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 EndedSeptember 30, 2005
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) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark whether the Registrant is an accelerated filer. Yes X No Indicate by check mark whether the Registrant is a shell company. Yes No X As of November 1, 2005, there were 77,554,158 shares of the Registrant's Common Stock outstanding, excluding 9,953,392 shares owned by a subsidiary.
TABLE OF CONTENTS
Page
AMERICAN FINANCIAL GROUP, INC. 10-Q
PART I
FINANCIAL INFORMATION
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars In Thousands)
September 30,
December 31,
2005
2004
Assets:
Cash and short-term investments
$ 641,308
$ 861,742
Investments:
Fixed maturities:
Available for sale - at market
(amortized cost - $14,087,625 and $13,035,165)
14,229,925
13,411,365
Trading - at market
276,368
292,233
Other stocks - at market
(cost - $470,798 and $456,053)
520,498
537,153
Policy loans
255,624
250,211
Real estate and other investments
330,567
283,929
Total cash and investments
16,254,290
15,636,633
Recoverables from reinsurers and prepaid
reinsurance premiums
3,463,535
3,440,592
Agents' balances and premiums receivable
816,904
518,464
Deferred policy acquisition costs
1,190,751
1,114,433
Other receivables
250,215
359,746
Investments of managed investment entity
-
392,624
Variable annuity assets (separate accounts)
629,627
620,007
Prepaid expenses, deferred charges and other assets
375,266
311,146
Goodwill
165,882
$23,146,470
$22,559,527
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$5,880,453
$ 5,337,270
Unearned premiums
1,761,006
1,612,035
Annuity benefits accumulated
8,340,272
8,132,106
Life, accident and health reserves
1,070,593
1,021,986
Payable to reinsurers
462,236
513,565
Long-term debt:
Holding company
667,630
685,083
Subsidiaries
349,120
343,590
Payable to subsidiary trusts
77,800
Debt of managed investment entity
371,368
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,243,920
1,194,584
Total liabilities
20,482,657
19,909,394
Minority interest
260,831
219,586
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 77,473,842 and 76,634,204 shares outstanding
77,474
76,634
Capital surplus
1,172,272
1,145,873
Retained earnings
1,059,536
976,340
Unrealized gain on marketable securities, net
93,700
231,700
Total shareholders' equity
2,402,982
2,430,547
2
CONSOLIDATED STATEMENT OF OPERATIONS
(In Thousands, Except Per Share Data)
Three months ended
Nine months ended
Income:
Property and casualty insurance premiums
$ 651,361
$ 549,296
$1,775,795
$1,565,617
Life, accident and health premiums
91,811
85,929
276,256
263,807
Investment income
214,076
201,631
640,734
589,613
Realized gains on securities
10,748
223,563
27,303
260,466
Revenues of managed investment entity
3,302
651
12,739
Other income
124,780
89,800
298,669
236,985
1,092,776
1,153,521
3,019,408
2,929,227
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
604,433
397,746
1,311,613
1,045,520
Commissions and other underwriting
expenses
181,283
151,055
497,589
459,833
Annuity benefits
81,648
82,482
246,529
228,513
Life, accident and health benefits
72,436
63,981
211,014
199,200
Annuity, supplemental insurance and
life acquisition expenses
34,296
29,439
103,366
92,292
Interest charges on borrowed money
18,367
18,050
54,789
53,235
Interest on subsidiary trust obligations
1,637
1,552
4,848
7,558
Expenses of managed investment entity
4,123
774
10,651
Other operating and general expenses
122,978
172,509
359,260
388,903
1,117,078
920,937
2,789,782
2,485,705
Operating earnings (loss) before
income taxes
(24,302)
232,584
229,626
443,522
Provision (credit) for income taxes
(5,199
78,031
84,577
144,673
Net operating earnings (loss)
(19,103)
154,553
145,049
298,849
Minority interest expense
(7,261)
(10,987)
(22,075)
(22,651)
Equity in net losses of investee,
net of tax
(66
(668
(4,904
(2,468
Earnings (loss) from continuing operations
(26,430)
142,898
118,070
273,730
Discontinued operations
(942)
(797)
Cumulative effect of accounting change
(3,756
(5,593
Net Earnings (Loss)
($ 26,430)
$ 138,200
$ 118,070
$ 267,340
Basic earnings (loss) per Common Share:
Continuing operations
($0.34)
$1.94
$1.53
$3.73
(.01)
(.05
(.08
Net earnings (loss) available to
Common Shares
$1.88
$3.64
Diluted earnings (loss) per Common Share:
$1.91
$1.51
$3.67
$1.85
$3.58
Average number of Common Shares:
Basic
77,335
73,626
77,060
73,396
Diluted
78,702
74,762
78,267
74,597
Cash dividends per Common Share
$.125
$.375
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in Thousands)
Common Stock
Unrealized
Common
and Capital
Retained
Gain on
Shares
Surplus
Earnings
Securities
Total
Balance at January 1, 2005
76,634,204
$1,222,507
$ 976,340
$231,700
$2,430,547
Net earnings
Change in unrealized
(138,000)
(138,000
Comprehensive income(loss)
(19,930)
Dividends on Common Stock
(28,859)
Shares issued:
Exercise of stock options
947,138
25,518
Dividend reinvestment plan
144,303
4,214
Employee stock purchase plan
19,873
633
Retirement plan contributions
113,414
3,622
Deferred compensation distributions
7,374
222
Directors fees paid in stock
9,320
300
Shares tendered in option exercises
(401,784)
(6,415)
(6,015)
(12,430)
Capital transactions of subsidiaries
(7,850)
Other
6,995
Balance at September 30, 2005
77,473,842
$1,249,746
$1,059,536
$ 93,700
$2,402,982
Balance at January 1, 2004
73,056,085
$1,108,840
$ 664,721
$302,600
$2,076,161
267,340
(69,600)
(69,600
Comprehensive income
197,740
(27,506)
872,499
22,083
6,151
167
20,908
616
107,898
3,212
34,218
977
11,666
339
(428,750)
(6,529)
(6,605)
(13,134)
(350
Balance at September 30, 2004
73,680,675
$1,129,355
$ 897,950
$233,000
$2,260,305
4
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)
Operating Activities:
Adjustments:
5,593
Equity in net losses of investee
4,904
2,468
22,075
22,651
Depreciation and amortization
148,442
127,986
Realized gains on investing activities
(68,320)
(274,577)
Net purchases/sales of trading securities
12,047
(85,683)
Deferred annuity and life policy acquisition costs
(94,021)
(95,035)
Increase in reinsurance and other receivables
(38,456)
(125,520)
Decrease (increase) in other assets
(5,053)
70,936
Increase in insurance claims and reserves
753,862
409,598
Increase (decrease) in payable to reinsurers
(251,267)
80,797
Increase (decrease) in other liabilities
(12,626)
127,035
Other, net
18,395
13,423
854,581
775,525
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(3,258,133)
(3,729,889)
Equity securities
(181,606)
(131,932)
Subsidiary
(17,500)
(10,382)
Real estate, property and equipment
(69,327)
(46,887)
Maturities and redemptions of fixed maturity
investments
864,715
972,067
Sales of:
1,331,269
2,370,684
202,968
48,958
44,727
15,542
Cash and short-term investments of businesses
acquired or sold, net
52,556
27,857
Increase in other investments
(9,615
(16,667
(1,039,946
(500,649
Financing Activities
Fixed annuity receipts
632,465
523,968
Annuity surrenders, benefits and withdrawals
(688,416)
(534,302)
Net transfers from variable annuity assets
10,127
1,996
Additional long-term borrowings
14,716
195,008
Reductions of long-term debt
(28,342)
(8,482)
Repurchases of trust preferred securities
(188,961)
Issuances of Common Stock
11,558
7,411
Subsidiary's issuance of stock in public offering
40,391
Cash dividends paid on Common Stock
(24,645)
(27,339)
(2,923
(642
(35,069
(31,343
Net Increase (Decrease) in Cash and Short-term Investments
(220,434)
243,533
Cash and short-term investments at beginning of period
861,742
593,552
Cash and short-term investments at end of period
$ 837,085
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
G.
B.
H.
I.
C.
J.
D.
E.
K.
F.
L.
________________________________________________________________________________
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) on securities) and the cost basis of that investment is reduced.
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
In 2003, the Financial Accounting Standards Board's ("FASB") Emerging Issues Task Force ("EITF") reached a final consensus on Issue 03-16, "Accounting for Investments in Limited Liability Companies" under which limited liability companies ("LLCs") are deemed to be the same as limited partnerships for which the equity method of accounting is generally required for ownership levels of "more than 3 to 5 percent." In accordance with EITF 03-16, the cumulative effect of changing from the cost to the equity method of accounting for AFG's investment in an LLC was recorded in the third quarter of 2004.
Derivatives
The terms of the interest rate swaps match those of the hedged 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.
Managed Investment Entity
Insurance
Reinsurance
7
Subsidiaries of AFG's 82%-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 (including realized gains and losses) of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be marked to market) 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 mark to market on the embedded derivatives offsets the investment income recorded on the mark to market of the 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 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 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, Supplemental Insurance and Life Acquisition Expenses
Unpaid Losses and Loss Adjustment Expenses
8
received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims; and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos and environmental claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
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 Operations in the period in which determined. In spite of 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
Variable Annuity Assets and Liabilities
Premium Recognition
Payable to Subsidiary Trusts
9
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
The following table illustrates the effect on net earnings (loss) (in thousands) and earnings (loss) per share had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the method prescribed by SFAS No. 123.
For SFAS No. 123 purposes, the "fair value" of $9.66 per option granted in the first nine months of 2005 and $8.92 in the first nine months of 2004 was calculated using the Black-Scholes option pricing model and the following assumptions: expected dividend yield of 2%; expected volatility of 28% in 2005 and 29% in 2004; risk-free interest rate of 4.3% for 2005 and 3.7% for 2004; and expected option life of 8.4 years in 2005 and 7.5 years in 2004. There is no single reliable method to determine the actual value of options at grant date. Accordingly, actual value of the option grants may be higher or lower than the SFAS No. 123 "fair value."
Net earnings (loss), as reported
($26,430)
$138,200
$118,070
$267,340
Pro forma stock option expense,
(1,875
(1,602
(5,614
(4,810
Adjusted net earnings (loss)
($28,305)
$136,598
$112,456
$262,530
Earnings (loss) per share (as reported):
Earnings (loss) per share (adjusted):
($0.37)
$1.86
$1.46
($0.36)
$1.84
$1.45
$3.54
10
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment," which revises SFAS 123 and eliminates the use of the intrinsic value method prescribed by APB 25. Under SFAS 123(R), companies must recognize compensation expense for all new share-based awards (including employee stock options), and the nonvested portions of prior awards, based on their fair value at the date of grant. AFG expects to implement the new standard on January 1, 2006, on a prospective basis. After that date, compensation expense will be recognized for all share-based grants over their respective vesting periods. While AFG currently uses the Black-Scholes pricing model to measure the fair value of employee stock options for purposes of disclosing pro forma earnings, the use of other models are also permitted under SFAS No. 123(R). AFG has not yet determined which model it will use to measure the fair value of future stock option grants, and accordingly, cannot quantify the exact impact of implementin g the new standard.
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
11
Farmers Crop Insurance Alliance, Inc.
Transport Insurance Company
National Health Annuity Business
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, supplemental insurance and life business markets primarily retirement annuities and various forms of supplemental insurance and life products. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
12
The following tables (in thousands) show AFG's revenues and operating profit (loss) by significant business segment and sub-segment. Operating profit (loss) represents total revenues less operating expenses.
Revenues (a)
Premiums earned:
Specialty
Property and transportation
$ 270,662
$ 166,466
$ 640,319
$ 436,324
Specialty casualty
183,794
181,781
550,858
537,289
Specialty financial
91,586
87,884
270,008
271,734
California workers' compensation
88,128
90,937
262,029
251,164
16,496
19,513
49,507
57,310
Other lines
695
2,715
3,074
11,796
651,361
549,296
1,775,795
1,565,617
71,336
64,794
209,821
192,221
Realized gains
7,561
179,135
16,857
209,088
76,636
50,009
179,666
143,684
806,894
843,234
2,182,139
2,110,610
Annuities, supplemental insurance
and life:
141,951
136,682
428,685
396,729
3,008
44,381
16,635
51,282
38,963
35,816
97,232
81,779
275,733
302,808
818,808
793,597
10,149
7,479
18,461
25,020
$1,092,776
$1,153,521
$3,019,408
$2,929,227
Operating Profit (Loss)
Underwriting:
$ 5,242
$ 769
$ 72,701
$ 43,644
19,475
2,264
33,709
13,934
(9,253)
(4,566)
(21,159)
(6,826)
29,406
9,416
63,970
21,488
(1,738)
(4,289)
(2,295)
(4,171)
Other lines (b)
(177,487
(3,099
(180,333
(7,805
(134,355)
495
(33,407)
60,264
Investment income, realized gains
and other
98,397
232,931
230,560
374,819
(35,958)
233,426
197,153
435,083
and life (c)
26,731
71,818
94,507
123,638
Other (d)
(15,075
(72,660
(62,034
(115,199
($ 24,302)
$ 232,584
$ 229,626
$ 443,522
(a) Revenues include sales of products and services as well as other income
earned by the respective segments.
(b) Includes a third quarter 2005 charge of $179.3 million to increase asbestos and environmental reserves.
(c) Includes a third quarter 2005 charge of $9.5 million related to environmental liabilities at GAFRI's former manufacturing operations.
(d) Includes holding company expenses. The third quarter of 2004 includes a charge of $52 million resulting from the settlement of litigation.
13
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$297,016
$296,843
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
61,993
75,100
3,764
8,283
$667,630
$685,083
GAFRI 7-1/2% Senior Debentures due November 2033
$112,500
GAFRI 6-7/8% Senior Notes due June 2008
100,000
GAFRI 7-1/4% Senior Debentures due January 2034
86,250
Notes payable secured by real estate
33,243
26,471
APU 10-7/8% Subordinated Notes due May 2011
8,139
8,181
8,988
10,188
$349,120
$343,590
At September 30, 2005, sinking fund and other scheduled principal payments on debt for the balance of 2005 and the subsequent five years were as follows (in millions):
Holding
Company
$ -
$ .5
2006
19.7
2007
62.8
.3
63.1
2008
100.3
2009
298.0
.4
298.4
2010
2.1
GAFRI has entered into interest rate swaps that effectively convert its 6-7/8% Senior Notes to a floating rate of 3-month LIBOR plus 2.9% (effective rate of approximately 6.8% at September 30, 2005 and 5.4% at December 31, 2004). The swaps realign GAFRI's mix of floating and fixed rate 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 at June 2, 2008 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), (ii) if the credit rating of the Notes is
14
significantly lowered, or, (iii) if AFG calls the notes for redemption. 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.
Date of
Amount Outstanding
Optional
Issuance
Issue (Maturity Date)
9/30/05
12/31/04
Redemption Dates
March 1997
GAFRI 8-7/8% Pfd (2027)
$42,800
On or after 3/1/2007
May 2003
GAFRI 7.35% Pfd (2033)
20,000
On or after 5/15/2008
NIC Variable Pfd (2033)
15,000
On or after 5/23/2008
NIC and GAFRI effectively provide unconditional guarantees of their respective trusts' obligations.
Stock Incentive Plans
The American Jobs Creation Act of 2004 provides a special one-time dividends received deduction on the repatriation of certain foreign earnings. Through October 2005, Great American Life Assurance Company of Puerto Rico paid $40 million in dividends to GAFRI. Deferred taxes had previously been accrued on these earnings. While AFG is still evaluating whether it will remit any additional qualified foreign earnings under this provision in 2005, it does not believe the impact of any such election will be material to its results of operations.
15
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
28
Ratios
Other Items
29
Sources of Funds
Proposed Accounting Standard
20
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 forward-looking 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. Examples of 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. AFG 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, since 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 retirement annuities and supplemental insurance and life products.
AFG reported a net loss for the third quarter of 2005 of $26.4 million or $.34 per share (diluted), compared to net earnings of $138.2 million or $1.85 per share recorded in the comparable period in 2004. Significantly improved underwriting results in AFG's Specialty property and casualty insurance operations and gains on the sale of Illinois coal assets were more than offset by a charge to strengthen asbestos and environmental ("A&E") reserves. Additionally, in the 2004 quarter, AFG reported a significant gain on the sale of Provident Financial Group, partially offset by a litigation charge.
Net earnings for the first nine months of 2005 were $118.1 million or $1.51 per share, compared to $267.3 million or $3.58 per share recorded in the comparable period in 2004. The decline reflects the items discussed above.
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. Management believes that the establishment of insurance reserves, especially asbestos and environmental-related reserves, the recoverability of annuity and life deferred policy acquisition costs, and the determination of "other than temporary" impairment on investments are the areas where the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical. For a discussion of these policies, see Management's Discussion and Analysis - "Critical Accounting Policies" in AFG's 2004 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
2003
Consolidated debt (1)
$1,095
$1,106
$1,102
Total capital (2)
3,696
3,575
3,187
Ratio of debt to total capital
29.6%
30.9%
34.6%
(1) Includes payable to subsidiary trusts.
(2) Includes consolidated debt, minority interest and
shareholders' equity (excluding unrealized gains (losses)
related to fixed maturity investments).
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.73 for the nine months ended September 30, 2005 (2.32 excluding the A&E charge) and 2.43 (1.91 excluding the Provident gain) for the entire year of 2004. Excluding annuity benefits, this ratio was 4.27 (6.96 excluding the A&E charge) and 7.07 (4.85 excluding the Provident gain), respectively. Although the ratio excluding interest on annuities 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
In November 2004, AFG replaced its existing credit line with a $300 million, four-year revolving credit facility. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on AFG's credit rating. No amounts have been borrowed under this agreement. This credit agreement provides ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent company.
Under a currently effective shelf registration statement, AFG can offer up to an aggregate of $517 million in additional equity or debt securities including 2.3 million shares of common stock remaining under a 2004 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.
Subsidiary Liquidity
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 resorting to sales 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.
As discussed in Note C, National Interstate Corporation issued 3.4 million shares of its common stock in a February 2005 initial public offering for net proceeds of $40.4 million.
In August 2004, GAFRI replaced its existing credit agreement with a $150 million four-year revolving credit facility; this facility was increased to $165 million in April 2005. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on GAFRI's credit rating. No amounts have been borrowed under this agreement. In addition, GAFRI can offer approximately $250 million in additional equity or debt securities under a currently effective shelf registration.
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.
Approximately 94% of the fixed maturities held by AFG at September 30, 2005, 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.
Individual portfolio securities are sold creating gains or losses as market opportunities exist. Since all of these securities are carried at market value in the balance sheet, there is virtually no effect on liquidity or 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 September 30, 2005, is shown in the following table (dollars in millions). Approximately $68 million of available for sale "Fixed maturities" and $15 million of "Other stocks" had no unrealized gains or losses at September 30, 2005.
With
Gains
Losses
Available for sale Fixed Maturities
Market value of securities
$ 6,990
$ 7,172
Amortized cost of securities
$ 6,737
$ 7,283
Gross unrealized gain (loss)
$ 253
($ 111)
Market value as % of amortized cost
104%
98%
Number of security positions
1,328
981
Number individually exceeding
$2 million gain or loss
Concentration of gains (losses) by
type or industry (exceeding 5% of
unrealized):
Banks, savings and credit institutions
$40.6
($ 5.9)
Gas and electric services
35.0
(3.1)
Mortgage-backed securities
19.1
(49.4)
U.S. Government and government agencies
14.3
(15.7)
Telephone communications
14.9
(1.9)
State and municipal
13.1
(7.4)
Percentage rated investment grade
92%
96%
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at September 30, 2005, based on their market 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
4%
2%
After one year through five years
21
25
After five years through ten years
44
After ten years
83
53
47
100
AFG realized aggregate losses of $4.5 million during the first nine months of 2005 on $132.7 million in sales of fixed maturity securities (five issues/issuers) that had individual unrealized losses greater than $500,000 at December 31, 2004. The market value of two of the securities increased an aggregate of $677,000 from December 31 to the sale date. The market value of the other three securities decreased an aggregate of $652,000 from December 31 to the sale date.
Although AFG had the ability to continue holding these investments, its intent to hold them changed due primarily to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular industry, or to modify asset allocation within the portfolio.
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Market
Aggregate
Value as
% of Cost
Value
Gain (Loss)
Basis
Fixed Maturities at September 30, 2005
Securities with unrealized gains:
Exceeding $500,000 (135 issues)
$1,769
$124
108%
Less than $500,000 (1,193 issues)
5,221
129
103
$6,990
$253
Securities with unrealized losses:
Exceeding $500,000 (42 issues)
$1,256
($ 36)
97%
Less than $500,000 (939 issues)
5,916
( 75)
99
$7,172
($111)
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 September 30, 2005
Investment grade with losses for:
One year or less (789 issues)
$5,825
($ 73)
99%
Greater than one year (135 issues)
1,081
(32
97
$6,906
($105)
Non-investment grade with losses for:
One year or less (43 issues)
$ 231
($ 4)
Greater than one year (14 issues)
35
(2
95
$ 266
($ 6)
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 2004 Form 10-K.
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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.
See Management's Discussion and Analysis - "Asbestos and Environmental Charge" for a discussion of AFG's third quarter 2005 charge to increase its A&E reserves.
RESULTS OF OPERATIONS
AFG reported an operating loss before income taxes of $24.3 million in the third quarter of 2005 compared to operating earnings before income taxes of $232.6 million in the 2004 quarter. A $39.5 million improvement in Specialty property and casualty insurance underwriting results compared to the 2004 quarter and $30.9 million in pretax gains from the sale of Illinois coal assets were more than offset by $189 million in pretax charges resulting from strengthening A&E reserves within AFG's run-off operations. The 2005 results include $40 million in pretax losses from hurricanes Katrina and Rita compared to $35 million in hurricane losses in the 2004 period. Results for the 2004 quarter include a $214 million pretax gain on the sale of Provident Financial Group securities and a $52 million litigation charge.
Nine month pretax operating earnings decreased $213.9 million compared to 2004 reflecting a $78.9 million improvement in Specialty property and casualty insurance underwriting results which was more than offset by the net effect of the other third quarter items discussed above.
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 D - "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:
$ 496.8
$ 527.7
$1,087.1
$1,105.8
359.6
364.8
1,080.7
1,116.4
133.1
114.7
367.6
342.5
93.5
97.3
289.8
283.7
(2.5
1.7
1.2
.2
Total Specialty
$1,080.5
$1,106.2
$2,826.4
$2,848.6
Net Written Premiums (GAAP)
$ 291.0
$ 172.4
$ 728.8
$ 525.3
192.3
189.4
567.4
581.5
107.9
91.5
294.7
277.5
84.2
87.4
260.5
252.0
16.4
19.8
48.4
50.2
$ 691.8
$ 560.5
$1,899.8
$1,686.5
Combined Ratios (GAAP)
Property and transportation (b)
98.1%
99.5%
88.7%
90.0%
89.4
98.7
93.9
97.4
Specialty financial (c)
110.1
105.2
107.8
102.5
66.7
89.7
75.5
110.6
122.0
104.6
107.3
Total Specialty (d)
93.3%
99.4%
91.8%
95.6%
(a)
AFG's aggregate combined ratio, including other (primarily discontinued) lines, was 120.6% and 99.9% for the three months ended September 30, 2005 and 2004 and 101.8% and 96.2% for the nine months ended September 30, 2005 and 2004, respectively. The aggregate ratio includes 27.5 points and 10.1 points, respectively, for the three and nine month periods of 2005 relating to the A&E charge.
(b)
Includes the effect of hurricane losses for the 2005 three and nine month periods of 10.8 points and 4.6 points, respectively, and for the 2004 three and nine month periods of 16.6 points and 6.3 points, respectively.
(c)
Includes the effect of hurricane losses for the 2005 three and nine month periods of 7.1 points and 2.4 points, respectively, and for the 2004 three and nine month periods of 2.9 points and 0.9 points, respectively.
(d)
Excludes discontinued operations. Includes the effect of hurricane losses of 6.2% and 2.3%, respectively, for the three and nine month periods of 2005 and 6.4% and 2.3%, respectively, for the three and nine month periods of 2004.
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Gross written premiums of the Specialty business were 2% lower for the third quarter and 1% lower for the nine months compared to the same periods in 2004. While certain operations experienced volume growth, overall premium levels for the Specialty insurance operations continued to be impacted by the moderating rate environment. Overall average rates in the 2005 third quarter were down slightly compared to the same period a year earlier. Net written premiums increased 23% for the third quarter and 13% for the nine months over the comparable 2004 periods, reflecting continued increases in retention of premiums under reinsurance agreements.
Property and transportation gross written premiums decreased 6% for the third quarter and 2% for the nine months compared to the 2004 periods, due primarily to the effect of lower commodity prices earlier in the year which were used to establish the insured value of crop insurance coverages and lower volume resulting from competitive pricing within the excess property insurance operations. Net written premiums increased 69% and 39% during the third quarter and nine months compared to the 2004 periods reflecting a reduction in reinsurance ceded, principally in the crop insurance and inland marine operations. Excluding the effect of hurricanes in both periods, the combined ratio for the 2005 quarter was 4.4 points higher than the 2004 third quarter, reflecting primarily the exceptionally strong profitability reported by the crop insurance business in the 2004 period. This group's combined ratio for the first nine months of 2005 was comparable to the 2004 period, excluding the effects of hurr icane losses in both years.
Asbestos and Environmental Reserve Charge AFG recently completed a comprehensive study of its asbestos and environmental exposures relating to the run-off operations of its property and casualty group. AFG has undertaken periodic reviews of its A&E reserves with the aid of an international independent actuarial firm and specialty outside counsel. As a result of its study, AFG recorded a 2005 third quarter pre-tax charge of $179 million, net of $26 million in reinsurance recoverables. This charge resulted in an increase in asbestos reserves of $124 million and environmental and other mass tort reserves of $55 million. At September 30, 2005, AFG's A&E reserves were $475 million, net of reinsurance recoverables. At that date, AFG's three year survival ratio was 21.8 times paid losses for the asbestos reserves and 13.2 times paid losses for the total A&E reserves (16.8 and 10.6 times paid losses, respectively, excluding amounts associated with the 2003 settlement of asbestos related coverage litigation for A.P. Green Industries).
This study reviewed open and closed A&E claims at June 30, 2005. With respect to asbestos, it considered both direct insurance and assumed reinsurance, products and non-products exposure, paid claims history, the pattern of new claims, settlements and projected development. As has been reported by others, the asbestos legal climate remains very difficult to predict. While some progress has been made in state asbestos tort reform, that progress has been somewhat offset by increased claims costs, increased defense costs, the assertion of non-products theories and an increasing number of claims against small to mid-sized insureds.
A primary driver of the increase in AFG's asbestos reserves is the use by independent actuaries of evolving methodologies, including developing parameters for estimating loss adjustment expenses and reducing reliance on extrapolation techniques. In addition, the independent actuaries have indicated that their views have evolved regarding estimation of the potential exposure for both products and non-products claims. In the actuaries' view, this refined approach has increased estimates of the company's indicated ultimate losses. The estimates of industry ultimate losses and AFG's historic premium market share have not changed since the 2001 study. In addition, there has been no significant change in AFG's payment patterns. In the 2005 study, the actuaries also have given additional weight to claims associated with peripheral defendants bringing direct insurance claims. While no single claim presents an unduly large exposure, the increase in the number of direct insurance claims from peripheral defend ants has increased the projections of future defense cost and loss exposure.
While tort reform is helping in some jurisdictions, the legal climate in many jurisdictions continues to deteriorate, with larger verdict values being experienced. Expanding coverage interpretations by some courts also has led to increased exposure to some policies in certain jurisdictions.
With respect to the environmental claims, the study considered both direct insurance and assumed reinsurance, projected exposure at both National Priorities List ("NPL") sites and non-NPL sites, historic payment patterns, patterns of new claims, settlements and projected development. The increase in environmental reserves is primarily due to an increase in clean up costs at certain sites above prior expectations and a recent unexpected increase in the number of new claims that have been reported to the Company. In addition, projected development on a few claims exceeded estimates in the previous 2001 study.
26
Establishing reserves for A&E claims relating to policies and participations in reinsurance treaties and former operations is subject to uncertainties that are significantly greater than those presented by other types of claims. For further discussion, see Management's Discussion and Analysis - "Uncertainties" in AFG's 2004 Form 10-K.
Investment Income
Realized Gains
In July 2004, AFG received common and preferred shares equivalent to 8.1 million common shares of National City Corporation in exchange for its ownership interest in Provident Financial Group and realized a $214.3 million pretax gain on the transaction.
Realized gains on securities include provisions for other than temporary impairment of securities still held as follows: third quarter of 2005 and 2004 -$3.9 million and $5.1 million; nine months of 2005 and 2004 - $11.5 million and $13.2 million, respectively.
Real Estate Operations
$65.9
$34.6
$124.6
$80.4
25.1
24.5
68.4
60.7
.5
1.4
1.5
Minority interest expense, net
.9
1.3
2.0
2.2
The increase in income from real estate operations reflects a $30.9 million pretax gain on the sale of Illinois coal reserves and to a lesser extent, acquisitions of new properties. Other income also includes net pretax gains on the sale of other real estate assets of $1.1 million in the third quarter and $10.1 million for the first nine months of 2005 and $3.9 million and $10.4 million for the 2004 periods.
Fourth Quarter Real Estate Sales
27
Other Income
Annuity Benefits
Historically, GAFRI has been able to react to changes in market interest rates and maintain a desired interest rate spread. Significant changes in projected investment yields could result in charges (or credits) to earnings in the period the projections are modified.
Annuity benefits in the third quarter of 2005 were comparable to the third quarter of 2004 as an increase in reserves due to new business was offset by lower average crediting rates. Annuity benefits for the first nine months of 2005 increased $18.0 million (8%) compared to the same period in 2004 reflecting a full nine months of activity on the block of annuity policies acquired in May 2004.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. GAFRI's actuarial assumptions include an assumed reinvestment rate of 5.5% in 2005 increasing ratably to an ultimate assumed reinvestment rate of 7.0%. If the current interest rate environment persists through the end of the year, including a flattened yield curve, GAFRI may be required to write-off DPAC related to its fixed annuity operations. In addition, continued spread compression, decreases in the stock market and adverse mortality could also lead to write-offs of DPAC in the future. Any potential write-off of DPAC is not expected to have a material impact on the company's liquidity or results of operations.
Interest Expense
Interest on Subsidiary Trust Obligations Interest charges decreased $2.7 million for the first nine months of 2005 compared to 2004 due to the retirement of trust preferred securities in the 2004 first quarter.
Other Operating and General Expenses
Minority Interest Expense
Cumulative Effect of Accounting Change
In July 2004, AFG recorded a $3.8 million after-tax charge resulting from implementation of EITF 03-16, "Accounting for Investments in Limited Liability Companies." This charge reflects the cumulative effect of changing from the cost method to the equity method of accounting for AFG's investment in a limited liability company. This charge reduced AFG's investment in this entity to zero. Management believes the fair value of this investment substantially exceeds its carrying value prior to the writedown.
Convertible Notes
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
Other than as discussed in Management's Discussion and Analysis - "Annuity, Supplemental Insurance and Life Acquisition Expenses," with respect to a potential write-off of deferred acquisition costs in the fourth quarter of 2005, as of September 30, 2005, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2004 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(e)) 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. Examples include subsidiary implementation of a new general ledger system and payroll system during the first quarter of 2005. There has been no change in AFG's business processes and procedures during the third fiscal quarter of 2005 that has materially affected, or is reasonably likely to materially affect, AFG's internal controls over financial reporting.
30
PART II
OTHER INFORMATION
ITEM 1
Legal Proceedings
As previously reported under "Legal Proceedings" in AFG's 2004 Form 10-K, Great American Insurance Company entered into an agreement in 2003, which was approved by the bankruptcy court, for the settlement of coverage litigation related to A.P. Green asbestos claims. The settlement is for $123.5 million (Great American has the option to pay in cash or over time with 5.25% interest). The agreement allows up to 10% of the settlement to be paid in AFG Common Stock. The settlement agreement is conditioned upon confirmation of a plan of reorganization that includes an injunction prohibiting the assertion against Great American of any present or future asbestos personal injury claims under policies issued to A.P. Green and related companies.
On September 15, 2005, A.P. Green filed its First Amended Plan of Reorganization. The plan is undergoing review for comment by interested parties. No assurance can be made that all conditions will be met; no payments are required until completion of the process. If the conditions are not met, the outcome of this litigation will again be subject to the complexities and uncertainties associated with a Chapter 11 proceeding and asbestos coverage litigation.
ITEM 6
Exhibits
Number
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.
31
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.
November 4, 2005
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)
32