American Financial Group, Inc. — Q3 2014 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2014. AFG primarily operates in specialty property and casualty insurance and fixed and fixed-indexed annuities.
Financial performance
- Third quarter: Revenue was $1.581 billion, up 10% from $1.443 billion. Net earnings attributable to shareholders were $116 million, or $1.28 diluted EPS, versus $83 million, or $0.92, a year earlier. Core net operating earnings, a non-GAAP measure, were $127 million, or $1.40 per diluted share, versus $97 million, or $1.06.
- First nine months: Revenue was $4.184 billion, up 12%. Shareholder net earnings were $325 million, or $3.56 diluted EPS, versus $313 million, or $3.44. Core net operating earnings were $317 million, or $3.47 per diluted share, versus $268 million, or $2.94.
- Property and casualty: Net earned premiums increased 19% to $1.132 billion in Q3 and 20% to $2.817 billion for nine months. Aggregate combined ratios, including discontinued lines, improved to 96.0% from 99.1% in Q3 and to 95.2% from 97.0% for nine months; below 100% indicates underwriting profit. P&C pretax earnings were $110 million in Q3 and $313 million for nine months.
- Annuity: Pretax earnings increased 10% to $86 million in Q3 and 5% to $243 million for nine months. Fixed-annuity net spread earned was 1.48% in Q3 and 1.41% for nine months.
- Cash flow: Nine-month operating cash flow was $674 million, compared with $388 million; investing used $2.435 billion, compared with $1.913 billion; financing provided $1.432 billion, compared with $1.151 billion. Cash declined $329 million to $1.310 billion.
- Balance sheet and debt: Total assets were $46.552 billion and total equity $5.078 billion at September 30. Long-term debt was $1.062 billion, up from $913 million at year-end 2013. Debt to total capital was 19.2%, versus 17.6% at year-end. AFG had no borrowings under its $500 million revolving facility; $12 million was outstanding under National Interstate’s facility.
- Investment and distributions: Net investment income rose to $377 million in Q3 and $1.117 billion for nine months. Cash dividends were $0.22 per share in Q3 and $0.66 for nine months. AFG repurchased $127 million of stock in the first nine months and reported an additional $40 million of repurchases in October.
Changes and drivers versus comparable periods
- Results benefited from stronger P&C underwriting, higher P&C investment income, higher annuity earnings and lower holding-company expenses. Lower realized securities gains partly offset those gains: $13 million in Q3 versus $56 million, and $44 million for nine months versus $154 million.
- The April acquisition of Summit added $268 million of net earned premiums in Q2 and Q3 and contributed to premium and investment-income growth. AFG paid $259 million and invested a further $140 million in capital; Summit’s reported results are included from April 1.
- Q3 statutory annuity premiums fell 31% to $809 million, which management attributed to disciplined pricing amid lower interest rates and increased competition. Nine-month annuity premiums rose 3% to $2.725 billion.
- Nine-month P&C favorable prior-year reserve development was $29 million, down from $70 million a year earlier. Q3 specialty casualty results included adverse development in certain liability claims.
Outlook, risks and unusual items
- Management expected full-year 2014 fixed-annuity net spread earned of 1.35%–1.40%, or 1.50%–1.55% excluding fair-value accounting effects on fixed-indexed annuity derivatives. It expected net interest spreads to continue narrowing as higher-yielding investments run off and reinvestment yields remain lower.
- AFG recorded $30 million of pretax special asbestos and environmental reserve charges in Q3: $24 million in P&C reserves and $6 million related to former railroad and manufacturing operations. Net P&C A&E reserves were $300 million at September 30. AFG reported no newly identified broad industry trends that it believed significantly changed overall reserve adequacy.
- Management planned fourth-quarter loss-recognition testing for its run-off long-term-care business. Its stated year-end 2013 loss-recognition margin was $64 million; if updated assumptions produced cumulative adverse effects exceeding that amount, AFG would record a charge for the excess. Management said low interest rates, including the October decline, would reduce the margin.
- Key exposures include insurance reserve estimation, asbestos and environmental claims, long-term-care assumptions, reinsurance recoverability, investment credit and valuation risk, interest-rate and market movements, catastrophe losses, competition and regulatory changes. A 100-basis-point immediate increase in rates was estimated to reduce fixed-maturity fair value by $1.515 billion pretax, or 5.0% of the portfolio.
- AFG issued $150 million of 6.25% subordinated debentures due 2054 in September. Proceeds were intended for general corporate purposes, potentially including share repurchases or redemption of some or all of its 7% senior notes beginning in September 2015. The filing states no general earnings guidance beyond the annuity spread outlook.
- AFG expected to use an available accounting alternative for consolidated CLOs under ASU 2014-13; management expected no material impact on shareholder net earnings. The filing also reports that disclosure controls were effective and no material third-quarter change in internal control over financial reporting occurred.
Most important facts for investors to verify
- Whether the Summit acquisition delivers sustainable underwriting returns, particularly given its contribution to Specialty casualty growth and loss ratios.
- Subsequent development in P&C, asbestos and environmental reserves, and the results of fourth-quarter long-term-care loss-recognition testing.
- Whether annuity spreads and sales meet management’s stated expectations amid lower reinvestment yields, competition and fair-value volatility.
- The quality and liquidity of the investment portfolio, including the effects of interest-rate changes and assets valued using broker quotes or other Level 3 inputs.
- Debt, capital deployment, repurchases and liquidity needs, including the effect of acquisition funding and policyholder cash flows.