American Financial Group, Inc. — Q2 2016 Form 10-Q
Business and period: AFG is an insurance holding company focused on specialty property and casualty (P&C) insurance and fixed and fixed-indexed annuities. This filing reports the quarter and six months ended June 30, 2016; financial amounts are in millions except per-share data.
Financial performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Total revenue | $1,581 | $1,543 | $3,056 | $2,840 |
| Net earnings attributable to shareholders | $54 | $141 | $155 | $160 |
| Diluted EPS | $0.62 | $1.57 | $1.76 | $1.79 |
| Core net operating earnings (non-GAAP) | $113 | $115 | $224 | $227 |
| Diluted core EPS (non-GAAP) | $1.28 | $1.28 | $2.53 | $2.54 |
| Net investment income | $423 | $404 | $834 | $792 |
| Operating cash flow | — | $426 | $576 |
Q2 shareholder earnings fell sharply, mainly reflecting a $65 Neon exited-lines charge, higher realized securities losses and a smaller property-sale gain than in the prior-year quarter. Six-month GAAP earnings were modestly lower; the prior-year comparison included a $162 pretax loss on the sale of AFG’s long-term-care businesses.
Insurance operating measures
- P&C: Q2 net earned premiums rose 4% to $1,027; six-month premiums rose 5% to $2,025. Specialty underwriting profit was $63 in Q2 and $149 for the half, versus $51 and $111, respectively. Specialty combined ratios improved to 93.9% in Q2 from 94.9%, and to 92.7% for six months from 94.2%. Including exited lines and the Neon charge, the aggregate combined ratios were 100.3% in Q2 and 95.9% for six months, versus 94.9% and 94.2%.
- Annuities: Pretax earnings decreased 14% to $76 in Q2 and 21% to $129 for six months. Fixed-annuity net spread earned fell to 1.08% from 1.39% in Q2 and to 0.91% from 1.30% for six months. Management attributed pressure chiefly to fair-value accounting for fixed-indexed annuity derivatives and reinvestment of maturing assets at lower yields.
- Annuity sales: Statutory premiums increased 22% to $1,098 in Q2 and 39% to $2,383 for six months. Management cited new products, distribution expansion and sales brought forward ahead of reductions in new-business crediting rates.
Financial position, cash flow and liquidity
- At June 30, 2016, total assets were $52.7 billion, total liabilities $47.5 billion and total equity $5.2 billion. Cash and cash equivalents were $1.55 billion; total cash and investments were $40.6 billion.
- Long-term debt was $998 carrying value ($1.02 billion principal), broadly unchanged from year-end. Debt to total capital was 18.3%, or 12.9% excluding subordinated debt and debt secured by real estate, compared with 18.5% and 13.1% at December 31, 2015. The $500 million revolving credit facility had no borrowings.
- Six-month cash flow was $426 provided by operations, $1.75 billion used in investing and $1.65 billion provided by financing; cash increased $328. Annuity receipts exceeded surrenders, benefits and withdrawals by approximately $1.43 billion.
- AFG reported $935 million of Federal Home Loan Bank advances within annuity liabilities and estimated about $600 million of additional FHLB borrowing capacity. Its insurance subsidiaries also held liquid short-term investments, though statutory capital or liquidity needs could increase under adverse conditions.
- Shareholders’ equity increased from $4.59 billion at year-end to $5.00 billion, with accumulated other comprehensive income rising from $304 million to $669 million, principally reflecting unrealized investment gains. AFG paid $0.56 per common share in dividends during the first six months and repurchased $98 million of stock.
Material changes, outlook and risks
- Neon: A second-quarter strategic review led to exits from certain UK and international medical malpractice and general liability lines. AFG recorded a $65 million pretax charge, including $57 million of reserve strengthening. Specialty casualty also faced higher current-year trade-credit losses and adverse development in some excess and surplus business.
- Investment and annuity sensitivity: Six-month realized securities losses were $34, versus gains of $18 in 2015; the filing reports $91 of net impairment charges after related adjustments. Management said it believed it could hold securities with unrealized losses until recovery and did not intend to sell them, but future impairments could be material. An immediate 100-basis-point rate increase was estimated to reduce after-tax AOCI by $634 million.
- Management outlook: AFG said it expects annuity net interest spreads to narrow as lower-yielding assets replace higher-yielding investments and as product economics permit lower spreads. It reduced new-annuity cost of funds from 2.50% at the start of 2016 to 2.16% by July 6, with further actions expected to take it to 1.96% by early September. These are management expectations, not earnings guidance; the filing provides no overall numerical earnings forecast.
- Regulatory and transaction matters: AFG expected the Department of Labor fiduciary rule to cause some transition-period sales disruption in 2017, but did not expect a material effect after planned product and compensation changes. On July 25, AFG announced a proposed purchase of the remaining National Interstate shares for approximately $320 million, plus a $0.50-per-share special dividend; completion was subject to minority-shareholder approval and was expected in Q4 2016. AFG estimated a $64 million tax benefit upon consummation.
- Other risks: The filing highlights uncertainty from Brexit for Neon’s London-based operations; interest-rate and securities-market changes; catastrophe losses; reserve adequacy, particularly asbestos, environmental and mass-tort claims; reinsurance collectability; and regulatory, legal and tax changes. AFG said there were no significant changes to previously disclosed contingencies and scheduled an internal asbestos and environmental reserve review for Q3 2016.
- Tax and controls: The reported effective tax rate was 54% for Q2 and 43% for the first six months, influenced by a valuation allowance associated with Neon losses. Excluding the Neon charge, management reported rates of 36% and 35%, respectively. Management concluded disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether the Neon reserve and exit charge is sufficient and whether the exited lines create further adverse development.
- Whether P&C underwriting results, favorable prior-year reserve development and catastrophe experience are sustainable; distinguish Specialty ratios from aggregate ratios that include exited lines.
- How fixed-indexed annuity fair-value movements, lower reinvestment yields and narrowing spreads affect future earnings and the value of annuity liabilities.
- The quality, impairment exposure and valuation inputs for AFG’s investment portfolio, including broker-priced Level 3 assets and the reported securities impairments.
- Whether the National Interstate acquisition receives the required approval, closes on expected terms and timing, and delivers the anticipated tax benefit.
- Developments in asbestos, environmental and other reserves, reinsurance recoverables, Brexit-related exposure and the company’s capacity to meet liquidity and capital needs.