American Financial Group, Inc. — Q2 2012 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2012. AFG is an insurance holding company focused on specialty property and casualty insurance, annuities, and supplemental insurance. Amounts are in millions except per-share data and ratios. Prior-year figures are as adjusted where noted.
Financial performance
| Metric | Q2 2012 | Q2 2011 | Six months 2012 | Six months 2011 |
|---|---|---|---|---|
| Total revenues | $1,150 | $1,093 | $2,263 | $2,132 |
| Operating earnings before tax | $136 | $60 | $282 | $162 |
| Net earnings attributable to shareholders | $99 | $48 | $212 | $136 |
| Diluted earnings per share | $1.01 | $0.46 | $2.15 | $1.29 |
| Core net operating earnings, non-GAAP | $90 | $74 | $175 | $165 |
| Core diluted EPS, non-GAAP | $0.91 | $0.72 | $1.77 | $1.57 |
AFG attributed stronger earnings chiefly to improved annuity and supplemental insurance results and P&C underwriting; lower P&C investment income partly offset the improvement. 2011 earnings included a $38 million after-tax-equivalent special asbestos and environmental reserve charge. Realized gains were $16 million in Q2 and $60 million in the first half of 2012, versus $19 million in each comparable 2011 period.
Insurance operations and margins
- P&C earned premiums rose to $640 million in Q2 from $609 million and to $1,243 million in the first half from $1,208 million. Specialty underwriting profit was $52 million in Q2 versus $29 million, and $100 million in the first half versus $84 million.
- Aggregate P&C combined ratio, including discontinued lines, was 92.9% in Q2 versus 103.4%, and 92.5% for the first half versus 97.2%. Specialty combined ratios were 91.8% and 91.9%, respectively, compared with 95.2% and 93.1%. A ratio below 100% indicates an underwriting profit.
- Overall average P&C renewal rates increased about 3% in both Q2 and the first half. Catastrophe losses were $11 million in Q2 and $14 million year to date, below the comparable 2011 amounts of $23 million and $31 million.
- Annuity and supplemental insurance pretax operating earnings were $78 million in Q2 versus $43 million, and $158 million for the first half versus $94 million. Management cited higher fixed-annuity earnings and improved Medicare supplement loss experience and persistency.
- First-half annuity sales were $1,708 million versus $1,578 million, primarily reflecting growth in non-403(b) indexed annuities. Life, accident and health premiums were $210 million versus $217 million for the first half.
Cash flow, balance sheet and liquidity
- At June 30, cash and cash equivalents were $1,523 million, total investments were $27,301 million, total assets were $37,052 million, and shareholders’ equity was $4,622 million. At December 31, 2011, the corresponding reported balances were $1,324 million, $25,577 million, $35,838 million and $4,411 million.
- First-half operating cash flow was $226 million, down from $534 million in 2011. Investing cash outflow was $826 million versus $741 million; financing cash inflow was $799 million versus $737 million. Cash increased $199 million during the first half.
- Long-term debt was $1,158 million, up from $934 million at year-end, reflecting issuance of $230 million of 6.375% senior notes due 2042. The reported debt-to-total-capital ratio was 22.4%, versus 19.2%; excluding $199 million of subsidiary debt called for redemption in July, the June ratio was 19.3%. No borrowings were outstanding under AFG’s $500 million revolving facility, which expires in August 2013.
- AFG repurchased 4.0 million shares for $153 million in the first half and about 1.1 million more for $42 million in July. The quarterly dividend was $0.175 per share.
- Available-for-sale fixed maturities were $22,981 million at fair value, with $1,608 million of pretax unrealized gains; 87% of fixed maturities were investment grade. A 100-basis-point immediate rise in interest rates was estimated to reduce fixed-maturity fair value by $1,031 million, or 4.4%.
Material changes, outlook and risks
- Proposed business sale: In May 2012, AFG agreed to sell its Medicare supplement and critical illness business to Cigna for approximately $295 million cash. Closing was expected in Q3 2012, with an estimated pretax gain of $150–$165 million. The operations were not classified as discontinued operations. After the sale, supplemental insurance would consist solely of run-off long-term care business.
- Interest-rate and long-term-care exposure: Management warned that persistently low rates could produce a material charge to earnings if future yields are forecast below assumptions. The long-term-care block is sensitive to claims, mortality, persistency and investment-yield assumptions; rate increases require regulatory approval. AFG reported year-end 2011 reserve-test headroom of about $30 million and said a 1% change in claims costs or 0.1% change in investment yields would each affect that headroom by about $10 million.
- Weather and reserves: Midwest drought was expected to adversely affect P&C property and transportation results in the second half of 2012; quota-share and stop-loss reinsurance would mitigate crop losses. AFG scheduled its internal asbestos and environmental reserve review for Q3 2012. Management identified insurance reserve adequacy, including asbestos, environmental, mass-tort and long-term-care reserves, as significant judgment areas.
- Investment and reinsurance risks: Risks include market and interest-rate movements, credit deterioration, mortgage-backed-security prepayments and defaults, impairments, and reinsurer collectability. Approximately 4% of assets measured at fair value were Level 3; most Level 3 assets were priced using non-binding broker quotes. CLO assets and liabilities are consolidated, but AFG stated it had no contractual obligation to provide additional CLO funding and limited its maximum exposure to its CLO investment.
- Tax litigation subsequent event: The IRS appeal period expired August 2, 2012, making a favorable court decision final. AFG reported it expected to recognize approximately $28 million of net earnings in Q3 2012 from tax and interest refunds and reduced tax reserves, with additional amounts possible as later tax years close. This benefit was not part of Q2 results.
- AFG adopted revised insurance acquisition-cost guidance retrospectively in 2012; 2011 comparatives were adjusted. Management reported disclosure controls were effective and no material change in internal control during the quarter.
Most important facts for investors to verify
- Whether the Cigna transaction closed as expected, the final proceeds and gain, and the effect on ongoing segment results.
- How crop losses from the 2012 drought affected second-half underwriting and how much reinsurance recovered.
- Results of the scheduled asbestos and environmental reserve review and any changes in long-term-care reserve assumptions or adequacy.
- Whether low interest rates, annuity spreads, crediting-rate reductions and investment returns altered earnings or policyholder behavior.
- The realization and timing of the tax benefit and any additional benefit from closing subsequent tax years.
- Changes in investment impairments, Level 3 valuations, CLO exposures, debt and capital ratios, and share repurchases.