Business context and reporting period
American Financial Group, Inc. (AFG) filed this Form 10-K for the fiscal year ended December 31, 2014. Through Great American Insurance Group, AFG primarily writes specialized commercial property and casualty insurance and sells fixed and fixed-indexed annuities. It also manages closed blocks of long-term care and life insurance and operates other businesses.
AFG acquired Summit Holding Southeast in April 2014 for $259 million and contributed a further $140 million to the business. Summit expanded AFG’s workers’ compensation operations; its results are included from April 2014.
Financial results and key metrics
| Metric | 2014 | 2013 |
|---|---|---|
| Total revenues | $5.713 billion | $5.092 billion |
| Earnings before income taxes | $626 million | $689 million |
| Net earnings attributable to AFG shareholders | $452 million | $471 million |
| Diluted earnings per share | $4.97 | $5.16 |
| Core net operating earnings (non-GAAP) | $439 million ($4.82 per diluted share) | $385 million ($4.22 per diluted share) |
| Net cash from operating activities | $1.222 billion | $760 million |
| Cash and investments | $36.210 billion | $31.313 billion |
| Long-term debt | $1.061 billion | $913 million |
| Shareholders’ equity | $4.879 billion | $4.599 billion |
AFG reported $3.619 billion of net cash used in investing activities and $2.101 billion of net cash provided by financing activities; cash and cash equivalents ended the year at $1.343 billion. Consolidated debt-to-total-capital was 19.2%, versus 17.6% in 2013; management’s stated target is no more than 25%. AFG’s parent held approximately $350 million in cash and securities and had $500 million available under its revolving credit facility, which expires in December 2016. Insurance subsidiaries’ capital ratios substantially exceeded regulatory risk-based capital requirements.
Property and casualty: Gross written premiums rose 14% to $5.477 billion and net earned premiums rose 21% to $3.878 billion. Underwriting gain increased to $212 million from $145 million; the GAAP combined ratio improved to 94.5% from 95.5%. Current-year catastrophe losses were $28 million, compared with $31 million in 2013. P&C pretax earnings were $456 million, including a $24 million special asbestos and environmental (A&E) charge, versus $375 million in 2013, which included a $54 million A&E charge.
Annuities: Pretax earnings were $328 million, compared with $323 million; core pretax earnings were $328 million in both years. Statutory annuity premiums declined 8% to $3.696 billion. Net spread earned on fixed annuities declined to 1.41% from 1.60%, including a negative 0.15 percentage-point impact from fixed-indexed annuity derivative accounting in 2014.
Investments and capital returns: Net investment income increased to $1.501 billion from $1.346 billion. The available-for-sale fixed maturity portfolio had a fair value of $30.734 billion, including $1.660 billion of net unrealized gains before related balance-sheet adjustments. AFG paid $1.91 per common share in dividends, including a $1.00 special dividend, and repurchased $191 million of shares.
Material changes versus the prior comparable period
- Shareholder net earnings fell 4% to $452 million, while core net operating earnings rose 14% to $439 million. The decline in reported earnings primarily reflected realized gains on securities falling to $52 million from $221 million; lower A&E charges and stronger P&C underwriting partly offset that effect.
- P&C growth was substantially influenced by Summit: 2014 included $414 million of Summit gross written premiums. Excluding Summit, P&C gross written premiums increased 5% for the year, according to management.
- The P&C unpaid loss and loss adjustment expense balance increased to $7.872 billion from $6.410 billion. The filing attributes a substantial part of the increase to $1.028 billion of reserves from acquired businesses, primarily Summit; the balance also reflects claims, reinsurance recoverables and other changes.
- Annuity sales were lower, particularly in the second half of the year. Management attributed the decrease to disciplined pricing in a declining interest-rate environment and increased competition. Annuity benefits accumulated increased to $23.764 billion from $20.944 billion.
- AFG issued $150 million of 6.25% subordinated debentures due 2054. The company also invested $399 million in Summit, including its purchase price and subsequent capital contribution.
Outlook, management commentary, risks and unusual items
The filing provides no specific numerical earnings or premium guidance. Management described a disciplined underwriting approach, with growth focused on businesses expected to meet profitability objectives. It expected annuity net interest spread to narrow as higher-yielding investments run off, and expected closed-block long-term care revenues and expenses generally to increase as the block ages.
- Reserves and contingencies: AFG recorded a $24 million pretax charge in 2014 to strengthen P&C A&E reserves, which were $289 million net of reinsurance ($366 million gross). It also recorded a $6 million charge for A&E exposures tied to former railroad and manufacturing operations. Those former-operations liabilities totaled approximately $90 million at year-end. Management considers reserves adequate, but says actual outcomes could differ materially; a range of reasonably possible A&E losses could not be estimated.
- Long-term care: AFG’s closed-block long-term care reserves were $807 million net of reinsurance. The December 2014 loss-recognition margin was only $11 million, down from $64 million a year earlier. Adverse changes in claims, investment yields, expenses, persistency or approved premium increases could eliminate the margin and require additional charges. No new loss-recognition charge was recorded in 2014.
- Interest rates and investments: A 100-basis-point increase in interest rates was estimated to reduce fixed maturity fair value by approximately $1.550 billion pretax. Lower reinvestment yields may pressure annuity spreads; higher rates could increase surrenders or cause investment losses. Credit, mortgage-backed securities, equity-market and valuation risks also remain.
- Reinsurance and catastrophes: AFG remains liable to policyholders if reinsurers fail to pay. P&C reinsurance recoverables on unpaid losses were approximately $2.23 billion, net of allowances. AFG’s fully collateralized catastrophe bond provides up to $95 million of coverage for eligible losses above $100 million per occurrence through 2016; severe events may exceed protection.
- Other exposures: The filing identifies competition and dependence on independent agents and bank distribution, regulatory and rating changes, cyber and system disruptions, litigation, and holding-company reliance on regulated subsidiary dividends as risks. Up to approximately $673 million of subsidiary dividends could be paid to AFG in 2015 without prior regulatory clearance.
- Unusual items and accounting: Fixed-indexed annuity derivatives are marked to market through earnings and can cause volatility that management says may not reflect the products’ long-term economics. Realized securities gains fell sharply year over year, while 2013 included a $5 million pretax guaranty-fund assessment charge and 2012 included a $153 million pretax long-term care charge and a $170 million pretax gain on the sale of Medicare supplement and critical illness businesses. AFG planned to early-adopt new CLO accounting guidance effective January 1, 2015; management expected presentation changes but no overall effect on shareholder net earnings.
Ernst & Young issued unqualified opinions on the financial statements and internal control over financial reporting. The internal-control assessment excluded Summit, which management planned to include in its 2015 assessment.
Important facts for investors to verify
- Whether P&C premium growth and underwriting profitability persist after separating Summit’s contribution, and how reserve development evolves, particularly in commercial auto, contractor and international claims.
- The adequacy and sensitivity of A&E, long-term care and other insurance reserves, including the long-term care loss-recognition margin and assumptions for future rate increases and reinvestment yields.
- Whether annuity sales recover and spreads stabilize as investment yields, crediting rates, competition and fixed-indexed derivative marks change.
- The quality, concentration and valuation of investments, including mortgage-backed securities, non-investment-grade holdings, Level 3 valuations and the impact of interest-rate movements.
- Reinsurance recoverability and the extent of catastrophe exposure after protection, as well as the timing and availability of dividends from insurance subsidiaries and renewal of the parent credit facility.