American Financial Group, Inc. — Q3 2012 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2012. Amounts are in millions of dollars except per-share data and ratios. Comparisons are to 2011 periods, as adjusted where applicable.
Business context and results
AFG operates principally in specialty property and casualty insurance and fixed and fixed-indexed annuities. In August 2012, it sold its Medicare supplement and critical illness businesses; remaining supplemental insurance operations consist of run-off long-term care and life businesses.
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total revenues | $1,563 | $1,335 | $3,826 | $3,467 |
| Operating earnings before tax | $285 | $156 | $567 | $318 |
| Net earnings attributable to shareholders | $226 | $97 | $438 | $233 |
| Diluted earnings per share | $2.39 | $0.95 | $4.50 | $2.23 |
| Core net operating earnings (non-GAAP) | $78 | $92 | $253 | $257 |
Reported earnings growth largely reflected the after-tax $101 million sale gain, a $28 million tax benefit from favorable tax litigation resolution, and higher realized securities gains. These were partly offset by asbestos and environmental (A&E) reserve charges. Core earnings declined as stronger annuity results were more than offset by weaker P&C underwriting and lower P&C investment income.
Financial position, cash flow and capital
- Balance sheet: At September 30, total assets were $39.6 billion, total liabilities $34.7 billion, and total equity $5.0 billion. Cash and investments were $28.0 billion, including $23.7 billion of available-for-sale fixed maturities and $1.0 billion of equity securities.
- Debt and liquidity: Long-term debt was $966 million, versus $934 million at year-end 2011. Debt to total capital was 19.2%, unchanged from year-end. AFG reported no borrowings on its $500 million parent revolving facility; it planned to replace it in Q4 with a four-year facility. National Interstate had $22 million outstanding on its $75 million credit agreement.
- Cash flow, nine months: Operating activities provided $487 million, investing activities used $938 million, and financing activities provided $753 million. Cash increased $302 million to $1.626 billion.
- Shareholder capital: AFG repurchased 8.3 million shares for $315 million during the first nine months and paid $50 million in common dividends. The quarterly dividend was $0.175 per share, compared with $0.1625 a year earlier.
Material changes and operating performance
- P&C: Specialty underwriting profit was $16 million in Q3 versus $58 million a year earlier; the nine-month amounts were $116 million and $142 million. Specialty combined ratios were 98.2% for Q3 and 94.4% year to date. The aggregate combined ratio, including discontinued lines and A&E charges, was 101.9% for Q3 and 96.3% year to date. Renewal rates increased about 3% in Q3 and year to date.
- Q3 underwriting was affected by $12 million of crop losses from Midwest drought and approximately $25 million less favorable reserve development in several Specialty casualty businesses. Management said the crop losses represented the full estimated annual amount, with further losses expected to fall within stop-loss reinsurance coverage.
- Annuity and supplemental insurance: Segment operating earnings before tax rose to $81 million in Q3 from $47 million and to $224 million for nine months from $157 million. Management cited maintained spreads on a larger fixed-annuity asset base and, in Q3, favorable equity-market performance.
- Annuity premiums were $723 million in Q3, down from $890 million; year-to-date premiums were $2.431 billion versus $2.468 billion. AFG attributed the quarterly decline to lower crediting rates and agent commissions in response to low interest rates.
- Investments: Investment income increased to $327 million in Q3 from $310 million and to $981 million for nine months from $916 million, primarily due to higher average invested assets. Securities realized gains were $85 million in Q3 and $145 million year to date. AFG recorded $19 million of securities impairment charges in the first nine months.
- Sale and financing transactions: The Medicare supplement and critical illness sale generated $307 million gross proceeds and a $155 million pretax gain. AFG also acquired the remaining 28% of Marketform for $17 million. It issued $355 million of long-dated notes and used proceeds to redeem higher-coupon debt.
Outlook, risks and unusual items
- No formal earnings or revenue guidance is provided in the supplied filing text. Management said persistently low rates could require lower future reinvestment assumptions and lead to a material charge; annuity spread flexibility is partly supported by the ability to reduce crediting rates, subject to contractual minimums.
- AFG identified insurance reserve adequacy—especially A&E and closed-block long-term care reserves—reinsurance recoverability, deferred acquisition cost recoverability, and investment valuation as key areas of estimation risk. Long-term care claims experience is limited and future rate increases require regulatory approval.
- AFG recorded a $31 million pretax P&C A&E reserve charge and a further $2 million charge for former railroad and manufacturing exposures. A separate $15 million adverse judgment related to a former railroad labor matter and an $8 million debt-retirement loss increased Q3 expenses.
- The final resolution of tax litigation produced approximately $28 million of Q3 net earnings benefit. The filing also says subsequent closure of certain tax years could reduce uncertain-tax-position liabilities by up to $28 million plus $13 million of related interest; timing and realization are not assured.
- After quarter-end, Superstorm Sandy caused significant damage. Management said it was too early to estimate AFG’s losses, but expected them to be less than 1% of shareholders’ equity, mitigated by reinsurance.
- Other exposures include interest-rate and market movements, mortgage-backed securities prepayment and credit risk, catastrophe losses, reserve development, reinsurer credit, and potential litigation. A 100-basis-point immediate rise in rates was estimated to reduce fixed-maturity fair value by $1.058 billion pretax.
Important facts for investors to verify
- Separate recurring operating performance from the sale gain, tax benefit, securities gains, reserve charges and other unusual items; reconcile the company’s non-GAAP core earnings measure.
- Monitor P&C underwriting results, crop exposure and prior-year reserve development, including adequacy of A&E reserves.
- Assess long-term care reserve assumptions, future interest-rate and reinvestment assumptions, and any resulting deferred acquisition cost or reserve charges.
- Track Superstorm Sandy claims development and reinsurance recoverability, alongside investment portfolio valuations and credit quality.
- Confirm the replacement of the revolving credit facility, debt costs and maturities, and the sustainability of share repurchases and dividends.