This Insurance Powerhouse Will Continue Outperforming

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

American International Group (NYSE: AIG) rose by nearly 5% on Friday after the company announced better than expected earnings figures on Thursday after the close. The stock is up by more than 20% in the last year, but make no mistake, there is still plenty of upside room in this recovering insurance giant.

After the storm

AIG made the worst possible kind of bet during the credit bubble; the company was insuring banks and other investors against potential losses in subprime mortgage assets, while at the same time loading its balance sheet with all kinds of complex and sophisticated derivatives. That would be like renting your car to Lindsay Lohan on Saturday nights, you can make a few bucks from time to time, but there is just no way it´s going to end up well.

When the crisis exploded, AIG was declared “to big to fail,” and the company received a $182 billion bailout from the federal government in order to backstop a crisis that was producing ripple effects all over the global financial system. In some sense, the AIG bailout could be considered an indirect way to help many other entities which had purchased insurance from the company.

Then came a long and arduous recovery process, the company reduced its workforce from 116,000 to around 60,000 employees; and it also disposed valuable segments like its Asian life insurance business among others. More importantly, under the new leadership of Robert Benmosche AIG has dramatically reduced its exposure to those toxic and obscure financial derivatives it inherited from the previous administration. The company has completely repaid the government, and it’s now in control of its own destiny.

<img alt="" src="http://g.fool.com/editorial/images/38418/aig-derivatives_large.jpg" />


Source: AIG earnings presentation.

Improving fundamentals

The recent earnings beat, fueled mostly by strong results in the Property Casualty segment, bodes well in terms of the turnaround prospects. Benmosche and his team have focused their attention in increasing profitability for this segment, and they seem to be on the right track judging by recent numbers.

AIG Property Casualty reported operating income of $1.6 billion in the first quarter of 2013, compared to $1.0 billion in the first quarter of 2012, reflecting increases in both underwriting income and net investment income. Improved underwriting margins for the segment were driven by a shift in the portfolio mix, the benefits of underwriting improvement initiatives which are enhancing the risk selection process, and higher prices.

Overall insurance operating income was up 28% from the same quarter last year, and  book value per share, excluding accumulated other comprehensive income (AOCI), increased by 12% in comparison to the first quarter of 2012. Now that the company has left its financial problems behind, AIG is free to focus on growth and profitability.

 Upside potential

When compared to competitors like Allstate (NYSE: ALL), Chubb (NYSE: CB) and Travelers (NYSE: TRV), AIG still has plenty of upside potential from a valuation point of view. The P/E is in line with that of other companies in the sector, but since AIG has higher expected growth rate, so it´s cheaper when it comes to PEG ratio – PE adjusted by growth expectations -.

<img alt="" src="http://g.fool.com/editorial/images/38418/valuation_large.jpg" />

Data from Finviz

The company´s price to book value – PB – ratio is around half the valuation of its competitors. This is probably because investors still have doubts about the company´s financial transparency, it is true that companies like Allstate, Chubb and Travelers don´t have the same stigma that AIG needs to overcome, and their balance sheets didn´t suffer as much during the credit crisis. But AIG has made remarkable improvements in that aspect over the last years, so this valuation gap could be exaggerated and on its way to getting reduced over the next years.

Return on equity - ROE- is still below average at AIG, but management has stated its goal of reaching the 10% level in the middle term. As long as the company continues delivering solid operating performance, that should be only a matter of time.

Besides, AIG has been capitalizing the opportunity to repurchase stock at bargain valuations over the last quarters. Since those repurchases are done at a price to book value ratio below 1, they increase book value per share. The company gets more than $1 in accounting equity value for each dollar it uses to buy its own stock, so as long as the purchase price is so low these kinds of buybacks will be accretive in terms of book value per share.

<img alt="" src="http://g.fool.com/editorial/images/38418/repurchase_large.jpg" />

Positive industry trends

Allstate managed to report better than expected earnings for the last quarter in spite of increased losses from catastrophic events, higher premiums and an improved combined ratio - the tally of losses and costs per $100 of written premiums – were the main reasons for the better than expected results in a challenging environment.

The same goes for Travelers, the company has faced two seriously damaging hurricanes in the last two years, yet increased premiums have produced earnings well above analyst´s expectations for the last quarter.  

Chubb did even better than its competitors, since it’s not very exposed to Property Casualty, it managed to report lower catastrophe losses for the last quarter. But that didn´t stop Chubb from rising insurance premiums, so earnings were strong both from the point of view of income and losses in the March quarter.

After years of lackluster industry returns due to falling premiums, high catastrophe losses and low returns on fixed income investments due to rock bottom interest rates, it looks like insurers are finally starting to raise their premiums and increase profitability. This improved scenario bodes well for AIG and its turnaround prospects.

 Bottom line

AIG has come a long way in cleaning its balance sheet and improving its operations, and the company is ready to focus on growth and profitability over the next years. The numbers for the last quarter send an optimistic signal about the evolution of its turnaround and even after a considerable run up, the stock is attractively valued. Besides, improved industry conditions are providing a considerable tailwind, so this insurance powerhouse is in a good position to continue outperforming the markets in the long term.

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Andrés Cardenal ows shares of AIG. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group and has the following options: Long Jan 2014 $25 Calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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