American Financial Group, Inc. — 2016 Form 10-K
Business context and reporting period. AFG is an insurance holding company operating primarily in specialty property and casualty insurance and fixed and fixed-indexed annuities, with smaller run-off life and long-term-care operations and other businesses. This filing covers the fiscal year ended December 31, 2016; comparisons are principally with 2015. Dollar amounts are in U.S. dollars.
Key financial metrics
| Metric | 2016 | 2015 |
|---|---|---|
| Total revenue | $6.498 billion | $6.145 billion |
| Earnings before income taxes | $787 million | $565 million |
| Net earnings attributable to shareholders | $649 million; diluted EPS $7.33 | $352 million; diluted EPS $3.94 |
| Core net operating earnings (non-GAAP) | $534 million; diluted EPS $6.03 | $486 million; diluted EPS $5.44 |
| Net cash provided by operating activities | $1.150 billion | $1.353 billion |
| Cash and investments | $41.433 billion | $37.736 billion |
| Total assets / shareholders’ equity | $55.072 billion / $4.916 billion | $49.837 billion / $4.592 billion |
| Long-term debt, carrying value | $1.283 billion | $998 million |
- Property and casualty: Gross written premiums rose 3% to $5.981 billion; net earned premiums increased 2% to $4.328 billion. Underwriting gain was $236 million versus $225 million. The GAAP combined ratio improved to 94.5% from 94.7%; a ratio below 100% indicates underwriting profit.
- Annuities: Pretax earnings increased 11% to $368 million. Fixed-annuity net spread earned was 1.29%, compared with 1.26%. Statutory annuity premiums rose 7% to $4.435 billion.
- Investments: Net investment income increased 4% to $1.696 billion. Available-for-sale fixed maturities had a $34.544 billion fair value; 89% were investment grade. A 100-basis-point immediate rate increase was estimated to reduce after-tax accumulated other comprehensive income by $679 million, after offsets.
- Cash flow and liquidity: Investing activities used $2.981 billion and financing activities provided $2.718 billion; cash and equivalents increased $887 million to $2.107 billion. Parent-only cash and securities were approximately $260 million, with a $500 million revolving facility available through June 2021 and no year-end borrowings under it. Insurance subsidiaries’ statutory capital ratios substantially exceeded RBC requirements.
- Leverage and capital returns: Debt-to-total-capital was 22.1% including subordinated debt and real-estate-secured debt, up from 18.5%; management’s stated target is at or below 25%. AFG repurchased $133 million of shares and paid $187 million in common dividends, including a $1-per-share special dividend.
Material changes versus 2015
- Shareholder net earnings rose $297 million, while core net operating earnings increased $48 million. The larger GAAP increase reflects non-core items, including $177 million of fourth-quarter tax benefits related to the National Interstate transaction and Neon restructuring, lower A&E charges, and a reversal from securities losses to gains. The 2016 effective tax rate was 15%; management reported 35% excluding specified items.
- AFG acquired the 49% of National Interstate it did not already own for $315 million in cash in November 2016. The transaction eliminated the noncontrolling interest and generated a $66 million tax benefit.
- P&C premiums and underwriting profit increased, but segment results varied: property and transportation underwriting profit improved substantially, while specialty casualty underwriting profit fell to $78 million from $146 million. Current-year catastrophe losses increased to $55 million from $35 million.
- Annuity pretax earnings increased, but annual net investment yield declined to 4.77% from 4.83% as higher-yielding investments matured or were sold and proceeds were reinvested at lower yields. Annuity benefits accumulated rose to $29.907 billion from $26.622 billion.
- AFG’s long-term-care business remained substantially in run-off following the 2015 sale of most of that business. Run-off segment pretax earnings were $4 million versus a $152 million loss in 2015, which included the sale loss.
Outlook, risks, contingencies and unusual items
- Outlook: The filing provides no specific earnings or revenue guidance. Management expects annuity net interest spreads to narrow over time. It stated that the Department of Labor fiduciary rule could affect 2017 annuity premiums, but did not expect a material effect on results if implemented in its then-current form.
- Reserves and unusual charges: AFG recorded a $36 million pretax charge to increase P&C asbestos and environmental reserves and a $65 million charge tied to Neon’s exit from certain medical-malpractice and general-liability lines. Net favorable prior-year development in the P&C Specialty operations was $61 million, but AFG reported aggregate adverse prior-year development of $32 million after special charges and other lines. Management emphasizes reserve estimates are judgmental and may change.
- A&E exposure: Gross P&C asbestos and environmental reserves were $443 million, with $337 million net of reinsurance. Former railroad and manufacturing operations also carried $77 million of environmental, personal-injury and other contingency liabilities. Ultimate exposure is uncertain and could differ materially from recorded amounts.
- Reinsurance and catastrophes: Recoverables from reinsurers were $2.737 billion, including $2.302 billion on unpaid P&C losses and LAE. AFG remains liable to policyholders if reinsurers fail to pay. Its Riverfront Re catastrophe bond coverage expired in January 2017 and had not been renewed as of the filing; management expected to purchase additional catastrophe reinsurance in the first quarter of 2017. Net catastrophe exposure to a modeled 500-year earthquake or windstorm was estimated below 4% of shareholders’ equity.
- Market and concentration risks: Fixed-income values and investment income are sensitive to interest rates and credit quality; low rates can pressure investment returns and annuity spreads, while rising rates can reduce bond values and potentially increase surrenders. Two financial-institution relationships represented 24% of total annuity sales in 2016, making distribution concentration material.
- Other items: Realized securities gains were $19 million in 2016, versus losses of $19 million in 2015; 2016 included $116 million of impairment charges, partly offset by gains before impairments. The filing identifies ongoing litigation and a proposed settlement of shareholder claims related to the National Interstate merger, subject to court approval; management did not expect other ordinary-course litigation to have a material adverse impact.
Important facts for investors to verify
- How much of the 2016 GAAP earnings increase is recurring: reconcile the $649 million shareholder net income with $534 million of core net operating earnings and the $177 million fourth-quarter tax benefits.
- Whether P&C reserve trends remain adequate, particularly for Neon, New York contractor claims, commercial auto, and asbestos and environmental exposures.
- Whether catastrophe reinsurance was renewed after the Riverfront Re coverage expired, and how changes in coverage, retention, or pricing affect net exposure.
- Whether annuity investment yields and spreads can withstand reinvestment at lower yields, interest-rate movements, and changes in policyholder surrenders.
- Whether annuity sales concentration at major financial institutions and the fiduciary-rule implementation affect distribution, premiums, or costs.
- How the increase in debt and the National Interstate acquisition affect leverage, capital flexibility, and future shareholder distributions.