SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Quarterly Period EndedJune 30, 2007
Commission File
AMERICAN FINANCIAL GROUP, INC.
Incorporated underthe Laws of Ohio
IRS Employer I.D.No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirementsfor the past 90 days. Yes X No
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer: Large Accelerated Filer X Accelerated Filer Non-Accelerated Filer
Indicate by check mark whether the Registrant is a shell company. Yes No X
As of August 1, 2007, there were 119,315,627 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)
June 30,
December 31,
2007
2006
Assets:
Cash and cash equivalents
$ 679.5
$ 1,329.0
Investments:
Fixed maturities:
Available for sale - at fair value
(amortized cost - $15,499.2 and $14,663.0)
15,237.3
14,624.3
Trading - at fair value
279.8
276.4
Equity securities - at fair value
(cost - $803.0 and $606.4)
920.5
729.4
Mortgage loans
299.1
264.5
Policy loans
269.2
267.1
Real estate and other investments
274.6
248.3
Total cash and investments
17,960.0
17,739.0
Recoverables from reinsurers and prepaid
reinsurance premiums
3,660.9
3,625.2
Agents' balances and premiums receivable
700.1
599.4
Deferred policy acquisition costs
1,342.6
1,266.9
Other receivables
318.1
425.0
Variable annuity assets (separate accounts)
717.2
700.5
Prepaid expenses and other assets
820.5
577.3
Goodwill
176.5
167.8
$25,695.9
$25,101.1
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 6,077.9
$ 6,027.7
Unearned premiums
1,782.1
1,653.9
Annuity benefits accumulated
9,829.1
9,456.7
Life, accident and health reserves
1,446.4
1,414.7
Payable to reinsurers
302.9
314.9
Long-term debt
897.3
921.0
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,384.4
1,398.9
Total liabilities
22,437.3
21,888.3
Minority interest
288.5
283.9
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 119,266,409 and 119,303,928 shares outstanding
119.3
Capital surplus
1,236.8
1,220.5
Retained earnings
1,655.7
1,533.6
Accumulated other comprehensive income (loss),
net of tax
(41.7
55.5
Total shareholders' equity
2,970.1
2,928.9
2
CONSOLIDATED STATEMENT OF EARNINGS (unaudited)
(In Millions, Except Per Share Data)
Three months ended
Six months ended
Income:
Property and casualty insurance premiums
$ 633.5
$615.0
$1,273.3
$1,194.1
Life, accident and health premiums
103.4
75.6
210.0
157.6
Investment income
249.0
233.5
494.8
465.4
Realized gains (losses) on securities
14.0
(7.5)
18.7
22.3
Other income
92.0
78.4
174.7
151.7
1,091.9
995.0
2,171.5
1,991.1
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
354.8
373.4
681.7
710.5
Commissions and other underwriting
expenses
208.5
168.6
418.7
341.9
Annuity benefits
90.4
84.0
179.2
166.8
Life, accident and health benefits
85.4
66.6
170.9
134.2
Annuity and supplemental insurance
acquisition expenses
40.7
30.2
85.2
63.8
Interest charges on borrowed money
17.7
17.1
35.8
35.6
Other operating and general expenses
181.9
108.5
292.6
221.9
979.4
848.4
1,864.1
1,674.7
Operating earnings before income taxes
112.5
146.6
307.4
316.4
Provision for income taxes
36.8
41.7
109.1
101.3
Net operating earnings
75.7
104.9
198.3
215.1
Minority interest expense
(10.1)
(7.2)
(18.6)
(15.0)
Equity in net losses of investee,
(.3
(.5
(.8
(1.0
Earnings from continuing operations
65.3
97.2
178.9
199.1
Discontinued operations, net of tax
1.7
25.7
25.3
Net Earnings
$ 67.0
$122.9
$180.6
$ 224.4
Basic earnings per Common Share:
Continuing operations
$ .55
$ .83
$1.50
$1.70
Discontinued operations
.01
.21
Net earnings available to Common Shares
$ .56
$1.04
$1.51
$1.91
Diluted earnings per Common Share:
$ .53
$ .81
$1.46
$1.66
$ .54
$1.02
$1.47
$1.87
Average number of Common Shares:
Basic
119.6
117.8
119.5
117.6
Diluted
122.4
120.4
119.7
Cash dividends per Common Share
$.10
$.092
$.20
$.183
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (unaudited)
(Dollars in Millions)
Accumulated
Common Stock
Other
Common
and Capital
Retained
Comprehensive
Shares
Surplus
Earnings
Income (Loss)
Total
Balance at December 31, 2006
119,303,928
$1,339.8
$1,533.6
$ 55.5
$2,928.9
Cumulative effect of accounting change
-
(14.9)
Net earnings
180.6
Other comprehensive income, net of tax:
Change in unrealized gain (loss)
on securities
(112.7)
Change in foreign currency translation
12.7
Change in unrealized pension and other
postretirement benefits
2.8
Total comprehensive income
83.4
Dividends on Common Stock
(23.9)
Shares issued:
Exercise of stock options
590,784
13.9
Dividend reinvestment plan
80,224
2.7
Employee stock purchase plan
17,488
.6
Deferred compensation distributions
31,863
1.1
Directors fees paid in stock
9,965
.4
Stock incentive plan
114,594
3.9
Other stock-based compensation expense
5.1
Shares acquired and retired
(855,939)
(9.6)
(19.1)
(28.7)
Shares tendered in option exercises
(26,498)
(.3)
(.6)
(.9)
Capital transactions of subsidiaries
(1.5
Balance at June 30, 2007
119,226,409
$1,356.1
$1,655.7
($ 41.7)
$2,970.1
Balance at December 31, 2005
117,101,271
$1,272.7
$1,134.1
$ 50.8
$2,457.6
224.4
Other comprehensive loss,
net of tax:
Change in unrealized gain on securities
(210.5)
(21.6)
767,547
17.4
99,539
2.6
18,766
.5
63,162
1.6
12,780
(192,021)
(2.1)
(3.3)
(5.4)
Stock-based compensation expense
3.3
1.2
3.8
Balance at June 30, 2006
117,871,044
$1,301.4
$1,333.6
($159.7
$2,475.3
4
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
Operating Activities:
$ 180.6
Adjustments:
Equity in net losses of investee
.8
1.0
18.9
20.8
Depreciation and amortization
95.2
77.3
Realized gains on investing activities
(35.1)
(84.1)
Net purchases/sales of trading securities
(41.0)
(13.0)
Deferred annuity and life policy acquisition costs
(103.2)
(66.9)
Decrease (increase) in reinsurance and other receivables
(19.7)
29.3
Decrease (increase) in other assets
(195.1)
Increase in insurance claims and reserves
209.2
243.0
Decrease in payable to reinsurers
(12.0)
(34.9)
Decrease in other liabilities
(15.6)
(82.8)
Other, net
9.7
11.7
Net cash provided by operating activities
271.9
510.3
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(1,946.4)
(1,635.4)
Equity securities
(224.4)
(125.8)
Subsidiaries
(1.7)
(2.6)
Real estate, property and equipment
(13.8)
(23.2)
Maturities and redemptions of fixed maturity investments
667.3
499.5
Sales of:
433.4
824.3
97.6
113.8
Subsidiary
37.5
22.9
34.4
Decrease in securities lending collateral
5.2
Cash and cash equivalents of businesses
acquired or sold, net
100.0
Increase in other investments
(54.8
(29.9
Net cash used in investing activities
(1,014.7
(207.4
Financing Activities
Annuity receipts
817.4
515.4
Annuity surrenders, benefits and withdrawals
(691.7)
(592.0)
Net transfers from variable annuity assets
31.9
7.2
Additional long-term borrowings
26.2
Reductions of long-term debt
(117.3)
(130.7)
Decrease in securities lending obligation
(5.2)
Issuances of Common Stock
13.3
11.8
Repurchases of Common Stock
Cash dividends paid on Common Stock
(21.2)
(19.0)
Net cash provided by (used in) financing activities
93.3
(179.5
Net Increase (Decrease) in Cash and Cash Equivalents
(649.5)
123.4
Cash and cash equivalents at beginning of period
1,329.0
471.9
Cash and cash equivalents at end of period
$ 595.3
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
E.
B.
F.
G.
C.
H.
D.
I.
________________________________________________________________________________
Basis of Presentation
Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
Stock Split
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) and the cost basis of that investment is reduced.
Certain AFG subsidiaries loan fixed maturity and equity securities to other institutions for short periods of time. The borrower is required to provide collateral on which AFG earns investment income, net of a fee to the lending agent. AFG records the collateral held (included in other assets) and the liability to return the collateral (included in other liabilities) in its
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Balance Sheet at fair value. The securities loaned remain a recorded asset on AFG's Balance Sheet. At June 30, 2007, the fair value of collateral held was approximately $154 million and the fair value of securities loaned plus accrued interest was approximately $151 million.
Derivatives
The terms of the interest rate swaps match those of the debt; therefore, the swaps are considered to be (and are accounted for as) 100% effective fair value hedges. Both the swaps and the hedged debt are adjusted for changes in fair value by offsetting amounts. Accordingly, since the swaps are included with long-term debt in the Balance Sheet, the only effect on AFG's financial statements is that the interest expense on the hedged debt is recorded based on the variable rate.
Reinsurance
Subsidiaries of AFG's 81%-owned subsidiary, Great American Financial Resources, Inc. ("GAFRI"), cede life insurance policies to a third party on a funds withheld basis whereby GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. GAFRI classifies the securities related to these transactions as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income record ed on the adjustment to fair value of the related trading portfolios.
7
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 gains on marketable securities, a component of "Accumulated Other Comprehensive Income (Loss), 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 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.
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
8
in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Annuity Benefits Accumulated
Life, Accident and Health Reserves
Variable Annuity Assets and Liabilities
Premium Recognition
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.
AFG records a liability for the inherent uncertainty in quantifying its income tax provisions. Interest and penalties related to these unrecognized tax benefits are recognized as a component of tax expense.
AFG implemented FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)" ("FIN 48") on January 1, 2007. FIN 48 sets forth criteria for recognition and measurement of tax positions taken or expected to be taken in a tax return. FIN 48 requires that companies recognize the impact of a tax position if that position is more
9
likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest, penalties, accounting in interim periods and disclosure. The cumulative effect of applying FIN 48 was recorded as a reduction to retained earnings at January 1, 2007 and is shown separately in the Statement of Changes in Shareholders' Equity. See Note G - "Income Taxes."
Stock-Based Compensation
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
Adjustments to net earnings:
Dilution of majority-owned subsidiaries
($0.4)
($0.9)
($0.5)
Assumed issuance of shares under
deferred compensation plan
0.2
(0.1)
Adjustments to weighted average common shares:
Stock-based compensation plans
2.9
2.1
Statement of Cash Flows
Great American Financial Resources
10
expects the merger to be completed in September 2007 and expects that GAFRI will use excess capital plus borrowings from AFG to fund the transaction.
Ceres Group, Inc.
Chatham Bars Inn
Old Standard Life Fixed Annuity Business
Great American Life Assurance Company of Puerto Rico
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 and professional liability and customized programs for small to mid-sized businesses, (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions, surety and fidelity products and trade credit insurance, and (iv) California workers' compensation. 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 determined based primarily upon si milar economic characteristics, products and services.
11
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
$ 238.8
$225.1
$ 467.4
$ 425.1
Specialty casualty
212.2
197.3
423.4
385.5
Specialty financial
112.4
97.5
226.8
193.7
California workers' compensation
58.7
75.8
121.5
153.1
11.3
18.8
33.9
Other lines
.1
.3
633.5
615.0
1,273.3
1,194.1
86.8
81.1
170.7
160.7
Realized gains
7.0
1.3
27.3
48.9
50.9
99.3
97.9
776.2
748.3
1,553.0
1,480.0
Annuity and supplemental insurance:
159.5
150.4
318.3
300.8
75.5
Realized gains (losses)
8.1
(8.8)
10.0
(5.1)
31.8
21.7
58.9
46.2
302.8
238.8
597.2
12.9
7.9
21.3
11.6
$1,091.9
$995.0
$2,171.5
$1,991.1
Operating Earnings Before Income Taxes
Underwriting:
$ 26.1
$ 31.1
$ 64.7
$ 73.2
67.3
28.4
126.3
43.0
10.6
14.3
1.4
16.3
25.1
28.8
Other (a)
(1.0)
(12.4)
Other lines (b)
(44.4
(3.9
(45.1
(5.0
70.2
73.0
172.9
141.7
Investment income, realized gains
and other
72.2
75.3
156.8
173.1
142.4
148.3
329.7
314.8
35.0
18.6
66.1
48.1
Other (c)
(64.9
(20.3
(88.4
(46.5
$ 112.5
$146.6
$ 307.4
$ 316.4
(a) Includes a first quarter 2007 charge of $13.5 million to adjust a
retroactive reinsurance gain.
(b) Includes a second quarter 2007 charge of $44.2 million to increase asbestos
and environmental reserves.
(c) Includes holding company expenses and a second quarter 2007 charge of
$41 million related to asbestos and environmental liabilities at former
railroad and manufacturing operations.
12
Included in deferred policy acquisition costs in AFG's Balance Sheet are $75.1 million and $95.0 million at June 30, 2007, and December 31, 2006, respectively, representing the present value of future profits ("PVFP") related to acquisitions by AFG's annuity and supplemental insurance business. In the second quarter of 2007, PVFP was reduced by $12.3 million due to a refinement of the purchase price allocation for the August 2006 Ceres acquisition. The PVFP amounts are net of $78.1 million and $70.5 million of accumulated amortization. Amortization of the PVFP was $2.4 million in the second quarter and $7.6 million during the first six months of 2007 and $1.6 million in the second quarter and $3.3 million in the first six months of 2006, respectively. The increase in amortization compared to the 2006 periods reflects the acquisition of Ceres.
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$173.1
$182.9
AFG Senior Convertible Notes due June 2033
189.7
AFG 7-1/8% Senior Debentures due February 2034
115.0
AFG 7-1/8% Senior Debentures due December 2007
59.5
3.7
541.0
550.9
GAFRI 7-1/2% Senior Debentures due November 2033
GAFRI 7-1/4% Senior Debentures due January 2034
86.3
GAFRI 6-7/8% Senior Notes due June 2008
28.5
31.5
GAFRI borrowings under AFG/GAFRI credit facility
16.0
Notes payable secured by real estate
67.7
67.8
American Premier Underwriters 10-7/8% Subordinated
Notes due May 2011
8.0
2.3
6.9
321.3
313.1
Payable to Subsidiary Trusts:
GAFRI 7.35% Subordinated Debentures due May 2033
20.0
GAFRI 8-7/8% Subordinated Debentures
22.0
National Interstate Variable Rate Subordinated
Debentures due May 2033
15.0
57.0
$897.3
$921.0
At June 30, 2007, scheduled principal payments on debt for the balance of 2007 and the subsequent five years were as follows: 2007 - $60.5 million; 2008 - $29.2 million; 2009 - $174.6 million; 2010 - $2.9 million; 2011 - $25.1 million; and 2012 - $1.4 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
$829.6
$853.2
Obligations secured by real estate
13
On March 1, 2007, GAFRI used funds borrowed under the AFG/GAFRI bank credit facility to redeem its $22 million in outstanding 8-7/8% Subordinated Debentures due 2027 for $22.9 million.
In March 2006, AFG and GAFRI replaced their existing credit agreements with a five-year revolving credit facility under which they can borrow a combined $500 million. AFG and GAFRI have agreed not to borrow more than $325 million and $200 million, respectively, under the credit facility and AFG has agreed to guarantee amounts borrowed by GAFRI. Amounts borrowed bear interest at rates ranging from 0.5% to 1.25% over LIBOR based on AFG's credit rating. At June 30, 2007, GAFRI had $16 million in borrowings outstanding under the credit facility (interest rate of 6.1% at June 30, 2007).
To achieve a desired balance between fixed and variable rate debt, GAFRI has entered into interest rate swaps that effectively convert its 6-7/8% fixed rate Senior Notes to a floating rate of 3-month LIBOR plus 2.9%.
AFG's Senior Convertible Notes were issued at a price of 37.153% of the principal amount due at maturity. Interest is payable semiannually at a rate of 4% of issue price per year through June 2008, after which interest at 4% annually will be accrued and added to the carrying value of the Notes. The Notes are redeemable at AFG's option at any time on or after June 2, 2008, at accreted value ranging from $371.53 per Note to $1,000 per Note at maturity. Generally, holders may convert each Note into 17.2524 shares of AFG Common Stock (at $21.53 per share currently) (i) if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value ($25.84 per share currently) for a specified period, (ii) if the credit rating of the Notes is significantly lowered, or, (iii) if AFG calls the notes for redemption. Based on the market price of AFG's Common Stock during the quarter ended June 30, 2007, the Notes are currently convertible through Septem ber 30, 2007. AFG has delivered cash in lieu of Common Stock upon conversion of the Notes and intends to continue to do so. Accordingly, shares issuable upon conversion of the Notes are not treated as dilutive.
Accumulated Other Comprehensive Income (Loss), Net of Tax
Net unrealized gain (loss) on securities
($62.0)
$50.7
Foreign currency translation adjustment
17.0
4.3
Unrealized pension and other postretirement benefits
Total accumulated other comprehensive income (loss)
($41.7)
$55.5
Stock Incentive Plans
14
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility (after consideration of other factors). The fair value of options granted in the first quarter of 2007 was $10.46 per share based on the following assumptions: expected dividend yield - 1.2%; expected volatility - 21.5%; expected term - 6 1/2 years; risk-free rate - 4.7%.
Total compensation expense related to stock incentive plans of AFG and its two public subsidiaries was as follows: second quarter of 2007 and 2006 - $4.1 million and $2.6 million; six months of 2007 and 2006 - $10.7 million and $4.8 million, respectively. Stock-based compensation expense for the first six months of 2007 includes $3.9 million in first quarter non-deductible stock awards.
As of January 1, 2007, AFG's 2004, 2005 and 2006 tax years remain subject to examination by the IRS. In addition, AFG has several tax years for which there are ongoing disputes. AFG has subsidiaries in various states, cities and provinces that are currently under audit for years ranging from 1995 through 2004. In April 2007, AFG signed a settlement agreement with a municipality. As a result of this settlement, AFG reduced its liability for unrecognized income tax benefits by $5.7 million ($3.7 million net of federal tax effect) in the second quarter of 2007.
15
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
16
Results of Operations
22
Overview
General
Critical Accounting Policies
17
Income Items
Liquidity and Capital Resources
18
Expense Items
26
Sources of Funds
Recent Accounting Standard
27
19
Proposed Accounting Standard
28
Uncertainties
_____________________________________________________________________________________________________
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. This safe harbor does not apply to statements with respect to the pending transaction with GAFRI. Some of the forward-looking statements can be identified by the use of words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate increases; and improved loss experience.
Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:
The forward-looking statements herein are made only as of the date of this report. The Company assumes no obligation to publicly update any forward-looking statements.
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, 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
of Financial Condition and Results of Operations - Continued
addition, because most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
At June 30, 2007, AFG (parent) had approximately $160 million in cash and securities and no amounts borrowed under the AFG/GAFRI bank line of credit. GAFRI had $16 million borrowed under this line at June 30, 2007.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance, and in the sale of traditional fixed, indexed and variable annuities and a variety of supplemental insurance products.
AFG's net earnings for the second quarter and first six months of 2007 were $67.0 million ($.54 per share, diluted) and $180.6 million ($1.47 per share, diluted), respectively, compared to $122.9 million ($1.02 per share, diluted) and $224.4 million ($1.87 per share) reported in the same periods of 2006. These results reflect higher earnings from the Company's ongoing insurance operations, lower gains from sales of real estate, and the effect of charges to strengthen reserves for asbestos and other environmental exposures ("A&E") within the property and casualty insurance run-off operations and A&E reserves related to former railroad and manufacturing operations.
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 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 2006 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
Ratios
2005
$ 897
$ 921
$1,000
Total capital (*)
4,291
4,160
3,703
Ratio of debt to total capital:
Including debt secured by real estate
20.9%
22.1%
27.0%
Excluding debt secured by real estate
19.7%
26.3%
(*) Includes long-term 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 2.39 for the six months ended June 30, 2007 and 2.62 for the entire year of 2006. Excluding annuity benefits, this ratio was 8.24 and 9.15, 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 March 2006, AFG and GAFRI replaced their existing credit agreements with a five-year revolving credit facility under which they can borrow a combined $500 million. AFG and GAFRI have agreed not to borrow more than $325 million and $200 million, respectively, under the credit facility and AFG has agreed to guarantee amounts borrowed by GAFRI. GAFRI had $16 million in borrowings outstanding under this agreement at June 30, 2007, bearing interest at a rate of 6.1% at June 30, 2007.
In addition to parent company cash and marketable securities of approximately $160 million, AFG can borrow approximately $230 million on its bank line and maintain its desired debt to total capital ratio of less than 25%.
Under a currently effective shelf registration statement, AFG can offer additional equity or debt securities. 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 requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In GAFRI's annuity business, where profitability is largely dependent on earning a "spread" between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. With declining rates, GAFRI 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 GAFRI's annuity products.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies.
Approximately 94% of the fixed maturities held by AFG at June 30, 2007, were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and noninvestment grade. Management believes that a high quality investment portfolio should generate a stable and predictable investment return.
Since fixed maturities and stocks are carried at fair value in the balance sheet, there is virtually no effect on financial condition upon the sale and ultimate realization of unrealized gains and losses.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at June 30, 2007, is shown in the following table (dollars in millions). Approximately $196 million of available for sale "Fixed maturities" had no unrealized gains or losses at June 30, 2007.
Securities
With
Unrealized
Gains
Losses
Available for Sale Fixed Maturities
Fair value of securities
$2,958
$12,083
Amortized cost of securities
$2,884
$12,419
Gross unrealized gain (loss)
$ 74
($ 336)
Fair value as % of amortized cost
103%
97%
Number of security positions
886
1,978
Number individually exceeding
$2 million gain or loss
Concentration of gains (losses) by type or
industry (exceeding 5% of unrealized):
Mortgage-backed securities
$14.3
($133.3)
Banks, savings and credit institutions
5.6
(53.5)
U.S. Government and government agencies
(16.9)
State and municipal
(19.5)
Insurance companies
Gas and electric services
9.5
(18.7)
Air transportation and courier services
4.2
(0.5)
Percentage rated investment grade
85%
Over 99% of AFG's mortgage-backed securities are rated "AAA." At June 30, 2007, approximately 3% of AFG's fixed maturity portfolio was invested in mortgage-backed securities in which the underlying collateral is sub-prime mortgages. At that date, the net unrealized loss on these securities was approximately $8.3 million. The securities are collateralized by fixed-rate mortgages and have an overall average life of less than 2 1/2 years. None of the securities have been subject to downgrades or "watch listing" by rating agencies. At June 30, 2007, AFG had no collateralized debt obligations secured by residential mortgages. Investments in private partnerships and hedge funds (included in other investments) were less than 0.2% of AFG's total cash and investments at June 30, 2007.
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at June 30, 2007, based on their fair values. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Maturity
One year or less
10%
4%
After one year through five years
39
21
After five years through ten years
29
34
After ten years
87
64
36
100
20
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Fair
Aggregate
Value as
% of Cost
Value
Gain (Loss)
Basis
Fixed Maturities at June 30, 2007
Securities with unrealized gains:
Exceeding $500,000 (24 issues)
$ 203
$ 19
110%
Less than $500,000 (862 issues)
2,755
55
102
$ 2,958
Securities with unrealized losses:
Exceeding $500,000 (177 issues)
$ 3,643
($159)
96%
Less than $500,000 (1,801 issues)
8,440
(177)
98
($336)
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.
Loss
Fixed Maturities with Unrealized
Losses at June 30, 2007
Investment grade with losses for:
One year or less (766 issues)
$ 4,503
($ 80)
98%
Greater than one year (1,120 issues)
7,222
(248
97
$11,725
($328)
Non-investment grade with losses for:
One year or less (54 issues)
$ 180
($ 3)
Greater than one year (38 issues)
178
(5
$ 358
($ 8)
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 2006 Form 10-K.
Based on its analysis, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they mature or recover in value. Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. 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 a future period. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
During the first half of 2006, AFG realized a loss of $444,000 on the sale of a fixed maturity security that had an unrealized loss greater than $500,000 at December 31, 2006. The fair value of this security increased by $177,000 from year-end 2006 to the sale date.
RESULTS OF OPERATIONS
AFG reported operating earnings before income taxes of $112.5 million for the second quarter of 2007 compared to $146.6 million for the 2006 second quarter. A $37.7 million improvement in Specialty property and casualty underwriting results compared to the 2006 quarter was more than offset by charges of $44.2 million to strengthen reserves for A&E exposure within the property and casualty insurance run-off operations and $43.0 million to increase A&E reserves related to former railroad and manufacturing operations. Results for the second quarter of 2007 also include $14.0 million in net realized gains on securities compared to net realized losses of $7.5 million in the 2006 quarter.
Six month pretax operating earnings decreased by $9.0 million compared to 2006 reflecting a $71.3 million improvement in Specialty property and casualty insurance underwriting results which was more than offset by the second quarter A&E charges 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 C - "Segments of Operations" for the detail of AFG's operating profit by significant business segment.
Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of losses, loss adjustment expenses, underwriting expenses and policy holder dividends 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 property and casualty insurance operations were as follows (dollars in millions):
Gross Written Premiums (GAAP)
$421
$400
$ 744
$ 718
350
367
711
742
139
135
277
254
61
75
129
160
1
$972
$980
$1,861
$1,874
Net Written Premiums (GAAP)
$277
$268
$ 522
$ 499
209
206
425
408
121
104
236
197
57
71
122
151
23
32
40
$681
$672
$1,337
$1,295
Combined Ratios (GAAP)
89.1%
86.2%
82.7%
68.3
85.6
70.1
88.8
90.6
99.4
93.8
80.2
78.5
79.4
81.2
Total Specialty
81.8
87.5
82.9
87.7
Aggregate (including discontinued
lines)
88.9%
88.1%
86.4%
Net written premiums for the Specialty insurance operations increased 1% for the second quarter and 3% for the first six months compared to the same periods in 2006. Premium growth continues to be impacted by the effect of significant rate declines in the California workers' compensation business. Excluding that business, the net written premiums of the other specialty groups grew 4% for the quarter and 6% for the six months compared to the 2006 periods. Apart from rate decreases in the California workers' compensation business, average rate levels in AFG's other specialty operations were down about 2% through the first half of the year.
The Specialty insurance operations generated an underwriting profit of $114.6 million in the 2007 second quarter, $37.7 million higher than the same quarter a year earlier, resulting from a higher amount of favorable reserve development and lower catastrophe losses. The results for the 2007 quarter include $45.0 million (7.1 points) of favorable reserve development and $5.0 million (0.8 points) of catastrophe losses, principally from severe storms in the northeastern and Midwestern parts of the United States. The results for the 2006 quarter include $12.2 million (2.0 points) of favorable development and $11.6 million (1.9 points) of catastrophe losses. Underwriting profit of the specialty insurance operations was $218.0 million for the first six months of 2007, 49% above the 2006 period, primarily reflecting the positive impact of more favorable reserve development within the Specialty casualty group and lower catastrophe losses.
excess property business, which was heavily reinsured, in the early part of 2006. Excluding that effect, gross written premiums for the 2007 three and six month periods were up 10% and 9%, respectively, over the 2006 periods due to growth in the crop, transportation and inland marine operations. Net written premiums were 4% and 5% higher than the respective 2006 periods. The combined ratio increased 2.9 points for the quarter and 3.5 points for the six months compared to the 2006 periods reflecting lower underwriting profits in the agricultural and trucking insurance operations which more than offset a significant improvement within the inland and ocean marine operations. The six-month results include $20.7 million (4.4 points) of favorable reserve development compared to $27 million (6.4 points) in the 2006 period.
Specialty casualty gross written premiums for the 2007 three and six month periods were 5% and 4% below the same 2006 periods due primarily to volume reductions in the excess and surplus and general liability lines resulting from stronger competition within these commercial casualty markets. Net written premiums were 1% and 4% higher than the respective 2006 periods due primarily to lower premiums ceded under reinsurance agreements. The 17.3 point improvement for the quarter and 18.7 point improvement for the six months in the combined ratio compared to the 2006 periods reflect $38.9 million (18.3 points) of favorable reserve development in the 2007 quarter and $80.4 million (19.0 points) for the six months of 2007 compared to negligible development in the 2006 periods. The 2007 favorable development was primarily in the general liability and excess and surplus businesses.
Specialty financial gross and net written premiums for the 2007 second quarter were up 3% and 15%, respectively, over the same period last year. Volume growth in the financial institutions, lease and loan and surety operations were partly offset by lower premiums resulting from the run-off of the residual value insurance ("RVI") business. The higher net written premium growth rate resulted from greater premium retention in the group's lease and loan operations. These factors, plus new business volume in the fidelity and crime operations during the 2007 first quarter, contributed to the strong premium growth through the first half of 2007. The 8.8 point improvement for the quarter and 5.5 point improvement for the six months in the combined ratio compared to the 2006 periods reflect significant improvement in the financial institutions, fidelity and crime and lease and loan operations, as well as better results within the run-off RVI business. Excluding the RVI business, this group's comb ined ratio was 89.3% for the first six months of 2007.
California workers' compensation gross written premiums were down 19% for both the second quarter and the six months compared to the 2006 periods, reflecting the effect of significantly lower premium rates. These rate reductions averaged about 24% through the first half of this year and demonstrate the positive effects of reform legislation in lowering workers' compensation costs for employers. Net written premiums for the second quarter and first six months of 2007 were about 20% below the same 2006 periods. This business' underwriting margins continue to benefit from the improved claims environment resulting from the California workers' compensation reform legislation. The second quarter of 2007 includes 9.0 points of favorable prior year development while the 2006 second quarter includes 2.2 points of favorable development. Results for the first six months of 2007 include 8.2 points of favorable development compared to less than a point in the 2006 period. Due to the long-tail nature o f this business, AFG continues to be conservative in recognizing the benefits from the reform legislation until a higher percentage of claims are paid and the ultimate impact of reforms can be determined.
24
Asbestos and Environmental Reserve Charge AFG recently completed the previously announced comprehensive study of its asbestos and environmental exposures relating to the run-off operations of its property and casualty group and its exposures related to former railroad and manufacturing operations and sites. Similar studies were completed in 2005 and 2003, respectively. The studies were done with the aid of respected outside actuarial and engineering firms and specialty outside counsel.
As a result of the study, AFG recorded a $44.2 million charge (net of reinsurance) to increase the property and casualty group's asbestos reserves by $30.8 million and its environmental reserves by $13.4 million. At June 30, 2007, the property and casualty group's A&E reserves were $455.6 million, net of reinsurance recoverables. At that date, AFG's three year survival ratio was 17.4 times paid losses for the asbestos reserves and 11.4 times paid losses for the total A&E reserves. These ratios compare favorably with A.M. Best's most recent report on A&E survival ratios (March 2007) which were 9.0 for asbestos and 8.0 for total industry A&E reserves. Excluding amounts associated with the settlements of asbestos related coverage litigation for A.P. Green Industries (see "Legal Proceedings" in AFG's 2006 Form 10-K) and another large claim, AFG's three year survival ratio was 10.6 and 7.8 times paid losses for the asbestos reserves an d total A&E reserves, respectively.
The primary causes of the increase
In addition to the property and casualty group, the study encompassed reserves for asbestos and environmental exposures of our former railroad and manufacturing operations. As a result of the study, AFG recorded a $43.0 million charge (included in other expenses) to increase the A&E reserves related to these former operations. The $19.0 million increase in asbestos reserves was the result of increasing estimates of the cost of mesothelioma claims partially offset by lower estimated overall claim counts. The $24.0 million increase in environmental reserves was due primarily to increased clean up estimates at certain former railroad and manufacturing sites.
The study relied on a ground-up exposure analysis. With respect to asbestos, it considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development. The asbestos legal climate remains very difficult to predict. While some progress has been made in state asbestos tort reform and judicial rulings, that progress has been somewhat offset by increased claims costs, increased defense costs, the assertion of non-products theories and an expanding pool of plaintiffs and defendants.
Life, Accident and Health Premiums and Benefits
25
Investment Income
Realized Gains
Realized gains on securities include provisions for other than temporary impairment of securities still held as follows: second quarter of 2007 and 2006 - $2.2 million and $2.8 million; six months of 2007 and 2006 - $11.3 million and $5.8 million, respectively.
Real Estate Operations
$26.6
$24.0
$47.5
$45.1
16.5
31.7
.7
2.2
Income from real estate operations includes net pretax gains on the sale of real estate assets of $7.5 million in the second quarter and $13.5 million in the first six months of 2007 compared to $6.2 million and $13.2 million for the 2006 periods.
Real Estate Operations - Discontinued
Other Income
Annuity Benefits
for future deaths and annuitizations. Changes in crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect these additional reserves. Significant changes in projected investment yields could result in charges (or credits) to earnings in the period the projections are modified.
Annuity benefits increased $6.4 million for the second quarter and $12.4 million the first six months of 2007 compared to the 2006 periods, reflecting higher sales of fixed-indexed annuities, partially offset by a lower average crediting rate.
Annuity and Supplemental Insurance Acquisition Expenses
The vast majority of GAFRI'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.
Other Operating and General Expenses
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," which permits entities to irrevocably elect to report certain financial assets and liabilities (including most insurance contracts) at fair value and recognize the unrealized gains and losses on such items in earnings. SFAS No. 159 is effective January 1, 2008, for calendar year companies. AFG is currently evaluating whether it will elect the fair value option for any of its eligible assets or liabilities.
Convertible Notes
_______________________________________________
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
As of June 30, 2007, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2006 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. There have been no changes in AFG's internal control over financial reporting during the second fiscal quarter of 2007 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 second fiscal quarter of 2007 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
Under AFG's shareholder-approved Stock Option Plan, 1,068 shares of AFG Common Stock were tendered at $35.32 per share in connection with the exercise of stock options in May 2007.
Submission of Matters to a Vote of Security Holders
AFG's Annual Meeting of Shareholders was held on May 17, 2007; there were three matters voted upon: (Item 1) election of nine directors, (Item 2) ratifying Ernst & Young LLP as independent registered public accounting firm and (Item 3) approval of the 2007 Annual Senior Executive Bonus Plan.
The votes cast for, against, withheld and the number of abstentions as to each matter voted on at the 2007 Annual Meeting is set forth below:
Name
For
Against
Withheld
Abstain
Item 1
Kenneth C. Ambrecht
104,841,439
N/A
554,105
Theodore H. Emmerich
104,132,644
1,262,901
James E. Evans
101,795,992
3,599,553
Terry S. Jacobs
104,851,937
543,607
Carl H. Lindner
100,523,760
4,871,783
Carl H. Lindner III
103,711,308
1,684,235
S. Craig Lindner
103,698,307
1,697,237
William R. Martin
104,141,600
1,253,944
William W. Verity
102,504,510
2,891,034
Item 2
105,166,837
167,573
61,078
Item 3
99,864,791
5,340,688
190,003
N/A - Not Applicable
ITEM 5
Other Information
Because AFG does not foresee the need to raise capital through equity issuances in the near future, it has exercised its right to terminate the equity distribution agreement with UBS Securities LLC.
OTHER INFORMATION - CONTINUED
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.
_____________________________________________________________
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, American Financial Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned duly authorized.
American Financial Group, Inc.
August 8, 2007
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)
30