American Financial Group, Inc. — Q3 2010 Form 10-Q
Reporting period: Three and nine months ended September 30, 2010. AFG is an insurance holding company focused on specialty property and casualty insurance, annuities, and supplemental insurance. Dollar amounts below are in millions except per-share data.
Financial performance and position
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Total revenue | $1,255 | $1,093 | $3,341 | $3,195 |
| Operating earnings before taxes | $208 | $203 | $513 | $577 |
| Net earnings attributable to shareholders | $132 | $127 | $346 | $358 |
| Diluted earnings per share | $1.21 | $1.09 | $3.11 | $3.07 |
| Operating cash flow | Not provided by quarter | Not provided by quarter | $781 | $761 |
- Q3 revenue increased about 15% year over year; nine-month revenue rose about 5%. Shareholder earnings increased about 4% in Q3 but fell about 3% for the nine-month period.
- Q3 pretax earnings included $35 million of realized gains, versus $4 million a year earlier. Nine-month realized securities gains were $72 million, compared with losses of $17 million in 2009.
- Property and casualty underwriting profit was $68 million for Q3 and $214 million for nine months, compared with $108 million and $326 million, respectively, in 2009. Combined ratios were 90.7% for Q3 and 88.8% for nine months (lower than 100% indicates underwriting profit); respective 2009 ratios were 82.7% and 81.9%.
- At September 30, cash and investments were $22.7 billion, cash and cash equivalents $1.14 billion, total assets $32.6 billion, and total equity $4.7 billion. Cash rose $20 million from year-end 2009. Nine-month operating cash flow of $781 million was outweighed by $1.37 billion of investing cash outflow; financing provided $613 million.
- Long-term debt was $954 million, up from $828 million at year-end 2009. Debt to total capital was 19.1%, versus 17.6%. AFG reported no borrowings under its new $500 million revolving credit facility at quarter-end.
Material changes and management commentary
- Management attributed stronger Q3 results principally to improved annuity and supplemental insurance results and higher realized gains, offset by weaker P&C underwriting and lower P&C investment income. For the first nine months, P&C underwriting profit was down $112 million and P&C investment income down $56 million year over year.
- AFG consolidated six managed CLOs beginning January 1, 2010, under new accounting guidance. This added $2.49 billion of CLO assets and $2.27 billion of liabilities to the balance sheet; the adoption-date $245 million net fair-value difference was recorded in appropriated retained earnings. CLO assets are not available for AFG’s general use, and AFG says it has no contractual obligation to provide additional support.
- AFG subsidiary National Interstate acquired Vanliner Group in July for $128 million in cash. The preliminary purchase-price allocation remains subject to final valuation and a 4.5-year balance-sheet guarantee.
- Management decided to de-emphasize career-agent sales of supplemental health products, including a marketing subsidiary; AFG recorded a $22 million goodwill impairment.
- AFG repurchased 7.4 million shares for $201 million in the first nine months. It issued $132 million of 7% senior notes due 2050 in September and replaced its credit facility with the three-year $500 million revolver in August.
Outlook, risks, and contingencies
- No earnings or premium guidance is provided. Management estimated 2011 P&C investment income would be approximately 10%–15% below 2010, reflecting lower reinvestment yields and changes in the investment portfolio. It expected annuity and supplemental insurance investment income to exceed the current year, supported by expected business growth and the ability to adjust credited rates.
- AFG cited market and interest-rate movements, credit deterioration, mortgage-backed securities and prepayment risk, reserve adequacy, catastrophe losses, reinsurance collectibility, competition and pricing, regulatory changes, and persistency, mortality and morbidity as risks that could affect results. A 100-basis-point immediate increase in interest rates was estimated to reduce fixed-maturity fair value by $932 million, or 4.7%.
- Q3 Specialty casualty results included $39 million of adverse reserve development related to Marketform, primarily its run-off Italian public-hospital business; related reserves were $131 million. AFG’s internal asbestos and environmental review increased reserves by $8 million. P&C asbestos and environmental reserves were $350 million net of reinsurance at September 30. Management said reserve estimates are judgmental and subject to change.
- The IRS appealed a court judgment in AFG’s favor concerning tax treatment of certain annuity reserves. Resolution could reduce unrecognized tax benefits by up to $36 million and accrued interest by $12 million; amounts remain unadjusted pending effective settlement. AFG also increased uncertain-tax-position liabilities by $19 million for timing of income recognition; management said resolution would not affect the annual effective tax rate but could accelerate tax payments.
- AFG recorded $42 million of residential MBS impairment charges and $18 million of corporate-security impairment charges in the first nine months. Management stated it intended and was able to hold securities with unrealized losses, but a change in that assessment could require further charges. The filing reports no significant change in the cited asbestos, environmental, and mass-tort contingencies from the 2009 Form 10-K.
- Management concluded disclosure controls were effective and reported no material third-quarter change in internal control over financial reporting.
Important facts for investors to verify
- Whether the weaker P&C underwriting trend, including Marketform reserve development and catastrophe losses, persists; compare combined ratios and reserve development in later filings.
- How investment income responds to lower yields and the changing MBS portfolio, and whether the stated 2011 investment-income outlook is realized.
- The quality, valuation assumptions, defaults, and nonrecourse limitations of CLO assets and liabilities, as well as the effect of consolidation on reported earnings and equity.
- Final Vanliner acquisition accounting and performance, and the outcome of the IRS appeal and other tax uncertainties.
- Future reserve development and impairment charges, including A&E claims and residential MBS; also monitor leverage, capital returns, and available parent-company liquidity.