American Financial Group, Inc. — Q3 2011 Form 10-Q
Business context and period. AFG is an insurance holding company focused on specialty property and casualty insurance, fixed and indexed annuities, and supplemental insurance. This unaudited report covers the quarter and nine months ended September 30, 2011; balance-sheet comparisons are with December 31, 2010. Dollar amounts are in millions except per-share data.
Financial performance and position
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Total revenue | $1,335 | $1,255 | $3,467 | $3,341 |
| Operating earnings before tax | $155 | $208 | $319 | $513 |
| Net earnings attributable to shareholders | $96 | $132 | $234 | $346 |
| Diluted earnings per share | $0.94 | $1.21 | $2.24 | $3.11 |
| Core net operating earnings, non-GAAP | $91 | $117 | $258 | $322 |
- Revenue and earnings: Q3 revenue rose 6%, while shareholder earnings fell 27%; nine-month revenue rose 4%, while shareholder earnings fell 32%. Investment income was $310 in Q3 and $916 for nine months. Realized securities gains were $8 and $27, respectively, down from $57 and $72 in the comparable periods.
- Underwriting: P&C earned premiums increased to $835 in Q3 and $2,043 for nine months. The aggregate P&C combined ratio was 93.2% in Q3 and 95.5% year to date, versus 90.7% and 89.4% in 2010. Ratios below 100% indicate underwriting profit. Specialty underwriting profit was $56 in Q3 versus $68 and $141 for nine months versus $214; the year-to-date result includes the effect of the reserve charge described below.
- Cash flow: Nine-month operating cash flow was $661, compared with $781 in 2010. Investing activities used $1,931, while financing activities provided $1,162. Cash and cash equivalents declined by $108 to $991.
- Balance sheet and liquidity: Total assets were $35,130, up from $32,454; total liabilities were $30,510, up from $27,834. Total equity was $4,620, unchanged. Long-term debt declined to $937 from $952. Debt-to-total-capital was 19.0%, versus 18.9% at year-end 2010 (17.9% excluding real-estate-secured debt). AFG had no borrowings on its $500 revolving credit facility, expiring August 2013; National Interstate had $22 outstanding on its separate credit facility.
- Investment portfolio: Available-for-sale fixed maturities were $21,552 at fair value, equity securities $930, and trading fixed maturities $441. Approximately 90% of fixed maturities were investment grade. AFG estimated that an immediate 100-basis-point rate increase would reduce fixed-maturity portfolio fair value by $1,056, or 4.8%, pretax.
- Shareholder returns: AFG repurchased 7.8 million shares for $263 during the first nine months. Cash dividends were $0.4875 per share year to date, compared with $0.4125 in 2010.
Material changes versus prior periods
- Earnings declined despite higher revenue. Management attributed the nine-month decrease to the asbestos and environmental reserve charge, lower P&C underwriting profit and investment income, and lower realized gains; improved annuity and supplemental results partly offset these items.
- P&C premiums and written premiums grew, particularly in property and transportation, reflecting crop premiums and the Vanliner acquisition. Renewal rates were flat overall. Crop profitability weakened, catastrophe losses increased, and certain program business produced underwriting losses.
- Annuity and supplemental pretax operating earnings increased 6% for nine months to $133, but fell 16% in Q3 to $41. Nine-month annuity premiums increased to $2,468 from $1,661, led by non-403(b) indexed products and indirect bank distribution.
- Cash flow from operations decreased, while investment purchases and annuity receipts contributed to substantial investing outflows and financing inflows, respectively.
Outlook, commentary, risks and unusual items
- Asbestos and environmental reserves: A second-quarter study led to a $50 pretax charge, net of reinsurance, to increase P&C asbestos reserves by $28 and environmental reserves by $22. A separate $9 charge increased reserves tied to former railroad and manufacturing operations ($3 asbestos; $6 environmental). At September 30, P&C A&E reserves were $375 net of reinsurance; former-operation environmental and personal-injury liabilities totaled $99. Management noted uncertainty in claims, litigation, and reserve estimates.
- Market and actuarial effects: A 14% Q3 decline in the S&P 500 adversely affected variable and indexed annuity results by approximately $8; lower rates added an estimated $4 negative impact to fixed indexed annuity results. Management expected much of the latter effect to reverse over time. No actuarial assumption “unlocking” was recorded through September, and management did not expect any Q4 unlocking to be material.
- Acquisition-cost risk: Management said persistent low interest rates could require a fixed-annuity deferred acquisition cost write-off; any such write-off was not expected to materially affect full-year earnings. A new accounting standard expected to be adopted retrospectively in 2012 was estimated to reduce deferred acquisition costs by 15%–20% and equity by about 3% at the reported dates.
- Managed investment entities: AFG consolidated six CLOs. Its maximum ultimate economic exposure was limited to its $60 fair-value investment at quarter-end, and it reported no contractual requirement or intent to provide further support. In October, AFG began marketing another CLO expected initially to have about $400 of assets and liabilities.
- Liquidity and risks: Management said it believed AFG and its insurance subsidiaries had sufficient liquidity. GALIC received a $100 FHLB advance in October, for up to five years, at LIBOR plus 0.02%, and invested the proceeds in fixed maturities. Key disclosed risks include reserve adequacy, reinsurance collectability, investment valuation and impairment, interest rates, market performance, catastrophe losses, regulation, competition, and litigation.
- Controls: Management concluded disclosure controls were effective and reported no material Q3 change in internal control over financial reporting.
The filing provides no specific earnings or revenue guidance. Management’s forward-looking statements are subject to the risks described in the filing.
Most important facts for investors to verify
- Whether the $50 P&C A&E reserve strengthening and $9 former-operations charge prove adequate as claims develop.
- How much of the earnings decline reflects ongoing underwriting and investment performance versus reserve, market, and realized-gain effects.
- Credit quality, valuation assumptions, and impairment exposure in the mortgage-backed securities portfolio, including non-agency residential holdings and Level 3 valuations.
- Whether low interest rates, equity-market volatility, or policyholder behavior affect annuity spreads, guarantees, deferred acquisition costs, and liquidity.
- The potential earnings, capital, and exposure implications of CLO consolidation and the proposed new CLO, along with the capacity to service debt and sustain repurchases and dividends.