UNITED STATES 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 EndedMarch 31, 2010
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes No
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or asmaller reporting company: Large Accelerated Filer X Accelerated Filer Non-Accelerated Filer Smaller Reporting Company
Indicate by check mark whether the Registrant is a shell company. Yes No X
As of May 1, 2010, there were 111,207,961 shares of the Registrant's Common Stock outstanding, excluding14.9 million shares owned by subsidiaries.
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 Millions)
March 31,
December 31,
2010
2009
Assets:
Cash and cash equivalents
$ 1,170
$ 1,120
Investments:
Fixed maturities, available for sale at fair value
(amortized cost - $17,125 and $16,730)
17,562
16,823
Fixed maturities, trading at fair value
381
372
Equity securities, at fair value (cost - $232 and $228)
410
411
Mortgage loans
376
Policy loans
271
276
Real estate and other investments
407
413
Total cash and investments
20,611
19,791
Recoverables from reinsurers
3,182
3,511
Prepaid reinsurance premiums
371
Agents' balances and premiums receivable
547
554
Deferred policy acquisition costs
1,425
1,570
Assets of managed investment entities
2,478
-
Other receivables
333
542
Variable annuity assets (separate accounts)
574
549
Other assets
561
577
Goodwill
208
Total Assets
$30,290
$27,683
Liabilities and Equity:
Unpaid losses and loss adjustment expenses
$ 6,160
$ 6,412
Unearned premiums
1,532
1,568
Annuity benefits accumulated
11,540
11,335
Life, accident and health reserves
1,604
1,603
Payable to reinsurers
357
462
Liabilities of managed investment entities
2,243
Long-term debt
824
828
Variable annuity liabilities (separate accounts)
Other liabilities
1,149
1,007
Total liabilities
25,983
23,764
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 111,129,916 and 113,386,343 shares outstanding
111
113
Capital surplus
1,212
1,231
Retained Earnings:
Appropriated - managed investment entities
225
Unappropriated
2,327
2,274
Accumulated other comprehensive income, net of tax
290
163
Total shareholders' equity
4,165
3,781
Noncontrolling interests
142
138
Total equity
4,307
3,919
Total liabilities and equity
2
CONSOLIDATED STATEMENT OF EARNINGS (unaudited)
(In Millions, Except Per Share Data)
Three months ended
Income:
Property and casualty insurance premiums
$ 579
$ 575
Life, accident and health premiums
115
109
Investment income
295
300
Realized gains (losses) on securities (*)
4
(41)
Income (loss) of managed investment entities:
22
Loss on change in fair value of assets/liabilities
(25)
Other income
44
63
1,034
1,006
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
304
272
Commissions and other underwriting expenses
204
199
Annuity benefits
108
Life, accident and health benefits
96
91
Annuity and supplemental insurance acquisition expenses
49
52
Interest charges on borrowed money
18
16
Expenses of managed investment entities
9
Other operating and general expenses
99
100
887
838
Operating earnings before income taxes
147
168
Provision for income taxes
59
58
Net earnings, including noncontrolling interests
88
110
Less: Net earnings (loss) attributable to
noncontrolling interests
(18
6
Net Earnings Attributable to Shareholders
$ 106
$ 104
Earnings Attributable to Shareholders per Common Share:
Basic
$.94
$.90
Diluted
$.93
$.88
Average number of Common Shares:
112.0
115.7
113.1
116.4
Cash dividends per Common Share
$.1375
$.13
(*)
Consists of the following:
Realized gains before impairments
$25
$ 35
Losses on securities with impairment
(14)
(184)
Non-credit portion recognized in other
comprehensive income (loss)
(7
Impairment charges recognized in earnings
(21
(76
Total realized gains (losses) on securities
$ 4
($ 41)
3
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (unaudited)
(Dollars in Millions)
Shareholders' Equity
Common Stock
Accum.
Noncon-
Common
and Capital
Retained Earnings
Other Comp
trolling
Total
Shares
Surplus
Appro.
Unappro.
Inc.(Loss)
Interests
Equity
Balance at December 31, 2009
113,386,343
$1,344
$ -
$2,274
$163
$3,781
$138
$3,919
Cumulative effect of accounting change
245
(4)
Net earnings
106
(18)
Other comprehensive income net of tax:
Change in unrealized gain on
securities
127
129
Change in foreign currency translation
1
5
Total comprehensive income
237
(15)
222
Allocation of losses of managed
investment entities
(20)
20
Dividends on Common Stock
(16)
Shares issued:
Exercise of stock options
312,661
Other benefit plans
337,993
Dividend reinvestment plan
4,753
Other stock-based compensation expense
Shares acquired and retired
(2,911,834)
(34)
(75)
Other
(1
Balance at March 31, 2010
111,129,916
$1,323
$ 225
$2,327
$290
$4,165
$142
$4,307
Balance at December 31, 2008
115,599,169
$1,351
$1,842
($703)
$2,490
$112
$2,602
17
(17)
104
Other comprehensive income (loss),
net of tax:
Change in unrealized gain (loss)
on securities
(1)
(4
84
89
Benefit plans
116,331
5,754
Stock-based compensation expense
Balance at March 31, 2009
115,721,254
$1,355
$1,948
($740)
$2,563
$116
$2,679
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
Operating Activities:
$ 88
$ 110
Adjustments:
Depreciation and amortization
47
Realized (gains) losses on investing activities
41
Net purchases of trading securities
(35)
Deferred annuity and life policy acquisition costs
(45)
(38)
Change in:
Reinsurance and other receivables
570
823
62
Insurance claims and reserves
(288)
(502)
(106)
(218)
43
8
Other operating activities, net
(14
Net cash provided by operating activities
393
422
Investing Activities
Purchases of fixed maturities
(1,312)
(1,088)
Purchases of real estate, property and equipment
(11)
Proceeds from maturities and redemptions of fixed maturities
508
380
Proceeds from sales of fixed maturities
497
397
Change in securities lending collateral
Managed investment entities:
Purchases of investments
(141)
Proceeds from sales and redemptions of investments
210
Other investing activities, net
(27
(8
Net cash used in investing activities
(303
(314
Financing Activities
Annuity receipts
387
266
Annuity surrenders, benefits and withdrawals
(311)
(320)
Additional long-term borrowings
29
Managed investment entities' retirement of liabilities
(28)
Change in securities lending obligation
Issuances of Common Stock
7
Repurchases of Common Stock
Cash dividends paid on Common Stock
Other financing activities, net
(5
Net cash provided by (used in) financing activities
(40
(57
Net Increase in Cash and Cash Equivalents
50
51
Cash and cash equivalents at beginning of period
1,120
1,264
Cash and cash equivalents at end of period
$1,170
$1,315
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
H.
B.
I.
C.
J.
D.
K.
E.
L.
F.
M.
G.
N.
________________________________________________________________________________
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. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to March 31, 2010, and prior to the filing date of this Form 10-Q, have been evaluated for potential recognition or disclosure herein.
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.
Fair Value Measurements
New accounting guidance adopted by AFG on January 1, 2010, requires additional disclosures about transfers between levels in the hierarchy of fair value measurements. The guidance also clarifies existing disclosure requirements related to the level of disaggregation presented and inputs used in determining fair values. Additional detail relating to the roll-forward of Level 3 fair values will be required beginning in 2011.
Investments
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.
Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities ("MBS") are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
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 at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced.
In 2009, AFG adopted new accounting guidance relating to the recognition and presentation of other-than-temporary impairments. Under the guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then an entity may separate other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit-related portion of an other-than-temporary impairment is measured by comparing a security's amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are required to be shown in the Statement of Earnings. If management intends to sel l an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is required to reduce the amortized cost of that security to fair value. AFG adopted this guidance effective January 1, 2009, and recorded a cumulative effect adjustment of $17 million to reclassify the non-credit component of previously recognized impairments from retained earnings to accumulated other comprehensive income (loss). Additional disclosures required by this guidance are contained in Note D - "Investments."
Derivatives
Reinsurance
assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.
Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaries retain 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. AFG 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. The securities related to these transactions are classified as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income r ecorded on the adjustment to fair value of the related trading portfolios.
Deferred Policy Acquisition Costs ("DPAC")
For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses, unamortized acquisition costs and policy maintenance costs exceed the related unearned premiums. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.
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. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and variable annuity policy charges, less death and annuitization benefits in excess of account balances and estimated future policy administration expenses. 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 (losses).
DPAC related to annuities is also adjusted, net of tax, for the 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 gains on marketable securities, a component of "Accumulated Other Comprehensive Income, net of tax" 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 annuity and supplemental insurance companies acquired ("PVFP"). PVFP 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. PVFP 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.
Managed Investment Entities
AFG manages, and has minor investments in, six collateralized loan obligations ("CLOs") that are VIEs. As further described in Note G, these entities issued securities in various tranches and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. Both the management fees (payment of which are subordinate to other obligations of the CLOs) and the investments in the CLOs are considered variable interests. Based on the new accounting guidance, AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) it has exposure to CLO losses (through its investments in the CLO subordinated debt tranches) and the right to receive benefits (through its subordinated management fees and returns on its investments), both of which could potentially be significant to the CLOs. Accordingly, AFG began consolidating these entities on January 1, 2010.
Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG's Consolidated Balance Sheet. As permitted under the new standard, the assets and liabilities of the CLOs have been recorded at fair value upon adoption of the new standard on January 1, 2010. At that date, the excess of fair value of the assets ($2.382 billion) over the fair value of the liabilities ($2.137 billion) of $245 million was included in AFG's Balance Sheet as appropriated retained earnings - managed investment entities, representing the cumulative effect of adopting the new standard that ultimately will inure to the benefit of the CLO debt holders.
At December 31, 2009, AFG's investments in the CLOs were included in fixed maturity securities and had a cost of approximately $700,000 and a fair value of $6.4 million. Beginning January 1, 2010, these investments are eliminated in consolidation.
AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The net gain or loss from accounting for the CLO assets and liabilities at fair value subsequent to January 1, 2010, is separately presented in AFG's Statement of Earnings. CLO earnings attributable to AFG's shareholders represent the change in fair value of AFG's investments in the CLOs and management fees earned. As further detailed in Note G - "Managed Investment Entities," all other CLO earnings (losses) are not attributable to AFG's shareholders and will ultimately inure to the benefit of the other CLO debt holders. As a result, such CLO earnings (losses) are included in "net earnings (loss) attributable to noncontrolling interests" in AFG's Statement of Earnings
and in appropriated retained earnings - managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2022), it is expected that losses attributable to noncontrolling interests will reduce appropriated retained earnings towards zero as the fair values of the assets and liabilities converge and the CLO assets are used to pay the CLO debt.
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
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses and excess benefits expected to be paid on future deaths and annuitizations ("EDAR"). The liability for EDAR is accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and variable annuity policy charges, and unearned revenues once they are recognized as income.
Life, Accident and Health Reserves
Variable Annuity Assets and Liabilities
AFG's variable annuity contracts contain a guaranteed minimum death benefit ("GMDB") to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder's account. A GMDB liability is established for future
10
excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.
Premium Recognition
Noncontrolling Interests
Income Taxes
AFG records a liability for the inherent uncertainty in quantifying its income tax provisions. Related interest and penalties are recognized as a component of tax expense.
Stock-Based Compensation
Benefit Plans
portion of the plan and matches a percentage of employee contributions to the savings fund. Company contributions are expensed in the year for which they are declared. 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
AFG's weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: first
11
quarter 2010 and 2009 - 5.0 million and 7.6 million, respectively. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2010 and 2009 periods.
Statement of Cash Flows
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, umbrella and excess liability and customized programs for small to mid-sized businesses and California workers' compensation, and (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions (including collateral and mortgage protection insurance), surety and fidelity products and trade credit insurance. AFG's annuity and supplemental insurance business markets traditional fixed, indexed and variable annuities and a variety of supplemental insurance products. AFG's reportable segments and their components were determine d based primarily upon similar economic characteristics, products and services.
12
The following tables (in millions) show AFG's revenues and operating earnings before income taxes by significant business segment and sub-segment.
Revenues
Premiums earned:
Specialty
Property and transportation
$ 216
$ 212
Specialty casualty
218
215
Specialty financial
128
130
579
575
92
107
Realized gains (losses)
(10)
15
696
701
Annuity and supplemental insurance:
202
196
Realized losses
(6)
(31)
25
32
336
306
$1,034
$1,006
Operating Earnings Before Income Taxes
Underwriting:
$ 32
$ 48
21
13
Other lines
(6
71
Investment and other operating income
81
(10
162
185
Operations
39
(31
38
Other (*)
(53
(25
$ 147
$ 168
Includes $8 million in earnings from managed investment entities attributable to AFG shareholders and $20 million in losses of managed investment entities attributable to noncontrolling interests in 2010.
Level 1 - Quoted prices for identical assets or liabilities in active markets (markets in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis). AFG's Level 1 financial instruments consist primarily of publicly traded equity securities and highly liquid government bonds for which quoted market prices in active markets are available and short-term investments of managed investment entities.
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets. AFG's Level 2 financial instruments include separate account assets, corporate and municipal fixed maturity securities, mortgage-backed securities ("MBS") and investments of managed investment entities priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, corroborated broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2.
Level 3 - Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable. The unobservable inputs may include management's own assumptions about the assumptions market participants would use based on the best information available in the circumstances. AFG's Level 3 is comprised of financial instruments, including liabilities of managed investment entities, whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, observable market information.
AFG's management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG's internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), changes in interest rates, general economic conditions and the credit quality of the specific issuers.
14
Assets and liabilities measured at fair value are summarized below (in millions):
Level 1
Level 2
Level 3
March 31, 2010
Available for sale ("AFS") fixed maturities:
U.S. Government and government agencies
$273
$ 247
$ 520
States, municipalities and political subdivisions
2,121
2,127
Foreign government
261
Residential MBS
3,489
3,861
Commercial MBS
1,750
1,756
All other corporate
8,672
356
9,037
Total AFS fixed maturities
282
16,540
740
Trading fixed maturities
377
Equity securities
213
173
24
Assets of managed investment entities ("MIE")
2,205
Variable annuity assets (separate accounts) (a)
Other investments
85
Total assets accounted for at fair value
$668
$19,954
$ 868
$21,490
Liabilities:
Derivatives embedded in annuity
benefits accumulated
$ 131
65
2,178
Total liabilities accounted for at fair value
$ 65
$2,309
$ 2,374
December 31, 2009
Fixed maturities:
Available for sale
$371
$15,683
$ 769
$16,823
Trading
Equity securities:
Common stocks
189
298
Perpetual preferred stocks
93
$568
$16,877
$ 795
$18,240
$ 113
(a) Variable annuity liabilities equal the fair value of annuity assets.
During the first quarter of 2010, there were no significant transfers between Level 1 and Level 2. Approximately 4% of the total assets measured at fair value on March 31, 2010, were Level 3 assets. Approximately 44% of these assets were MBS whose fair values were determined primarily using non-binding broker quotes; the balance was primarily private placement debt securities whose fair values were determined internally using significant unobservable inputs, including the evaluation of underlying collateral and issuer creditworthiness, as well as certain Level 2 inputs such as comparable yields and multiples on similar publicly traded issues. The fair values of the liabilities of managed investment entities were determined using non-binding broker quotes, which were reviewed by AFG's investment professionals.
Changes in balances of Level 3 financial assets and liabilities during the first quarter of 2010 and 2009 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.
realized/unrealized
gains (losses)
included in
Consolidate
Purchases,
Balance at
Managed
comp.
sales,
Transfer
Dec. 31,
Inv.
Net
income
issuances and
into
out of
Entities
(loss)
settlements
AFS fixed maturities:
State and municipal
$ 23
($17)
$ 6
435
(83)
311
45
23
Assets of MIE
90
Liabilities of MIE
(2,100)
28
(2,178)
Embedded derivatives
(113)
(12)
(131)
Other comp.
sales, issuances
into (out
2008
Net income
income (loss)
and settlements
of) Level 3
AFS fixed maturities
$706
$ 3
($12)
$ 9
$689
(7)
(5)
(96)
(2)
(86)
Fair Value of Financial Instruments
Carrying
Fair
Value
Fixed maturities
17,943
17,195
408
373
Variable annuity assets
(separate accounts)
Annuity benefits accumulated(*)
$11,328
$10,774
$11,123
$10,365
876
839
Liabilities of managed investment
entities
Variable annuity liabilities
Excludes life contingent annuities in the payout phase.
The carrying amount of cash and cash equivalents approximates fair value. Fair values for mortgage loans are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. The fair value of policy loans is estimated to approximate carrying value; policy loans have no defined maturity dates and are inseparable from insurance contracts. The fair value of annuity
benefits was estimated based on expected cash flows discounted using forward interest rates adjusted for the Company's credit risk and includes the impact of maintenance expenses and capital costs. Fair values of long-term debt are based primarily on quoted market prices.
Amortized
Gross Unrealized
Cost
Gains
Losses
U.S. Government and government
agencies
$ 505
$ 15
$ 599
$ 612
$ 14
($ 1)
States, municipalities and
political subdivisions
2,096
(13)
1,764
1,789
40
258
264
3,949
144
(232)
4,142
3,956
126
(312)
1,676
86
1,434
1,431
8,641
457
(61
8,530
8,771
375
(134)
$17,125
$17,562
$751
($314)
$16,730
$581
($488)
$ 286
$177
$ 112
$ 298
$187
$ 122
$ 124
$ 8
($ 6)
$ 116
($ 9)
The non-credit related portion of other-than-temporary impairment charges are included in other comprehensive income (loss). Such charges taken for securities still owned at March 31, 2010 and December 31, 2009, respectively were: residential MBS - $270 million and $284 million; commercial MBS - $3 million in both periods; corporate bonds - $4 million in both periods.
The following tables show gross unrealized losses (in millions) on fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2010 and December 31, 2009.
Less Than Twelve Months
Twelve Months or More
Unrealized
Fair Value as
Loss
% of Cost
$ 77
99%
-%
595
91%
98
98%
325
95%
(216)
1,082
83%
105
(9
540
(52
901
($35)
$1,675
($279)
$2,147
89%
Common Stocks
$ 2
75%
Perpetual Preferred Stocks
94%
$ 45
$ 232
(8)
470
69
90%
(37)
458
93%
(275)
1,392
84%
209
(24)
395
(19
895
(115
1,336
92%
($67)
$2,345
97%
($421)
$3,192
88%
79%
$ 47
At March 31, 2010 the gross unrealized losses on fixed maturities of $314 million relate to approximately 1,000 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 57% of the gross unrealized loss and 80% of the fair value. MBS comprised approximately 76% of the gross unrealized losses on the available for sale fixed maturity portfolio at March 31, 2010.
Gross Unrealized Losses on MBS
Gross Unrealized Losses on All Other Corporates
The following tables progress the credit portion of other-than-temporary impairments on fixed maturity securities for which the non-credit portion of an impairment has been recognized in other comprehensive income (loss) (in millions).
Balance at January 1
$ 99
$14
Additional credit impairments on:
Previously impaired securities
19
Securities without prior impairments
Reductions - disposals
Balance at March 31
$122
$61
The table below sets forth the scheduled maturities of available for sale fixed maturities as of March 31, 2010 (in millions). 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. MBS had an average life of approximately 4 years at March 31, 2010.
Fair Value
Amount
%
Maturity
One year or less
$ 604
$ 615
3%
After one year through five years
4,803
5,015
After five years through ten years
5,033
5,239
30
After ten years
1,060
1,076
11,500
11,945
68
MBS
5,625
5,617
Certain risks are inherent in connection with fixed maturity securities, including loss upon default, price volatility in reaction to changes in interest rates, and general market factors and risks associated with reinvestment of proceeds due to prepayments or redemptions in a period of declining interest rates.
There were no investments in individual issuers (other than U.S. Treasury Notes) that exceeded 10% of Shareholders' Equity at March 31, 2010 or December 31, 2009.
Net Unrealized Gain on Marketable Securities
Deferred Tax and
Amounts Attributable
to Noncontrolling
Pre-tax
Unrealized gain on:
Fixed maturity securities
$437
($155)
$282
178
(63)
(168)
(109)
Annuity benefits and other liabilities
$450
($160)
$ 93
($ 33)
$ 60
183
(65)
118
(12
$258
($ 92)
$166
Realized gains (losses) and changes in unrealized appreciation (depreciation) related to fixed maturity and equity security investments are summarized as follows (in millions):
Fixed
Tax
Maturities
Securities
Other(*)
Effects
Quarter ended March 31, 2010
Realized before impairments
$ 27
$ 1
($ 3)
($ 8)
$17
Realized - impairments
Change in Unrealized
350
(147)
(69)
Quarter ended March 31, 2009
$ 55
($13)
$22
(95)
27
(49)
(53)
Primarily adjustments to deferred policy acquisition costs related to annuities.
Realized gains includes net gains of $17 million in the first quarter of 2010 and $36 million in the first quarter of 2009 from the mark-to-market of certain MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. Gross realized gains and losses (excluding impairment writedowns and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
Gross gains
$21
Gross losses
(21)
Certain securities held in AFG's investment portfolio, primarily interest-only MBS with interest rates that float inversely with short-term rates, are considered to contain embedded derivatives. AFG has elected to measure these securities (in their entirety) at fair value in its financial statements. These investments are part of AFG's overall investment strategy and represent a small component of AFG's overall investment portfolio.
AFG has entered into $700 million notional amount of pay-fixed interest rate swaptions (options to enter into pay-fixed/receive floating interest rate swaps at future dates expiring between 2012 and 2015) to mitigate interest rate risk in its annuity operations. AFG paid $19 million to purchase these swaptions, which represents its maximum potential economic loss over the life of the contracts.
AFG's indexed annuities, which represented 25% of annuity benefits accumulated at March 31, 2010, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG's strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be generally offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives.
As discussed under "Reinsurance" in Note A, certain reinsurance contracts in AFG's annuity and supplemental insurance business are considered to contain embedded derivatives.
The following derivatives are included in AFG's Balance Sheet at fair value (in millions):
Derivative
Balance Sheet Line
Asset
Liability
MBS with embedded derivatives
$156
$226
Interest rate swaptions
Indexed annuities
(embedded derivative)
131
Equity index call options
66
61
Reinsurance contracts
$240
$141
$311
$118
The following table summarizes the gain (loss) included in the Statement of Earnings for changes in the fair value of these derivatives for the first quarter of 2010 and 2009 (in millions):
Statement of Earnings Line
Realized gains
$36
$40
Property and casualty insurance
$ 334
$ 338
Policy acquisition costs
867
853
Policyholder sales inducements
207
Present value of future profits ("PVFP")
184
190
Impact of unrealized gains and losses
(168
Total annuity and supplemental
1,091
1,232
$1,425
$1,570
The PVFP amounts in the table above are net of $154 million and $148 million of accumulated amortization at March 31, 2010 and December 31, 2009, respectively. Amortization of the PVFP was $6 million in the first three months of 2010 and $8 million in the same period in 2009.
In analyzing expected cash flows related to these entities, AFG determined that it will not receive a majority of the residual returns nor absorb a majority of the entities' expected losses. Accordingly, AFG was not required to consolidate these variable interest entities prior to 2010. Beginning in 2010, accounting standards for determining the primary beneficiary of a variable interest entity changed from the above quantitative assessment to a qualitative assessment as outlined in Note A - "Accounting Policies, Managed Investment Entities." Under the new guidance, AFG determined that it is the primary beneficiary of the CLOs it manages and began consolidating the CLOs on January 1, 2010.
AFG's maximum ultimate exposure to economic loss on its CLOs is limited to its investment in the CLOs, which had an aggregate fair value of $10 million at March 31, 2010.
The revenues and expenses of the CLOs are separately identified in AFG's Statement of Earnings, after elimination of $4 million in management fees and $4 million in income attributable to shareholders of AFG as measured by the change in the fair value of AFG's investments in the CLOs. AFG's "Operating earnings before income taxes" for the first three months of 2010 includes $20 million in CLO losses attributable to noncontrolling interests.
The $25 million net loss from changes in the fair value of assets and liabilities of managed investment entities included in the Statement of Earnings for the first quarter of 2010 includes gains of $81 million from changes in the fair value of CLO assets and losses of $106 million from changes in the fair value of CLO liabilities. The aggregate unpaid principal balance of the CLOs' fixed maturity investments exceeded the fair value of the investments by $175 million at March 31, 2010. The aggregate unpaid principal balance of the CLOs' debt exceeded its fair value by $425 million at that date. The CLO assets include $67 million in loans (aggregate unpaid principal balance of $122 million) for which the CLOs are not accruing interest because the loans are in default.
Direct obligations of AFG:
9-7/8% Senior Notes due June 2019
$350
7-1/8% Senior Debentures due February 2034
468
Subsidiaries
Obligations of AAG Holding (guaranteed by AFG):
7-1/2% Senior Debentures due November 2033
112
7-1/4% Senior Debentures due January 2034
Notes payable secured by real estate
due 2010 through 2016
Secured borrowings ($18 and $19 guaranteed by AFG)
National Interstate bank credit facility
American Premier Underwriters 10-7/8% Subordinated
Notes due May 2011
340
Payable to Subsidiary Trusts:
AAG Holding Variable Rate Subordinated Debentures
due May 2033
$824
$828
Scheduled principal payments on debt for the balance of 2010 and the subsequent five years were as follows: 2010 - $9 million; 2011 - $20 million; 2012 - $27 million; 2013 - $20 million; 2014 - $2 million and 2015 - $14 million.
As shown below (in millions), the majority of AFG's long-term debt is unsecured obligations of the holding company and its subsidiaries:
Unsecured obligations
$710
Obligations secured by real estate
Other secured borrowings
AFG can borrow up to $500 million under its revolving credit facility, which expires in March 2011. Amounts borrowed bear interest at rates ranging from .5% to 1.25% (currently .75%) over LIBOR based on AFG's credit rating. At March 31, 2010, no borrowings were outstanding under the credit facility.
In April 2009, AFG paid $136 million to redeem its outstanding 7-1/8% Senior Debentures at maturity. In June 2009, AFG issued $350 million of 9-7/8% Senior Notes due 2019 and used the proceeds to repay borrowings under the credit facility.
In 2009, AFG subsidiaries borrowed a total of $59 million at interest rates ranging from 3.8% to 4.25% over LIBOR (weighted average interest rate of 4.3% at March 31, 2010). The loans require principal payments over the next four years.
Accumulated Other Comprehensive Income (Loss), Net of Tax
Pretax
Foreign
Accumulated
Net Unrealized
Currency
Gains (Losses)
Translation
Comprehensive
on Securities
Adjustment
Other (a)
Income (Loss)
$ 258(b)
($ 86)
$163(b)
Unrealized holding gains on securities
arising during the period
(70)
Realized gains included in net income
(3)
Foreign currency translation gains
$ 450
($154)
($1,058)
($18)
($11)
$374
$10
(27)
Unrealized holding losses on securities
(67)
(43)
Realized losses included in net income
Foreign currency translation losses
($1,111)
($22)
$393
$11
(a) Net unrealized pension and other postretirement plan benefits.
(b) Includes $73 million at March 31, 2010, and $98 million at December 31, 2009 in net pretax unrealized losses
($48 million and $63 million net of tax) related to securities for which only the credit portion of an other-than-
temporary impairment has been recorded in earnings.
Stock Based Compensation
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility over a period equal to the expected term. The expected term was estimated based on historical exercise patterns and post vesting cancellations. The fair value of options granted during 2010 was $8.90 per share based on the following assumptions: expected dividend yield - 2.2%; expected volatility - 39%; expected term - 7.5 years; risk-free rate - 3.2%.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries was $5.2 million for the first quarter of 2010 compared to $4.6 million for the 2009 quarter.
As discussed in Note K - "Income Taxes," to AFG's 2009 Form 10-K, AFG has several tax years for which there are ongoing disputes with the Internal Revenue Service ("IRS"). AFG filed a suit for refund in the U.S. District Court in Southern Ohio as a result of its dispute with the IRS regarding the calculation of tax reserves for certain annuity reserves pursuant to Actuarial Guideline 33. Oral arguments on joint motions for summary judgment were presented in June 2009. On March 15, 2010, the Court issued an Order denying both motions. AFG and the IRS are preparing a joint stipulation of the amount of the refund that AFG would be entitled to. AFG expects that the Court would then issue a final judgment. It is possible that the Government may appeal the decision. AFG's liabilities for uncertain tax positions will not be adjusted until the case is "effectively settled." Resolution of the open years could result in a decrease in the liability for unrecognized tax benefits by up to $36 million and a decrease in related accrued interest of $11 million. These amounts do not include tax and interest paid to the IRS in 2005 and 2006, for which the suit was filed, totaling $17 million.
CONDENSED CONSOLIDATING BALANCE SHEET
(In millions)
AAG
All Other
Consol.
AFG
GAFRI
Holding
Subs
Entries
Consolidated
Cash and investments
$ 200
$ 24
$20,389
($ 2)
$20,611
Recoverables from reinsurers and
prepaid reinsurance premiums
3,553
1,648
Investment in subsidiaries and
affiliates
4,636
1,670
1,751
686
(8,743
Total assets
$4,853
$1,701
$1,757
$30,726
($8,747)
Unpaid losses, loss adjustment expenses
and unearned premiums
$ 7,692
Annuity, life, accident and health
benefits and reserves
13,145
13,144
219
137
220
1,945
(213
2,080
688
327
25,162
(215)
1,680
1,430
5,422
(8,532)
$ 33
$19,535
$19,791
3,892
1,831
1,876
4,189
1,539
1,624
687
(8,039
$4,428
$1,577
$1,630
$28,069
($8,021)
$ 7,980
12,939
12,938
140
179
2,018
647
329
22,935
(169)
1,555
1,301
4,996
(7,852)
26
CONDENSED CONSOLIDATING STATEMENT OF EARNINGS
FOR THE THREE MONTHS ENDED
MARCH 31, 2010
Income
Income of managed investment entities
Investment and other income
341
339
Equity in earnings of subsidiaries
192
(281
193
42
1,036
(286)
Insurance benefits and expenses
761
Other expenses
82
(3
855
165
181
(278)
Provision (credit) for income taxes
72
(99
Net earnings, including noncontrolling
interests
(179)
Net Earnings Attributable to
Shareholders
$106
$27
$ 127
($179)
MARCH 31, 2009
(42)
374
363
180
(208
177
1,016
(213)
722
817
(207)
(69
Net earnings, including
(138)
$104
$ 125
($138)
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
$ 109
Equity in net earnings of subsidiaries
(124)
(26)
(33)
Dividends from subsidiaries
(105)
(2
305
Net cash provided by (used in)
operating activities
448
(105
Investing Activities:
Purchases of fixed maturities, property
and equipment
(1,350)
Capital contributions to subsidiaries
Proceeds from maturities and redemptions
of fixed maturities
Proceeds from sales and redemptions of
investments
(29
investing activities
(305
Financing Activities:
Annuity surrenders, benefits and
withdrawals
Managed investment entities' retirement
of liabilities
Capital contributions from parent
Cash dividends paid
financing activities
(84
Net increase (decrease) in cash and cash
equivalents
Cash and cash equivalents at beginning
of period
197
911
$171
$ 993
Net earnings (loss), including
(116)
(102)
(36
353
312
484
(102
(1,096)
(1,099)
(32)
75
394
(32
(15
(313
31
102
(17
(127
Net increase in cash and cash equivalents
160
1,102
$164
$ 5
$1,146
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
Uncertainties
Overview
Critical Accounting Policies
Results of Operations
Liquidity and Capital Resources
General
Ratios
Income Items
Parent and Subsidiary Liquidity
Expense Items
33
Recent Accounting Standards
_____________________________________________________________________________________________________
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", "projects", "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 changes; and improved loss experience.
Actual results and/or financial condition could differ materially from those contained in or implied by such forward-looking statements for a variety of reasons including but not limited to:
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.
of Financial Condition and Results of Operations - Continued
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, 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.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance, focusing on specialized commercial products for businesses and in the sale of traditional fixed, indexed and variable annuities and a variety of supplemental insurance products.
Net earnings attributable to AFG's shareholders for the first three months of 2010 were $106 million ($.93 per share, diluted) compared to $104 million ($.88 per share, diluted) reported in the same period of 2009. The improved results reflect realized gains on investments attributable to lower other-than-temporary impairment charges, improved results in the annuity and supplemental insurance group, offset by lower underwriting profit in the property and casualty insurance operations and lower investment income.
CRITICAL ACCOUNTING POLICIES
Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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 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 2009 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
$ 824
$ 828
$1,030
Total capital (*)
4,732
4,698
4,351
Ratio of debt to total capital:
Including debt secured by real estate
17.4%
17.6%
23.7%
Excluding debt secured by real estate
16.3%
16.4%
22.5%
Includes long-term debt, noncontrolling interests and shareholders' equity (excluding unrealized gains (losses) related to fixed maturity investments and appropriated retained earnings related to managed investment entities).
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.30 for the three months ended March 31, 2010 and 2.58 for the entire year of 2009. Excluding annuity benefits, this ratio was 8.83 and 11.06, respectively. Although the ratio excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
Parent Holding Company Liquidity
AFG can borrow up to $500 million under its revolving credit facility, which expires in March 2011. There were no borrowings outstanding under this agreement at March 31, 2010. Management expects to have a new credit agreement completed by the end of 2010.
During the first three months of 2010, AFG repurchased 2.9 million shares of its Common Stock for $75 million.
AFG retired the $136 million of 7-1/8% Senior Debentures at maturity in April 2009, using cash on hand. In June 2009, AFG issued $350 million of 9-7/8% Senior Notes due 2019.
Under tax allocation agreements with AFG, its 80%-owned U.S. subsidiaries generally pay taxes to (or recover taxes from) AFG based on each subsidiary's contribution to amounts due under AFG's consolidated tax return.
Subsidiary Liquidity
investments at cost. Membership in the FHLB provides the annuity and supplemental insurance operations with a substantial additional source of liquidity. No funds have been borrowed from the FHLB.
National Interstate, a 52.5%-owned property and casualty insurance subsidiary, can borrow up to $75 million, subject to certain conditions, under an unsecured credit agreement expiring in December 2012. Amounts borrowed bear interest at rates ranging from .45% to .9% (currently .65%) over LIBOR based on National Interstate's credit rating. There was $15 million outstanding under this agreement at March 31, 2010.
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 the 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. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG's annuity products.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses. In addition, these subsidiaries have sufficient capital to meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies. Nonetheless, changes in statutory accounting rules, significant declines in the fair value of the insurance subsidiaries' investment portfolios or significant ratings downgrades on these investments, could create a need for additional capital.
Fair values for AFG's portfolio are determined by AFG's internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on closing prices obtained from the pricing services. For mortgage-backed securities ("MBS"), which comprise approximately one-third of AFG's fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the other two-thirds of AFG's fixed maturity portfolio, approximately 95% are priced using pricing services and the balance
is priced internally or by using non-binding broker quotes. When prices obtained for the same security vary, AFG's internal investment professionals select the price they believe is most indicative of an exit price.
The pricing services use a variety of observable inputs to estimate fair value of fixed maturities that do not trade on a daily basis. Based upon information provided by the pricing services, these inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data, and measures of volatility. Included in the pricing of MBS are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Due to the lack of transparency in the process that brokers use to develop prices, valuations that are based on brokers' prices are classified as Level 3 in the GAAP hierarchy unless the price can be corroborated, for example, by comparison to similar securities priced using observable inputs.
Data obtained from external sources is reviewed by AFG's internal investment professionals who ensure the fair value is representative of an exit price and consistent with accounting standards. Prices obtained from a broker or pricing service are adjusted only in cases where they are deemed not to be representative of an appropriate exit price (fewer than 1% of the securities).
In general, the fair value of AFG's fixed maturity investments is inversely correlated to changes in interest rates. The following table demonstrates the sensitivity of such fair values to reasonably likely changes in interest rates by illustrating the estimated effect on AFG's fixed maturity portfolio that an immediate increase of 100 basis points in the interest rate yield curve would have at March 31, 2010 (dollars in millions). Increases or decreases from the 100 basis points illustrated would be approximately proportional.
Fair value of fixed maturity portfolio
$17,943
Pretax impact on fair value of 100 bps
increase in interest rates
($ 897)
Pretax impact as % of total fixed maturity portfolio
(5.0%)
Approximately 92% of the fixed maturities held by AFG at March 31, 2010, 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 the high quality investment portfolio should generate a stable and predictable investment return.
AFG's $5.7 billion investment in MBS represented approximately one-third of its fixed maturities at March 31, 2010. MBS are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates.
34
Summarized information for AFG's MBS (including those classified as trading) at March 31, 2010, is shown (in millions) in the table below. Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The majority of the Alt-A securities and substantially all of the subprime securities are backed by fixed-rate mortgages. The average life of the residential and commercial MBS is approximately 4 and 5 years, respectively.
% Rated
Investment
Collateral type
Gain (Loss)
Grade
Residential:
Agency-backed
$ 530
$ 554
105%
$24
100%
Non-agency prime
2,250
2,242
Alt-A
844
770
(74)
60
Subprime
308
Commercial
1,711
1,791
80
$5,705
$5,697
The National Association of Insurance Commissioners ("NAIC") assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. Beginning with year-end 2009 reporting of MBS by insurance companies, the NAIC retained a third-party investment management firm to assist in the determination of appropriate NAIC designations for all non-agency residential mortgage-backed securities based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At March 31, 2010, 98% (based on statutory carrying value of $5.6 billion) of AFG's MBS securities had an NAIC designation of 1 or 2.
35
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at March 31, 2010, is shown in the following table (dollars in millions). Approximately $530 million of available for sale "Fixed maturities" and $44 million of "Equity securities" had no unrealized gains or losses at March 31, 2010.
With
Available for Sale Fixed Maturities
Fair value of securities
$13,210
$3,822
Amortized cost of securities
$12,459
$4,136
Gross unrealized gain (loss)
$ 751
($ 314)
Fair value as % of amortized cost
106%
Number of security positions
2,679
1,018
Number individually exceeding
$2 million gain or loss
46
Concentration of gains (losses) by type or
industry (exceeding 5% of unrealized):
Mortgage-backed securities
$ 230
($ 238)
Banks, savings and credit institutions
States and municipalities
Gas and electric services
95
Percentage rated investment grade
96%
80%
Equity Securities
$ 313
$ 53
Cost of securities
$ 128
$ 185(*)
($ 7)
Fair value as % of cost
245%
(*) Includes $146 million on AFG's investment in Verisk Analytics, Inc.
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at March 31, 2010, 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.
4%
1%
Mortgage-backed securities (average
life of approximately four years)
36
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Aggregate
Value as
Basis
Fixed Maturities at March 31, 2010
Securities with unrealized gains:
Exceeding $500,000 (438 issues)
$ 5,774
$ 485
109%
$500,000 or less (2,241 issues)
7,436
Securities with unrealized losses:
Exceeding $500,000 (201 issues)
$ 1,176
($ 219)
$500,000 or less (817 issues)
2,646
(95
97
$ 3,822
The following table summarizes (dollars in millions) the unrealized loss for all securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
Securities with Unrealized
Losses at March 31, 2010
Investment grade fixed maturities with losses for:
Less than one year (357 issues)
$1,539
($ 26)
One year or longer (360 issues)
1,511
(154
$3,050
($180)
Non-investment grade fixed maturities with losses for:
Less than one year (57 issues)
$ 136
One year or longer (244 issues)
636
(125
$ 772
($134)
85%
Common equity securities with losses for:
Less than one year (10 issues)
One year or longer (2 issues)
Perpetual preferred equity securities with losses for:
Less than one year (2 issues)
One year or longer (16 issues)
$ 49
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 by the amount of the charge. The determination of whether unrealized losses are "other-than-temporary" requires judgment based on subjective as well as objective factors as detailed in AFG's 2009 Form 10-K under Management's Discussion and Analysis - "Investments."
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 recover in value and, at March 31, 2010, had no intent to sell them. Although AFG has the ability to continue holding its
37
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. Should AFG's ability or intent 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 future periods. Significant declines in the fair value of AFG's investment portfolio could have a significant adverse effect on AFG's liquidity.
MANAGED INVESTMENT ENTITIES
Beginning January 1, 2010, new accounting standards require AFG to consolidate its investments in six collateralized loan obligation ("CLO") entities that it manages and owns an interest in (in the form of debt). See Note A - "Accounting Policies - Managed Investment Entities" and Note G - "Managed Investment Entities." The effect of consolidating these entities is shown in the tables below (in millions). The "Before CLO Consolidation" columns include AFG's investment and earnings in the CLOs on an unconsolidated basis, which would be comparable to periods prior to adopting the new standards.
Before CLO
Consolidation
As Reported
Cash and other investments
$20,621
($10)(a)
7,201
$27,822
$2,478
($10)
Unpaid losses, loss adjustment expenses and
unearned premiums
Annuity, life, accident and health benefits
and reserves
2,253
(10)(a)
Long-term debt and other liabilities
2,904
23,740
Common Stock and Capital surplus
1,323
Retained earnings:
Accumulated other comprehensive income
3,940
4,082
(a) Elimination of the fair value of AFG's investment in CLOs.
Three months ended March 31, 2010
Consolidation(a)
Insurance premiums
$ 694
Loss on change in fair value of
assets/liabilities
(29)
4 (b)
Realized gains (losses) on securities
(4)(b)
48
1,045
(4)(c)
Interest on borrowed money and other expenses
117
878
167
(20
($20)
$20
(a)
Includes $4 million in realized gains representing the change in fair value of AFG's CLO investments plus $4 million in CLO management fees earned.
(b)
Elimination of the change in fair value of AFG's investments in the CLOs.
(c)
Elimination of management fees earned by AFG.
(d)
Allocate losses of CLOs attributable to other debt holders to noncontrolling interests.
RESULTS OF OPERATIONS
AFG reported operating earnings before income taxes of $147 million for the first quarter of 2010 compared to $168 million for the 2009 first quarter. Results for the first quarter of 2010 include (i) $20 million in losses of managed investment entities attributable to noncontrolling interests, (ii) $4 million in realized gains on securities, compared to realized losses of $41 million in the first quarter of 2009, (iii) a $28 million decline in Specialty property and casualty underwriting results, and (iv) a $5 million improvement in the annuity and supplemental insurance results.
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 B - "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 losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. A combined ratio under 100% indicates an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.
Premiums, combined ratios and prior year development for AFG's property and casualty insurance operations were as follows (dollars in millions):
Gross Written Premiums
$277
$316
347
369
122
135
$744
$818
Net Written Premiums
$216
$202
238
248
119
$566
$585
Combined Ratios
85.2%
77.3%
91.5
81.2
83.4
89.7
Total Specialty
86.6
81.7
Aggregate (including discontinued lines)
87.6%
81.9%
Favorable (Unfavorable) Prior Year Development
$28
Other specialty
64
Other (primarily asbestos and environmental
charges)
$39
$63
The overall decreases in gross and net written premiums in the first quarter of 2010 is the result of soft market conditions and competitive pressures, depressed economic conditions and a decision to exit certain automotive-related lines of business. The decrease in net written premiums was partially offset by higher levels of retained crop premium as cessions under the crop quota share agreement returned to historical levels (approximately 50%). Excluding crop operations, gross and net written premiums decreased 8% and 7%, respectively, in the first quarter of 2010 compared to the same period of 2009. Overall average renewal rates for the first three months of 2010 were flat when compared with the same period of last year.
The Specialty insurance operations generated underwriting profits of $77 million in the first quarter of 2010, compared to $105 million in the first quarter of 2009. The reduced profit in 2010 is primarily the result of a $19 million decrease in favorable reserve development and a $7 million increase in catastrophe losses when compared to the first quarter of 2009.
Specialty casualty gross and net written premiums decreased for the first quarter of 2010 compared to the same period in 2009 due primarily to a soft pricing environment and competitive market conditions in the excess and surplus markets and California workers' compensation business, as well as volume reductions resulting from decreased demand for general liability coverages in the homebuilders market. Growth in gross and net written premiums in the executive liability and Marketform operations partially offset these declines. This group reported an underwriting profit of $18 million in the first quarter of 2010, compared to $40 million in the first quarter of 2009. The reduced profits are primarily the result of a $13 million decrease in favorable reserve development. Additionally, lower underwriting results in the general liability operations (primarily those that serve the homebuilders industry), Marketform, excess and surplus lines and the California workers' compensation businesses were partially offset by improvements in the targeted markets operations.
Specialty financial gross and net written premiums decreased from the 2009 first quarter due primarily to the exit from certain automotive-related lines of business during 2009. This group reported underwriting profit of $21 million in the first quarter of 2010 compared to $13 million in the first quarter of 2009. Additional favorable reserve development in the run-off automobile residual value insurance business and higher underwriting profits in the financial institutions business contributed to the improvement. Lower underwriting profits in the surety and fidelity operations partially offset these results.
Annuity and Supplemental Insurance Operations
Statutory Annuity Premiums
403(b) Fixed and Indexed Annuities:
First Year
$ 11
$ 16
Renewal
Single Sum
Subtotal
78
Non-403(b) Indexed Annuities
132
Non-403(b) Fixed Annuities
Bank Fixed Annuities
54
Variable Annuities
Total Annuity Premiums
$386
$266
The increase in annuity premiums for the first three months of 2010 compared to the same period in 2009 reflects increased sales of indexed and traditional fixed annuities in the non-403(b) single premium market and increased sales of fixed annuities through the bank distribution channel, partially offset by lower overall sales of 403(b) fixed and indexed annuities.
Life, Accident and Health Premiums and Benefits
Premiums
Supplemental insurance operations
First year
$ 21
$ 19
87
Life operations (in run-off)
$115
$109
Benefits
$ 86
$ 78
$ 96
$ 91
Investment Income
The amortized cost of AFG's portfolio of non-agency residential MBS decreased $131 million during the first three months of 2010 due primarily to paydowns. As these securities continue to pay down, management expects to reinvest the proceeds principally in high quality corporate bonds placing downward pressure on AFG's investment portfolio yield.
Realized Gains (Losses) on Securities
Realized gains (losses) before impairments:
Disposals
$19
Change in the fair value of derivatives
Adjustments to annuity deferred policy
acquisition costs and related items
Impairment charges:
(30)
(103)
The change in fair value of derivatives includes net gains of $17 million in 2010 and $36 million in 2009 from the mark-to-market of MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. See Note E - "Derivatives."
Other Income
Annuity Benefits
Changes in investment yields, crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect these additional reserves and could result in charges (or credits) to earnings in the period the projections are modified.
Annuity and Supplemental Insurance Acquisition Expenses
The vast majority of the annuity and supplemental insurance group's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Unanticipated spread compression, decreases in the stock market, adverse mortality experience and higher than expected lapse rates could lead to write-offs of DPAC or PVFP in the future.
Interest Charges on Borrowed Money
New accounting standards implemented in 2010, are discussed in Note A - "Accounting Policies" under the following subheadings.
Accounting Standard
Note A Reference
Improvements to Financial Reporting by
Enterprises Involved with Variable
Interest Entities
Fair Value Measurements and Disclosures
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
As of March 31, 2010, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2009 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 the controls and procedures are effective. New accounting standards require AFG to consolidate six collateralized loan obligation entities that it manages beginning January 1, 2010. Controls and procedures have been designed to ensure that the information required to consolidate these entities and report on them is available and prepared in accordance with generally accepted accounting principles. There have been no other changes in AFG's internal control over financial reporting during the first fiscal quarter of 2010 that materially affected, or are reasonably likely to materially affect, AFG's internal control over financial reporting.
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 first fiscal quarter of 2010 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
Total Number
Maximum Number
of Shares
Purchased as
that May
Number
Average
Part of Publicly
Yet be Purchased
Price Paid
Announced Plans
Under the Plans
Purchased
Per Share
or Programs
or Programs (a)
January
1,260,300
$25.25
1,706,965
February
1,063,300
$25.06
5,643,665
March
588,234
$28.12
5,055,431
Represents the remaining shares that may be repurchased under the Plans authorized by AFG's Board of Directors in November 2009 and February 2010. In February 2010, AFG's Board of Directors authorized the repurchase of five million additional shares.
ITEM 6
Exhibits
Exhibit Description
Computation of ratios of earnings to fixed charges.
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.
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.
May 7, 2010
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)