American International Group Inc (AIG) — Q2 2015 Transcript

Thank you, Anthony. Before we get started this morning, I'd like to remind you that today's presentation may contain 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 the factors described in our first and second quarter 2015 Form 10-Q, and our 2014 10-K under Management's Discussion and Analysis of Financial Condition and Results of Operations, and also 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 our financial supplement, which is available on our website. At this time I'd like to turn the call over to our CEO, Peter Hancock. Peter?

Thanks, Liz, and thank you all for joining us this morning. I'd like to discuss key highlights from the second quarter; the progress we're making towards our financial targets, the quality and strength of our balance sheet, and provide an update on capital management. I'm pleased with our overall momentum and believe our scale and focus on being our clients' most valued insurer will lead to continued success across our businesses. Turning to page 3, our key operating metrics. Trends include improved combined ratios for commercial insurance. Strong alternative investment returns contributed to investment income, despite pressure on consumer base yields. John and Kevin will provide additional comments on the performance of their respective businesses and how they're being positioned for sustained profitability. Our second quarter results demonstrated our commitment to balancing growth, profitability, and risk. We have more work to do on our reduction target, but we've made progress. Book value per share excluding AOCI and DTA was over $62, up 3% for the quarter and 10% from a year ago. We expect continued growth in book value per share, as our business deliver improved profitability and we deploy excess capital. Following the update to our capital plan, we announced an additional $5 billion share repurchase authorization and a 124% increase in our quarterly dividend to $0.28 this quarter, which highlights our growing confidence in sustainable earnings. Given the substantial increase to our dividend, we will include dividend growth in the 10% or more book value growth target. On the expense front we continue to simplify our businesses and processes, while continuing to invest in technology and infrastructure, which is driving our 3% to 5% in net expense reduction and allows us to focus on providing the greatest value to our customers. David will provide additional details on general operating expenses in his remarks. The shifting profitability dynamics of Commercial Insurance markets impacted our second quarter ROE, but does not diminish our outlook. We expect to reach our 50-basis point target for the year, adjusted for the lost AerCap earnings and the timing of capital deployment associated with the AerCap sale proceeds. Continued underwriting improvements and expense reductions are the key to reaching this target. We also believe that the current normalized ROE under GAAP doesn't fully reflect actions taken in recent years to build intrinsic value and further enhance balance sheet quality. For example, our investment gains taking program has put pressure on investment income, but allowed for DTA utilization that freed up capital for share repurchases. While this was the right economic decision, the negative near-term ROE impact is about 70 basis points. In the quarter and through July we actively repurchased shares below our estimate of intrinsic value. Since our fourth quarter earnings call through the end of July we've repurchased approximately 80 million shares for $4.7 billion, leaving $1.3 billion remaining under our previous authorization. I would note that for a portion of the quarter we were in blackout due to the AerCap sale. In July we also extended our debt maturities, further enhancing balance sheet quality. Our current debt-to-capital ratio is approximately 16% and shareholders' equity, excluding AOCI and DTA, is over $80 billion, which we believe positions AIG for sustainable profitable growth. In our annual shareholder's letter we referred to floating or selling businesses that lack synergy with our core operations. While we believe that our core insurance businesses largely meet our customers' needs and our economic return objectives, we are actively considering divestitures to sculpt the company into a more coherent organization. We also consider acquisitions as a potential strategy to build capabilities that meet our customers' needs, enhance our infrastructure, contribute to growth, and that are not overly capital-intensive. Our mission is to empower our clients to be their most valued insurer through our risk and claims expertise as well as our financial strength. Now I'd like to turn it over to David.

Thank you, Peter, and good morning, everyone. This morning I'll speak to our quarterly financial results, the progress towards our financial objectives, and our capital management. Turning to slide 4, you can see our insurance pre-tax operating income in the second quarter declined about 8% from a year ago. Commercial Insurance results included higher prior year loss reserve development, offset by reserve discount benefit, higher count losses, somewhat offset by higher investment income and lower operating expenses. Commercial Insurance results included the quarterly change in workers' compensation discount, which was a $270 million benefit, given the second quarter increase in interest rates and credit spreads. Net adverse prior year development, net of reinsurance premium and premium adjustments of $279 million, was due largely to our commercial auto book. Within Consumer, less favorable mortality results in life and lower net investment income in personal insurance drove the comparison. Reported net income in the second quarter was $1.8 billion and included net after-tax realized capital gains of $79 million, which included an after-tax realized capital gain associated with the sale of a portion of our holdings in Springleaf of just over $230 million and an after-tax realized capital loss of just over $350 million associated with the sale of a portion of our AerCap shares, including the write-down to fair value of our remaining stake. We continue to hold about 10.7 million shares or about 5.4% of AerCap's outstanding shares. We also incurred a little over $200 million in after-tax loss on extinguishment of debt, as we continue to pursue economically attractive debt repurchases. Slide 5 provides details on the corporate and other operations. As I mentioned last quarter, given the substantial progress in the wind down of the Direct Investment Book and Global Capital Markets, or DIB-GCM, we are no longer reporting DIB-GCM as a separate component of Corporate and Other. Earnings generated by the assets and derivative positions of the former DIB-GCM are being reported in a line called income from other assets. In addition to the returns from these assets, this line includes earnings associated with the legacy real estate investments, the legacy life settlement portfolio, and the parent company liquidity portfolio. Income from other assets was just over $500 million in the second quarter. Earnings from our investment in AerCap through the date of the sale were $127 million. Our 5.4% stake in AerCap is being accounted for under the available-for-sale method, and thus no equity method earnings will be recognized going forward. PICC generated about $170 million in pre-tax operating income in the quarter. This mark-to-market will be volatile from period to period as we have seen since June 30. Our reported operating tax rate was just over 34%, in line with but at the high end of our expectations. Turning to our financial objectives on slide 6. Book value per share ex-AOCI and DTA continues to grow at a strong rate with a 7% increase year to date and a 10% increase year over year, reflecting net earnings and the accretive share repurchases. With respect to ROE, we estimate a normalized ROE for purposes of measuring our progress against an internal baseline of 7.4%. On this basis, ROE year to date is roughly flat to that baseline. The normalization adjustments for workers' compensation discount, prior-year development, better than expected investment returns, and lower than expected cat losses, among other things, together lowered our reported operating ROE by roughly 260 basis points for the quarter and 150 basis points for the year. Our reported operating ROE, excluding AOCI and DTA, was 9.3% for the quarter and 8.8% year to date. General operating expenses, which are summarized on slide 7, were $2.9 billion in the second quarter and $5.7 billion year to date, down 3.6% for the quarter and 3.5% year to date from the same period a year ago. The favorable effects of a strengthening U.S. dollar benefited the year-over-year comparisons, but were offset by other noteworthy items in the quarter. Increase in expenses from completed acquisitions were not offset by any divestitures. Higher pension costs associated with the current low interest rate environment negatively impacted year-over-year comparisons and should have less of an impact as rates rise. I would emphasize that the trends can vary from quarter to quarter. That being said, we remain focused and committed to operational and cost efficiency, and we are on track to achieve our 3% to 5% objective through consolidation initiatives, such as our work in Japan, utilization of scaled service centers in lower-cost locations, and other cost optimization initiatives. On slide 8 you can see our current capital structure. During the quarter we deployed over $2.3 billion towards the purchase of approximately 40 million shares. We also purchased an additional $965 million worth of shares in July. Our current unused authorization stands at roughly $6.3 billion. We continue to manage the cost and maturity profile of our debt. In April we repurchased in cash tender offers $1.3 billion, aggregate purchase price. In July we repurchased in cash and tender offers an additional $3.7 billion in aggregate purchase price. Also in July we issued a total of $2.5 billion of 10-year, 20-year, and 30-year notes. We also issued $290 million of 30-year callable notes. The average interest rate on our financial debt, including the hybrids, is now below 5%. We continue to be opportunistic in our debt capital management, which is focused on the cost and the maturity profile of our debt. We currently do not expect any meaningful change in our debt to total capital ratios from their current levels. Cash flow to the holding company remains strong, as you can see on slide 9. The holding company received total distributions from our insurance subsidiaries of about $2.1 billion during the quarter, including over $700 million in tax-sharing payments. We expect insurance company dividends and distributions to be somewhere between $3 billion and $4 billion for the balance of the year. Now I'd like to turn the call over to John.

Thank you, David, and good morning, everyone. Today I would like to discuss second quarter results, market trends, and our outlook for the remainder of 2015. Pre-tax operating income for the Commercial segment was $1.5 billion, compared to $1.6 billion in the prior-year quarter due to mixed results across the segment. Commercial Property Casualty pre-tax operating income declined largely due to cat losses that were higher than the unusually low quarter a year ago, but still below expectations. Mortgage Guaranty delivered another strong performance. Institutional Markets completed a large terminal funding annuity in the quarter. Turning to slide 11. Commercial Property Casualty had modest top-line premium growth in the quarter, excluding the effects of foreign exchange. Specialty and Financial Lines recorded strong premium growth, which was largely offset by declines in Casualty and Property. Casualty, and in particular U.S. Casualty, was impacted by our continuing strategy to optimize the portfolio, while competitive market pressures affected U.S. Property E&S lines. We continue to see strong growth in our large limit and middle market property business globally, which is less catastrophe-exposed than the E&S book. It is also where we are making significant investments in engineering and client risk services. Financial Lines grew in all regions, particularly in strategic areas such as M&A and cyber risk. Specialty had strong growth in programs, marine, and trade credit lines and included $30 million in revenue growth from the acquisition of NSM. Market conditions in aerospace continue to be challenging, and we are taking appropriate underwriting actions in that industry segment. Rates across Commercial Property Casualty declined slightly in the quarter, excluding U.S. property, which was down 5.3%. There was significant rate pressure in the Excess & Surplus Property business in the U.S., where rates decreased by 7.8% during the quarter. Specialty and Financial Lines recorded moderate – excuse me, modest rate increases globally. Our diversification by product and region somewhat mitigates the impact of competitive market trends. But given our efforts to optimize the portfolio and to walk away from inadequately priced business, we expect net premiums to be roughly flat for the second half of the year, excluding FX. The accident year loss ratio was 66.6% in the quarter, a slight increase from the prior year, reflecting higher severe losses in Specialty and an increased loss fix in segments of U.S. Casualty, partially offset by improved loss experience in Property. For the quarter and year to date, severe losses are running slightly above expectations. We believe the second half accident year loss ratio will improve by approximately 1 point to 2 points, meaning that the full-year result will be close to the low end of our initial 1 point to 2 point full-year outlook. We remain confident in the actions we are taking to improve underwriting profitability. In the second quarter we increased commercial auto liability reserves by $285 million after frequency and severity trends exceeded expectations following the economic recovery. We have also taken appropriate underwriting actions in this segment as a result of those trends. General operating expenses continue to improve, decreasing 3% compared to the same period last year, excluding the benefit from foreign exchange. Our organizational efficiency initiatives continue to come through, even as we invest in IT, shared services, and client risk services. Net investment income increased 6% and included $54 million of PICC appreciation and strong alternative investment returns. This more than offset lower interest and dividend income, which was driven by the low interest rate environment and our smaller investment portfolio, reflecting continued pay down of loss reserves. We expect trends related to the low interest rate environment and the relative size of the investment portfolio to continue for the remainder of the year. Turning to slide 12, Mortgage Guaranty pre-tax operating income was $157 million versus $210 million a year ago. The year ago results benefited from $89 million of favorable prior-year development versus $17 million this year. Operating earnings grew 16% year over year, excluding the effect of prior-year development. Results reflect record-breaking new insurance written, favorably impacted by a drop in mortgage rates, which is driving refinance and purchase volumes, and improvements in existing home sales due to lower down payment requirements. Additionally, delinquency rates continue to show an improving trend. In a rising interest rate environment we would expect new production to slow, although the outlook for the remainder of the year is better than we expected at the start of 2015. During July, the Mortgage Insurance business also completed an innovative MI cap bond issuance, which transferred about $300 million of 2009 through 2013 risk to the capital markets. Turning to page 13, Institutional Markets pre-tax operating income decreased to $151 million from $170 million in the prior-year quarter, primarily driven by lower call and tender income, partially offset by higher investment yields on alternatives backing reserves and surplus. During the second quarter, Institutional Markets completed a large terminal funding annuity transaction for $527 million in premium and covering about 2,700 participants. We participate in this market on a case-by-case basis, subject to our ability to achieve appropriate returns. While performance in the quarter overall was mixed, we continued to make good progress on our long-term strategies to improve the profitability and sustainability of the portfolio, while differentiating our offering to our clients. Thank you. And now I'd like to turn the call over to Kevin.

Thank you, John, and good morning, everyone. This morning I'll discuss the trends in our Consumer Insurance businesses, provide an update on our ongoing investments in Japan, and comment on the Department of Labor's proposed fiduciary rule. In the second quarter, our Consumer Insurance businesses generated pre-tax operating income of just over $1 billion. Our performance this quarter benefited from strong alternative investment income and continued fee income growth, which was offset by lower base portfolio income, less favorable mortality experience, and lower investment income and underwriting income in Personal Insurance. Base portfolio income decreased as a result of lower reinvestment rates and lower invested assets, principally driven by significant dividends to AIG parent over the last 12 months. Turning to slide 15, operating income for Retirement was $804 million for the quarter and benefited from strong alternative investment income performance and higher fees due to growth in separate account assets. On slide 16 you can see that base yields for Group Retirement benefited in the quarter from additional accretion income. We expect base yields to decline 2 basis points to 4 basis points quarterly for the remainder of the year, given higher interest rates. The impact to net investment spreads was partially mitigated by adhering to disciplined new business pricing and active management of crediting rates. The outflow of older policies, which carry higher crediting rates than current rates offered, also contributed to the reduction in our cost of funds, which has declined for both Fixed Annuities and Group Retirement over the last four quarters. Assets under management ended the quarter at $225 billion, 1% lower than a year ago, reflecting lower unrealized gains due to higher interest rates and the aforementioned substantial distributions to AIG parent over the last 12 months. Assets under management also reflected strong net flows from retirement income solutions and positive separate account investment performance that was partially offset by net outflows for Fixed Annuities and Group Retirement. Net flows for Fixed Annuities continued to be affected by low interest rates. We will continue to maintain pricing discipline in this environment. The level of surrenders in our Group Retirement business declined both sequentially and compared to a year ago. We expect group surrenders to occur periodically as planned consolidations continue, although we are seeing a lower level than the prior year. As for Retirement Income Solutions, although recent market results suggest pressure on new sales of variable annuities, our index annuity sales continued to gain momentum. Macro trends support the growing customer need for quality income solutions. Now let me turn to the Department of Labor's fiduciary rule proposal that I commented on briefly last quarter. At AIG we share the DoL's goal of ensuring that financial advisors work in their clients' best interest. We endeavor to put that goal into practice every day. However, we believe that the proposal as it stands may lead to unintended consequences for consumers that are inconsistent with the DoL's stated goals. We expressed these concerns in a comment letter we submitted to DoL on July 21. In this letter, we focused on the policy considerations that we believe the DoL should consider to ensure that consumers have all the knowledge and tools necessary to actively plan, save for, and ultimately enjoy their retirement. We were encouraged by the recent news that the DoL plans to make modifications to the proposal. We will continue to monitor this closely and work with the DoL and our industry peers to help achieve an outcome that benefits the American consumer. In terms of likely business impact, we participate broadly in the retirement value chain through the Advisory space, Group Retirement, Fixed Annuities, Indexed Annuities, and Variable Annuities. If the rule as promulgated were to be implemented, each part of the business may be impacted differently, with likely the greatest impact on the Advisory business and least impact on the Fixed and Indexed Annuity business. Because of our broad participation in the value chain, we are confident that we have the resources and expertise to respond as needed in any future environment and to continue to meet the growing needs of consumers for guaranteed lifetime income and other saving solutions. Slide 17 presents results for our Global Life business. Life pre-tax operating income of $149 million declined, primarily due to reduced contribution from mortality gains from the year-ago quarter, which more than offset strong alternative investment income performance. Mortality remains within our pricing assumptions, although less favorable compared to the same period last year. General operating expenses increased from the same period last year due to the expansion of our Life business in Japan and the U.K., and strategic investment in technology and distribution platforms. The acquisitions of Ageas Protect Limited, now AIG Life Limited, and Laya Healthcare have added about $25 million to quarterly run rate general operating expenses for Life. Life premiums and deposits grew 6% from the year-ago period, excluding the effects of foreign exchange, reflecting the continued growth in Japan and the acquisition of AIG Life Limited. Turning to slide 18. Personal Insurance reported pre-tax operating income of $70 million, which reflects a decline in net investment income and lower underwriting income from the prior-year quarter. Net premiums written grew 2% from the same quarter a year ago, excluding the effects of foreign exchange, reflecting increased production in the Automobile business across all regions and in the Property business, primarily in the U.S. and Japan, due to new business growth in both Japan and the U.S. and improved client retention in the U.S. This growth was partially offset by decreased production in warranty service programs in the U.S., as new premiums reflect an increased deductible structure we instituted to improve performance in this portfolio. The personal insurance accident year loss ratio improved 0.6 points from the same quarter a year ago, reflecting lower losses in warranty relative to the increased deductible and in A&H. The lower loss ratio associated with the warranty program was largely offset by an increase in the related profit-sharing arrangement, contributing to the 1-point increase in acquisition ratio from the prior year. The general operating expense ratio increased from the same period last year, primarily due to higher employee-related expenses and the timing of technology-related projects. We continue to invest in our businesses, including in Japan and our other strategic growth countries, such as China and Brazil, which have impacted our reported combined ratios. With respect to the Japan integration we remain intensely focused on execution of this major program of works. We expect to complete the integration of the two companies in the second half of 2016 or later, pending approval from the relevant authorities in Japan. While this integration date is slightly later than our original expectations, it does not impact our view of the attractive returns from this initiative. In our Private Client Group in Personal Insurance we remain focused on the high end of the U.S. market, targeting those individuals requiring a broad range of risk management services and insurance. For example, we currently insure 40% of the Forbes richest Americans. We have been adding resources, capabilities, and additional product offerings for our clients and brokers to further enhance our position and capitalize on recent market opportunities in this segment. The Private Client Group annualized net premiums written totals about $1.4 billion. To close for our Consumer businesses we remain focused on achieving profitable growth and effectively managing risk by executing on our customer focus strategies, maintaining a prudent risk profile, and targeting capital-efficient growth opportunities. Now I'd like to turn it back to Liz to open up the Q&A.

Before we begin the Q&A, I'd like to just say I know that the webcast was a little delayed this morning. We'll be posting Peter's remarks immediately following the call for anyone who was on the webcast and missed those. Operator, could we open up the lines for Q&A?

I just have one question, Kevin, on – in International Consumer looks like the expense ratio was 41% or so in the quarter. It was up both year over year and versus the quarter. That was in North America Commercial – or Consumer. Can you talk a little bit about what happened there? And how should we be thinking about that? And was any of the tech spend that you referred to in that part of the business?

I'm sorry, Mike. Can you just – can you repeat the last part of that question?

I just – whether any of the sort of technology spend that you referenced in your remarks were incorporated in that higher expense ratio?

In North America we are investing in the Private Client Group business as I mentioned. And that does include introducing some new administrative platforms. But I think the primary source of increase in our expense ratios really is for the investments that we're making in our growth markets in China and Brazil and also in preparation for the merger in Japan.

Okay. Right. But I mean year over year that North America expense ratio was up from 34% to 41%?

Okay. All right. I think you're referring to the acquisition ratio, which is relevant to the warranty services program. But this loss ratio was offset by an impact from a profit-sharing arrangement.

Okay.

And that profit-sharing arrangement shows up in the acquisition ratio.

So does that continue? Or is that something that is a one-quarter phenomenon?

It varies a bit quarter to quarter, depending on the underlying loss ratio performance in the warranty business, which is a little bit volatile. As you go back to 2013, you'll recall there was a spike in the losses there. And that's when we introduced the deductible into the program. So we're continuing to monitor the experience there. I think that the bulk of the earned premium change for the new program will be through in the next two quarters.

Got it. Great. And then just one question, Peter, on hold-co liquidity, I mean clearly you got $13.5 billion there, just over that, now. And you've got the repurchase authorization set up in front of you. How should we be thinking about once you kind of move through some of this capital, what's the right number that you should have at the holding company or what do you expect to have at the holding company sort of on a run rate basis? Thanks.

So that's a somewhat dynamic number. It relates to the degree to which we're able to upstream excess capital from the subsidiaries, while maintaining the confidence of local stakeholders that care very much about those standalone entity capital ratios and liquidity positions. Some portion of that liquidity at the holding company is actually contingent capital to support the group-wide risk levels. As we did in the aftermath of Superstorm Sandy, we promptly injected about $1 billion into the P&C sub. So it's not all surplus for general purposes. It's earmarked for that. The risk profile is dynamic, depending on the growth of the underlying businesses. But we are very mindful of maintaining positive momentum with the rating agencies. And so the pacing of our capital return is based on your relative value of our stock versus any acquisition opportunities and organic growth opportunities. And the surplus is there in between those actions. So I think that there's no fixed number that you can plug into a model. It's somewhat dynamic.

Great. Thank you.

Thank you. Good morning. I have a couple of questions this morning. The first I guess is for John. John, you indicated that you still expect 1 point to 2 points of year-over-year improvement in the Commercial Lines accident year loss ratio in the back half of the year. If we look at the first half of the year though, it's – I guess it's slightly down. So I guess it's less clear to me where your confidence is stemming from in that case, particularly given the pricing dynamics that we're seeing. So maybe you can give us some color on that?

Sure, John. As I've talked about before, pricing is just one element of our underwriting improvement. Risk selection, mix of business, and investments in claims are also important levers. I mentioned our investment in client risk services. Peter talked about our vision to be our clients' most valued insurer. We're winning business more today on that value proposition rather than in the past. So it's not strictly price. In the second half of the year, I would expect Property underwriting – some of our shorter tail results in both Property and Specialty to return to more normal levels. As I said at the beginning of the year, there's some volatility obviously with the short tail lines.

Yeah.

In addition to that, we did increase commercial auto liability reserves by $285 million after frequency and severity trends exceeded expectations following the economic recovery. We have also taken appropriate underwriting actions in this segment as a result of those trends. General operating expenses continue to improve, decreasing 3% compared to the same period last year, excluding the benefit from foreign exchange. Our organizational efficiency initiatives continue to come through, even as we invest in IT, shared services, and client risk services. Net investment income increased 6% and included $54 million of PICC appreciation and strong alternative investment returns. This more than offset lower interest and dividend income, which was driven by the low interest rate environment and our smaller investment portfolio, reflecting continued pay down of loss reserves. We expect trends related to the low interest rate environment and the relative size of the investment portfolio to continue for the remainder of the year. Turning to slide 12, Mortgage Guaranty pre-tax operating income was $157 million versus $210 million a year ago. The year ago results benefited from $89 million of favorable prior-year development versus $17 million this year. Operating earnings grew 16% year over year, excluding the effect of prior-year development. Results reflect record-breaking new insurance written, favorably impacted by a drop in mortgage rates, which is driving refinance and purchase volumes, and improvements in existing home sales due to lower down payment requirements. Additionally, delinquency rates continue to show an improving trend.

Okay. That's helpful. Thank you. And then maybe a question for David. So DIB and GCM have now collapsed into this Other line with your Life Settlement investments, real estate, and other stuff. Can you maybe give us a sense for all those things included in that Other investments net? What's a reasonable normal level of earnings contribution from all of those varying assets? Whether on an annual basis, a quarterly basis, some way to give us a sense? Because I think we've sort of lost sight of any real clarity there.

Thanks, John. Sure. I guess a couple of ways to think about that. The amount of assets that are there, we give you some insight into that in the financial supplement; I think it's page 11. It's in the $30 billion range. And we lay all that out. And that's where all the assets in the Corporate and Other column there reside. As you say we've got the assets and the cash positions of the assets that were dedicated to the DIB-GCM. And that again, they haven't materially changed since we last reported them. You've got the mark-to-market. And you do have some terminations still from time to time. So if you think about the earnings there, there was about $500 million of earnings this period. If you add to that the earnings on PICC, they're included in that $30-odd billion on page 11, as well as the AerCap shares. That was all in that. So you've got about $800 million worth of earnings on $30-odd billion of assets. So, again, it will move around. It will be variable from period to period. But that's kind of how you ought to think about it, is comparing that balance sheet to those earnings. And again, you can get a sense of things like PICC, which is going to have some variability to it.

Okay. And then if I could sneak one more follow-up in. Just thinking about the normalizing adjustments to the ROE, you're removing 100% of the unfavorable prior-year development. I guess you're just doing that in each period just for your comparability purposes. You're not really trying to signal to us – or maybe you are – that prior-year development is expected to essentially go away or be a zero drag or a zero contribution, are you?

Well I'll start. Peter, if you want to comment as well. But we do normalize 100% of it. Likewise, we normalize 100% of the discount change. Again, we make our best estimates on the reserves, so we're not signaling either we expect favorable or unfavorable. We're making our best estimates. And you've seen a reserve development on both sides of that.

I guess maybe – yeah, sorry. Maybe just a better way of asking the question is, when you think about that 50 basis points or better of ROE improvement, you're not assuming any drag or contribution from prior-year?

Correct.

That's correct.

Thank you. With regard to the rapid consolidation in the Property Casualty sector, can you talk about what you think the implications are for Chubb and ACE getting together? And whether that means AIG perhaps needs to do a large deal?

It's Peter here. No, I don't think that it has any implications for us needing to do a deal. We are already by many measures one of the largest insurers in the sector. I think that margin pressure and other issues may be driving others to consolidate. We've got a lot of work to do to digest the acquisition and merger in Japan with Fuji Fire and Marine. We've got work to do to divest things that don't fit well within our vision of the company in the future. We will be making more modest acquisitions to add capability. What it does do is create opportunity for us both in terms of customers, talent, and a slight shift in the balance of power between carriers and brokers. In the high net worth space in the U.S., for instance, you've gone from four carriers to two in the space in the last 6 months with that consolidation and the Fireman's deal. There are puts and takes. But I don't see any change in our strategy as a function of this. Maybe a better market for anything that we sell.

On the divestitures comment, Peter, what areas perhaps would AIG look to exit?

We haven't specified any particular properties. But we're looking very carefully through our strategic review of where the synergies exist today, where they could exist in the future, and where we feel there are particularly strong bids for assets that may or may not fit in our future. We won't declare that until we're ready to sell.

I see. And then on the pace of the buyback, clearly it ramped up dramatically I think in part driven by the AerCap divestiture. Should we consider that roughly $2 billion-plus a quarter buyback pace as a run rate now?

We signaled in the first quarter that we were shifting from what we described as a metronome-like buyback pace to a more dynamic buyback strategy. The reason for that is various, but in particular as the share price appreciates, we are very value-conscious. We look at the relative value of buybacks versus alternative uses of capital. We certainly don't want to be buying back stock above intrinsic. I think it's a number that will be somewhat dynamic as a function of opportunities to grow our core businesses through organic growth. More importantly, market dynamics in terms of the share price versus intrinsic.

Of course. And put another way, the remaining $6.3 billion authorization, do you think that could be completed say by early 2016?

I can see situations where it could be completed by the end of this year. And I can see situations where it might extend a bit. I don't think there is a strong constraint. We've got daily limits in terms of the permissible amounts per day. But I think we have room to accelerate this well within the 2015 calendar year. It will be dynamic.

Good morning and thank you. First question, Peter, you mentioned that the 50-basis point ROE improvement this year is adjusted for the AerCap divestiture, which means that you're excluding this out. I just wonder what's the earnings impact from recent divestiture, including AerCap as well as you've – last quarter you mentioned about like redistributing about $2 billion of released capital from your DIB and GCM?

David, why don't you take that?

Yeah. Kai, it's David. On the AerCap, the foregone earnings that we would've expected on a pre-tax basis were somewhere around $400 million or so for the balance of the year. Dependent on the assumptions on the capital redeployment that will drive or will affect the actual ROE adjustment. It's somewhere in the 30 basis points to 35 basis points on a full-year basis. So you can see the parameters.

And about the Direct Investment Book?

Yeah, sure. The $2 billion of capital that we released was part of the consideration and part of the capital that we evaluated in amending our capital plan. So it has been taken into account.

Would that have an impact on the earnings going forward?

No, not really. It was earning only a modest amount.

Okay. That's great. Then follow-up maybe for John. Could you talk a bit more about the Commercial Auto business? And also is that the – it's not just for – is this just for this sort of accident year? And also is that related also to your – the $279 million reserve changes in the Commercial lines?

Sure, Kai. It was about a $285 million charge to strengthen commercial auto reserves. I was certainly disappointed in the result. The book had performed pretty well through 2010. In fact, I performed very well during the height of the recession in 2008 and 2009. We expected a return to more normal loss trends during the economic recovery and began to see that. But over the last couple of years we saw some data emerging that changed our outlook a bit. We began taking some underwriting action more than a year ago and pushed some rate increases through more than a year ago. But both frequency and severity exceeded our expectations. Some of the data we saw a year ago we thought may have been a bit of an anomaly. As we did our deeper dive and updated things throughout the course of the last four quarters, that turned out to not be the case. We've revised those plans and our pricing targets based on the deeper view we just did in the second quarter and are taking action in the market right now.

Great. Well thanks so much for all the answers.

I would just make a further comment about this. While this is a fairly sizable adverse development in recent accident years, the cumulative development in recent accident years is still positive, including this. That's an important contextual fact.

I mean we've had about close to $200 million of favorable development from 2011 through 2014 accident years.

Inclusive of this.

Including the Commercial Auto charge.

Great. Thank you.

Good morning. First question for either David or Peter. If I look at the 50 basis point ROE improvement guide that you're reaffirming, that would imply for next year. I grant that I heard what you said about AerCap for this year. But for next year that would still imply about we'll call it $580 million of earnings power, which would be about 45% per share earnings growth over what you had produced this quarter. Now I realize this quarter had some negative items in it. But that's pretty steep earnings growth in a year. Can you comment on conviction level on getting there or at least close to there? And whether or not you need some serious tailwinds to emerge to get there?

Well I think that for a start the way we think about this year-on-year improvement is to normalize a lot of the noise. So as much as possible of that improvement is within our control. Probably the most important driver that's in our control is expenses. We have a number of major initiatives to deliver on our expense targets. We have a high degree of confidence that 2016 will meet or exceed our expense targets. Other dynamics are less in our control, as John has talked about in terms of shifting profitability dynamics in the Commercial sector. We have the benefit of an extremely diverse book and a dynamic allocation of capital and business mix to respond to those changing dynamics. We also have the possibility of capital deployment and the timing of that in a way that will be accretive.

Got you. And, Peter, in thinking about the – on the expense side. I know Kevin had mentioned the second half of 2016 or later is when you expect the Japan merger to close. Is that really the biggest lever that you have out there? Will that be a big cliff-type scenario in the overall expense base of the company? Or is it not likely to be that extreme?

It's one of several. It's one that has been in the pipeline for such a long time that we have referred to it many times in previous calls. It's a substantial amount of money. It does tail off pretty fast after the merger occurs. You'll see a cliff improvement after that merger date, which is at the end of 2016, a little later than we had originally signaled. There are many other expense initiatives underway that cover all dimensions of the company and particularly in holding company and support functions.

Okay.

Shared services have also been underway for some time. As I've talked about in previous calls, you have a sort of mirroring effect as you migrate jobs to shared service centers, where you duplicate the cost base until you've done the migration. While we get these net expense savings, we have not slowed down our project spend. We have a slight increase in project spend this year versus last year. So the gross cuts in expenses are deeper. We recognize that long-term sustainable expense savings can only come from better use of technology, and that technology can only happen if we spend the money on the projects now. It's a substantial effort going underway in a number of different dimensions.

Got you. Thanks. And then just one follow-up for John or David on thinking about Property Casualty catastrophe budget. Last year it was $1.5 billion. This year, year to date, according to the normalized ROE guide, it's only come in at around $500 million according to your budget, even though the cats themselves have been lower than that. Should we assume a similar budget for this year, which would mean about another $1 billion of cat budget for the balance of this year? Or is there likely to be a change when you think about planning for catastrophes?

It's not a material change year over year. What jumps to mind in asking the question is the precision in which you're thinking about kind of modeled cats during the course of the second half of the year. There could be a very meaningful deviation relative to the budgeted results. We had about $250 million, $260 million in cat losses in the third quarter last year, less than half of our budgeted AL in the quarter. But you're roughly in the right range.

Okay. Thanks.

Yeah. Thanks. A couple of questions, most have been answered. The Direct Investment Book, can you give us some sense of how much equity is left in that book?

Yeah. Jay, hi. It's David. We still have about $5 billion or so of capital that is dedicated to or required by that. So it still hasn't materially changed since the $2 billion release.

And just a quick follow-up on that one. The run-off of the DIB you seem to have accelerated over the past year or 2 years. The pace of that run-off, should we think of that continuing at this pace? Or should it slow from here?

A couple of things. Let's break it up into the pieces. The termination or the wind-down of the derivative positions is obviously coming to an end. The acceleration of the final leg of that wind-down will slow over time. The monetization of the capital will be largely a function of how the equity tranches in the CDOs that had been tranched internally, how that ultimately winds down. We'll continue to monetize both the equity tranche of that and do that internally. But you could expect that that's going to take several years to monetize. Peter, you want to add to that?

I think that while there's some element of this wind-down that is legacy, the ability to do internal securitizations allows us to invest in certain asset classes that are not particularly well treated under statutory capital rules in the insurance companies themselves. By holding the equity at the holding company, we can efficiently participate in parts of the capital markets which we'd otherwise incur very substantial capital charges within the regulated entity. There’s an element of that holding company capital that will always be reserved for those sorts of operations so we can invest with the greatest degree of freedom in the capital markets.

Very good. And then the second question was, given all the change in your debt structure, can you give us some sense of what the ongoing quarterly interest expense will be, given all the changes you've made?

I think – hang on let me grab the – in the fin stuff you can see we've got a page right there. I think it was about $270 million this particular quarter. We had some modest refinancings that were done in July. You can factor those in. We bought in about $3 billion of higher coupon debt and reissued 10s, 20s, and 30s at below that. The average is now below 5%, the average of our debt. Or the senior debt plus the hybrids is below 5%, just below 5%.

Okay. We'll do that math. Thank you.

Thank you for fitting me in. So, Peter, I was hoping to ask you a sort of broader question about the market structure and how you think things play out from here. So pricing is falling a lot, and people in the sort of smaller faced part of the business – domestically focused guys like, for example, Travelers – talk a lot about the end of the traditional cycle, sort of this post-cycle world, given data and analytics and more discipline and accountability. Broadly, the business has become much more boring as a result. But you guys write much larger accounts, the specialty lines, global risk. And against that you've – which historically has meant that there has been terribly cyclically part of the business, which is the place you play. However, you're very actively investing in data and analytics. You've put in place a lot of tools to drive discipline and accountability. We're also now seeing that you guys, as well as some others, have a fair amount of market share in this business. As you think about sort of the market power you have to be leaders, as well as your own investments and basically being a smarter and, well, better-run firm, should we be thinking about you of having a soft market strategy of basically trying to just be a post-cycle firm? Or is this something where we should be looking and saying that's just not really possible in the markets you play and so we ought to be looking at you and holding you sort of more accountable to traditional soft market strategies and judging on that basis?

It's a very interesting question. The opening statement that we have very substantial declines in pricing is perhaps a broader generalization than I would use. You've seen it happen in U.S. Property Cat pricing. One of the biggest tools we have to manage that particular cycle is the willingness to look at our Property book globally and diversify away from the heavy concentration in Gulf wind exposure. That helps. I think data and analytics will help manage and understand better how to estimate expected outcomes. The drivers of the unexpected outcomes need to be divided between things that are driven by external factors or not, the systematic factors. One of the big trends in the future will be greater use of alternative capital to lay off that risk. If you have a strong interest in non-traditional players to take on systematic risk like Florida wind, we can still serve our clients well while tapping into that cheap capital. That’s factored into our thinking. The best response to cyclicality is to be nimble in our capital usage, both how we allocate our internal capital and how we take advantage of other people's capital and weave it into our offering to our clients. It requires a deeper understanding of our risk, segmentation of risk between the parts of the risk that are idiosyncratic versus systematic. Well-trained underwriters who are equipped with good tools are critical. We are very committed to that future, which we think positions us to be our clients' most valued insurer.

That's helpful, Peter. If I could ask just one more quick on sort of a bit more closer to the execution. One of the things you guys have been actively doing is pursuing strategic organic growth. Now some tactical acquisitions to expand your footprint. This is coming at a time that you guys still have a fair amount of wood to chop in driving margins in your core business. How you're balancing the dual objectives you're giving the organization of realizing the margin potential of your core business, as well as trying to build a future portfolio that's the portfolio you want?

That's a great question. We recently had the top 200 leaders of the company get together for a few days to debate that exact point. One framework we used was three horizons. Acknowledging that the world around us is changing rapidly, we need to focus on the future for sustainable value with a 5 to 10-year time horizon. We need to be grounded in the present to deliver on our promises in terms of better operating performance. We need a credible plan to bridge from the present to the future. As individual leaders, we need to balance our time between those three. We need individuals that specialize in each so we have adequate attention paid to all three. There’s high alignment around how we need to change and adapt, but we must maintain the right balance between urgent priorities to improve short-term performance and our opportunities over the long term.

Okay. Thank you for the thoughtful answer. Good luck.

Thank you, operator. I think we've surpassed our time here. I'd like to follow up with anyone who's in the queue after the call. Thank you all for joining this morning's earnings call.