Business context and reporting period
American Financial Group, Inc. (AFG) is an insurance holding company focused on specialty property and casualty insurance, fixed and indexed annuities, and supplemental insurance. This unaudited Form 10-Q covers the three months ended March 31, 2011; comparisons are with the first quarter of 2010 unless otherwise noted. Dollar amounts are in millions except per-share data.
Financial performance and position
- Revenue and earnings: Total revenues were $1,039, up 0.5% from $1,034. Operating earnings before income taxes were $95, down from $147. Net earnings attributable to shareholders were $83 versus $106; diluted EPS was $0.79 versus $0.93. The filing attributes the earnings decline mainly to lower P&C underwriting results and investment income, partly offset by improved annuity and supplemental insurance results.
- Insurance operations: P&C premiums earned rose to $599 from $579. Specialty underwriting income was $46 versus $77, and the aggregate P&C combined ratio increased to 92.3% from 87.6% (below 100% indicates underwriting profit). Favorable prior-year reserve development was $21 versus $39. Life, accident and health premiums were $110 versus $115. Annuity and supplemental insurance pretax results rose to $49 from $38.
- Investment income and impairments: Investment income was $300 versus $295; higher average invested assets were partly offset by lower fixed-maturity yields. Realized securities gains were zero versus $4. AFG recorded $14 of gross security impairment charges, partly offset by $4 of related acquisition-cost adjustments, leaving a $10 net impairment loss in realized results.
- Cash flow: Operating cash flow was $389 versus $393. Investing activities used $257 versus $303; financing provided $268 compared with $40 used in the prior-year quarter. Cash and cash equivalents increased $400 to $1,499 from year-end 2010.
- Balance sheet and liquidity: At March 31, total assets were $32,948, total liabilities $28,336, and total equity $4,612. Cash and investments totaled $23,537. Shareholders’ equity was $4,463, compared with $4,470 at year-end. Management said it believed AFG and its insurance subsidiaries had sufficient liquidity to meet requirements.
- Debt and capital: Long-term debt was $949, slightly below $952 at year-end. Debt to total capital was 18.7%, or 17.7% excluding real-estate-secured debt. The $500 revolving credit facility, expiring in August 2013, was undrawn; National Interstate had $20 outstanding under its separate facility. Interest expense increased to $21 from $18.
- Dividends and repurchases: Cash dividends were $0.1625 per common share versus $0.1375. AFG repurchased 2.5 million shares for $84 during the quarter.
Material changes versus the prior period
- P&C underwriting income fell, chiefly because favorable reserve development declined; specialty casualty and specialty financial underwriting results weakened. Property and transportation results were broadly stable.
- P&C investment income declined $19, while annuity and supplemental operations improved $8, reflecting better fixed-annuity earnings and expense savings.
- Annuity receipts increased to $672 from $386, led by indirect bank-channel and non-403(b) indexed-annuity sales. These receipts are reported as financing cash flows, not revenue.
- AFG’s share count declined following repurchases; weighted-average diluted shares were 106.2 million versus 113.1 million.
- Managed investment entity fair-value losses were $33 versus $25; losses attributable to noncontrolling interests were $35 versus $20. These consolidated CLO amounts are substantially not attributable to AFG shareholders.
Outlook, commentary, risks and unusual items
- The filing provides no numerical earnings or premium guidance. Management described liquidity and insurance-subsidiary capital as adequate, while noting that statutory-rule changes, investment-value declines or ratings downgrades could create additional capital needs.
- AFG reported flat overall average renewal rates in P&C. It cited a soft excess-and-surplus pricing environment, exited excess workers’ compensation, and did not renew two programs that failed return thresholds. The Vanliner acquisition contributed to transportation premium growth.
- Management identified insurance reserve adequacy and contingencies from former railroad and manufacturing operations as key areas of potential material loss. An outside-assisted 2011 asbestos and environmental reserve study had commenced and was expected to finish by the end of Q2. Reserve estimates are judgmental and may change.
- Investment risks include credit losses, interest-rate and reinvestment risk, mortgage-backed securities prepayments, and uncertainty in non-agency residential mortgage valuations. AFG estimated an immediate 100-basis-point rate increase would reduce fixed-maturity fair value by $901, or 4.5%. Management said it intended and was able to hold securities with unrealized losses, but changes in circumstances could require impairment charges.
- AFG consolidated six managed CLOs under accounting rules. Their assets and liabilities were reported separately; AFG stated it had no obligation to fund them and its maximum ultimate exposure was its $20 investment at fair value. CLO investments included $6 of loans in default and not accruing interest.
- On May 3, 2011, after quarter-end, an appeals court vacated confirmation of the A.P. Green bankruptcy plan and remanded a limited silica-trust issue. AFG’s $123.5 settlement was fully accrued; management believed the court action would not ultimately affect the settlement.
- New insurance acquisition-cost guidance effective January 1, 2012 is expected to result in fewer costs being deferred. Management was assessing its impact and expected retrospective adoption.
Important facts for investors to verify
- Whether subsequent reserve reviews, particularly the 2011 asbestos and environmental study, change reported reserve adequacy or earnings.
- Whether P&C underwriting performance and favorable prior-year reserve development stabilize, and how renewal pricing and exited business affect premiums.
- How investment yields, credit quality, mortgage-backed securities, and potential impairment charges affect investment income, fair values, and capital.
- Whether annuity sales growth translates into sustainable profitability after crediting costs, surrenders, acquisition-cost amortization, and interest-rate movements.
- How CLO fair-value volatility and noncontrolling-interest allocations affect reported consolidated results, and whether the A.P. Green proceedings alter the fully accrued settlement.