American Financial Group, Inc. — Q3 2015 Form 10-Q
Business context and reporting period. AFG is an insurance holding company focused on specialty property and casualty insurance and fixed and fixed-indexed annuities. This unaudited report covers the quarter and nine months ended September 30, 2015; comparisons are with the corresponding 2014 periods. Amounts are in millions except per-share data and ratios.
Key financial results
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Total revenue | $1,684 | $1,581 | $4,519 | $4,184 |
| Earnings before income taxes | $99 | $145 | $355 | $436 |
| Net earnings attributable to shareholders | $63 | $116 | $223 | $325 |
| Diluted EPS | $0.71 | $1.28 | $2.49 | $3.56 |
| Core net operating earnings (non-GAAP) | $123 | $127 | $350 | $317 |
| Diluted core EPS (non-GAAP) | $1.38 | $1.40 | $3.92 | $3.47 |
- Revenue and earnings: Q3 revenue rose about 7%, while shareholder net earnings fell about 46%. Nine-month revenue rose about 8%, while net earnings fell about 31%. The effective tax rate was 33% for Q3 and 32% for the nine-month period.
- Property and casualty: Q3 net earned premiums were $1,173, up 4%; core pretax earnings were $157, up 17%. Specialty combined ratio improved to 92.9% from 93.8% (below 100% indicates underwriting profit). Including discontinued lines, the aggregate ratio worsened to 98.7% from 96.0%. For nine months, net earned premiums were $3,104, up 10%; core pretax earnings were $413, up 23%; Specialty combined ratio improved to 93.7% from 94.4%, while the aggregate ratio rose to 96.0% from 95.2%.
- Annuities: Q3 pretax earnings were $67, down 22%; nine-month pretax earnings were $230, down 5%. Fair-value changes on fixed-indexed annuity derivatives, net of related deferred acquisition cost amortization effects, reduced pretax earnings by $22 in Q3 and $28 for the nine months. Q3 annuity premiums increased 63% to $1,321; nine-month premiums rose 11% to $3,033.
- Cash flow: Nine-month operating cash flow was $907, versus $674 in 2014; investing used $3,415, versus $2,435; financing provided $2,059, versus $1,432. Cash and equivalents declined $449 during the period to $894.
- Balance sheet and debt: At September 30, total assets were $50,557 and total liabilities $45,651; shareholders’ equity was $4,724. Long-term debt was $880, down from $1,061 at year-end 2014. Debt to total capital was 16.5%, versus 19.2% at year-end. The company redeemed $132 of 7% senior notes at par on September 30. A $500 parent revolving facility had no borrowings; National Interstate had $12 outstanding on its $100 facility.
- Investment income and dividends: Nine-month net investment income increased to $1,217 from $1,117. Common dividends were $0.25 per share in Q3 and $0.75 for the nine months, versus $0.22 and $0.66 in 2014.
Material changes and unusual items
- AFG reported a $162 pretax loss in Q1 on the pending sale of substantially all its run-off long-term care business. The after-tax impact was $105, or $1.18 per diluted share. The transaction was expected to close before year-end 2015, subject to customary conditions and regulatory approvals. AFG estimated after-tax proceeds of $105–$115, including tax benefits, excluding possible additional proceeds of up to $13 tied to release of statutory liabilities.
- The sale of the Le Pavillon Hotel generated a $51 pretax gain in Q2 ($26 after tax and noncontrolling interests). Together with the LTC sale loss and other unusual items, this makes reported nine-month earnings materially different from core earnings.
- Q3 special asbestos and environmental reserve charges were $67 pretax in the P&C segment and $12 pretax for former railroad and manufacturing operations, versus $24 and $6, respectively, in Q3 2014. P&C A&E reserves were $336 net of reinsurance at quarter-end. Management cited increased estimated indemnity/defense costs and environmental remediation costs.
- AFG recorded $35 of Q3 impairment losses on securities, including $23 on equities and $17 on fixed maturities, partly offset by related adjustments; nine-month impairment charges on securities were $69 net in the income statement. Q3 realized securities results were a $16 loss, versus a $13 gain in 2014. Nine-month realized gains were $2, versus $44.
- AFG adopted new CLO accounting guidance in 2015 that changed presentation of CLO liabilities and noncontrolling interests but, according to the filing, did not affect shareholder net earnings. CLO assets and liabilities are consolidated, separately presented, and nonrecourse to AFG; AFG’s stated maximum exposure is limited to its CLO investments.
Outlook, liquidity, and principal risks
- No specific consolidated earnings or revenue guidance is provided. Management said annuity net interest spreads are expected to narrow in the future as higher-yielding investments run off and current products can achieve target profitability at lower spreads.
- Management said it believes parent and insurance-subsidiary liquidity is sufficient. The parent had access to its undrawn $500 revolving credit facility through December 2016; GALIC had $740 of FHLB advances and estimated about $800 of additional FHLB borrowing capacity.
- Management identified reserve adequacy and contingencies from former railroad and manufacturing operations as key potential loss areas. Estimates for asbestos, environmental and long-term-care claims, reinsurance recoverability, and investment impairments require significant judgment.
- Other disclosed exposures include interest-rate and securities-market movements, credit deterioration and impairment, annuity persistency and guaranteed benefits, catastrophe losses, reinsurance availability and collectability, regulatory or accounting changes, and the risk that the long-term-care sale may not close. AFG estimated that a 100-basis-point immediate rise in rates would reduce fixed-maturity fair value by about $1,669 and after-tax AOCI by about $584, after estimated offsets.
Most important facts for investors to verify
- Closing status, final consideration, tax benefits, and statutory-liability release proceeds for the pending long-term-care sale.
- Development of asbestos, environmental, and legacy railroad/manufacturing reserves, including whether further reserve strengthening is needed.
- Underlying P&C underwriting trends: aggregate versus Specialty combined ratios, reserve development, renewal pricing, and growth excluding Summit acquisition effects.
- Fixed-indexed annuity fair-value volatility, guaranteed withdrawal benefit costs, investment yields, and the direction of annuity spreads and sales.
- Investment portfolio credit quality, impairments and unrealized losses; liquidity and capital impacts from market movements and claims obligations.
- Reconciliation of GAAP results to management’s non-GAAP core earnings and the impact of unusual sale, reserve, and impairment items.