American Financial Group, Inc. — Q1 2012 Form 10-Q
Business context and reporting period. Unaudited results cover the three months ended March 31, 2012, compared with the first quarter of 2011. AFG operates primarily in specialty property and casualty insurance and annuity and supplemental insurance.
Key financial results
Amounts are in millions of dollars except per-share data and ratios.
| Metric | Q1 2012 | Q1 2011 |
|---|---|---|
| Total revenues | $1,113 | $1,039 |
| Operating earnings before tax | $146 | $102 |
| Net earnings attributable to shareholders | $113 | $88 |
| Diluted earnings per share | $1.14 | $0.83 |
| Core net operating earnings | $85; $0.86 diluted | $91; $0.85 diluted |
| Operating cash flow | $10 | $389 |
- Reported earnings included $44 million of realized securities gains, versus no net securities gains in Q1 2011; the company’s reconciliation shows the after-tax contribution as $28 million. Gains included $27 million from sales of Verisk Analytics shares.
- Property and casualty premiums were $603 million, compared with $599 million. Life, accident and health premiums were $105 million, down from $110 million. Investment income was $322 million, up from $300 million.
- Specialty P&C underwriting profit was $48 million versus $55 million. The aggregate combined ratio was 92.1%, compared with 90.9%; catastrophe losses were $4 million versus $8 million. Favorable prior-year reserve development was $19 million versus $21 million.
- Annuity and supplemental insurance operating earnings before tax increased to $80 million from $51 million. Annuity premiums rose to $803 million from $672 million, primarily on higher non-403(b) indexed annuity sales.
- At March 31, total assets were $36.211 billion, shareholders’ equity $4.580 billion, cash and cash equivalents $1.422 billion, and total cash and investments $26.478 billion. Long-term debt was $931 million; debt to total capital was 18.7% (17.7% excluding real-estate-secured debt).
- Cash and investments increased by $901 million from year-end 2011; total assets rose $373 million. Accumulated other comprehensive income increased to $714 million from $580 million, largely reflecting unrealized investment gains.
Material changes versus the prior period
- Shareholder net earnings increased 28%, and diluted EPS increased to $1.14 from $0.83. Core operating earnings, however, declined to $85 million from $91 million; reported earnings benefited from securities gains versus prior-year losses.
- Revenue increased about 7%, aided by higher investment income and managed investment entity investment income. P&C underwriting profit and investment income in that segment declined, while annuity and supplemental operations improved.
- Operating cash flow fell to $10 million from $389 million. The filing reports large working-capital movements, including changes in reinsurance receivables, claims reserves and amounts payable to reinsurers; insurer cash flows should be assessed alongside investment and financing activity.
- AFG retrospectively adopted the insurance acquisition-cost guidance effective January 1, 2012. Year-end 2011 deferred policy acquisition costs were adjusted from $1.105 billion to $901 million and shareholders’ equity from $4.545 billion to $4.411 billion. Comparative 2011 earnings were also revised.
- AFG repurchased 1.5 million shares for $56 million during the quarter and paid $17 million in common dividends. The quarterly dividend per share was $0.175, versus $0.1625.
Outlook, risks and unusual items
- No specific earnings or revenue guidance is provided. Management said it believed parent and insurance-subsidiary liquidity and capital were sufficient for expected needs.
- The parent had no borrowings under its $500 million revolving credit facility, which expires in August 2013. National Interstate had $22 million outstanding on a subsidiary facility; it expected to replace that facility before its December 2012 expiration, potentially at higher cost.
- Management reported average annuity crediting rates of about 3.0% and average guaranteed minimum rates of about 2.4%, indicating an average 60-basis-point reduction capacity if low market rates persist. Lower investment yields, spread compression, lapses and adverse mortality can pressure annuity earnings and acquisition-cost recoverability.
- A 100-basis-point immediate increase in interest rates was estimated to reduce the fair value of the fixed-maturity portfolio by approximately $1.027 billion, or 4.5%, before tax. The portfolio included $921 million of Level 3 available-for-sale fixed maturities; broker-quote valuations and mortgage-backed-security assumptions involve estimation uncertainty.
- AFG recorded $4 million of residential mortgage-backed-security impairment charges in Q1. Management said it intended and was able to hold securities with unrealized losses, but warned that changed intent or ability, market declines or credit deterioration could require material future impairment charges.
- Management identifies insurance reserve adequacy, reinsurance recoverability, deferred acquisition-cost recoverability, investment valuation, and legacy asbestos, environmental and mass-tort exposures as significant judgment or risk areas. It reported no significant change in the previously disclosed contingencies.
- AFG consolidates eight collateralized loan obligation entities (CLOs). Its CLO investment fair value was $135 million, its stated maximum exposure to economic loss; AFG said it had no contractual obligation or intention to provide further financial support. CLO fair-value movements and losses attributable to other debt holders affect reported results and noncontrolling interests.
- Subsequent event: On May 4, 2012, the Sixth Circuit affirmed a favorable district-court ruling in AFG’s IRS dispute over certain annuity reserve tax calculations. If the IRS does not seek a discretionary appeal within 90 days, AFG said it expects to record approximately $27 million of net earnings. The filing also describes discussions concerning subsequent tax years; the ultimate outcome remains contingent.
Important facts for investors to verify
- Whether the appellate tax ruling became final, whether the approximately $27 million benefit was recognized, and the status of related tax years and amounts.
- Whether the gap between reported earnings and core operating earnings persists, including the contribution of realized investment gains and the performance of annuity and supplemental lines.
- Trends in P&C combined ratios, renewal pricing, catastrophe losses and favorable prior-year reserve development.
- Operating cash-flow trends and the drivers of quarter-to-quarter movements in reinsurance balances, insurance reserves and annuity flows.
- Changes in portfolio credit quality, residential MBS exposure, Level 3 valuations, unrealized losses and impairment charges, including sensitivity to interest rates.
- Progress in replacing National Interstate’s credit facility and any changes to parent or subsidiary liquidity, debt, capital, or share-repurchase activity.