AMERICAN FINANCIAL GROUP INC quarterly report, Q3 FY2016

American Financial Group, Inc. — Q3 2016 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2016. AFG primarily operates in specialty property and casualty insurance and fixed and fixed-indexed annuities. Figures are in millions of dollars except per-share data and ratios.

Financial results and position

Metric	Q3 2016	Q3 2015	Nine months 2016	Nine months 2015
Total revenue	$1,705	$1,687	$4,761	$4,527
Earnings before tax	$178	$99	$470	$355
Net earnings attributable to shareholders	$109	$63	$264	$223
Diluted earnings per share	$1.23	$0.71	$2.98	$2.49
Core net operating earnings (non-GAAP)	$134	$123	$358	$350
Net investment income	$433	$425	$1,267	$1,217

For the first nine months, operating cash flow was $673 million, investing cash flow was negative $2.446 billion, and financing cash flow was positive $2.192 billion. Cash increased $419 million to $1.639 billion.
At September 30, cash and investments totaled $41.805 billion; total assets were $54.845 billion, total liabilities $49.487 billion, and shareholders’ equity $5.161 billion.
Long-term debt was $1.300 billion on the balance sheet ($1.326 billion principal). AFG issued $300 million of 3.5% senior notes due 2026 in August. Debt-to-total-capital was 22.0%, up from 18.5% at year-end 2015; excluding subordinated debt and real-estate-secured debt, it was 17.1%.
AFG’s P&C combined ratio was 96.3% for Q3 versus 98.7% a year earlier, including exited lines and special A&E charges. For the first nine months, it was 96.0% in both years. A ratio below 100% indicates underwriting profit.
Available-for-sale fixed maturities had $1.808 billion of net unrealized gains before related balance-sheet adjustments. Shareholders’ accumulated other comprehensive income rose to $753 million from $304 million at year-end 2015, largely reflecting investment-market gains.

Material changes versus comparable periods

Q3 shareholder earnings rose $46 million year over year. Higher core earnings, lower special asbestos and environmental (A&E) charges, and a swing from securities losses to gains contributed. Nine-month earnings rose $41 million, with the prior-year period burdened by the estimated loss on the long-term-care business sale.
Q3 core earnings increased to $134 million from $123 million; nine-month core earnings increased to $358 million from $350 million. P&C and annuity results were key contributors, though holding-company costs increased.
Q3 P&C net earned premiums declined 1% to $1.159 billion; gross written premiums fell 3%. Nine-month net earned premiums increased 3% to $3.184 billion. Nine-month specialty underwriting profit increased, notably in property and transportation, while casualty and specialty financial underwriting profit declined.
Annuity pretax earnings increased 60% in Q3 to $107 million, but rose only 3% for the nine months to $236 million. Q3 annuity premiums fell 29% year over year; nine-month premiums increased 10%. Management attributed the Q3 sales decline partly to lower crediting rates.
Q3 included $41 million of pretax A&E charges: $36 million in P&C and $5 million related to former railroad and manufacturing operations, compared with $79 million in Q3 2015. The first nine months also included a $65 million pretax charge for Neon’s exit of certain business lines.
First-nine-month securities results were a $32 million loss versus a $2 million gain a year earlier, including $107 million of impairment charges net of related adjustments, versus $69 million in 2015.

Outlook, commentary, risks and contingencies

AFG agreed to acquire the remaining 49% of National Interstate Corporation (NATL) for approximately $320 million, subject to approval by NATL shareholders unaffiliated with AFG. The vote was scheduled for November 10, 2016, and closing was expected in Q4. AFG stated the transaction would produce an estimated $66 million tax benefit when completed. A shareholder lawsuit challenging the transaction was filed October 7; AFG said it believes the allegations are without merit.
In November 2016, AFG declared a $1.00-per-share special dividend, approximately $87 million, in addition to its regular quarterly dividend. Q3 regular dividends were $0.28 per share, versus $0.25 a year earlier.
Management expects the Department of Labor fiduciary rule, scheduled for implementation in April 2017, to negatively affect annuity premiums next year, but does not expect a material effect on results or financial position. Management also expects annuity net interest spreads to narrow over time as reinvestment yields remain pressured.
Hurricane Matthew was expected to generate $10 million to $15 million of pretax P&C losses. Other principal exposures include reserve uncertainty, especially asbestos and environmental claims; catastrophe losses; reinsurer collectability; interest-rate and investment-market movements; and annuity persistency, mortality and minimum-rate guarantees.
AFG reported $340 million of P&C A&E reserves net of reinsurance. Management said it believes loss reserves are adequate, but noted the estimates are judgmental and may change. Management also identified former railroad and manufacturing environmental and occupational claims as significant uncertainty areas.
AFG’s London-based Neon operation may be adversely affected by uncertainty following the UK’s Brexit vote. AFG also cautioned that investment impairment charges could be material if its ability or intent to hold impaired securities changes.
AFG said parent and insurance-subsidiary liquidity was sufficient. Its $500 million revolving credit facility had no borrowings; National Interstate had $18 million outstanding on its credit agreement. Annuity subsidiary GALIC had $935 million of Federal Home Loan Bank advances and estimated about $500 million of additional borrowing capacity.
No formal earnings guidance was provided. Management’s forward-looking statements are subject to market, economic, regulatory, catastrophe, reserve, reinsurance, competitive and transaction-related risks.

Most important facts for investors to verify

Whether NATL shareholders approved the buyout, whether it closed, and the realized tax benefit and funding effects.
Subsequent development in P&C reserves, particularly A&E and Neon exited-line claims, and the impact of Hurricane Matthew.
Whether annuity sales and profitability respond as expected to lower crediting rates, declining investment yields and the DOL fiduciary rule.
The sustainability of core earnings growth relative to GAAP earnings, given impairments, special reserve charges, fair-value movements and prior-year disposal items.
Changes in debt, liquidity, investment marks and credit quality; approximately 89% of fixed maturities were investment grade, and a modeled 100-basis-point rate increase implied an estimated $694 million after-tax reduction in AOCI.