a ratings perspective, the NAIC is no longer purely ratings-based, public ratings-based. It looks at stress tests. If you can buy distressed assets at very favorable prices, then they look very good under stress tests. They're positively convex. The NAIC recognizes that, assigning them an NAIC 1 rating. There's still opportunities to optimize on the strategic asset allocation. Our new money rate, I think at 4%, is reasonable.
Last week, or maybe it was even a few days earlier than that, Chartis bought some AIA stock from AIG. What does that mean about the capital flexibility between the sub and the holdco? How might that affect capital management at the holdco going forward?
Well, we are going through a number of maneuvers to simplify our capital between the holding company and the subsidiaries. We implemented a framework with the rating agencies about 18 months ago, which is quite unusual in our industry. It sort of fits within what we call a philosophy of strength from above. Not only do we have standalone capital ratios at the operating companies that are first in class in the industry. To give you a sense, over 400 RBC in Chartis, over 500 in SunAmerica. Standalone, very strong ratings. We also have over 30 capital maintenance agreements from the holding company down to these entities.
The purpose of this is to put in place a long-term strategy where we maintain a sizable buffer of capital and liquidity at the holding company that's available to supplement the capital of each of the entities when needed. Now, why would you want to do that? Well, think about these capital maintenance agreements as the arteries and veins in a body. The blood can circulate in a body. In this case, it's dividends going up, capital injections going down in a dynamic way that allows us to capture diversification benefits. What we discovered during the crisis more than any other company is the lack of fungibility of capital. We had to make a $20 billion margin call at the holding company and getting liquidity from the ample liquidity that was available within the network of legal entities to where it was needed fast enough simply wasn't possible.
We're acutely aware of the benefits of fungibility of capital. To get there, we are simplifying capital structures, moving assets to where they are best held. The AIA shares that you mentioned are an appropriate investment in modest size for Chartis as a temporary holding of those assets and is part of a maneuver to fine-tune our capital between the holding company and the subs. The general philosophy is to have excess capital held at the holding company. We are simultaneous with some of the capital maneuvers that you've written about, simplifying a lot of legal entities. We're going in Chartis alone from 450 legal entities in 2007 to about 290 by 2015. That's quite considerable simplification, but it means moving assets up and down before you consolidate. That's part of that.
In terms of going forward. Yeah, it's CSS.
Thank you.
In terms of going forward for 2012 on the investment side, what's the kind of redeployment in terms of where are you? Can you add some more yield to the point in time right now? Is the company going to take some more risks on the portfolio?
We are continuing to get closer to an efficient strategic asset allocation. We're not there yet. I continue to find tax-exempt municipals a less attractive investment class than some of the other alternatives. I think that the opportunities that we see to redeploy to other asset classes will lead to I think a better return on risk for the portfolio as a whole. Importantly, we think about portfolio risk holistically, not just looking at individual asset classes side by side. We're looking at the correlations between them. As I mentioned earlier, we recognize that we've never had to sell a bond to pay a claim, and that having longer term sticky liabilities gives us a certain comparative advantage in some asset classes where we are confident in the underlying quality of the assets, even if they're not as easily tradable as some others.
We're willing to take more liquidity risk, but less market risk. I don't particularly like equities. I do quite like some of the illiquid distressed mortgage assets that are available.
Finally, reserves. The company's going forward business reserves have been basically negligible one way or the other on movement. There was some reserve charge in the runoff portfolio of about $100 million-$150 million. Where is the comfort level of management on the runoff portfolio and how can investors get more comfortable with that, especially given even looking at triangles, the years that are being affected aren't even available to be viewed anymore?
Well, I think that as I alluded to earlier, our total reserves are $67 billion. Important denominator when looking at any adjustments up or down in reserve development. Percentage wise, we have had reserve adjustments quarter by quarter over the last five quarters, less than 0.1% of reserves. Very modest adjustments on a net basis. On a gross basis, there have been some pluses and minuses that are bigger than that. The good news is that the sheer diversity of our activities means that you do have these ups and downs. We are trying to estimate long term trends. To do so, we are using all the traditional actuarial methods. We have over 1,000 individual loss triangles that go back much longer than we publicly disclose. We have new actuaries, internal and external, looking at those to develop tail factors.
I think that the first thing is you got new sets of eyes looking at the data, we're also looking at it through a different lens. We initiated a project about 10 months ago called the Structural Drivers Project that looks beyond just what the trends are, why the trends are going where they are. These structural drivers identify what are the underlying root causes of reserve development. That is giving us greater confidence in our reserve number because we can explain why. It's also feeding back into different claims management techniques and different technical underwriting techniques. To give you a sense of the scale of that in one product line alone, Workers' Comp, we shared over 27 million claims invoices with the Johns Hopkins School of Public Health to do data mining on these structural drivers.
That's been a very fruitful collaboration, which we're now replicating in a lot of other lines of business. That's giving us, I think, a lot of ways to triangulate on that. Finally, we're committed to increased transparency in our disclosures. We do a lot of voluntary disclosures. We did a bunch of supplemental disclosures last year in addition to Schedule P. We did some more this year. We are all ears if there's more data that would help you reach your own conclusions on our reserves. We want this to be an issue that's behind us. Some of the products that gave us some challenges in terms of reserve additions in 2009 and 2010 are businesses that we have radically shrunk in terms of their incremental contribution to the business. It becomes a less and less of an important issue going forward.
Peter, thanks for coming. We're out of time. That's it.
Thank you for coming.