Monday, December 19, 2005

A Fresh Start at AIG

Barron's, Jonathan R. Laing, 19 December 2005

It has been a tumultuous year for insurance giant American International Group and its shareholders. But better times are coming for both of them.

For one thing, AIG's franchise, at home and abroad, seems as sound as ever. For another, its new leaders have been cooperating with ongoing investigations into abuses in the insurance industry, something that could convince regulators to be reasonable in reaching a settlement with the company for its own transgressions.

AIG's annus horribilis began in February, when it was subpoenaed by New York Attorney General Eliot Spitzer and the SEC, regarding its accounting for what turned out to be a sham 2000 reinsurance deal with Warren Buffett's General Re. Within months, AIG had admitted to a host of other accounting shenanigans that had artificially inflated its income and shareholders' equity by billions of dollars from 2000 through 2004.

By March, AIG's 80-year-old CEO, Maurice "Hank" Greenberg, had been ousted, along with his CFO, Howard Smith, and several other senior executives because of their apparent roles in the accounting problems. The split between AIG and Greenberg, an industry icon after nearly four decades at the insurer's helm, was nasty; the press had a field day covering the mudslinging. But the company has distanced itself from its former chief, whose woes seem to be mounting. Last week, Spitzer released a report contending that, 35 years ago, Greenberg had violated the will of AIG's founder, Cornelius Vander Starr, defrauded a foundation Vander Starr started and eventually wrested control of AIG via gains generated by the alleged fraud.

In April, AIG's stock fell some 30% below the 73.46 it had fetched in February. Since then, fear that AIG might be the next Enron or WorldCom has abated. The stock has recovered nicely, recently changing hands around 66. In fact, it still looks inexpensive and could very well be materially higher within 12 months.

John Hall, an insurance analyst for Wachovia Securities, argues that AIG could easily hit about 78 next year -- two times the $39 book value he expects the company to boast by the end of 2006. "This multiple is hardly a heroic assumption with the S&P 500 currently selling at three times its book value," says Hall. He arrives at that book value by adding his estimated 2006 earnings of $5.70 a share to his estimate of year-end 2005 book of $34.40, minus about 75 cents a share to reflect expected dividend payments and a conservative estimate of how much AIG will pay to settle the accounting scandal.

Even UBS analyst Andrew Kligerman, a onetime AIG bull who now has a Neutral rating on the stock and grumbles that the scandal left him feeling like he had been "kicked in the teeth," concedes that many portfolio managers think the big insurer deserves a multiple higher than the S&P 500's, because of its likely ability to deliver 15%-plus returns on equity and 10%-to-12% compounded annual earnings growth. Even using his conservative 2006 earnings estimate of $5.19 a share and assigning AIG a current S&P P/E ratio of 18 would yield a stock price above 93 next year.

Why is AIG's outlook strong? For one thing, the accounting restatements and adjustments made this year for 2000 through 2004, though stinging, weren't devastating. The first restatement's reduction in income for the five-year period -- $3.9 billion -- constituted only 10% of AIG's income for that period. The total hit to 2004 net worth or book value was $2.26 billion -- less than 5% of the $82.77 billion in shareholder's equity reported before the restatement. A second -- and, maintains AIG's new CEO, Martin Sullivan, last -- restatement last month had no meaningful impact on year-end 2004 shareholders' equity. It cut net by just $133 million for 2004 and by $84 million for this year's first nine months.

Likewise AIG's earnings appear to be back on its customary steep growth trajectory. In the nine months ended Sept. 30, the company reported a 21% jump in net income before capital gains or losses, to $10 billion, or $3.82 a share, versus $8.3 billion, or $3.14, a year earlier. The comparison was helped by the downward restatements and adjustments taken in 2004 that slashed full-year results by $1.32 billion, or 12%, to $9.73 billion. Also this year's nine-month results got a boost of $1.6 billion, compared with $617 million a year earlier, from derivative hedges that didn't qualify for hedge accounting.

The nine-month results for 2005 also had included the largest after-tax catastrophe losses ever suffered by AIG -- $1.6 billion from hurricanes and other storms. "In a year of record losses for our industry, our company's geographic and product diversity really were on display for all to see," Sullivan recently gushed to Barron's.

Much of the pessimism hanging over AIG revolves around the conviction that it will be slammed when it finally settles with Spitzer, the New York Insurance Department and the SEC. Estimates of AIG's eventual settlement costs, including class-action suits, run well above $1 billion. This number is partly based on the $850 million that insurance brokerage Marsh McLennan (MMC) paid out this year to settle charges that it had engaged in bid-rigging to collect kickbacks through "contingent commissions" from major insurers like AIG in return for sending them business from Marsh clients.

AIG under Greenberg frequently incurred regulators' wrath for its belligerence and grudging cooperation with outside inquiries. In 2003, the SEC excoriated AIG for allegedly withholding material information. The agency fined AIG $10 million for helping Brightpoint, an Indiana cellphone distributor, delay taking an $11.8 million loss via a sham insurance transaction that spread the deficit over future periods.

In the fall of 2004, the SEC and the Justice Department chastised AIG for allegedly making inadequate disclosure of a criminal investigation into the Brightpoint imbroglio and another case involving PNC Financial Services (PNC). AIG was accused of helping the Pittsburgh banking concern remove bad loans and venture-capital investments from its balance sheet. In the end, the insurer paid $126 million to settle both cases.

If, under Greenberg, AIG resembled the Kremlin, glastnost now reigns under Sullivan, the warm, black-slapping Brit who began working for the insurer in London as a 17-year-old telex clerk 34 years ago. Upon succeeding Greenberg in mid-March, he launched a full-bore investigation into the accounting and governance practices across AIG's 130-country empire, in addition to working closely with Spitzer's office on its original inquiry into AIG's reinsurance deals with Gen Re. Some 36 multi-discipline teams fanned out through the company, "turning over every stone in an effort to make AIG's operations completely transparent," as Sullivan puts its. The self-investigation found plenty. Over the next few months, results were posted on AIG's Website; ultimately, a 150-page special report detailing the accounting lapses went to regulators.

There was the off-shore reinsurance company Union Excess, secretly controlled by AIG, which used it to offload $1.2 billion in insurance claims from AIG's balance sheet, fraudulently pumping up reported earnings. A disastrous auto-warranty insurance program started by Greenberg's son, Evan, that generated $295 million in premiums and $777 million in claims was transmogrified from an underwriting loss into a capital loss (Wall Street pays scant attention to such losses, compared with underwriting deficits).

Gains in various AIG hedge funds and municipal-bond investments were transmuted into investment income via fancy option strategies that let the company harvest and alter capital gains while risklessly reinstating their investment positions in the funds. Why? Because Wall Street analysts value insurers' investment income more highly than capital gains.

But those were the bad old days. Now, AIG seems to be scoring points with regulators by being more open. And this may win it a more reasonable settlement. A person close to Spitzer acknowledges that nearly all the claims made in the office's May civil complaint against the company, Greenberg and Howard Smith came from data uncovered by AIG itself, save for the original Gen Re allegations. (In that case, Gen Re apparently ratted on AIG in order to reduce the heat it was taking itself.) "One can't say enough about AIG's cooperation," the Spitzer associate says.

Regulators may also go easy on AIG because its financial games, while clearly hurting shareholders, didn't victimize policyholders and other customers. In contrast, Marsh McLennan's price-fixing injured its clients, who had relied on the broker to find them the best coverage at the best price.

True, the company might never again be the growth machine it was under Greenberg, when it seemed to be capable of consistently delivering earnings gains of 15% a year. In fact, Greenberg himself couldn't hit that target in his later years, which may have encouraged the accounting abuses.

Still, after the various restatements and adjustments, AIG earnings did grow at a not-too-shabby compound annual 12.2% clip from 2000 through 2004. And that indicates how much AIG has going for it, particularly under its new, seasoned and well-regarded management team. It has pledged to tighten AIG's operating controls and to inject new discipline into the company's acquisition policies and capital deployment strategies. The forensic accounting exertions earlier this year uncovered AIG operations with substandard returns on investment.

And AIG has a myriad of growth engines. Its foreign life and retirement services unit, which chips in about 30% of operating earnings, should continue its lusty growth, particularly as the immense Asian market, in which the company is the top foreign player, expands. Growing affluence abroad figures to make AIG's higher-margin annuity products increasingly popular.

AIG's U.S. life and retirement services business likewise figures to enjoy a growth spurt, as aging baby boomers begin to live off of, rather than accumulate, wealth. With relatively few of them having traditional pensions, annuities will likely be a fast-growing part of their retirement plan because of the security of guaranteed payments for life these products afford.

Meanwhile, disasters like the recent spate of hurricanes, which damaged billions of dollars worth of homes, commercial structures and energy facilities, ironically help property and casualty insurers in the long run, by allowing them to boost premium rates more easily. This is precisely what is happening in the U.S. property and onshore and offshore energy sectors. The recent catastrophes have also helped insurers impose more stringent terms and conditions on commercial policies.

As always, AIG is less vulnerable to any rate-cutting within the insurance industry because it derives much of its operating income from less competitive markets overseas and in specialized exotic niches in the U.S., such as kidnap insurance.

The future also seems bright for AIG's airliner-leasing unit, ILFC, and its capital-markets operation, despite the higher financing costs both face because of AIG's credit downgrade to double-A. The worldwide aircraft market is starting a dramatic upcycle. And the booming growth in global derivatives and commodities trading will benefit the capital-markets group.

So, more than likely, the American International Group's soap opera of the past 11 months will have a happy ending for shareholders, if not for Greenberg.

Expelling the Ghost of AIG Past

The New York Times, Jenny Anderson, 18 December 2005

Less than two weeks after Hurricane Katrina ravaged New Orleans, Scott Tramel, an insurance executive, was sitting in a makeshift office - a former filing room in a sales office - in Baton Rouge when he saw a shock of white hair cross the hallway. He turned to his colleague, a fellow underwriter at the American Home Insurance Company, a subsidiary of the American International Group, with a look of surprise. "I think that's Martin Sullivan," he said, referring to AIG's chief executive.

Less than a week after the storm, Mr. Sullivan, along with his wife, Antoinette, and a small group of employees, loaded the company's Bombardier Global Express, a high-speed business jet, with $5,600 in consumer goods, $1,000 worth of polo shirts and $1,300 in battery-operated electronics, which he delivered, unannounced, to offices in the region struck by the hurricane. "They weren't just worried about us being on the job; they were honestly concerned about our well-being as people," Mr. Tramel said.

Katrina is not the only storm that Mr. Sullivan has had to weather this year. After 34 years at AIG, the world's largest insurance company, he took over the top job in March amid a decidedly man-made disaster. Regulators had discovered accounting problems at AIG, and the board swiftly ousted the chairman and chief executive, Maurice R. Greenberg, who over the course of 38 years had built the insurer into a behemoth with a market capitalization of $170 billion.

Last week, regulators lashed out at Mr. Greenberg again, issuing a report accusing him and others of having cheated a foundation he runs 35 years ago. No charges have been brought, and Mr. Greenberg, who is known as Hank, denies any wrongdoing.

When Mr. Sullivan, 51, took the reins of AIG - whose 2004 revenue, $98 billion, exceeded the current gross domestic product of Venezuela - the company's lawyers and regulators were running it temporarily; its former boss and mentor was in exile (with acrimony between Mr. Greenberg and AIG growing by the day); and investors were wondering whether they might have the next Enron on their hands.

Nine months later, it is clear that AIG is no Enron. It has survived the restatement of five years' earnings and has reported three quarters of solid profit, and its army of lawyers is close to hammering out the final details of a civil settlement with federal and state regulators over allegations that ranged from bid-rigging to improper reinsurance arrangements.

Like some other chief executives catapulted into power amid crisis - Richard D. Parsons at Time Warner comes to mind - Mr. Sullivan has steadied the ship. He has done this through the force of his personality - he can be charming and ingratiating - and by the simple fact that he is not the manager accused of creating the problems. But with the skies clearing, investors are left wondering whether the nice, new chief executive will be able to match the performance of the company's former patriarch, architect and bully-in-chief.

"The big question they have is: What kind of growth rate can they achieve?" said David Schiff, the editor of Schiff's Insurance Observer, an industry newsletter. "In the old days, investors believed they'd have 15 percent growth year after year. If you are going to grow at 15 percent forever, that growth can make up for anything."

Andrew S. Kligerman, an analyst at UBS, added: "Hank Greenberg is a genius, he knows AIG like the palm of his hand and he can speak to any detail of his company without the assistance of any executive. Martin's certainly a capable executive, but whether he can master the intricacies of AIG is another question."

Those kinds of comments, which are common, suggest that AIG is Mr. Greenberg. Mr. Sullivan declined to discuss Mr. Greenberg, but he did make clear that he planned to keep AIG's entrepreneurial spirit and thought that the company could continue to grow at double-digit rates. "The single biggest question I get is, 'Will the culture change?' And candidly my answer is no," he said in his holiday-adorned 18th-floor office in Lower Manhattan. "The culture is the entrepreneurial culture, and my view is, it's in the organization."

As for whether he is tough enough, Mr. Sullivan said, "I would not be able to be in this position without tough choices." After all, Mr. Greenberg was ready to name him heir apparent.

Mr. Sullivan exudes a kind of ruddy optimism that, when combined with his broad smile and stocky stance, has a certain Santa Claus-like cheer to it. In conversation he laughs easily and does not shy away from jokes: he recently asked an analyst who was host for a lunch conference at the Pierre Hotel in Manhattan whether he could get some gin in his water glass. His warmth appears irrepressible and he seems to have charmed even the most irascible regulators. When he met the New York attorney general, Eliot Spitzer, who was leading the investigation into AIG, Mr. Sullivan, who is British, cheekily asked if he was part of the O'Spitzer clan.

While Mr. Greenberg also had a famous wit, it often appeared in public when he was using it against someone. He loved to deride analysts for what he felt were stupid questions, and managers for what he thought were lackluster results.

The contrast is lost on few: if Mr. Greenberg ordered, Mr. Sullivan asks. If the former chief knew more than everyone, Mr. Sullivan asks to be educated. Mr. Greenberg surrounded himself with a tight circle of senior executives, while Mr. Sullivan eats lunch with midlevel employees who are permitted to submit anonymous questions ahead of time, lest they be intimidated. And if the former chief executive and chairman took pride in how he built AIG, Mr. Sullivan loves to tell midlevel employees that if he can be chief executive, anyone can be chief executive.

"Martin's the first to find out, to listen and to get different points of view," said Frank G. Zarb, the chairman of AIG's board. "It's a great quality for a young C.E.O. He doesn't have his mind made up before he has the facts."

A native of London's gritty East End, Mr. Sullivan joined American International Underwriters as a clerk in 1971, when he was 17. It was his second job in insurance, and he earned £850 a year, or a bit more than $2,000 at the time, in his first year. He admired his boss, who he said taught him, "Always have standards; never let them slip." Within three years he had become an underwriter, and by 1983 he was running the insurance-property department for all of Britain.

AIG has diversified over the years, but underwriting - writing premiums and estimating the risk underlying them - is the heart of its business and where Mr. Sullivan made his career. He rose quickly through the European ranks, taking over AIG Europe in 1993. He was brought to New York three years later to become the chief operating officer of all foreign property and casualty operations, and in 2002, Mr. Greenberg chose him and Edmund Tse, then senior vice chairman of life insurance, to be co-chief operating officers. It was a clear horse race to succeed Mr. Greenberg.

Mr. Sullivan had to put his experience to the test last February. That month, federal and state authorities issued subpoenas to AIG over questionable accounting transactions, one of which Mr. Greenberg initiated himself, according to a lawsuit filed later by Mr. Spitzer.

It was not AIG's first round with regulators. In 2003, AIG paid $10 million to settle a civil suit brought by the Securities and Exchange Commission contending that it had helped Brightpoint, a struggling cellphone distributor, mask losses with certain insurance products. A year later AIG paid $126 million to settle all criminal and regulatory liabilities with state and federal regulators over the Brightpoint deal and similar allegations about products it sold to the PNC Financial Services Group.

Mr. Greenberg made clear that he did not welcome regulatory scrutiny. In the Brightpoint settlement, the S.E.C. cited a lack of cooperation by AIG in determining the fine, and Mr. Greenberg famously ended one earnings call by accusing regulators of turning foot faults into murder charges. "Hank's attitude was that we were interfering with his running of the business," said one regulator who was prohibited from talking on the record about continuing investigations.

While AIG had tussled with federal regulators, it was the February subpoenas that catalyzed AIG's board, which was already concerned about the handling of Brightpoint and other matters. After eight hours of contentious debate on a Sunday in March, the board decided to ask Mr. Greenberg to resign and to promote Mr. Sullivan.

Oddly enough, Mr. Sullivan had already been picked for the job. Earlier in the year, members of the board, with Mr. Greenberg's blessing, had decided that Mr. Sullivan would succeed Mr. Greenberg, though not right away, say two people briefed on the discussions. But the escalating investigation accelerated the timing of the transition and the heir apparent became king in the most unceremonious of coronations.

The conditions for Mr. Sullivan's arrival could not have been worse: the firm was virtually paralyzed by the investigations. Lawyers were running the company, his mentor of many years was in exile and Mr. Sullivan suddenly had one of the most complex financial-services companies on his hands. He knew the property and casualty business, which accounts for about one-third of AIG's revenue, but there were divisions, including capital markets and aircraft leasing, that he had to learn from scratch.

Both easing and complicating the transition was Mr. Sullivan's long tenure at the company. "I've grown up with these guys," he said of the management team around him. "We've worked together for so many years, it's not like I'm the new kid on the block." But there was also his personal relationship with Mr. Greenberg, for whom he had worked for decades. "I've put a lot of the feelings to one side," he said. "From Day 1, I have stayed focused on what's good for AIG"

One senior AIG executive said he had assumed that Mr. Sullivan was upset by what happened to Mr. Greenberg, but added that "he would feel it was poor form to show it." Others agreed that Mr. Sullivan has concealed his feelings about Mr. Greenberg's fate, focusing instead on what the senior executive said was a simple message: "We don't have the luxury of emotion. No matter how we feel we have to move forward."

He certainly had plenty to distract him in his first eight weeks on the job. Federal and state investigations widened, and investors feared that Mr. Spitzer might indict the company. It was unclear whether AIG's bizarrely consistent results were just a fiction.

As AIG's stock plummeted - it fell more than 30 percent from Feb. 10 to April 25 - Mr. Sullivan met personally with Mr. Spitzer and told him that he and AIG would cooperate, negating the need for any more subpoenas, according to someone briefed on the meeting. Mr. Spitzer put out a statement saying that he anticipated a civil resolution with AIG The stock's free fall halted.

Mr. Sullivan, meanwhile, had to move to get AIG out of the mess it had landed in. He oversaw an internal review of all of the company's businesses, which was no small challenge. AIG operates in 130 countries and has 92,000 employees. Domestic brokerage, for instance, which is just one unit of one business, has 49 companies.

The company's profile reads like a financial services yellow pages. It has four major businesses, and it is a giant in each of them. AIG is, for example, the largest underwriter of commercial and industrial insurance in the United States, as well as the top underwriter of director and officer insurance, professional liability insurance and environmental and aviation insurance, to name a handful. It is the top life insurer in Japan, the largest corporate investor in United States Treasury bonds and has the second-largest consumer finance business in the world.

The entire colossus had to be examined under a microscope. Thirty-seven internal teams were formed, reporting back to the board's outside counsel as well as to Mr. Sullivan and the company's chief financial officer, Steven J. Bensinger, who was also new to his post. They worked 15 to 18 hours a day, seven days a week, for two and a half months, Mr. Bensinger said. The message to employees was this: cooperate - or else. Many did. Some cooperated and then stopped; they were fired. Others cooperated and lost their jobs anyway.

"The sole objective of every person involved in this effort was to make the best reasoned judgments, get it right and put it behind us," said Mr. Bensinger, who, along with Mr. Sullivan, would have to sign the company's financial statement. The process took a toll. "No one involved in this process would ever want to repeat it," said Mr. Bensinger.

The internal investigation revealed widespread wrongdoing, much of which it laid on the doorstep of Mr. Greenberg and AIG's former chief financial officer, Howard I. Smith. On May 26, after the internal investigation was completed, Mr. Spitzer sued the company, along with Mr. Greenberg and Mr. Smith, accusing them of using accounting gimmickry to mask AIG's true financial condition. Both men deny any wrongdoing and say they plan to fight the charges.

Three days later, AIG restated five years' worth of earnings. Net income for 2004 was cut by $1.32 billion, or 12 percent, to $9.73 billion. Over all, the restatement reduced AIG's net income from 2000 through 2004 by $3.9 billion, or 10 percent.

The regulatory clouds have not cleared. The company is expected to settle civil charges filed by state regulators and the S.E.C. early next year, said two people briefed on the negotiations. The Justice Department continues to weigh potential criminal charges against Mr. Greenberg, and the United States Attorney's office in Manhattan is investigating whether Mr. Greenberg orchestrated an effort to manipulate the company's stock price, according to people officially briefed on the inquiry.

Mr. Greenberg has not faded into the background. He continues to control two former AIG affiliates - one that controls $25 billion worth of AIG stock and another that operates insurance brokerage agencies.

As Mr. Greenberg considers what to do in the ninth decade of his life, the company he built is thriving without him. AIG reported a profit of $1.72 billion in the third quarter, including after-tax catastrophe-related losses of $1.57 billion. "We've demonstrated a real resilience," Mr. Sullivan said.

There have been awkward moments. In October, Mr. Sullivan was in China meeting with government and business leaders when he ran into Mr. Greenberg, whose relationships in China are long and deep. "It was sad," one senior executive said, referring to the meeting of former friends halfway around the world. "It should not have come to this."

The challenges for Mr. Sullivan are formidable. He must prove that being different from Mr. Greenberg does not mean being not as good. He must deliver the double-digit growth that he has said is possible. And he would like to see more of his family. (At a recent dinner, he joked that he had not anticipated that an industry event would constitute a "date night" with his wife.)

Regardless of Mr. Greenberg's fate, the future of AIG is in the hands of a chief executive with deep loyalties and roots in the business. Mr. Schiff, the industry analyst, said that while Mr. Greenberg was certainly central to AIG, the company's future was not lost without him. "It's just one person," he said.

There is already a lot of work for the next person. Mr. Sullivan heads back to China for one last trip before Christmas. Is he concerned he might miss the holiday?

"Christmas? I haven't celebrated Easter," he laughed.