UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Quarterly Period EndedSeptember 30, 2008
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, a non-accelerated filer or asmaller reporting company: Large Accelerated Filer X Accelerated Filer Non-Accelerated Filer Smaller Reporting Company
Indicate by check mark whether the Registrant is a shell company. Yes No X
As of November 1, 2008, there were 115,535,313 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)
September 30,
December 31,
2008
2007
Assets:
Cash and cash equivalents
$ 1,193.6
$ 815.9
Investments:
Fixed maturities:
Available for sale - at fair value
(amortized cost - $15,829.9 and $15,188.1)
14,645.3
15,140.7
Trading - at fair value
295.6
274.1
Equity securities - at fair value:
Common stocks (cost - $305.1 and $723.4)
377.9
750.7
Preferred stocks (cost - $185.2 and $191.1)
138.5
172.6
Mortgage loans
329.5
358.8
Policy loans
279.2
273.2
Real estate and other investments
294.3
268.1
Total cash and investments
17,553.9
18,054.1
Recoverables from reinsurers and prepaid
reinsurance premiums
3,980.7
3,664.1
Agents' balances and premiums receivable
998.8
560.6
Deferred policy acquisition costs
2,055.4
1,394.4
Other receivables
541.3
475.4
Variable annuity assets (separate accounts)
524.4
692.5
Other assets
1,060.3
762.0
Goodwill
209.8
204.4
$26,924.6
$25,807.5
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 6,568.0
$ 6,168.4
Unearned premiums
2,039.1
1,668.2
Annuity benefits accumulated
10,580.5
10,096.6
Life, accident and health reserves
1,552.3
1,483.7
Payable to reinsurers
531.2
363.8
Long-term debt
952.2
936.9
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,285.8
1,251.4
Total liabilities
24,033.5
22,661.5
Minority interest
114.5
99.9
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 115,442,774 and 113,499,080 shares outstanding
115.4
113.5
Capital surplus
1,229.9
1,186.5
Retained earnings
1,817.7
1,733.5
Accumulated other comprehensive income (loss),
net of tax
(386.4
12.6
Total shareholders' equity
2,776.6
3,046.1
2
CONSOLIDATED STATEMENT OF EARNINGS (unaudited)
(In Millions, Except Per Share Data)
Three months ended
Nine months ended
Income:
Property and casualty insurance premiums
$ 850.6
$ 757.5
$2,104.4
$2,030.8
Life, accident and health premiums
109.3
105.6
325.9
315.6
Investment income
283.1
252.7
820.3
747.5
Realized gains (losses) on securities
(150.1)
(7.1)
(293.5)
11.6
Other income
77.0
78.4
231.8
237.8
1,169.9
1,187.1
3,188.9
3,343.3
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
551.8
436.0
1,185.8
1,117.7
Commissions and other underwriting
expenses
226.0
219.7
659.0
638.4
Annuity benefits
100.9
94.5
287.6
273.7
Life, accident and health benefits
81.1
87.1
253.8
258.0
Annuity and supplemental insurance
acquisition expenses
46.1
40.0
140.9
125.2
Interest charges on borrowed money
16.3
17.8
52.3
53.6
Other operating and general expenses
119.7
108.8
355.5
387.4
1,141.9
1,003.9
2,934.9
2,854.0
Operating earnings before income taxes
28.0
183.2
254.0
489.3
Provision for income taxes
9.5
62.7
91.4
171.3
Net operating earnings
18.5
120.5
162.6
318.0
2.4
(7.8
(5.4
(26.4
Earnings from continuing operations
20.9
112.7
157.2
291.6
Discontinued operations, net of tax
-
1.7
Net Earnings
$ 20.9
$ 112.7
$ 157.2
$ 293.3
Basic earnings per Common Share:
Continuing operations
$.18
$.96
$1.38
$2.46
Discontinued operations
.01
Net earnings available to Common Shares
$2.47
Diluted earnings per Common Share:
$.93
$1.34
$2.39
$2.40
Average number of Common Shares:
Basic
115.2
117.6
114.0
118.9
Diluted
116.9
119.8
117.0
121.6
Cash dividends per Common Share
$.125
$.10
$.375
$.30
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, 2007
113,499,080
$1,300.0
$1,733.5
$ 12.6
$3,046.1
Net earnings
Other comprehensive income (loss),
net of tax:
Change in unrealized gain (loss)
on securities
(389.0)
Change in foreign currency translation
(10.2)
Change in unrealized pension and other
postretirement benefits
.2
Total comprehensive loss
(241.8)
Dividends on Common Stock
(42.7)
Shares issued:
Redemption of convertible notes
2,364,640
24.4
Exercise of stock options
1,234,365
24.9
Other benefit plans
186,024
5.2
Dividend reinvestment plan
209,297
5.5
Other stock-based compensation expense
7.7
Shares acquired and retired
(1,803,000)
(20.7)
(26.7)
(47.4)
Shares tendered in option exercises
(247,632)
(2.8)
(3.6)
(6.4)
Capital transactions of subsidiaries
1.1
Balance at September 30, 2008
115,442,774
$1,345.3
$1,817.7
($386.4)
$2,776.6
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)
293.3
Other comprehensive income, net of tax:
(71.1)
20.6
2.9
Total comprehensive income
245.7
(35.8)
641,460
14.9
185,534
6.4
126,523
4.0
7.1
(4,700,139)
(53.2)
(80.2)
(133.4)
(26,498)
(.3)
(.6)
(.9)
Effect of minority interest repurchased
(8.0)
(1.1
Balance at September 30, 2007
115,530,808
$1,317.6
$1,695.4
($ .1)
$3,012.9
4
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
Operating Activities:
Adjustments:
5.4
26.7
Depreciation and amortization
185.8
139.7
Realized (gains) losses on investing activities
287.2
(26.9)
Net (purchases) sales of trading securities
47.5
(34.8)
Deferred annuity and life policy acquisition costs
(143.3)
(154.6)
Increase in reinsurance and other receivables
(657.0)
(321.1)
Increase in other assets
(74.7)
(178.6)
Increase in insurance claims and reserves
672.1
483.8
Increase in payable to reinsurers
165.8
96.6
Increase (decrease) in other liabilities
(71.3)
10.3
Other, net
12.9
Net cash provided by operating activities
865.2
621.0
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(4,998.5)
(2,894.6)
Equity securities
(138.5)
(416.4)
Subsidiaries
(112.2)
(239.7)
Real estate, property and equipment
(35.9)
(25.0)
Maturities and redemptions of fixed maturity investments
1,534.6
1,125.5
Sales of:
2,670.3
1,164.1
334.6
125.4
8.5
24.0
Decrease in securities lending collateral
43.7
11.2
Cash and cash equivalents of businesses acquired
44.3
Increase in other investments
(10.8
(108.5
Net cash used in investing activities
(659.9
(1,234.0
Financing Activities
Annuity receipts
1,275.9
1,204.5
Annuity surrenders, benefits and withdrawals
(1,049.9)
(1,057.3)
Net transfers from variable annuity assets
39.6
51.3
Additional long-term borrowings
600.0
142.0
Reductions of long-term debt
(584.9)
(167.5)
Decrease in securities lending obligation
(43.7)
(11.2)
Issuances of Common Stock
14.5
Repurchases of Common Stock
Cash dividends paid on Common Stock
(37.2)
(31.7)
(0.6
2.0
Net cash provided by financing activities
172.4
13.2
Net Increase (Decrease) in Cash and Cash Equivalents
377.7
(599.8)
Cash and cash equivalents at beginning of period
815.9
1,329.0
Cash and cash equivalents at end of period
$1,193.6
$ 729.2
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
F.
B.
G.
C.
H.
D.
I.
E.
________________________________________________________________________________
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.
Fair Value Measurements
Investments
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced.
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) in its Balance Sheet at fair value. The obligation to return the collateral is included in other liabilities. The securities loaned remain a recorded asset on AFG's Balance Sheet. The fair value of collateral held was approximately $89 million at September 30, 2008, and $139 million at December 31, 2007. The fair value of securities loaned plus accrued interest was approximately $96 million and $139 million at those dates.
Derivatives
Reinsurance
Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaries retain the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies'
7
assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to these transactions are classified as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value 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 on securities result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains (losses).
DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of "Accumulated Other Comprehensive Income (Loss), net of tax" in the shareholders' equity section of the Balance Sheet. In light of the increasing significance of unrealized losses on fixed maturity securities during the third quarter of 2008, AFG refined its method of estimating the impact of unrealized losses on DPAC, more closely aligning the impact with the expected gross profits over the lives of the related annuity contracts. This refinement impacted the accumulated other comprehensive income (loss) component of shareholders' equity at September 30, 2008, but had no impact on net earnings. Had this change in estimate been made at June 30, 2008, shareholders' equity would have been 4% higher due to a r eduction in "other comprehensive loss" of approximately $120 million for the six-month period then ended.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
DPAC includes the present value of future profits on business in force of annuity and supplemental insurance companies acquired ("PVFP"). PVFP represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. PVFP is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
8
Unpaid Losses and Loss Adjustment Expenses
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Annuity Benefits Accumulated
Life, Accident and Health Reserves
Variable Annuity Assets and Liabilities
Premium Recognition
Minority Interest
Income Taxes
9
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. Related interest and penalties 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 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.
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
$ -
($.1)
($1.0)
Assumed issuance of shares under
deferred compensation plan
(.8)
Adjustments to weighted average
common shares:
Stock-based compensation plans
2.3
1.9
2.7
Convertible notes
AFG's weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: third
quarter of 2008 and 2007 - 3.9 million and 2.5 million; nine months of 2008 and 2007 - 4.2 million and 1.1 million, respectively.
10
Statement of Cash Flows
Marketform Group
Strategic Comp Holdings
Great American Financial Resources
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
$ 457.6
$ 350.1
$ 915.9
$ 817.5
Specialty casualty
199.1
206.6
611.3
630.0
Specialty financial
123.7
125.1
369.9
351.9
California workers' compensation
51.6
57.1
155.3
178.6
51.7
52.4
Other lines
.1
.3
.4
850.6
757.5
2,104.4
2,030.8
98.1
89.6
296.3
260.3
Realized gains (losses)
(57.7)
(4.6)
(133.1)
5.1
42.7
42.6
124.7
126.6
933.7
885.1
2,392.3
2,422.8
Annuity and supplemental insurance:
183.0
161.2
523.7
479.5
(93.0)
(6.2)
(157.8)
3.8
29.8
33.1
90.4
92.0
229.1
293.7
782.2
890.9
8.3
14.4
29.6
$1,169.9
$1,187.1
$3,188.9
$3,343.3
Operating Earnings Before Income Taxes
Underwriting:
$ 12.0
$ 58.5
$ 63.6
$ 123.2
46.6
39.0
143.1
165.3
(1.9)
8.2
19.8
22.5
10.5
12.8
33.7
37.9
Other (a)
4.7
(13.7)
7.3
(26.1)
Other lines (b)
.9
(3.0
(7.9
(48.1
72.8
101.8
259.6
274.7
Investment and other operating income
83.3
79.3
252.4
226.4
(57.7
(4.6
(133.1
98.4
176.5
378.9
506.2
Operations (c)
49.2
34.7
120.3
103.8
(93.0
(6.2
(157.8
(43.8)
28.5
(37.5)
107.6
Other (c)(d)
(26.6
(21.8
(87.4
(124.5
$ 28.0
$ 183.2
$ 254.0
$ 489.3
(a) Includes a benefit of $9.0 million in the first nine months of 2008 and a charge of $25.5 million in the first nine months of 2007 related to retroactive reinsurance gains.
(b) Includes a second quarter 2008 charge of $12.0 million and a second quarter 2007 charge of $44.2 million to increase asbestos and environmental reserves.
(c) GAFRI's $2.0 million second quarter 2007 environmental liabilities charge and holding company interest and debt expense of $5.2 million for the 2007 third quarter and $16.2 million for the first nine months of 2007 were reclassified from "Annuity and supplemental insurance" to "Other" to be consistent with the current year presentation.
(d) Includes second quarter charges of $3.0 million in 2008 and $43.0 million in 2007 related to asbestos and environmental liabilities at former railroad and manufacturing operations.
12
D.Fair Value Measurements
Level 1 - Quoted prices for identical assets or liabilities in active markets (markets in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis).
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets.
Level 3 - Valuations derived from valuation techniques in which one or more significant inputs are unobservable. The unobservable inputs may include management's own assumptions about the assumptions market participants would use based on the best information available in the circumstances.
AFG's Level 1 financial instruments consist primarily of publicly traded equity securities, highly liquid government bonds and separate account assets and liabilities for which quoted market prices in active markets are available. AFG's Level 2 financial instruments include primarily corporate and municipal fixed maturity securities and mortgage-backed securities priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, corroborated broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2. AFG's Level 3 is comprised of financial instruments whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, readily available market information. AFG's management is responsible for the valuation proce ss and uses data from outside sources in establishing fair value. This data is reviewed by internal investment professionals who determine appropriate fair value measurements.
Assets and liabilities measured at fair value on September 30, 2008, are summarized below (in millions):
Level 1
Level 2
Level 3
Available for sale ("AFS")
$ 346
$13,634
$665
$14,645
Trading
291
296
331
126
59
516
Separate account assets (a)
524
Other investments
34
49
89
Total assets accounted for at fair value
$1,235
$14,111
$735
$16,081
Liabilities:
Derivatives embedded in annuity
benefits accumulated
$111
$ 111
(a) Separate account liabilities equal the fair value for separate account assets.
Approximately 4-1/2% of the total assets measured at fair value were Level 3 assets. Approximately 44% of these assets were mortgage-backed securities whose fair values were determined primarily using non-binding broker quotes; the balance was primarily private placement debt and equity securities whose fair values were determined internally using significant unobservable inputs,
13
including the evaluation of underlying collateral and issuer creditworthiness, as well as certain Level 2 inputs such as comparable yields and multiples on similar publicly traded issues.
Changes in balances of Level 3 financial assets and liabilities during the third quarter and first nine months of 2008 are presented below (in millions). Transfers into (out of) Level 3 are due to a change in the availability of market observable inputs for individual securities.
Fixed Maturities
Equity
Embedded
AFS
Securities
Assets
Balance at July 1, 2008
$682
$ 10
$ 60
$ 3
$124
Total realized/unrealized gains (losses):
Included in net income
(15)
(1)
(16)
Included in other comprehensive
income (loss)
(20)
Purchases, sales, issuances and settlements
44
Transfers into (out of) Level 3
(26
(4
$ 5
$ 59
$ 6
Balance at January 1, 2008
$527
$ 11
$ 56
$155
(61)
(39)
164
(10)
17
14
Included in other assets in AFG's Balance Sheet at September 30, 2008, is $82.3 million in amortizable intangible assets (net of accumulated amortization of $32.0 million) related to property and casualty insurance acquisitions, primarily the 2008 acquisitions of Marketform and Strategic Comp. Amortization of these intangibles was $6.1 million in the third quarter and $18.2 million during the first nine months of 2008 compared to $2.3 million in the third quarter and $5.1 million in the first nine months of 2007.
Direct obligations of AFG:
7-1/8% Senior Debentures due April 2009
$173.3
$173.2
7-1/8% Senior Debentures due February 2034
115.0
Senior Convertible Notes
189.7
Borrowings under bank credit facility
350.0
95.0
641.2
575.8
Obligations of AAG Holding (guaranteed by AFG):
7-1/2% Senior Debentures due November 2033
112.5
7-1/4% Senior Debentures due January 2034
86.3
6-7/8% Senior Notes
21.0
Notes payable secured by real estate
due 2008 through 2016
67.1
67.5
National Interstate bank credit facility
15.0
American Premier Underwriters 10-7/8% Subordinated
Notes due May 2011
7.9
8.0
2.2
291.0
326.1
Payable to Subsidiary Trusts:
AAG Holding 7.35% Subordinated Debentures
due May 2033
20.0
National Interstate Subordinated Debentures
35.0
$952.2
$936.9
At September 30, 2008, scheduled principal payments on debt for the balance of 2008 and the subsequent five years were as follows: 2008 - $.3 million; 2009 - $174.6 million; 2010 - $1.3 million; 2011 - $359.1 million; 2012 - $16.4 million; and 2013 - $1.5 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
$885.1
$869.4
Obligations secured by real estate
AFG has a revolving credit facility under which it can borrow up to $500 million through March 2011. Amounts borrowed bear interest at rates ranging from .5% to 1.25% (currently .75%) over LIBOR based on AFG's credit rating. At September 30, 2008, AFG had $350 million in borrowings outstanding under the credit facility (interest rate of 4.4% at September 30, 2008).
In July 2008, AFG entered into a 364 day revolving credit facility under which it can borrow up to $120 million at an interest rate of 2.25% over LIBOR. No amounts have been borrowed under this credit facility.
In the second quarter of 2008, AFG paid $189.7 million in cash and issued 2.4 million shares of Common Stock to redeem its Senior Convertible Notes. AFG paid cash in lieu of Common Stock for all conversions of the Notes prior to the redemption. Since AFG had previously expressed its intent to use cash for the accreted value of the Notes and the option to use stock for the conversion premium, shares issuable for amounts in excess of the accreted value of the Notes are included in AFG's calculation of diluted earnings per share for the first nine months of 2008.
In May 2008, National Interstate borrowed $15 million under its credit facility to redeem its $15 million in outstanding variable rate Subordinated Debentures due May 2033. In June 2008, GAFRI paid $28.5 million to redeem its outstanding 6-7/8% Senior Notes at maturity.
15
In the first nine months of 2008, AFG repurchased approximately 1.8 million shares of its Common Stock for $47.4 million. In the second quarter of 2008, AFG issued 2.4 million shares of Common Stock in connection with the redemption of its Senior Convertible Notes.
Accumulated Other Comprehensive Income (Loss), Net of Tax
Net unrealized loss on securities
($407.4)
($18.4)
Foreign currency translation adjustment
17.7
27.9
Unrealized pension and other
3.3
3.1
Total accumulated other
comprehensive income (loss)
$12.6
Net Unrealized Loss on Securities
Deferred Tax and
Pre-tax
Net
September 30, 2008
Unrealized gain (loss) on:
Fixed maturity securities
($1,184.6)
$417.5
($767.1)
26.1
(7.7)
18.4
Securities lending collateral
(7.8)
(2.7)
542.1
(189.8)
352.3
Annuity benefits and other
(12.7
4.4
(8.3
($ 636.9)
$229.5
December 31, 2007
($ 47.4)
$ 16.5
($ 30.9)
8.8
6.9
(2.0)
1.3
(0.7)
10.7
(3.7)
7.0
(1.0
(.7
$ 12.5
($ 18.4)
Stock Incentive Plans
16
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility over a period equal to the expected term. The expected term was estimated based on historical exercise patterns and post vesting cancellations. The fair value of options granted during 2008 was $7.93 per share based on the following assumptions: expected dividend yield - 1.8%; expected volatility - 28%; expected term - 7.5 years; risk-free rate - 3.2%.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries was as follows: third quarter of 2008 and 2007 - $3.3 million and $2.5 million, respectively; nine months of 2008 and 2007 - $11.8 million and $13.2 million, respectively. Stock-based compensation expense for the first nine months of 2008 and 2007 includes $2.0 million and $3.9 million, respectively, in first quarter non-deductible stock awards.
CONDENSED CONSOLIDATING BALANCE SHEET
(In millions)
AAG
All Other
Consol.
AFG
GAFRI
Holding
Subs
Entries
Consolidated
Cash and investments
$ 61.0
$ 10.3
$17,484.2
($ 1.6)
$17,553.9
Recoverables from reinsurers and
prepaid reinsurance premiums
14.3
17.5
2,155.3
142.3
2,335.8
Investment in subsidiaries and
affiliates
3,492.2
997.8
1,072.5
720.7
(6,283.2
$3,567.5
$1,025.6
$1,078.9
$27,395.1
($6,142.5)
Unpaid losses, loss adjustment expenses
and unearned premiums
$ 8,607.1
Annuity, life, accident and health
benefits and reserves
12,134.4
(1.6)
12,132.8
.7
219.4
91.3
(.4)
Other liabilities
149.7
68.9
2,297.3
(168.8
2,455.9
790.9
69.6
328.2
23,130.1
(170.8)
24,148.0
956.0
4,265.0
(5,971.7
$ 52.8
$ 4.6
$17,998.5
($ 1.8)
$18,054.1
14.0
6.5
2,003.4
2,134.3
3,764.5
1,168.5
1,316.6
1,111.9
(7,361.5
$3,831.3
$1,191.5
$1,323.1
$26,732.9
($7,271.3)
$ 7,836.6
11,582.1
(1.8)
11,580.3
.8
340.4
91.7
(71.8)
209.4
75.5
108.9
2,269.0
(255.2
2,407.6
785.2
76.3
449.3
21,779.4
(328.8)
22,761.4
1,115.2
873.8
4,953.5
(6,942.5
18
CONDENSED CONSOLIDATING INCOME STATEMENT
FOR THE THREE MONTHS ENDED
SEPTEMBER 30, 2008
Income
(153.4)
2.6
Investment and other income
1.6
361.5
(5.4)
360.1
Equity in earnings of subsidiaries
50.3
(47.6
(43.0
40.3
52.6
(45.2)
(43.0)
1,168.0
37.5
Insurance benefits and expenses
1,005.9
12.5
3.2
(5.9)
Other expenses
9.7
3.7
101.9
117.3
22.2
8.4
1,111.0
(5.8
1,139.5
Earnings before income taxes
30.4
(48.9)
(51.4)
57.0
43.3
18.7
(14.7
23.7
Net Earnings (Loss)
($ 0.2)
($ 36.7)
$ 33.3
$ 33.6
SEPTEMBER 30, 2007
(.2)
(11.8)
1.2
1.8
3.9
341.5
(16.1)
331.1
194.9
21.9
26.2
10.0
(253.0
200.4
25.6
1,202.8
(267.9)
877.3
19.2
4.1
(14.5)
5.8
2.8
105.0
116.6
25.0
3.0
9.9
986.4
(12.6
1,011.7
175.4
22.6
216.4
(255.3)
6.1
66.3
(74.2
$112.7
$16.5
$ 14.5
$ 150.1
($181.1)
19
FOR THE NINE MONTHS ENDED
(2.5)
2.5
9.2
1,068.8
(25.6)
1,052.1
322.0
(51.2
(32.7
(238.1
319.2
(42.0)
(32.7)
3,205.6
(261.2)
2,527.1
45.3
22.3
11.1
(26.5)
25.3
14.1
4.5
317.8
(.8
360.9
70.6
14.2
26.8
2,856.0
(27.3
2,940.3
Earnings (loss) before income taxes
248.6
(56.2)
(59.5)
349.6
(233.9)
Provision (credit) for income taxes
(20.8
(17.8
131.0
(92.4
$157.2
($35.4)
($ 41.7)
$ 218.6
($141.5)
7.2
(3.4)
1,011.3
985.3
540.0
83.0
106.9
36.8
(766.7
549.8
96.7
103.5
3,399.9
(806.6)
2,413.0
56.9
27.6
12.0
(43.2)
30.0
9.4
362.5
9.0
413.8
86.9
30.5
2,787.5
(34.2
2,880.4
462.9
87.0
73.0
612.4
(772.4)
21.1
196.7
(245.4
59.4
51.9
415.7
(527.0)
(3.8
$293.3
$61.3
$ 51.9
$ 417.6
($530.8)
20
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
Net earnings (loss)
($ 35.4)
Equity in net (earnings) loss
of subsidiaries
(204.7)
28.8
24.1
151.8
Dividends from subsidiaries
263.0
72.5
(335.8)
Other adjustments, net
7.8
(11.2
718.7
(10.3
708.0
Net cash provided by (used in)
operating activities
223.3
(17.5
57.9
937.3
(335.8
Investing Activities:
Purchase of investments, property and
equipment
(4.5)
(5,124.6)
(5,172.9)
Purchase of subsidiaries
Capital contributions to subsidiaries
(210.2)
(111.6)
(100.0)
421.8
Maturities and redemptions of fixed
maturity investments
1,548.7
(20.0)
Sale of investments, property and
2,970.8
3,013.4
(2.5
(1.5
81.2
77.2
investing activities
(212.4
(113.2
(100.0
(636.1
401.8
Financing Activities:
Annuity surrenders, benefits and
withdrawals
585.0
(519.9)
(.1)
(69.5)
(15.4)
19.5
Capital contribution from parent
135.0
111.6
175.2
(421.8)
Cash dividends paid
335.8
(44.3
financing activities
134.9
42.1
61.4
(66.0
Net increase in cash and cash equivalents
10.9
4.2
362.6
Cash and cash equivalents at beginning
of period
15.6
797.7
$ 26.5
$ 6.8
$1,160.3
21
$ 61.3
Equity in net earnings of subsidiaries
(350.6)
(58.4)
(74.8)
(36.8)
520.6
244.0
148.1
(422.1)
(227.0
239.7
(.4
305.2
10.2
327.7
(40.3
390.7
6.7
686.0
(422.1
(4.8)
(3,348.5)
17.3
(3,336.0)
(237.8)
(1.7)
Capital contribution to subsidiaries
(4.0)
(198.8)
202.8
5.0
32.2
1,143.7
(55.4)
71.8
1,241.7
(17.3)
1,313.5
(99.9
(97.3
70.4
(387.1
(1,064.7
147.4
50.0
(60.5)
(154.3)
55.4
13.5
1.0
198.8
(202.8)
(142.8)
(279.3)
422.1
(12.0
(9.2
(162.1
(6.3
(95.8
Net increase (decrease) in cash and
cash equivalents
(132.0)
6.3
(474.5)
146.0
1,180.2
$ 14.0
$ 9.1
$ .4
$ 705.7
22
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
23
Uncertainties
30
Overview
24
Results of Operations
Critical Accounting Policies
General
Liquidity and Capital Resources
25
Income Items
Sources of Funds
Expense Items
36
26
Recent Accounting Standards
37
_____________________________________________________________________________________________________
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Some of the forward-looking statements can be identified by the use of words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate changes; 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.
of Financial Condition and Results of Operations - Continued
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, because most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance, focusing on specialized commercial products for businesses and in the sale of traditional fixed, indexed and variable annuities and a variety of supplemental insurance products.
AFG's net earnings for the third quarter and first nine months of 2008 were $20.9 million ($.18 per share, diluted) and $157.2 million ($1.34 per share, diluted), respectively, compared to $112.7 million ($.93 per share, diluted) and $293.3 million ($2.40 per share, diluted) reported in the same periods of 2007. These results reflect net realized losses on investments in 2008, including other than temporary impairments. In addition, improved earnings in AFG's annuity and supplemental insurance operations and increased investment income were offset by lower property and casualty underwriting profits due in part to an increase in catastrophe losses.
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 2007 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
Ratios
2006
$ 952
$ 937
$ 921
Total capital (*)
4,269
4,108
4,160
Ratio of debt to total capital:
Including debt secured by real estate
22.3%
22.8%
22.1%
Excluding debt secured by real estate
21.1%
21.5%
20.9%
(*) 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 1.73 for the nine months ended September 30, 2008 and 2.40 for the entire year of 2007. Excluding annuity benefits, this ratio was 5.07 and 8.49, 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
AFG can borrow up to $500 million under its revolving credit facility, which expires in 2011. AFG had $350 million in borrowings outstanding under this agreement at September 30, 2008, bearing interest at a rate of 4.4%. In October 2008, AFG borrowed an additional $115 million under its credit facility and repurchased $37.3 million of its 7-1/8% Senior Debentures due April 2009 for $37.2 million. At October 31, 2008, AFG (parent) had enough cash and marketable securities to retire the remaining $136 million in Senior Debentures due April 2009.
In July 2008, AFG entered into a 364 day credit facility under which it can borrow up to $120 million at an interest rate of 2.25% over LIBOR. No amounts have been borrowed under this credit facility.
In the second quarter of 2008, AFG paid $189.7 million in cash and issued 2.4 million shares of Common Stock to redeem its Senior Convertible Notes. The cash used in the redemption was funded primarily with borrowings under AFG's revolving credit facility.
In the first nine months of 2008, AFG repurchased approximately 1.8 million shares of its Common Stock for $47.4 million.
Under tax allocation agreements with AFG, its 80%-owned U.S. subsidiaries generally pay taxes to (or recover taxes from) AFG based on each subsidiary's contribution to amounts due under AFG's consolidated tax return.
Subsidiary Liquidity
In June 2008, GAFRI used cash on hand to redeem its $28.5 million in 6-7/8% notes at maturity.
The liquidity requirements of AFG's insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In the annuity business, where profitability is largely dependent on earning a "spread" between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG's annuity products.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies.
Management responsible for the valuation of AFG's portfolio uses data from pricing services and non-binding broker quotes in determining fair value. Prices obtained from these sources are reviewed by internal investment professionals who are familiar with the securities being priced and the markets in which they trade. Equity securities are generally priced using closing prices obtained from pricing services. For mortgage-backed securities, which comprise about one-third of AFG's fixed maturities, prices are generally obtained from two or three of these sources. If the prices vary, AFG's investment professionals select the price they believe most appropriate based on their knowledge of the market. For the other two-thirds of AFG's fixed maturities, 93% are priced using a pricing service and the balance is priced internally or by using a non-binding broker quote. Prices obtained from a broker or pricing service are adjusted only in cases where they are deemed not to be representative of an appropriat e exit price (fewer than 1% of the securities).
Increasing turmoil in the global financial markets has caused credit spreads (the difference in rates between U.S. government bonds and other fixed maturities) to widen significantly during the third quarter of 2008. These wider spreads were the primary cause of AFG's pretax net unrealized loss on fixed maturities rising from $472 million at June 30, 2008, to $1.2 billion at September 30, 2008.
Approximately 94% of the fixed maturities held by AFG at September 30, 2008, 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.
AFG's $5.6 billion investment in mortgage-backed securities ("MBSs") represented approximately one-third of its fixed maturities at September 30, 2008. MBSs are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates. Approximately 97% of AFG's mortgage-backed securities are rated "AAA" or "AA." At September 30, 2008, AFG owned approximately $437 million (representing 3% of AFG's total fixed maturity portfolio) of mortgage-backed securities in which the underlying collateral is subprime mortgages. At that date, the net unrealized loss on these securities was approximately $68 million. The securities are collateralized by substantially all fixed-rate mortgages and have an overall average life of approximately 4 years. At September 30, 2008, AFG owned approximately $1.0 billion in Alt-A securiti es (risk profile between prime and subprime) with an average life of approximately 5 years, the vast majority of which are backed by fixed rate mortgages. The unrealized loss on Alt-A securities was $124 million at September 30, 2008. Based on current information, management does not believe that AFG's ultimate loss on the subprime or Alt-A securities will be material to its financial condition.
At September 30, 2008, AFG owned approximately $778 million in securities with credit enhancement provided by bond insurers, including $546 million of insured municipal bonds, $111 million in insured subprime securities (included in the $437 million in total subprime exposure discussed above) and $99 million in insured corporate bonds. Approximately 92% of the insured municipal bonds carry an explicit underlying rating (i.e. without credit enhancement) with an average of A+, and 63% of the corporate bonds carry an explicit underlying rating with an average of A-. None of the insured subprime securities carry an explicit underlying rating. Management does not believe the risk of loss on the securities without underlying credit ratings is material to AFG's financial condition.
27
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at September 30, 2008, is shown in the following table (dollars in millions). Approximately $299 million of available for sale "Fixed maturities" and $145 million of "Equity securities" had no unrealized gains or losses at September 30, 2008.
With
Unrealized
Gains
Losses
Available for Sale Fixed Maturities
Fair value of securities
$3,213
$11,133
Amortized cost of securities
$3,125
$12,406
Gross unrealized gain (loss)
$ 88
($ 1,273)
Fair value as % of amortized cost
103%
90%
Number of security positions
1,029
1,850
Number individually exceeding
$2 million gain or loss
165
Concentration of gains (losses) by type or
industry (exceeding 5% of unrealized):
Mortgage-backed securities
$ 34.3
($ 515.1)
Banks, savings and credit institutions
(367.2)
States and municipalities
(16.0)
Gas and electric services
5.3
(37.4)
Direct obligations of the U.S. Government
13.3
Percentage rated investment grade
97%
94%
Equity Securities
$ 159
$ 212
Cost of securities
$ 67
$ 278
$ 92
($ 66)
Fair value as % of cost
237%
76%
31
117
Number of individually exceeding
1
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at September 30, 2008, based on their fair values. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Maturity
One year or less
8%
2%
After one year through five years
56
After five years through ten years
33
After ten years
76
Mortgage-backed securities (average
life of 5-1/2 years)
41
100
28
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 September 30, 2008
Securities with unrealized gains:
Exceeding $500,000 (32 issues)
$ 409
$ 32
108%
Less than $500,000 (997 issues)
2,804
102
$ 3,213
Securities with unrealized losses:
Exceeding $500,000 (600 issues)
$ 6,400
($1,107)
85%
Less than $500,000 (1,250 issues)
4,733
(166
97
($1,273)
The following table summarizes (dollars in millions) the unrealized loss for all securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
Loss
Securities with Unrealized
Losses at September 30, 2008
Investment grade fixed maturities with losses for:
Less than one year (1,356 issues)
$ 8,432
($ 749)
92%
One year or longer (296 issues)
2,043
(411
83
$10,475
($1,160)
Non-investment grade fixed maturities with losses for:
Less than one year (116 issues)
$ 356
($ 44)
89%
One year or longer (82 issues)
302
(69
81
$ 658
($ 113)
Common equity securities with losses for:
Less than one year (42 issues)
($ 16)
87%
One year or longer (6 issues)
(2
78
$ 117
($ 18)
Perpetual preferred equity securities with losses for:
Less than one year (32 issues)
$ 70
($ 30)
70%
One year or longer (37 issues)
(18
58
$ 95
($ 48)
66%
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 2007 Form 10-K. With respect to the perpetual preferred equity securities with unrealized losses shown separately in the table above, management considered the hybrid nature of these investments, the fact that they continue to pay dividends and that they have maintained their investment grade ratings in concluding that the impairment was temporary.
29
Based on its analysis, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they recover in value. 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 future periods. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
RESULTS OF OPERATIONS
AFG reported operating earnings before income taxes of $28.0 million for the third quarter of 2008 and $183.2 million for the 2007 third quarter. The decrease is primarily due to $150 million in realized losses on investments in the 2008 period. The results also reflect higher earnings from annuity and supplemental insurance operations and higher investment income, both of which were offset by a $32.9 million decline in Specialty property and casualty underwriting results (due primarily to catastrophe losses).
Nine month pretax operating earnings decreased $235.3 million in 2008 compared to 2007, reflecting (i) realized losses on investments of $293.5 million recorded in 2008, (ii) a $55.3 million decline in Specialty property and casualty operations, (iii) an increase in investment income of $72.8 million and (iv) a reduction of $72.2 million in asbestos and environmental charges.
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 policyholder 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)
$1,079
$ 775
$1,822
$1,519
323
319
983
1,030
158
163
448
440
67
61
189
190
(1
$1,626
$1,319
$3,440
$3,180
Net Written Premiums (GAAP)
$ 536
$ 393
$1,044
$ 915
210
195
636
620
132
131
371
367
60
172
178
55
$ 960
$ 798
$2,279
$2,135
Combined Ratios (GAAP)
97.4%
83.3%
93.0%
85.0%
76.6
73.7
101.6
93.4
94.6
93.6
79.7
77.5
78.3
78.7
Total Specialty
91.5
86.2
87.4
84.1
Aggregate (including
discontinued lines)
91.3%
86.6%
87.7%
86.5%
Favorable (Unfavorable) Prior Year
Development
$17
$13
$ 55
$34
88
96
Other specialty
(12
(27
57
192
Special A&E charges
(12)
(44)
(3
$58
$24
$184
$79
Premium growth for the Specialty insurance operations has been impacted primarily by the Marketform operations, which were acquired in January 2008, and increases in crop insurance operations. Apart from rate decreases in the California workers' compensation business, average renewal rate levels in AFG's other specialty operations were down about 3% through the first nine months of the year.
The Specialty insurance operations generated underwriting profits of $71.9 million and $267.5 million in the third quarter and first nine months of 2008, respectively, compared to $104.8 million and $322.8 million for the same periods of 2007. Higher catastrophe losses, the effects of a softer market, increased losses in the run-off automobile residual value insurance ("RVI") operations and lower underwriting profits in the crop business more than offset higher favorable reserve development.
Pretax losses from catastrophes (principally wind-related storm damage from hurricanes Gustav and Ike and tornadoes in the Midwestern part of the United States) totaled $37.5 million (4.4 points) for the third quarter and $65.0 million (3.1 points) for the first nine months of 2008. By comparison, catastrophe losses for 2007 were negligible.
Property and transportation gross and net written premiums increased significantly in the 2008 periods due to the effect of higher spring commodity pricing on crop insurance premiums. The property and transportation group reported an underwriting profit of $12.0 million in the 2008 third quarter, $46.5 million lower than the 2007 third quarter. The combined ratio of 97.4% for the quarter increased 14.1 points over the 2007 period as a result of higher catastrophe losses in the property and inland marine operations and lower underwriting profits in the crop operations, which were offset somewhat by higher favorable reserve development. Excluding the impact of catastrophes, AFG's underlying property and transportation businesses continued to have strong underwriting results. Results for the third quarter and first nine months of 2008 include $29.8 million (6.5 points) and $53.7 million (5.9 points), respectively, of catastrophe losses. Favorable reserve develo pment in the Property and transportation group in the first nine months of 2008 is primarily due to lower than expected claim frequency in crop and ocean marine products and lower severity in farm losses. Favorable development in the comparable 2007 period relates primarily to lower than expected frequency and severity in specialty commercial automobile, ocean marine, inland marine and farm products.
Specialty financial gross written premiums for the quarter decreased slightly from the prior period, primarily from declines in the lease and loan and financial institutions businesses, which were offset somewhat by higher premiums in other operations. Gross and net written premiums for the 2008 nine month period were comparable to the 2007 period. This group reported an underwriting loss of $1.9 million for the third quarter of 2008. This group's combined ratio
32
was 101.6%, an increase of 8.2 points over the 2007 third quarter. These results were driven in large measure by underwriting losses in the run-off RVI operations, which resulted from further declines in used SUV and luxury car prices. Through the first nine months of the year, improvements in AFG's surety and fidelity and crime operations and higher favorable reserve development helped to offset lower underwriting results in the RVI and financial institutions businesses. Favorable reserve development in Specialty financial during the first nine months of 2008 and 2007 resulted from lower than expected claim severity in the surety and fidelity and crime products.
California workers' compensation gross and net written premiums increased for the quarter, as increased sales of the recently targeted excess workers' compensation products offset the effects of continued lower rates in the traditional workers compensation business. This group reported solid profitability with a combined ratio of 79.7% in the 2008 third quarter compared to 77.5% in the same period a year earlier. Through the first nine months of 2008, the combined ratio was 78.3%, a slight improvement over the 2007 period. The improved claims environment resulting from the California workers' compensation reform legislation has continued to benefit AFG's results as well as those of the industry. The California renewal rate reductions averaged about 15% through the first nine months of the year and indicates some moderation in rate reductions compared to the last several years. In October 2008, the California Insurance Commissioner approved a 5% average increase in premium rates eff ective January 1, 2009. AFG expects to file for a similar rate increase. The favorable reserve development in California workers' compensation in the first nine months of 2008 and 2007 reflects the continuing impact of the reform legislation passed in 2003 and 2004. As claims incurred in 2003 through 2005 are now reaching a higher percentage of settlement and maturity, management is able to estimate the ultimate costs of these claims with more precision. Current estimates of settlement costs are lower than originally anticipated.
Due to the long-tail nature of this business, AFG has been conservative in reserving for the favorable effects of the reform legislation on more recent claims until a higher percentage of claims are paid and the ultimate impact of reforms can be estimated with more precision.
Asbestos and Environmental Reserve Charges During the second quarter of 2008, AFG completed its comprehensive internal review of asbestos and environmental exposures relating to the run-off operations of its property and casualty group and exposures related to former railroad and manufacturing operations and sites. Previous studies, which were done with the aid of outside actuarial and engineering firms and specialty outside counsel, were completed in 2007, 2005 and 2003, respectively.
As a result of the internal review, AFG recorded a $12 million charge (net of reinsurance recoverables) to increase the property and casualty group's asbestos and environmental reserves in the second quarter of 2008. During the course of this review, there were no newly identified emerging trends or issues that management believes significantly impact the overall adequacy of AFG's A&E reserves. The modest increases were primarily due to reassessments of the potential loss on certain outstanding cases.
The review relied on a comprehensive exposure analysis by AFG's internal A&E claims specialists in consultation with in-house actuaries and outside specialty counsel. It considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development, as
appropriate. As has been observed by others, the asbestos legal climate remains very difficult to predict. While progress continues to be made in state asbestos tort reform and judicial rulings, that progress has been somewhat offset by the lack of reform in certain jurisdictions, increased claims costs, increased defense costs, the assertion of non-products theories and an expanding pool of plaintiffs and defendants. Environmental claims likewise present challenges in prediction, due to uncertainty regarding the interpretation of insurance policies, complexities regarding multi-party involvements at sites, evolving clean up standards and protracted time periods required to assess the level of clean up required at contaminated sites.
At September 30, 2008, the property and casualty group's A&E reserves were $405.9 million, net of reinsurance recoverables. At that date, AFG's three year survival ratio was 9.6 times paid losses for the asbestos reserves and 8.9 times paid losses for the total A&E reserves. These ratios compare favorably with A.M. Best's most recent report (published in 2007) on A&E survival ratios which were 8.6 for asbestos and 7.9 for total industry A&E reserves.
The 2007 A&E study resulted in a second quarter 2007 pretax charge of $44.2 million (net of reinsurance) to increase the property and casualty group's A&E reserves.
Statutory Annuity Premiums
403(b) Fixed and Indexed Annuities:
First Year
$ 14
$ 34
$ 47
Renewal
121
104
Single Sum
43
101
103
Subtotal
87
256
254
Non-403(b) Indexed Annuities
142
214
442
686
Non-403(b) Fixed Annuities
99
68
250
204
Bank Fixed Annuities
138
Variable Annuities
64
Total Annuity Premiums
$486
$386
$1,303
$1,204
The increase in annuity premiums for the 2008 periods compared to the 2007 periods reflects increased annuity sales through the new bank distribution channel, as well as increased sales of traditional fixed annuities. These increases were partly offset by lower sales of indexed annuities in the single premium market.
Life, Accident and Health Premiums and Benefits
Premiums
Supplemental insurance operations
First year
$ 21
$ 19
$ 61
$ 48
79
242
243
Life operations (in run-off)
$109
$106
$326
$316
Benefits
$ 76
$217
$221
$ 81
$ 87
$254
$258
The decrease in life, accident and health benefits for the third quarter and first nine months of 2008 compared to the 2007 periods is due primarily to favorable results in AFG's long term care business.
Investment Income
Realized Gains (Losses) on Securities
Net realized gains (losses)
on disposals
($ 64.8)
$ 8.5
($ 82.9)
$38.5
Charges for impairment
(117.6)
(18.2)
(288.0)
(29.5)
Changes in the fair value of
derivatives
44.9
Other(*)
21.6
32.5
($150.1)
($ 7.1)
($293.5)
$11.6
(*) Adjustments to the amortization of annuity deferred policy acquisition
costs related to realized gains and losses on securities are included
in realized gains (losses).
Net realized losses on disposals for 2008 include third quarter losses of $79.9 million on the sales of securities issued by Fannie Mae, Freddie Mac, Washington Mutual, Lehman Brothers and AIG. Approximately 21% and 45% of the impairment charges for the third quarter and first nine months of 2008, respectively, were attributable to investments in financial institutions, primarily banks and credit institutions. In addition, 28% of the third quarter 2008 impairment charges related to investments in communications companies.
35
Real Estate Operations
$18.5
$17.3
$59.2
$64.8
16.6
17.2
49.1
48.9
Minority interest expense
Income from real estate operations includes net pretax gains on the sale of real estate assets of $.5 million in the third quarter and $6.4 million in the first nine months of 2008 compared to a $.8 million loss and $12.7 million gain for the 2007 periods.
Annuity Benefits
The $6.4 million and $13.9 million increases in annuity benefits for the third quarter and first nine months of 2008, respectively, compared to the 2007 periods is due primarily to growth in the annuity business.
Annuity and Supplemental Insurance Acquisition Expenses
The vast majority of the annuity and supplemental insurance group's DPAC asset relates to its fixed annuity, variable annuity and run-off life insurance lines of business. AFG does not expect a material write-off of DPAC related to its annuity businesses in 2008. AFG minimizes the stock market risk embedded in its indexed annuities by purchasing highly-matched over-the-counter call options. Since AFG's variable annuity business is relatively small and very few policies have living benefit or similar features, AFG expects any DPAC write-off related to variable annuities to be immaterial. However, 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
Discontinued Operations
See AFG's 2007 Form 10-K for a discussion of certain accounting standards issued in 2007 and effective in 2009.
In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities," which is effective January 1, 2009, for calendar year companies. SFAS No. 161 amends and expands the disclosure requirements of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements.
In May 2008, the FASB issued FSP No. APB 14-1, "Accounting for Convertible Debt Instruments That May be Settled in Cash upon Conversion (Including Partial Cash Settlement)." FSP APB 14-1 requires an issuer of convertible debt instruments that may be settled for cash (including partial cash settlements) to separately account for the liability and equity components in a manner that reflects the issuer's nonconvertible debt borrowing rate at the date of issuance. The difference between the fair value of the debt component and the initial proceeds from issuance is recorded as a component of equity. The resulting debt discount would be amortized as additional interest expense over the period the debt is outstanding. FSP APB 14-1 is effective for fiscal years beginning after December 15, 2008 and shall be applied retrospectively to all periods presented. Accordingly, the new rule would change the accounting for AFG's Senior Convertible Notes which were redeemed in June 2008. AFG does not believe that the adoption of the new rule will result in material changes to its previously issued financial statements.
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
Other than the increase in unrealized losses on fixed maturity securities (as discussed in Management's Discussion and Analysis - "Investments") and the decrease in the fair value of AFG's long-term debt, both related to the widening of credit spreads during the first nine months of 2008, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2007 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 third fiscal quarter of 2008 that materially affected, or are reasonably likely to materially affect, AFG's internal control over financial reporting. AFG acquired Marketform Group Limited and Strategic Comp Holdings, LLC effective January 1, 2008. These companies have been excluded from management's assessment of 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 third fiscal quarter of 2008 that has materially affected, or is reasonably likely to materially affect, AFG's internal controls over financial reporting.
38
PART II
OTHER INFORMATION
Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
Total Number
Maximum Number
of Shares
Purchased as
that May
Number
Average
Part of Publicly
Yet be Purchased
Price Paid
Announced Plans
Under the Plans
Purchased
Per Share
or Programs
Or Programs (a)
1st quarter
1,003,000
$26.37
2,059,100
2nd quarter
800,000
$26.22
1,259,100
3rd quarter
(a)
Represents the remaining shares that may be repurchased under the Plan authorized by AFG's Board of Directors in 2007.
39
OTHER INFORMATION - CONTINUED
ITEM 6
Exhibits
Exhibit Description
Computation of ratios of earnings to fixed charges.
Certification of the Co-Chief Executive Officer pursuant
to section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to
section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Co-Chief Executive Officers and Chief
Financial Officer pursuant to section 906 of the Sarbanes-
Oxley Act of 2002.
_____________________________________________________________
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, American Financial Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned duly authorized.
American Financial Group, Inc.
November 7, 2008
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)
40