SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Quarterly Period EndedJune 30, 2006
Commission File
AMERICAN FINANCIAL GROUP, INC.
Incorporated underthe Laws of Ohio
IRS Employer I.D.No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirementsfor the past 90 days. Yes X No
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer: Large Accelerated Filer X Accelerated Filer Non-Accelerated Filer
Indicate by check mark whether the Registrant is a shell company. Yes No X
As of August 1, 2006, there were 78,613,014 shares of the Registrant's Common Stock outstanding, excluding9,953,392 shares owned by a subsidiary.
TABLE OF CONTENTS
Page
AMERICAN FINANCIAL GROUP, INC. 10-Q
PART I
ITEM I - FINANCIAL STATEMENTS
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (unaudited)
(Dollars In Thousands)
June 30,
December 31,
2006
2005
Assets:
Cash and cash equivalents
$ 595,262
$ 471,849
Investments:
Fixed maturities:
Available for sale - at fair value
(amortized cost - $14,574,674 and $14,272,314)
14,180,374
14,326,614
Trading - at fair value
273,509
271,851
Other stocks - at fair value
(cost - $544,310 and $501,459)
611,410
556,659
Policy loans
257,910
258,744
Real estate and other investments
480,524
338,254
Total cash and investments
16,398,989
16,223,971
Recoverables from reinsurers and prepaid
reinsurance premiums
3,203,039
3,263,128
Agents' balances and premiums receivable
698,956
574,882
Deferred policy acquisition costs
1,181,076
1,139,515
Other receivables
301,407
388,078
Variable annuity assets (separate accounts)
649,810
643,506
Prepaid expenses, deferred charges and other assets
502,452
416,030
Goodwill
166,882
$23,102,611
$22,815,992
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 5,863,639
$ 5,790,709
Unearned premiums
1,795,205
1,643,954
Annuity benefits accumulated
8,802,800
8,417,298
Life, accident and health reserves
937,537
1,088,016
Payable to reinsurers
264,108
298,664
Long-term debt
901,571
999,703
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,163,095
1,215,490
Total liabilities
20,377,765
20,097,340
Minority interest
249,543
261,110
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 78,580,696 and 78,067,514 shares outstanding
78,581
78,068
Capital surplus
1,222,813
1,194,600
Retained earnings
1,333,609
1,134,074
Unrealized gain (loss) on marketable securities, net
(159,700
50,800
Total shareholders' equity
2,475,303
2,457,542
2
CONSOLIDATED STATEMENT OF EARNINGS (unaudited)
(In Thousands, Except Per Share Data)
Three months ended
Six months ended
Income:
Property and casualty insurance premiums
$615,022
$575,335
$1,194,106
$1,124,434
Life, accident and health premiums
75,506
92,389
157,549
184,445
Investment income
233,461
212,451
465,364
426,658
Realized gains (losses) on securities
(7,482)
22,094
22,330
16,555
Other income
78,448
81,757
151,740
158,067
994,955
984,026
1,991,089
1,910,159
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
373,357
358,802
710,468
707,180
Commissions and other underwriting
expenses
168,620
157,415
341,956
316,306
Annuity benefits
83,536
84,119
166,811
164,881
Life, accident and health benefits
67,030
69,607
134,194
138,578
Annuity and supplemental insurance
acquisition expenses
30,179
32,841
63,760
68,243
Interest charges on borrowed money
17,107
20,053
35,607
39,633
Other operating and general expenses
108,534
112,997
221,868
222,596
848,363
835,834
1,674,664
1,657,417
Operating earnings before income taxes
146,592
148,192
316,425
252,742
Provision for income taxes
41,707
54,148
101,289
89,336
Net operating earnings
104,885
94,044
215,136
163,406
Minority interest expense
(7,171)
(8,778)
(15,044)
(14,681)
Equity in net losses of investee,
net of tax
(528
(4,394
(978
(4,838
Earnings from continuing operations
97,186
80,872
199,114
143,887
Discontinued operations, net of tax
25,664
753
25,246
613
Net Earnings
$122,850
$ 81,625
$ 224,360
$ 144,500
Basic earnings per Common Share:
Continuing operations
$1.24
$1.05
$2.54
$1.87
Discontinued operations
.32
.01
Net earnings available to Common Shares
$1.56
$1.06
$2.86
$1.88
Diluted earnings per Common Share:
$1.21
$1.03
$2.48
$1.84
$1.53
$1.04
$2.80
$1.85
Average number of Common Shares:
Basic
78,540
77,102
78,396
76,920
Diluted
80,278
78,230
79,831
78,031
Cash dividends per Common Share
$.1375
$.125
$.275
$.25
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (unaudited)
(Dollars in Thousands)
Common Stock
Unrealized
Common
and Capital
Retained
Gain (Loss)
Shares
Surplus
Earnings
on Securities
Total
Balance at January 1, 2006
78,067,514
$1,272,668
$1,134,074
$ 50,800
$2,457,542
Net earnings
-
224,360
Change in unrealized
(210,500)
(210,500
Comprehensive income
13,860
Dividends on Common Stock
(21,534)
Shares issued:
Exercise of stock options
511,698
17,415
Dividend reinvestment plan
66,359
2,564
Employee stock purchase plan
12,511
511
Deferred compensation distributions
42,108
1,646
Directors fees paid in stock
8,520
365
Shares tendered in option exercises
(128,014)
(2,100)
(3,291)
(5,391)
Stock-based compensation expense
3,311
Capital transactions of subsidiaries
1,172
Other
3,842
Balance at June 30, 2006
78,580,696
$1,301,394
$1,333,609
($159,700)
$2,475,303
Balance at January 1, 2005
76,634,204
$1,222,507
$ 976,340
$231,700
$2,430,547
144,500
(5,500)
(5,500
139,000
(19,202)
783,988
20,538
106,050
2,982
14,105
438
Retirement plan contributions
76,431
2,373
7,374
222
9,320
300
(401,784)
(6,415)
(6,015)
(12,430)
(7,315)
779
Balance at June 30, 2005
77,229,688
$1,236,409
$1,095,623
$226,200
$2,558,232
4
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Thousands)
Operating Activities:
Adjustments:
Equity in net losses of investee
978
4,838
20,813
14,814
Depreciation and amortization
77,309
100,240
Realized gains on investing activities
(84,141)
(25,607)
Net purchases/sales of trading securities
(13,040)
9,596
Deferred annuity and life policy acquisition costs
(66,860)
(62,719)
Decrease in reinsurance and other receivables
29,347
233,269
Decrease (increase) in other assets
17,747
(17,521)
Increase in insurance claims and reserves
243,022
82,467
Decrease in payable to reinsurers
(34,859)
(229,396)
Increase (decrease) in other liabilities
(82,822)
75,181
Other, net
11,708
17,035
Net cash provided by operating activities
510,373
511,578
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(1,635,403)
(2,287,028)
Equity securities
(125,793)
(124,173)
Subsidiary
(2,620)
Real estate, property and equipment
(23,206)
(62,566)
Maturities and redemptions of fixed maturity
investments
499,544
620,182
Sales of:
824,318
1,161,516
113,841
86,422
37,500
34,352
11,783
Cash and cash equivalents of businesses
acquired or sold, net
99,960
Increase in other investments
(29,912
(2,330
Net cash used in investing activities
(207,419
(596,194
Financing Activities
Fixed annuity receipts
515,414
452,401
Annuity surrenders, benefits and withdrawals
(591,995)
(446,860)
Net transfers from variable annuity assets
7,152
4,668
Additional long-term borrowings
26,197
100
Reductions of long-term debt
(130,733)
(17,717)
Issuances of Common Stock
11,798
6,683
Subsidiary's issuance of stock in public offering
40,391
Cash dividends paid on Common Stock
(18,970)
(16,220)
1,596
(3,084
Net cash provided by (used in) financing activities
(179,541
20,362
Net Increase (Decrease) in Cash and Cash Equivalents
123,413
(64,254)
Cash and cash equivalents at beginning of period
471,849
861,742
Cash and cash equivalents at end of period
$ 797,488
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
E.
B.
F.
G.
C.
H.
D.
I.
________________________________________________________________________________
Basis of Presentation
Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
Investments
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced.
Derivatives
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
The terms of the interest rate swaps match those of the debt; therefore, the swaps are considered to be (and are accounted for as) 100% effective fair value hedges. Both the swaps and the hedged debt are adjusted for changes in fair value by offsetting amounts. Accordingly, since the swaps are included with long-term debt in the Balance Sheet, the only effect on AFG's financial statements is that the interest expense on the hedged debt is recorded based on the variable rate.
Insurance
Reinsurance
Subsidiaries of AFG's 81%-owned subsidiary, Great American Financial Resources, Inc. ("GAFRI"), cede life insurance policies to a third party on a funds withheld basis whereby GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. GAFRI classifies the securities related to these transactions as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of t he related trading portfolios.
Deferred Policy Acquisition Costs ("DPAC")
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the
7
change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in "Unrealized gain (loss) on marketable securities, net" in the shareholders' equity section of the Balance Sheet.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
DPAC includes the present value of future profits on business in force of insurance companies acquired by GAFRI, which represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The present value of future profits is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
Annuity and Supplemental Insurance Acquisition Expenses
Unpaid Losses and Loss Adjustment Expenses
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Annuity Benefits Accumulated
Life, Accident and Health Reserves
8
Variable Annuity Assets and Liabilities
Premium Recognition
Payable to Subsidiary Trusts
Minority Interest
Income Taxes
Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized.
Stock-Based Compensation
Prior to the implementation of SFAS No. 123(R), AFG accounted for stock options and other stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under this method, no compensation expense
9
for stock option grants was recognized because options are granted at exercise prices equal to the fair value of the shares at the dates of grant. See Note F - "Shareholders' Equity" for further information on stock options.
Benefit Plans
AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.
Earnings Per Share
Statement of Cash Flows
Chatham Bars Inn
Old Standard Life Fixed Annuity Business
Great American Life Assurance Company of Puerto Rico
10
Farmers Crop Insurance Alliance, Inc.
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes inland and ocean marine, agricultural-related business and commercial automobile, (ii) Specialty casualty, which includes executive and professional liability, umbrella and excess liability and excess and surplus, (iii) Specialty financial, which includes fidelity and surety bonds and collateral protection, and (iv) California workers' compensation. AFG's annuity and supplemental insurance business markets primarily retirement annuities and various forms of supplemental insurance. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
11
The following tables (in thousands) show AFG's revenues and operating earnings before income taxes by significant business segment and sub-segment.
Revenues (a)
Premiums earned:
Specialty
Property and transportation
$225,106
$201,586
$ 425,109
$ 369,657
Specialty casualty
197,303
182,897
385,518
367,064
Specialty financial
97,468
86,652
193,691
178,422
California workers' compensation
75,812
86,577
153,127
173,901
18,826
16,604
35,557
33,011
Other lines
507
1,019
1,104
2,379
615,022
575,335
1,194,106
1,124,434
81,107
70,116
160,636
138,485
Realized gains
1,270
8,449
27,323
9,296
50,864
51,462
97,898
103,030
748,263
705,362
1,479,963
1,375,245
Annuities and supplemental insurance:
150,407
141,574
300,801
286,734
Realized gains (losses)
(8,796)
13,582
(5,075)
13,627
21,679
22,092
46,259
41,796
238,796
269,637
499,534
526,602
7,896
9,027
11,592
8,312
$994,955
$984,026
$1,991,089
$1,910,159
Operating Earnings Before Income Taxes
Underwriting:
$ 31,114
$ 38,518
$ 73,165
$ 67,459
28,355
7,666
42,974
14,234
603
(7,838)
1,415
(11,906)
16,326
21,542
28,840
34,564
488
612
329
(557)
(3,841
(1,382
(5,041
(2,846
73,045
59,118
141,682
100,948
Investment income, realized gains
and other
75,305
66,277
173,158
132,163
148,350
125,395
314,840
233,111
Annuities and supplemental insurance
18,570
40,661
48,083
66,590
Other (b)
(20,328
(17,864
(46,498
(46,959
$146,592
$148,192
$ 316,425
$ 252,742
(a) Revenues include sales of products and services as well as other income
earned by the respective segments.
(b) Includes holding company expenses.
Included in deferred policy acquisition costs in AFG's Balance Sheet are $44.2 million and $54.1 million at June 30, 2006, and December 31, 2005,
12
respectively, representing the present value of future profits ("PVFP") related to acquisitions by AFG's annuity and supplemental insurance business. The PVFP amounts are net of $64.7 million and $82.5 million of accumulated amortization. The decrease in PVFP reflects the January 2006 sale of GAPR. Amortization of the PVFP was $1.6 million in the second quarter and $3.3 million in the first six months of 2006 and $2.2 million in the second quarter and $5.9 million in the first six months of 2005, respectively.
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$199,433
$226,052
AFG Senior Convertible Notes due June 2033
189,857
AFG 7-1/8% Senior Debentures due February 2034
115,000
AFG 7-1/8% Senior Debentures due December 2007
59,493
3,777
3,768
567,560
594,170
Subsidiaries
GAFRI 7-1/2% Senior Debentures due November 2033
112,500
GAFRI 7-1/4% Senior Debentures due January 2034
86,250
GAFRI 6-7/8% Senior Notes due June 2008
36,390
100,000
Notes payable secured by real estate
26,003
33,112
American Premier Underwriters 10-7/8% Subordinated
Notes due May 2011
8,094
8,125
7,814
8,586
277,051
348,573
Payable to Subsidiary Trusts:
GAFRI 8-7/8% Subordinated Debentures due
January 2027
21,960
GAFRI 7.35% Subordinated Debentures due May 2033
20,000
National Interstate Variable Rate Subordinated
Debentures due May 2033
15,000
56,960
$901,571
$999,703
At June 30, 2006, sinking fund and other scheduled principal payments on debt for the balance of 2006 and the subsequent five years were as follows: 2006 - $.5 million; 2007 - $60.8 million; 2008 - $36.9 million; 2009 - $200.5 million; 2010 - $2.2 million; and 2011 - $8.2 million.
During the first six months of 2006, AFG repurchased $26.8 million of its 7-1/8% Debentures due 2009 for $28.3 million in cash and GAFRI repurchased $63.6 million of its 6-7/8% Notes for $65.8 million in cash.
In March 2006, AFG and GAFRI replaced their existing credit agreements with a new five-year revolving credit facility under which they can borrow a combined $500 million. AFG and GAFRI have agreed not to borrow more than $325 million and $200 million, respectively, under the credit facility and AFG has agreed to guarantee amounts borrowed by GAFRI. Amounts borrowed bear interest at rates ranging from 0.5% to 1.25% over LIBOR based on AFG's credit rating.
To achieve a desired balance between fixed and variable rate debt, GAFRI has entered into interest rate swaps that effectively convert its 6-7/8% fixed rate Senior Notes to a floating rate of 3-month LIBOR plus 2.9%. In connection with
13
the 2006 debt repurchases discussed above, GAFRI paid an additional $1.9 million to effectively terminate the portion of the interest rate swaps that covered the repurchased debt.
AFG's Senior Convertible Notes were issued at a price of 37.153% of the principal amount due at maturity. Interest is payable semiannually at a rate of 4% of issue price per year through June 2008, after which interest at 4% annually will be accrued and added to the carrying value of the Notes. The Notes are redeemable at AFG's option at any time on or after June 2, 2008, at accreted value ranging from $371.53 per Note to $1,000 per Note at maturity. Generally, holders may convert each Note into 11.5016 shares of AFG Common Stock (at $32.30 per share currently) (i) if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value ($38.76 per share currently) for a specified period, (ii) if the credit rating of the Notes is significantly lowered, or, (iii) if AFG calls the notes for redemption. Based on the market price of AFG's Common Stock during the quarter ended June 30, 2006, the Notes are currently convertible through Septem ber 30, 2006. AFG intends to deliver cash in lieu of Common Stock upon conversion of the Notes; accordingly, shares issuable upon conversion of the Notes are not treated as dilutive.
Stock Incentive Plans
At June 30, 2006, there were 11.1 million shares of AFG Common Stock reserved for issuance under AFG's stock incentive plan. Options generally become exercisable at the rate of 20% per year commencing one year after grant; those granted to non-employee directors of AFG are fully exercisable upon grant. Options expire ten years after the date of grant. Data for stock options issued under AFG's stock incentive plans is presented below:
Average
Aggregate
Remaining
Intrinsic
Exercise
Contractual
Value
Price
Term
(in millions)
Outstanding at January 1, 2006
6,389,288
$28.14
Granted
936,450
$40.31
Exercised
(511,698)
$31.76
Forfeited/Cancelled
(20,700
$35.58
Outstanding at June 30, 2006
6,793,340
$29.52
5.9 years
$90.9
Options exercisable June 30, 2006
4,172,550
$27.90
4.3 years
$62.7
Options and other awards available
for grant at June 30, 2006
4,331,366
The total intrinsic value of options exercised during the six months ended June 30, 2006 and 2005 was $4.7 million and $5.8 million, respectively. During the six months ended June 30, 2006, AFG received $10.9 million in cash from the exercise of stock options. The total tax deduction related to the exercises was $3.4 million.
14
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility (after consideration of other factors). AFG began using the SEC's simplified method of calculating expected term with its 2006 grants. The fair value of options granted in the first six months of 2006 and 2005 was $9.98 per share and $9.66 per share, respectively, based on the following assumptions:
Expected dividend yield
1-1/2%
2%
Expected volatility
19%
28%
Expected term (in years)
6.5
8.4
Risk-free rate
4.6%
4.3%
Total compensation expense related to stock incentive plans for the second quarter and first six months of 2006 was $2.6 million and $4.8 million, respectively. Related tax benefits totaled $529,000 for the quarter and $972,000 for the six months. Included in these totals are $717,000 for the quarter and $1.5 million for the six months in compensation expense and $117,000 for the quarter and $235,000 for the six months in tax benefits related to stock incentive plans of two AFG subsidiaries. As of June 30, 2006, there was a total of $20.9 million of total unrecognized compensation expense related to nonvested stock options granted under AFG's plans. That cost is expected to be recognized over a weighted average of 3.6 years.
The following table illustrates the effect on net earnings (in thousands) and earnings per share for the second quarter and first six months of 2005, had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the method used beginning in 2006.
Second
Six
Quarter
Months
Net earnings, as reported
$81,625
$144,500
Pro forma stock option expense, net of tax
(1,784
(3,433
Adjusted net earnings
$79,841
$141,067
Earnings per share (as reported):
Earnings per share (adjusted):
$1.83
$1.82
15
A summary of the hotel operations sold follows (in millions):
Operations:
Revenue
$ 2.4
$10.6
$ 3.9
$16.5
Pretax earnings (loss)
(.2)
1.4
(1.0)
1.2
Provision (benefit) for income taxes
(.1)
.5
(.3)
(.1
.1
Earnings (loss) from discontinued
operations
.8
(.6)
.6
Gain on sale, net of tax (*)
25.8
$25.7
$ .8
$25.2
$ .6
(*) After transaction costs, contingencies, the write-off of certain
deferred annuity acquisition costs associated with the gain recognition
and minority interest.
On August 7, 2006, GAFRI acquired Ceres Group, Inc. for $204.4 million, using cash on hand and borrowings under its bank line of credit. Ceres sells health and life insurance products through two primary business segments and had assets of approximately $770 million at December 31, 2005. Its senior segment includes Medicare supplement and other senior health, life and annuity products for Americans age 55 and over. The medical segment includes major medical health insurance for individuals, families, associations and small businesses.
In connection with the acquisition, Ceres entered into reinsurance agreements under which all of its medical business and half of its in-force senior business were ceded to unaffiliated companies. Following the acquisition, Ceres paid a $60 million return of capital distribution to GAFRI, a portion of which is expected to be used to repay all amounts borrowed under its bank line in connection with the acquisition.
16
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
17
Results of Operations
23
Overview
General
Critical Accounting Policies
18
Income Items
Liquidity and Capital Resources
19
Expense Items
26
Sources of Funds
Recent Accounting Standard
27
20
Proposed Accounting Standard
28
Uncertainties
_____________________________________________________________________________________________________
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Some of the forward-looking statements can be identified by the use of words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate increases; and improved loss experience.
Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:
The forward-looking statements herein are made only as of the date of this report. The Company assumes no obligation to publicly update any forward-looking statements.
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings,
of Financial Condition and Results of Operations - Continued
shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, because most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
At June 30, 2006, AFG (parent) had approximately $120 million in cash and securities and no amounts borrowed under its bank line of credit.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance and in the sale of retirement annuities and supplemental insurance products.
AFG's net earnings for the second quarter and first six months of 2006 were $122.9 million ($1.53 per share, diluted) and $244.4 million ($2.80 per share), respectively. Net earnings for the three and six month periods of 2005 were $81.6 million ($1.04 per share) and $144.5 million ($1.85 per share), respectively. The improvement in both periods reflects continued improvement in property and casualty underwriting results, a gain on the sale of a resort hotel, higher investment income and the favorable resolution of tax issues. Results for the second quarter of 2005 also included net realized gains on securities compared to net realized losses in the 2006 quarter.
CRITICAL ACCOUNTING POLICIES
Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. The areas where management believes the degree of judgment required to determine amounts recorded in the financial statements make accounting policies critical are as follows:
For a discussion of these policies, see Management's Discussion and Analysis - "Critical Accounting Policies" in AFG's 2005 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
AFG's debt to total capital ratio on a consolidated basis is shown below (dollars in millions).
2004
$ 902
$1,000
$1,106
Total capital (*)
3,829
3,703
3,575
Ratio of debt to total capital
23.5%
27.0%
30.9%
(*) Includes long-term debt, minority interest and
shareholders' equity (excluding unrealized gains (losses)
related to fixed maturity investments).
Parent Holding Company Liquidity
Under a currently effective shelf registration statement, AFG can offer additional equity or debt securities, including 2.3 million shares of common stock under an equity distribution agreement with UBS Securities LLC. The shelf registration provides AFG with greater flexibility to access the capital markets from time to time as market and other conditions permit.
During the first six months of 2006, AFG repurchased $26.8 million of its 7-1/8% Debentures due 2009 for $28.3 million in cash.
Subsidiary Liquidity
During the first six months of 2006, GAFRI repurchased $63.6 million of its 6-7/8% Senior Notes due 2008 for $65.8 million in cash.
The liquidity requirements of AFG's insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In GAFRI's annuity business, where profitability is largely dependent on earning a "spread" between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on GAFRI's annuity products. With declining rates, GAFRI receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies.
Approximately 94% of the fixed maturities held by AFG at June 30, 2006, were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and noninvestment grade. Management believes that a high quality investment portfolio should generate a stable and predictable investment return.
Since fixed maturities and stocks are carried at fair value in the balance sheet, there is virtually no effect on financial condition upon the sale and ultimate realization of unrealized gains and losses.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at June 30, 2006, is shown in the following table (dollars in millions). Approximately $114 million of available for sale "Fixed maturities" had no unrealized gains or losses at June 30, 2006.
Securities
With
Gains
Losses
Available for sale Fixed Maturities
Fair value of securities
$2,217
$11,849
Amortized cost of securities
$2,139
$12,322
Gross unrealized gain (loss)
$ 78
($ 473)
Fair value as % of amortized cost
104%
96%
Number of security positions
663
1,901
Number individually exceeding
$2 million gain or loss
1
Concentration of gains (losses) by type or
industry (exceeding 5% of unrealized):
Mortgage-backed securities
$ 8.9
($196.0)
Banks, savings and credit institutions
5.6
(58.5)
U.S. Government and government agencies
1.0
(29.7)
Insurance companies
3.5
(29.3)
State and municipal
3.6
(26.9)
Gas and electric services
8.7
(25.7)
Air transportation and courier services
10.8
(0.7)
Percentage rated investment grade
82%
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at June 30, 2006, based on their fair values. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Maturity
One year or less
8%
After one year through five years
41
22
After five years through ten years
33
After ten years
91
63
37
21
AFG realized aggregate losses of $6.6 million during the first six months of 2006 on $149.1 million in sales of fixed maturity securities (five issues/issuers) that had individual unrealized losses greater than $500,000 at December 31, 2005. These securities were "AAA" rated mortgage-backed securities that decreased in fair value by an aggregate of $3.0 million from year-end 2005 to the sale date due to an increase in the general level of interest rates.
Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains.
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Fair
Value as
% of Cost
Basis
Fixed Maturities at June 30, 2006
Securities with unrealized gains:
Exceeding $500,000 (35 issues)
$ 203
$ 30
117%
Less than $500,000 (628 issues)
2,014
48
102
$ 2,217
Securities with unrealized losses:
Exceeding $500,000 (286 issues)
$ 5,043
($280)
95%
Less than $500,000 (1,615 issues)
6,806
(193
97
($473)
The following table summarizes (dollars in millions) the unrealized loss for all fixed maturity securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
Fixed Maturities with Unrealized
Losses at June 30, 2006
Investment grade with losses for:
One year or less (1,425 issues)
$ 9,390
($358)
Greater than one year (365 issues)
1,971
(99
95
$11,361
($457)
Non-investment grade with losses for:
One year or less (85 issues)
$ 390
($ 10)
98%
Greater than one year (26 issues)
98
(6
94
$ 488
($ 16)
97%
When a decline in the value of a specific investment is considered to be "other than temporary," a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced. The determination of whether unrealized losses are "other than temporary" requires judgment based on subjective as well as objective factors. A listing of factors considered and resources used is contained in the discussion of "Investments" under Management's Discussion and Analysis in AFG's 2005 Form 10-K.
Based on its analysis, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they mature or recover in value. Should either of these beliefs change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
RESULTS OF OPERATIONS
Operating earnings before income taxes for the second quarter of 2006 were comparable to the second quarter of 2005 as a $13.9 million improvement in property and casualty underwriting results and a $21 million increase in investment income were offset by a $29.6 million decline in realized gains on securities and lower earnings in GAFRI's supplemental insurance operations.
Six-month pretax operating earnings improved $63.7 million compared to 2005 reflecting a $40.7 million improvement in property and casualty underwriting results and a $38.7 million increase in investment income partially offset by lower earnings in GAFRI's supplemental insurance operations.
Property and Casualty Insurance - Underwriting
Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their financial statements better understand the company's performance. See Note C - "Segments of Operations" for the detail of AFG's operating profit by significant business segment.
Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of underwriting losses, loss adjustment expenses and underwriting expenses to premiums. A combined ratio under 100% is indicative of an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.
Premiums and combined ratios for AFG's Specialty property and casualty insurance operations were as follows (dollars in millions):
Gross Written Premiums (GAAP)
Specialty:
$400.6
$312.9
$ 718.4
$ 590.3
366.9
363.6
742.0
721.1
134.5
118.8
253.6
234.5
75.6
92.3
160.2
196.3
1.9
2.4
(.3
3.7
Total Specialty
$979.5
$890.0
$1,873.9
$1,745.9
Net Written Premiums (GAAP)
$268.1
$235.3
$ 498.8
$ 437.8
205.9
189.4
408.0
375.1
104.7
90.7
197.4
186.8
71.6
82.8
151.2
176.3
21.4
17.0
39.6
32.0
$671.7
$615.2
$1,295.0
$1,208.0
Combined Ratios (GAAP)
86.2%
80.9%
82.7%
81.8%
85.6
95.8
88.8
96.1
99.4
109.0
99.3
106.6
78.5
75.1
81.2
80.1
97.4
96.3
99.1
101.7
87.5%
89.4%
87.7%
90.8%
(a)
AFG's aggregate combined ratio, including other (primarily runoff) lines, was 88.1% and 89.7% for the quarter ended June 30, 2006 and 2005 and 88.1% and 91.0% for the six months ended June 30, 2006 and 2005, respectively.
Net written premiums for the specialty insurance operations increased 9% for the second quarter and 7% for the six months compared to the same periods in 2005. Significant premium growth from the Property and transportation and Specialty casualty groups were partially offset by a decline in the California workers' compensation premiums. The specialty insurance operations generated an underwriting profit of $76.9 million in the 2006 second quarter, $16.4 million higher than the 2005 quarter. The combined ratio improved nearly two points compared to the 2005 quarter despite approximately $11.6 million (1.9 points) of catastrophe losses, principally from tornadoes in the Midwest, compared to about $6 million (1 point) of such losses in the 2005 second quarter. Underwriting profit for the first half of 2006 was $146.7 million, 41% above the 2005 period, reflecting the positive impact of favorable reserve development within the Specialty casualt y and Property and transportation groups.
Property and transportation net written premiums for the second quarter and six months of 2006 increased 14% over each of the 2005 periods due primarily to growth in the property and inland marine operations, new premium volume from the 2005 acquisition of Farmers Crop Insurance Alliance and higher commodity prices used to establish 2006 crop insurance coverages. This group's underwriting results for
24
the 2006 second quarter include about 4.2 points from the Midwest storm losses compared to about 2 points of catastrophe losses in the 2005 period. Most of the lines of business in this group continue to report excellent profitability. Even though this group's combined ratio of 82.7% for the first half of 2006 is up about a point compared to the 2005 period, underwriting profit is 8% higher due to profitable premium growth.
Due to recent upward revisions in industry models of correlated catastrophe exposure associated with writing both workers' compensation and excess property coverage in California, AFG decided to stop writing most of its earthquake-exposed excess property coverage in California effective in April 2006. This excess property business had net written premiums of $17 million in 2005. Prior to this action, AFG's excess property and California workers' compensation exposure to a catastrophic earthquake that models indicate could occur once in every 500 years (a "500-year event") was less than 10% of AFG's shareholders' equity. Once the existing excess property policies expire, AFG's exposure to a California earthquake 500-year event will be reduced to less than 1% of AFG's equity.
Specialty casualty net written premiums for the 2006 second quarter and six-month period were 9% higher than in the respective 2005 periods due primarily to volume growth as well as lower premiums ceded under reinsurance agreements, principally in the executive liability operation and excess and surplus lines. This group's combined ratio improved 10.2 points for the second quarter as 2006 results include a half of a point of favorable reserve development while the 2005 quarter includes 6.7 points of unfavorable reserve development primarily in the executive and professional liability operations. The 7.3 point improvement in the combined ratio for the six months of 2006 compared to 2005 reflects strong underwriting profits in the executive liability operations, excess and surplus lines and coverage for not-for-profit businesses.
Specialty financial net written premiums for the 2006 second quarter were 15.5% higher than the 2005 second quarter as growth in the surety and fidelity operations and financial institution services more than offset premium declines in the residual value business, which is being placed in run-off as the remaining contracts expire. Through the first half of the year, net written premiums were up about 6% compared to the same 2005 period. This group continued to be profitable through the first half of the year. The combined ratio for the second quarter and first six months of 2006 improved 9.6 points and 7.3 points, respectively, over the 2005 periods. This improvement reflects a significant reduction in losses from the residual value business.
California workers' compensation net written premiums for the second quarter and first six months of 2006 were 14% below the 2005 periods, reflecting the effect of lower rates, partly offset by good business retention and volume growth. Underwriting margins continue to benefit from an improved claim environment resulting from the workers' compensation reforms enacted in California.
Life, Accident and Health Premiums and Benefits
25
the independent agent and captive agent channels. Prior to the Ceres acquisition, GAFRI's supplemental insurance products were sold through relatively few national marketing organizations.
Investment Income
Realized Gains (Losses)
Realized gains (losses) on securities include provisions for other than temporary impairment of securities still held as follows: second quarter of 2006 and 2005 - $2.8 million and $5.7 million; six months of 2006 and 2005 - $5.8 million and $7.6 million, respectively.
Real Estate Operations
$24.0
$24.8
$45.1
$42.2
17.1
14.5
31.5
28.9
.3
.7
Minority interest expense, net
2.2
.9
Other income includes net pretax gains on the sale of real estate assets of $6.2 million in the second quarter and $13.2 million in the first six months of 2006 and $6.4 million and $9.0 million for the 2005 periods.
Real Estate Operations - Discontinued
Annuity Benefits
Annuity benefits for the second quarter and six months of 2006 were comparable to the 2005 periods as the effect of internal growth and the acquisition of Old Standard Life fixed annuity business were offset by lower average effective crediting rates and the sale of GAPR.
Significant changes in projected investment yields could result in charges (or credits) to earnings in the period the projections are modified.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and run-off life insurance lines of business. Unanticipated spread compression, decreases in the stock market, and adverse mortality experience could lead to write-offs of DPAC in the future.
Interest Expense
Interest expense decreased $2.9 million (15%) for the second quarter and $4.0 million (10%) for the six months due primarily to the retirement of debt during the first half of 2006 and late 2005, partially offset by a higher effective interest rate on GAFRI's floating rate debt.
Other Operating and General Expenses
Recent Account Standard
Convertible Notes
_________________________________________________________________
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
As of June 30, 2006, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2005 Form 10-K.
ITEM 4
Controls and Procedures
AFG's management, with participation of its Co-Chief Executive Officers and its principal financial officer, has evaluated AFG's disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG's Co-CEOs and principal financial officer concluded that these disclosure controls and procedures were effective.
In the ordinary course of business, AFG and its subsidiaries routinely enhance their information systems by either upgrading current systems or implementing new systems. There has been no change in AFG's business processes and procedures during the second fiscal quarter of 2006 that has materially affected, or is reasonably likely to materially affect, AFG's internal controls over financial reporting.
PART II
OTHER INFORMATION
Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
Submission of Matters to a Vote of Security Holders
AFG's Annual Meeting of Shareholders was held on May 18, 2006; there were three matters voted upon: (Item 1) election of nine directors, (Item 2) ratifying Ernst & Young LLP as independent registered public accounting firm and (Item 3) shareholder proposal regarding political contributions.
The votes cast for, against, withheld and the number of abstentions and brokernon-votes as to each matter voted on at the 2006 Annual Meeting is set forth below:
Broker
Name
For
Against
Withheld
Abstain
Non-Votes
Item 1
Kenneth C. Ambrecht
70,459,507
N/A
446,237
Theodore H. Emmerich
70,124,444
781,300
James E. Evans
68,983,775
1,921,969
Terry S. Jacobs
70,542,414
363,330
Carl H. Lindner
68,226,598
2,679,146
Carl H. Lindner III
68,710,887
2,194,857
S. Craig Lindner
68,967,786
1,937,958
William R. Martin
70,126,498
779,246
William W. Verity
70,063,940
841,804
Item 2
70,660,274
215,758
29,712
Item 3
12,841,876
50,992,738
2,525,497
4,545,633
N/A - Not Applicable
ITEM 6
Exhibits
Number
Exhibit Description
Certification of the Co-Chief Executive Officer pursuant
to section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to
section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Co-Chief Executive Officers and Chief
Financial Officer pursuant to section 906 of the Sarbanes-
Oxley Act of 2002.
29
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, American Financial Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned duly authorized.
American Financial Group, Inc.
August 8, 2006
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)
30