American Financial Group, Inc. — Q1 2013 Form 10-Q
Business context and period: Results cover the three months ended March 31, 2013, compared with the first quarter of 2012. AFG primarily writes specialty property and casualty insurance and sells fixed and fixed-indexed annuities. The Medicare supplement and critical illness businesses were sold in August 2012, affecting year-over-year comparisons.
Financial performance and position
| Metric | Q1 2013 | Q1 2012 / prior date |
|---|---|---|
| Total revenue | $1.148 billion | $1.087 billion |
| Net earnings attributable to shareholders | $120 million; diluted EPS $1.32 | $113 million; diluted EPS $1.14 |
| Core net operating earnings (non-GAAP) | $84 million; diluted $0.92 per share | $85 million; diluted $0.86 per share |
| Operating cash flow | $59 million | $10 million |
| Cash and cash equivalents | $1.529 billion | $1.705 billion at Dec. 31, 2012 |
| Long-term debt | $950 million | $953 million at Dec. 31, 2012 |
| Total shareholders’ equity | $4.733 billion | $4.578 billion at Dec. 31, 2012 |
Revenue increased about 6% and shareholder net earnings about 6% year over year; diluted EPS rose about 16%, with average diluted shares declining to 91.0 million from 99.4 million. Realized securities gains were $57 million versus $44 million; core earnings were nearly flat. Net investment income was $326 million versus $317 million.
Cash used in investing was $470 million, compared with $183 million; financing provided $235 million versus $271 million. Cash declined $176 million during the quarter. The consolidated debt-to-total-capital ratio was 18.7% (17.7% excluding real-estate-secured debt), down from 19.4% (18.4%) at year-end. AFG had no borrowings on its $500 million parent revolving facility; National Interstate had $12 million outstanding on its credit facility.
Material changes and operating trends
- Property and casualty: Net earned premiums increased 14% to $687 million; gross written premiums rose 12% to $925 million. Pretax earnings declined to $99 million from $103 million. Underwriting gain fell to $43 million from $48 million, and the aggregate combined ratio deteriorated to 93.8% from 92.1% (below 100% still indicates an underwriting profit). March storms contributed $10 million of catastrophe losses. Favorable prior-year reserve development was $28 million versus $19 million.
- Annuities: Pretax earnings rose 27% to $76 million, reflecting business growth and unusually strong investment results. Fixed-annuity net spread earned increased to 1.58% from 1.43%. Statutory annuity premiums fell 22% to $624 million, consistent with management’s actions in response to lower interest rates and competition.
- Run-off long-term care and life: Pretax loss was $1 million versus $1 million of income. The sold Medicare supplement and critical illness segment had contributed $6 million pretax income in Q1 2012 and had no Q1 2013 operations.
- Investment and equity: Available-for-sale fixed maturities were $24.775 billion at fair value, with $2.020 billion of gross unrealized gains and $52 million of gross unrealized losses. AOCI was $869 million, up from $831 million at year-end.
Outlook, risks and unusual items
- No formal earnings or revenue guidance is provided. Management expects annuity net interest spreads to narrow, despite the quarter’s strong investment results. New annuity premiums were affected by reductions in policy crediting rates and agent commissions, as well as competitive pressure.
- Management identifies insurance-reserve adequacy—particularly asbestos, environmental, mass-tort and run-off long-term-care reserves—and contingencies from former railroad and manufacturing operations as key areas of potential material loss. Estimates depend on significant judgment; actual outcomes may differ.
- AFG reported $52 million of gross unrealized fixed-maturity losses and said it intended and was able to hold the affected securities until recovery. Management cautions that changes in credit quality, market conditions or intent to hold could lead to impairment charges. An immediate 100-basis-point rise in rates was estimated to reduce fixed-maturity fair value by $1.154 billion pretax, or 4.6%.
- About 86% of fixed maturities were investment grade. Approximately 3% of assets carried at fair value were Level 3; many such valuations rely on non-binding broker quotes. Annuity derivatives and market-sensitive assumptions also affect reported earnings.
- AFG consolidates managed CLO entities. Its maximum economic loss exposure was limited to its CLO investments, with aggregate fair value of $338 million; AFG said it had no contractual funding requirement and did not intend to provide financial support. A temporary CLO warehousing entity’s assets were transferred and liabilities repaid after quarter-end in April 2013.
- After quarter-end, in May 2013, Great American paid a $122.3 million A.P. Green asbestos settlement and expected to make a further $1.2 million attorney payment after court approval. The full settlement had been accrued in prior years, so the payments had no additional earnings or financial-position impact.
- Management concluded disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether P&C premium growth and renewal-rate increases can continue without weakening underwriting results; monitor combined ratios, catastrophe losses and reserve development.
- Whether annuity investment returns and spreads can hold up as management expects spreads to narrow, and whether lower sales persist amid competition and low interest rates.
- Developments in long-term-care, asbestos, environmental and other claims reserves, plus recoverability and payment capacity of reinsurers.
- Investment portfolio credit quality, unrealized losses, Level 3 valuation assumptions and sensitivity to changes in interest rates and markets.
- Cash generation, liquidity at the parent and insurance subsidiaries, debt levels, and the distinction between AFG resources and nonrecourse CLO assets and liabilities.
- How ongoing results compare with core net operating earnings, which excludes realized securities gains and is a non-GAAP measure.