AMERICAN FINANCIAL GROUP INC quarterly report, Q2 FY2018

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American Financial Group, Inc. — Q2 2018 Form 10-Q

Business context and reporting period. AFG is an insurance holding company focused on specialty property and casualty insurance and fixed, fixed-indexed and variable-indexed annuities. This unaudited filing covers the quarter and six months ended June 30, 2018; comparisons are with the corresponding 2017 periods. Dollar amounts are in millions except per-share data.

Financial performance and position

  • Second-quarter results: Total revenue was $1,833, up from $1,646. Net earnings attributable to shareholders were $210, or $2.31 diluted per share, versus $145, or $1.61. Core net operating earnings, a non-GAAP measure, were $185, or $2.04 per diluted share, versus $145, or $1.61.
  • First-half results: Total revenue was $3,452 versus $3,222. Shareholder net earnings were $355, or $3.92 diluted per share, versus $298, or $3.32. Core net operating earnings were $404, or $4.46 per diluted share, versus $296, or $3.29.
  • Revenue drivers: Q2 property and casualty net earned premiums rose 9% to $1,161; first-half premiums rose 9% to $2,268. Net investment income was $530 for Q2 and $1,025 for the first half, compared with $460 and $895, respectively.
  • Property and casualty underwriting: The Q2 combined ratio was 93.7% versus 93.4% (below 100% indicates underwriting profit); underwriting gain was $72 in both periods. For the first half, the combined ratio was 92.8% in both years, while underwriting gain rose to $163 from $150. First-half favorable prior-year reserve development was $100, versus $50 a year earlier.
  • Annuities: Pretax earnings increased to $99 in Q2 from $85 and to $224 for the first half from $181. Fixed-annuity net spread earned was 1.18% in Q2 versus 1.11%, and 1.36% for the first half versus 1.19%.
  • Cash flow: For the first half, operating cash flow was $823 versus $574; investing activities used $2,485 versus $1,994; financing activities provided $1,134 versus $1,520. Cash and cash equivalents declined $528 to $1,810 from year-end 2017.
  • Balance sheet and liquidity: At June 30, total assets were $61,834, total liabilities $56,750 and shareholders’ equity $5,084. Cash and investments totaled $46,779. Long-term debt carrying value was $1,301 (principal $1,318), unchanged from year-end; no revolving-facility borrowings were outstanding, and $500 of capacity was available. Debt to total capital was 21.2%, including subordinated debt, versus 21.8% at year-end.
  • Tax and shareholder returns: The first-half effective tax rate was 20%, versus 30%, principally reflecting the lower U.S. statutory rate. Cash dividends were $2.20 per common share in the first half; a $1.50-per-share special dividend was paid in May.

Material changes and unusual items

  • Shareholder earnings benefited from stronger annuity results, higher P&C investment income, improved first-half P&C underwriting, lower interest expense and the lower tax rate. First-half realized securities results shifted to a $62 loss from an $11 gain; Q2 realized gains were $31 versus $8.
  • AFG adopted accounting guidance requiring most equity-security fair-value changes to be recorded in earnings. It recorded $57 of holding losses on equity securities still held at June 30 during the first half. These accounting-driven earnings effects contribute to period-to-period volatility.
  • Second-quarter annuity assumption “unlocking,” prompted primarily by higher fixed-indexed annuity option costs, produced a net $27 charge. Management said it would conduct its regular detailed assumption review in Q4 2018.
  • Unrealized securities losses reduced first-half other comprehensive income by $445 after tax. Accumulated other comprehensive income fell to $147 from $813 at year-end; adoption of the equity-security guidance also reclassified a $221 net gain from AOCI to retained earnings.
  • AFG recorded a $5 charge in Q2 to increase liabilities for environmental exposures of former railroad and manufacturing operations. The filing reported no significant change in previously disclosed contingencies, including asbestos, environmental and mass-tort matters.

Outlook, commentary and risks

  • No specific consolidated earnings or revenue guidance is provided in the supplied filing text. Management noted that high limited-partnership returns supporting P&C and annuity investment income should not necessarily be expected to recur.
  • Management expects annuity net interest spreads to narrow over time as current products can meet target profitability at lower spreads. It also cites lower reinvestment yields on maturing assets as a partial offset to investment growth and strong partnership earnings.
  • Management described liquidity at the parent and insurance subsidiaries as sufficient. GALIC had $871 of FHLB advances outstanding and estimated approximately $300 of additional borrowing capacity.
  • Key risks include insurance reserve estimates, particularly asbestos and environmental claims; catastrophe and severe-weather losses; reinsurance availability and collectability; investment-market, interest-rate and credit changes; annuity option costs and policyholder behavior; and regulatory, tax and competitive changes. AFG estimated that an immediate 100-basis-point increase in interest rates would reduce after-tax AOCI by approximately $822.
  • Management scheduled an internal review of asbestos and environmental liabilities for completion in Q3 2018. AFG also identified possible future DPAC or acquired-future-profit write-offs if spreads compress, markets decline, mortality worsens or lapses exceed expectations.

Most important facts for investors to verify

  1. Whether earnings growth persists after separating recurring core results from securities fair-value changes, the $27 annuity unlocking charge and unusually strong limited-partnership returns.
  2. Whether P&C current-year loss trends and favorable prior-year reserve development remain sustainable, and the results of the planned environmental and asbestos reserve review.
  3. How annuity option costs, reinvestment yields, surrender behavior and spread compression affect profitability, reserves and acquisition-cost recoverability.
  4. Whether unrealized investment losses, interest-rate sensitivity and credit or reinsurance exposures materially affect statutory capital, liquidity or shareholder equity.
  5. How cash generation, the special dividend and available borrowing capacity compare with ongoing policyholder obligations and holding-company needs.