AIG Reaches Deal to Sell Mortgage-Insurance Unit to Arch Capital for About $3.4 Billion

American International Group Inc. struck a deal to sell its mortgage-guarantee unit for about $3.4 billion, as the insurer speeds up the return of cash to restive shareholders.

AIG had disclosed plans early this year to stage an initial public offering of the mortgage business, known as United Guaranty, while retaining a majority stake. Selling the unit outright to Bermuda-based insurer and reinsurer Arch Capital Group Ltd. helps it more quickly meet a goal of returning $25 billion to shareholders.

Indeed, there have been several instances lately in which companies have opted for sales instead of initial public offerings as the new-issue market languishes. The Wall Street Journal, which reported news of the deal talks before they were confirmed Monday afternoon, reported in early August that AIG was open to an outright sale of the mortgage-insurance unit.

According to the terms of the deal, Arch will pay $2.2 billion in cash, plus $975 million in Arch preferred stock and $250 million in another type of preferred stock, dividends or cash.

AIG will also keep mortgage-insurance business under an existing agreement between United Guaranty and AIG subsidiaries involving years 2014 through 2016, meaning it retains some of the earnings from the profitable unit.

Home buyers who put down less than 20% of the purchase price are required to obtain mortgage insurance to protect the lender from losses. Since the housing-bubble burst, mortgage insurers have posted better results due to the increasing quality of underlying loans and fewer defaults as the U.S. economy gradually improves.

AIG’s mortgage-insurance operation is the leader in the U.S. market, with more than a fifth of the share. The unit has been one of the company’s star performers of late. But it is considerably smaller than AIG’s other businesses and has long operated as a separate entity. That makes it easier to shed than other parts of the company—one of the world’s biggest property-casualty businesses with a leading U.S. life-insurance operation—as it seeks to slim down and make good on the ambitious capital-return pledge.

For the six months through June 30, the unit delivered $350 million in pretax operating income out of a companywide total of $2.57 billion.

In its second-quarter earnings release in early August, AIG said its year-to-date return of capital to shareholders—mostly from share buybacks—stood at $7.9 billion. The board said then it would add $3 billion to its stock-buyback plan.

The deal announcement offered no details about what happens to Donna DeMaio, chief executive of AIG’s mortgage-insurance operation. Both AIG and Arch would like to keep her, people familiar with the situation said. But she may assume a different management role within AIG rather than continue to run United Guaranty.

Last fall and early this year, AIG was in a public showdown with billionaire investors Carl Icahn and John Paulson, who called for a three-way split of the insurance conglomerate and criticized its performance. In a filing Monday, Mr. Icahn disclosed he added to his AIG stake, buying 1.2 million additional shares.

The investors contended that if AIG split into parts, it could escape onerous regulations imposed by federal policy makers under its designation as a “systemically important financial institution.” Federal regulators had tagged AIG with the label after its near-collapse in 2008, which necessitated one of the biggest bailouts—since fully repaid—of the financial crisis.

AIG Chief Executive Peter Hancock maintained that such a three-way split wasn’t in shareholders’ best interests. He instead updated the company’s strategy in January with measures that he said would better serve investors—including the plan to return $25 billion by the end of 2017 and the IPO of United Guaranty, among other divestitures.

In May, AIG expanded its board to include Mr. Paulson and a representative of Mr. Icahn’s firm.

In a memo to employees, Mr. Hancock said Arch wasn’t the only interested party, writing that “AIG continued to consider expressions of interest from strategic buyers throughout the process.” Some analysts and bankers speculated recently that big Japanese property-casualty insurers might bid.

AIG shares rose 0.6% to close at $59.22. Arch shares rose 3.1% to $77.09. AIG’s shares are down 4.4% so far this year.

For the second quarter, AIG posted a 6.3% increase in net income as it deliberately shrank the amount of insurance sold to weed out its exposure to poorly performing business lines. It said it had made strong progress in increasing profitability in its core property-casualty unit and improving its overall return on equity, which investors had been urging.

Arch is big in property-casualty insurance, too. The company, with a market value of about $9 billion, has been seeking to expand its mortgage-insurance business, which represents about 11% of its premium revenue.

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