Following its remarkable recovery from the financial crisis, American International Group (NYSE:AIG) is once again a giant within the diverse insurance industry. While the megainsurer has provided consistent financial results, analysts believe it could be leaving profits behind -- but they'd be wrong.
AIG reported earnings a few weeks ago, with a huge EPS-estimates beat, but investors largely dismissed the win when they realized that some of the underlying factors within the insurer's operations were not so rosy.
One of the biggest takeaways from AIG's earnings report was the deterioration of its combined ratio -- a measure of the losses and expenses carried by insurers. Analysts were quick to jump on the negative trend, but they may have been misguided.
Breaking down ratios
The combined ratio is one of the most important metrics when analyzing an insurer's performance. With various components, the ratio can provide details of both an insurer's losses and expenses.
At first glance, AIG enjoyed a 22 point decline in its overall combined ratio versus the prior year, much like most of its competitors. But the drop was due solely to dramatically lower incidences of catastrophic losses. Compared to 2012's Hurricane Sandy aftermath, 2013 was extremely calm and less expensive.
Ultimately, the surprise pessimism was a result of an increase of the company's underlying expense ratio, which strips out the impact of catastrophic losses, reserves, and claims, on a consecutive quarters basis. Though it doesn't seem like much, the two point increase AIG reported was enough to make investors think twice about rewarding the company for its hard work.
A little context
So should you be concerned about AIG's rising expense ratio?
One thing that investors should remember is that an insurer's combined ratio, including its expense levels, will not trend in a straight line from quarter to quarter. Looking at AIG's ratio trend versus some of the other top insurers -- Allstate (NYSE:ALL), Berkshire Hathaway's (NYSE:BRK-B) Geico, Progressive (NYSE:PGR), and Traveler's Companies (NYSE:TRV) -- you can see that it's not wavering more than most.
However, despite the consistent expense levels over the past five quarters, AIG remains at the high end of the range for the percentage of premiums needed to cover expenses:
As one of the analysts on the insurer's conference call aptly noted, AIG's pre-crisis success was partially due to its ability to keep costs low compared to its competitors. Versus the 34% average expense ratio AIG has carried in the last few quarters, the company's pre-crisis levels barely hit the mid-twenties.
There are two very big factors which have lead to the elevated expense levels for AIG, and both have to do with transitions.
Transition 1: direct versus agent
The differentiation between companies in the chart above can be explained by one simple factor: how heavily are sales dependent on agents? Both AIG and Traveler's Companies are heavily centered on agents, leading to higher compensation expenses; Progressive and Geico are known for their direct selling approaches, which keeps expenses low.
If AIG started making an effort to increase its direct selling (like Traveler's has in the past year or so), there's plenty of room for massive savings. But that may not be the direction management wants to go.
Transition 2: Leadership
CEO Robert Benmosche stated that there continues to be a focus on improvement of all parts of the combined ratio, including expenses, but that investors and analysts should remember that the company has been making some large expenditures in order to create new efficiencies. Though those expenses, including restructuring and expansion costs, have created an increasing trend, they are not permanent and will lend to better operations management in the future.
Neither Benmosche nor Peter Hancock, the CEO of AIG Property Casualty, made any indication that expense management was a concern. In fact, Hancock went so far as to say that the combined ratio was the result of what the company can do for its customers -- not a factor in AIG's competitive advantage.
Hancock's sentiment should convince investors that AIG's focus is on quality before all else, so don't expect a big surge in new direct selling initiatives anytime soon.
For now, investors in AIG shouldn't be concerned at all about the company's combined ratio. As the conference call demonstrated, management is firmly aware of what is driving expenses higher and remain confident that the firm is on the right path.
Though there would certainly be big incentive to decrease compensation expense through a transition to direct selling, AIG's rebuilding has created a deep sense of focus on high-quality operations, instead of chasing savings opportunities.
A big year ahead
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Jessica Alling has no position in any stocks mentioned. The Motley Fool recommends American International Group, Berkshire Hathaway, and Progressive. The Motley Fool owns shares of American International Group and Berkshire Hathaway and has the following options: long January 2016 $30 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.