American Financial Group, Inc. — Q2 2014 Form 10-Q
Business context and reporting period
AFG is an insurance holding company focused on specialty property and casualty (P&C) insurance and fixed and fixed-indexed annuities, with a run-off long-term care and life business. This unaudited report covers the three and six months ended June 30, 2014, compared with the same 2013 periods. Amounts are in millions of dollars except per-share data and ratios.
Financial performance and position
| Metric | Q2 2014 | Q2 2013 | First half 2014 | First half 2013 |
|---|---|---|---|---|
| Total revenue | $1,392 | $1,139 | $2,603 | $2,287 |
| Earnings before taxes | $130 | $126 | $291 | $301 |
| Net earnings attributable to shareholders | $106 | $110 | $209 | $230 |
| Diluted earnings per share | $1.15 | $1.20 | $2.28 | $2.52 |
| Core net operating earnings, non-GAAP | $99 | $87 | $190 | $171 |
| Cash provided by operating activities | — | $499 | $196 |
Revenue rose 22% in Q2 and 14% in the first half. Shareholder net earnings declined 4% and 9%, respectively, principally because realized securities gains were lower: $12 versus $41 in Q2 and $31 versus $98 in the first half. Core net operating earnings increased 14% in Q2 and 11% in the first half, mainly reflecting stronger P&C underwriting. Diluted EPS was $1.15 for Q2 and $2.28 for the first half. Dividends were $0.22 per share in Q2 and $0.44 for the first half.
P&C underwriting profit was $29 in Q2 versus $19 a year earlier and $87 for the first half versus $62. The aggregate combined ratio improved to 96.9% in Q2 from 97.2%, and to 94.8% for the first half from 95.5%; below 100% indicates underwriting profit. However, the aggregate loss and loss-adjustment-expense ratio rose to 64.6% in Q2 from 60.5% and to 61.2% for the first half from 58.9%. Prior-year reserve development shifted to $14 of adverse development in Q2 from $22 favorable; first-half favorable development was $18 versus $57.
Annuity pretax earnings were $84 in Q2 versus $77, and $157 for the first half versus $153. Fixed-annuity net spread earned was 1.46% in Q2 and 1.38% for the first half, compared with 1.65% and 1.61%, respectively, in 2013. Net investment income increased, but yields and spreads faced pressure as higher-yielding investments ran off and reinvestment rates were lower.
At June 30, 2014, total assets were $45,355, cash and cash equivalents $2,116, shareholders’ equity $4,985 and long-term debt $912. At December 31, 2013, those balances were $42,087, $1,639, $4,599 and $913, respectively. The consolidated debt-to-total-capital ratio was 16.9%, down from 17.6%; the company reported no borrowing under its $500 revolving credit facility. Operating cash flow was $499 for the first half, versus $196 in 2013; management attributed the increase primarily to timing of P&C claims payments and reinsurance recoveries. Investing activities used $970 and financing activities provided $948; financing cash flows include annuity policyholder receipts and withdrawals.
Material changes and unusual items
- AFG acquired Summit Holding Southeast on April 1 for $259 and contributed a further $140 of capital, for a reported total investment of $399 pending adjustments. Summit added $134 of Q2 net earned premiums; its reported $135 of Q2 gross written premiums contributed materially to specialty casualty growth. Purchase-price allocation was preliminary.
- P&C gross written premiums increased 24% in Q2 and 18% in the first half, reflecting Summit and growth in other specialty casualty businesses. Overall renewal rates rose approximately 3% in both periods.
- Q2 catastrophe losses were $10 versus $19. The first-half total was $22 versus $29. Lower catastrophe losses helped results, but adverse reserve development and a higher loss ratio partly offset that benefit.
- Investment-market movements affected reported results. Other comprehensive income was $124 in Q2 and $244 for the first half, versus losses of $277 and $238 in 2013; shareholders’ accumulated other comprehensive income was $799 at June 30. Fixed-indexed annuity derivative mark-to-market losses are recorded in earnings and may produce volatility.
- In July, AFG finalized an IRS settlement for tax years 2008–2009 and expected to reduce uncertain-tax-position liabilities and related interest by $20 in Q3; approximately $4 was expected to favorably affect the effective tax rate.
- AFG repurchased $44 of common stock in the first half and $24 more in July. It also obtained supplemental catastrophe reinsurance providing up to $95 of coverage for qualifying losses above $100 through 2016, at an approximate annual cost of $5.
Outlook, commentary and risks
Management expected full-year 2014 net spread earned on fixed annuities of 1.35%–1.40%, below 1.60% in 2013, and stated that net interest spreads were expected to continue narrowing. Management cited lower reinvestment yields and runoff of higher-yielding assets. No broader earnings or revenue guidance is provided in the supplied filing text.
Management said it believed liquidity was sufficient and insurance subsidiaries had adequate resources to meet claims, benefits and operating needs. It identified reserve adequacy and contingencies involving former railroad and manufacturing operations as principal areas of potential material loss. The annual in-depth asbestos and environmental reserve review was expected in Q3 2014. The closed long-term care block had a $64 loss-recognition margin at December 31, 2013; assumptions depend on claims, persistency, rate-increase approvals and reinvestment rates, and an external actuarial review was expected by year-end.
Other key exposures include catastrophe and severe-weather losses; reinsurance availability and counterparty performance; interest-rate, credit and securities-market movements; mortgage-backed-security prepayment and valuation risk; and annuity persistency, mortality, morbidity and surrender behavior. AFG estimated an immediate 100-basis-point increase in rates would reduce fixed-maturity portfolio fair value by $1,467 pretax, or 5.0%. Management stated that no significant changes had occurred in the contingencies previously disclosed in its 2013 Form 10-K.
Most important facts for investors to verify
- Whether Summit’s subsequent contribution to premium growth and underwriting results is sustainable, and how its final purchase-price allocation and post-closing adjustments compare with the preliminary figures.
- Whether P&C loss ratios, reserve development and catastrophe experience improve or deteriorate, particularly in transportation and specialty casualty.
- Whether annuity spreads meet the stated 1.35%–1.40% full-year outlook as investment yields, crediting rates and indexed-annuity derivative marks change.
- Whether long-term care, asbestos, environmental and other claim reserves remain adequate after the planned reviews and updated actuarial analysis.
- How investment portfolio fair values, reinsurance recoverables, liquidity and capital respond to interest-rate, credit-market and reinsurer developments.