SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Quarterly Period EndedMarch 31, 2004
Commission File
AMERICAN FINANCIAL GROUP, INC.
Incorporated underthe Laws of Ohio
IRS Employer I.D.No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark whether the Registrant is an accelerated filer. Yes X No As of May 1, 2004, there were 73,372,953 shares of the Registrant's Common Stock outstanding, excluding 9,953,392 shares owned by a subsidiary.
TABLE OF CONTENTS
Page
AMERICAN FINANCIAL GROUP, INC. 10-Q
PART I
FINANCIAL INFORMATION
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars In Thousands)
March 31,
December 31,
2004
2003
Assets:
Cash and short-term investments
$ 485,416
$ 593,552
Investments:
Fixed maturities:
Available for sale - at market
(amortized cost - $12,082,253 and $11,724,181)
12,653,253
12,101,981
Trading - at market
223,419
195,390
Other stocks - at market
(cost - $293,033 and $258,466)
550,233
454,866
Policy loans
214,859
215,571
Real estate and other investments
272,382
266,435
Total cash and investments
14,399,562
13,827,795
Recoverables from reinsurers and prepaid
reinsurance premiums
2,900,249
3,131,775
Agents' balances and premiums receivable
498,250
502,458
Deferred acquisition costs
899,934
851,199
Other receivables
242,421
320,517
Assets of managed investment entity
404,152
424,669
Variable annuity assets (separate accounts)
587,350
568,434
Prepaid expenses, deferred charges and other assets
283,704
402,081
Goodwill
169,026
168,330
$20,384,648
$20,197,258
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 4,810,272
$ 4,909,109
Unearned premiums
1,618,070
1,594,839
Annuity benefits accumulated
7,104,643
6,974,629
Life, accident and health reserves
1,033,947
1,018,861
Payable to reinsurers
302,915
408,518
Long-term debt:
Holding company
684,703
574,618
Subsidiaries
347,883
262,244
Payable to subsidiary trusts (issuers of preferred
securities)
77,800
265,472
Liabilities of managed investment entity
384,424
406,547
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
953,455
950,267
Total liabilities
17,905,462
17,933,538
Minority interest
207,822
187,559
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 73,313,545 and 73,056,085 shares outstanding
73,314
73,056
Capital surplus
1,041,963
1,035,784
Retained earnings
728,787
664,721
Unrealized gain on marketable securities, net
427,300
302,600
Total shareholders' equity
2,271,364
2,076,161
2
CONSOLIDATED STATEMENT OF EARNINGS
(In Thousands, Except Per Share Data)
Three months ended
Income:
Property and casualty insurance premiums
$486,801
$542,785
Life, accident and health premiums
90,325
79,510
Investment income
192,087
201,879
Realized gains (losses) on:
Securities
36,216
1,733
Subsidiary
-
(39,386)
Revenues of managed investment entity
4,891
Other income
63,973
53,401
874,293
839,922
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
309,630
370,912
Commissions and other underwriting expenses
146,997
156,391
Annuity benefits
72,266
74,847
Life, accident and health benefits
69,314
63,096
Annuity and life acquisition expenses
30,154
26,298
Interest charges on borrowed money
17,088
13,048
Interest on subsidiary trust obligations
4,461
Expenses of managed investment entity
3,382
Other operating and general expenses
102,733
97,850
756,025
802,442
Operating earnings before income taxes
118,268
37,480
Provision for income taxes
37,382
5,634
Net operating earnings
80,886
31,846
Minority interest expense, net of tax
(5,504)
(7,582)
Equity in net earnings (losses) of investees, net of tax
(918
557
Earnings from continuing operations
74,464
24,821
Discontinued operations
573
299
Cumulative effect of accounting change
(1,837
Net Earnings
$ 73,200
$ 25,120
Basic earnings per Common Share:
Continuing operations
$1.02
$.36
.01
(.03
Net earnings available to Common Shares
$1.00
Diluted earnings per Common Share:
$ .98
Average number of Common Shares:
Basic
73,172
69,289
Diluted
74,344
69,403
Cash dividends per Common Share
$.125
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in Thousands)
Common Stock
Unrealized
Common
and Capital
Retained
Gain on
Shares
Surplus
Earnings
Total
Balance at January 1, 2004
73,056,085
$1,108,840
$664,721
$302,600
$2,076,161
Net earnings
73,200
Change in unrealized
124,700
Comprehensive income
197,900
Dividends on Common Stock
(9,134)
Shares issued:
Exercise of stock options
173,950
4,028
Dividend reinvestment plan
4,233
112
Employee stock purchase plan
6,683
189
Retirement plan contributions
37,468
1,095
Deferred compensation distributions
33,620
959
Directors fees paid in stock
1,506
39
Other
15
Balance at March 31, 2004
73,313,545
$1,115,277
$728,787
$427,300
$2,271,364
Balance at January 1, 2003
69,129,352
$ 992,171
$409,777
$323,900
$1,725,848
25,120
(31,000)
(31,000
Comprehensive income (loss)
(5,880)
(8,642)
103,492
2,110
12,157
256
278,434
5,437
3,300
71
1,050
24
Shares acquired and retired
(4)
(2,321
Balance at March 31, 2003
69,527,781
$ 997,748
$426,255
$292,900
$1,716,903
4
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)
Operating Activities:
Adjustments:
1,837
Equity in net (earnings) losses of investees
918
(557)
5,504
2,569
Depreciation and amortization
39,075
41,300
Realized (gains) losses on investing activities
(39,764)
37,130
Deferred annuity and life policy acquisition costs
(30,756)
(44,748)
Decrease (increase) in reinsurance and other receivables
324,344
(195,939)
Decrease in other assets
28,958
28,610
Increase (decrease) in insurance claims and reserves
(58,608)
235,949
Increase (decrease) in payable to reinsurers
(105,603)
8,490
Increase (decrease) in other liabilities
(19,849)
53,575
Other, net
(20,851
3,198
270,671
269,544
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(1,686,323)
(1,817,002)
Equity securities
(44,584)
(8,168)
(10,382)
Real estate, property and equipment
(3,277)
(5,124)
Maturities and redemptions of fixed maturity
investments
276,096
522,366
Sales of:
1,095,928
873,948
14,662
1,820
186,269
2,768
386
Cash and short-term investments of acquired
(former) subsidiaries, net
1,295
(86,781)
Decrease (increase) in other investments
(9,596
4,656
(363,413
(327,630
Financing Activities
Fixed annuity receipts
152,932
214,519
Annuity surrenders, benefits and withdrawals
(159,367)
(140,294)
Net transfers from (to) variable annuity assets
(3,698)
8,629
Additional long-term borrowings
194,733
18,311
Reductions of long-term debt
(6,114)
(171,601)
Repurchases of trust preferred securities
(188,961)
Issuances of Common Stock
3,891
217
Cash dividends paid on Common Stock
(9,022)
(6,532)
212
(167
(15,394
(76,918
Net Decrease in Cash and Short-term Investments
(108,136)
(135,004)
Cash and short-term investments at beginning
of period
593,552
871,103
Cash and short-term investments at end of period
$ 736,099
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
H.
B.
I.
C.
J.
D.
K.
E.
F.
L.
G.
________________________________________________________________________________
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.
Subsidiary Realignment
Investments
current mortgage loan rates and the structure of the security. Other factors affecting prepayments include the size, type and age of underlying mortgages,
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
the geographic location of the mortgaged properties and the creditworthiness of the borrowers. Variations from anticipated prepayments will affect the life and yield of these securities.
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.
Derivatives
The terms of the interest rate swap match those of the hedged debt; therefore, the swap is considered to be (and is accounted for as) a 100% effective fair value hedge. Both the swap and the hedged debt are adjusted for changes in fair value by offsetting amounts. Accordingly, since the swap is included with long-term debt in the Balance Sheet, the only effect on AFG's financial statements is that the interest expense on the hedged debt is recorded based on the variable rate.
Managed Investment Entity
Insurance
7
Reinsurance
Subsidiaries of Great American Financial Resources, Inc. ("GAFRI"), an 82%-owned subsidiary, cede life insurance policies to a third party on a funds withheld basis whereby GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance (including realized gains and losses) of the retained assets. Effective October 1, 2003, GAFRI implemented SFAS No. 133 Implementation Issue B36 ("B36"). Under B36, these reinsurance contracts are considered to contain embedded derivatives (that must be marked to market) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. As permitted under B36, GAFRI reclassified the securities related to these transactions from "available for sale" to "trading". The mark to market on the embedded derivatives offsets the investment income recorded on the mark to market of the related trading portfolios.
Deferred Policy Acquisition Costs ("DPAC")
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of expected gross profits on the policies. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in "Unrealized gain on marketable securities, net" in the shareholders' equity section of the Balance Sheet.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
DPAC includes the present value of future profits on business in force of insurance companies acquired by GAFRI, which represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The present value of future profits is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
8
Annuity and Life Acquisition Expenses
Unpaid Losses and Loss Adjustment Expenses
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. In spite of the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Annuity Benefits Accumulated
Life, Accident and Health Reserves
Variable Annuity Assets and Liabilities
Premium Recognition
9
Policyholder Dividends
Payable to Subsidiary Trusts (Issuers of Preferred Securities)
Minority Interest
Income Taxes
Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized.
Stock-Based Compensation
10
The following table illustrates the effect on net earnings (in thousands) and earnings per share had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the method prescribed by SFAS No. 123. For SFAS No. 123 purposes, the "fair value" of $8.92 per option granted in the first quarter of 2004 and $5.60 in the first quarter of 2003 was calculated using the Black-Scholes option pricing model and the following assumptions: dividend yield of 2%; expected volatility of 29% in 2004 and 30% in 2003; risk-free interest rate of 3.7% for 2004 and 3.6% for 2003; and expected option life of 7.5 years in 2004 and 7.4 years in 2003. There is no single reliable method to determine the actual value of options at grant date. Accordingly, actual value of the option grants may be higher or lower than the SFAS No. 123 "fair value".
Net earnings, as reported
$73,200
$25,120
Pro forma stock option expense, net of tax
(1,217
(1,521
Adjusted net earnings
$71,983
$23,599
Earnings per share (as reported):
$0.36
$0.98
Earnings per share (adjusted):
$0.34
$0.97
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.
Discontinued Operations
11
Earnings Per Share
Statement of Cash Flows
Fidelity Excess and Surplus Insurance Company
Direct automobile insurance business
Infinity Property and Casualty Corporation
Since AFG disposed of substantially all of its Personal insurance business in 2003, it has revised its reporting of the Specialty insurance business into the following components: (i) Property and Transportation which includes inland and ocean marine, agricultural-related business and commercial automobile, (ii) Specialty Casualty which includes executive and professional liability, umbrella and excess liability and excess and surplus, (iii) Specialty Financial which includes fidelity and surety bonds and collateral protection and (iv) California Workers' Compensation. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
12
AFG's annuity, supplemental insurance and life business markets primarily retirement annuities and various forms of supplemental insurance and life products.
The following tables (in thousands) show AFG's revenues and operating profit (loss) by significant business segment and sub-segment. Operating profit (loss) represents total revenues less operating expenses.
Revenues (a)
Premiums earned:
Specialty
Property and transportation
$124,916
$132,194
Specialty casualty
174,494
155,600
Specialty financial
84,362
59,234
California workers' compensation
77,429
58,786
20,617
22,034
Personal
4,981
114,938
Other lines
(1
486,801
542,785
63,725
70,199
Realized gains (losses)
25,995
15,236
42,605
32,948
619,126
661,168
Annuities, life and health (b)
247,012
220,946
Other (c)
8,155
(42,192
$874,293
$839,922
Operating Profit (Loss)
Underwriting:
$ 20,659
$ 5,242
10,793
(1,228)
(754)
(5,699)
3,739
4,717
(1,816)
6,489
(44)
5,212
Other lines (d)
(2,403
749
30,174
15,482
Investment and other income
80,948
69,728
111,122
85,210
Annuities, life and health
29,087
15,563
(21,941
(63,293
$118,268
$ 37,480
(a) Revenues include sales of products and services as well as other
income earned by the respective segments.
(b) Investment income comprises the majority of these revenues. Includes
impairment charges of $1.2 million and $21.7 million for the three
months ended March 31, 2004 and 2003, respectively.
(c) Other revenues and operating profit (loss) for 2003 include the loss on
the public offering of Infinity. Operating profit (loss) includes
holding company expenses.
(d) Represents development of lines in "run-off"; AFG has ceased underwriting
new business in these operations.
13
Upon formation in 1999, the CDO issued securities in various senior and subordinate classes and the proceeds were invested in primarily floating rate, secured bank loans, and to a lesser extent, high yield bonds, all of which serve as collateral for the securities issued by the CDO. None of the collateral was purchased from AFG. Income from the CDO's investments is used to service its debt and pay other operating expenses, including management fees to AFG. AFG's investment in this CDO is subordinate to the senior classes (approximately 92% of the total securities) issued by the CDO. To the extent there are defaults and unrecoverable losses on the underlying collateral resulting in reduced cash flows, AFG's class would bear losses first.
The assets (substantially all cash and investments carried at market as "trading securities") of this managed investment entity are separately disclosed in the Balance Sheet because they are not available for use to satisfy AFG obligations. Likewise, the CDO liabilities (substantially all debt) are separately disclosed because they represent claims against only the CDO's assets and not against AFG's other assets. Accordingly, AFG's exposure to loss on this investment is limited to its investment (approximately $11.5 million at March 31, 2004).
Beginning in 2004, the operating results of the CDO are included in AFG's Statement of Earnings. However, due to the non-recourse nature of the instruments issued by the CDO, any excess losses included in AFG's results that are not absorbed by AFG's investment over the life of the CDO will ultimately reverse when the CDO is liquidated. Accordingly, while implementation of FIN 46 impacts the timing of income recognition, it does not impact the overall amount of income recognized over the life of this investment.
AFG is the investment manager and has an investment of $6.3 million in another CDO (included in fixed maturities) at March 31, 2004, which is not required to be consolidated. This CDO was formed in 2000 and had approximately $475 million in investments at March 31, 2004.
14
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$296,682
$301,501
AFG Senior Convertible Notes due June 2033
189,857
AFG 7-1/8% Senior Debentures due February 2034
115,000
AFG 7-1/8% Senior Debentures due December 2007
75,100
8,064
8,160
$684,703
$574,618
GAFRI 7-1/2% Senior Debentures due November 2033
$112,500
GAFRI 6-7/8% Senior Notes due June 2008
100,000
GAFRI 7-1/4% Senior Debentures due January 2034
86,250
Notes payable secured by real estate
26,919
27,063
APU 10-7/8% Subordinated Notes due May 2011
11,415
11,433
10,799
11,248
$347,883
$262,244
At March 31, 2004, sinking fund and other scheduled principal payments on debt for the balance of 2004 and the subsequent five years were as follows (in millions):
Holding
Company
$ -
$ 1.5
2005
11.2
2006
19.4
2007
80.2
.1
80.3
2008
100.1
2009
298.0
298.1
In the first quarter of 2004, AFG issued $115 million principal amount of 7-1/8% senior debentures due 2034 and GAFRI issued $86.3 million principal amount of7-1/4% senior debentures due 2034. Proceeds from both offerings were used primarily to redeem at face value a portion of the outstanding trust preferred securities.
GAFRI has entered into interest rate swaps which effectively convert its 6-7/8% 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 at June 2, 2008 to $1,000 per Note at maturity. Generally, holders may convert each Note into 11.5016 shares of AFG Common Stock (i) if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value, (ii) if the credit rating of the Notes is significantly lowered, or (iii) if AFG calls the notes for redemption.
AFG may borrow up to $280 million under its credit agreement. The line consists of two facilities: a 364-day revolving facility, extendable annually, for one-third of the total line and a revolving facility for the remaining two-thirds with
a maturity in November 2005. Amounts borrowed bear interest at rates ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. In addition, GAFRI has an unsecured credit agreement under which it can borrow up to $155 million at floating rates based on prime or Eurodollar rates through December 2004.
In accordance with FIN 46, variable interest entities that issued preferred securities subsequent to January 31, 2003, are not consolidated for reporting purposes. Beginning December 31, 2003, previously consolidated subsidiary trusts were deconsolidated for reporting purposes under FIN 46. Accordingly, the subordinated debt due the trusts is shown as a liability in AFG's Balance Sheet. The preferred securities supported by the payable to subsidiary trusts consisted of the following (in thousands):
Date of
Amount Outstanding
Optional
Issuance
Issue (Maturity Date)
3/31/04
12/31/03
Redemption Dates
October 1996
AFG 9-1/8% TOPrS (2026)
$95,459
Redeemed March 2004
November 1996
GAFRI 9-1/4% TOPrS (2026)
65,013
March 1997
GAFRI 8-7/8% Pfd (2027)
42,800
70,000
On or after 3/1/2007
May 2003
GAFRI 7.35% Pfd (2033)
20,000
On or after 5/15/2008
Variable Rate Pfd (2033)
15,000
On or after 5/23/2008
In 2003, a GAFRI subsidiary and a 68%-owned subsidiary of GAI issued an aggregate of $35 million in trust preferred securities maturing in 2033.
The AFG 9-1/8% trust preferred securities and the GAFRI 9-1/4% trust preferred securities were redeemed at face value in March 2004. In addition, during the first quarter of 2004, GAFRI repurchased $27.2 million of its 8-7/8% preferred securities for $28.5 million in cash.
Subsidiaries' common stock
$200,873
$180,937
Managed investment entity
6,949
6,622
$207,822
$187,559
Minority Interest Expense
Interest of noncontrolling investors
in earnings of:
$4,827
$2,569
677
Accrued distributions by consolidated
subsidiaries on preferred securities:
Trust issued securities, net of tax
3,570
AFC preferred stock
1,443
$5,504
$7,582
16
The Senior Convertible Notes due in 2033 could be converted under certain conditions into 5.9 million shares of AFG Common Stock.
Stock Options
Included in equity in net earnings of investees for the first quarter of 2003 was $1.4 million representing AFG's equity in net earnings from Infinity after the date of the initial sale of 61% of Infinity in mid-February 2003.
17
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
18
Results of Operations
25
Overview
General
Critical Accounting Policies
19
Income Items
Liquidity and Capital Resources
Expense Items
28
Ratios
Other Items
29
Sources of Funds
20
Proposed Accounting Standard
30
Uncertainties
23
_____________________________________________________________________________________________________
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Some of the forward-looking statements can be identified by the use of forward-looking words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Examples of such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate increases; and improved loss experience.
Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:
The forward-looking statements herein are made only as of the date of this report. AFG assumes no obligation to publicly update any forward-looking statements.
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings,
of Financial Condition and Results of Operations - Continued
shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, since most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
In the first quarter of 2004, AFG and GAFRI issued just over $200 million in senior debentures and used approximately $189 million of the proceeds to retire higher coupon debt due unconsolidated subsidiary trusts that, in turn, retired preferred securities.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance and in the sale of retirement annuities and supplemental insurance and life products. With the sale of Infinity in 2003, AFG narrowed the focus of its property and casualty business to its specialized commercial products for businesses.
AFG's net earnings for the first three months of 2004 were $73.2 million or $.98 per share, significantly higher than the $25.1 million or $.36 per share recorded in the comparable period in 2003. The improvement results from net realized gains versus net realized losses in the 2003 period and from improved underwriting results.
CRITICAL ACCOUNTING POLICIES
Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. Management believes that the establishment of insurance reserves, especially asbestos and environmental-related reserves, and the determination of "other than temporary" impairment on investments are the two areas where the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical. For further discussion of these policies, see "Liquidity and Capital Resources - Investments" and "Liquidity and Capital Resources - Uncertainties."
LIQUIDITY AND CAPITAL RESOURCES
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.20 for the quarter ended March 31, 2004, and 1.69 for the entire year of 2003. Excluding annuity benefits, this ratio was 5.63 and 3.71, 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.
AFG's bank credit line consists of two facilities: a 364-day revolving facility, extendable annually, for one-third of the total line and a revolving facility for the remaining two-thirds which matures in November 2005. Amounts borrowed bear interest at rates ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. This credit agreement provides ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent company. While the credit line provides up to $280 million of availability, there were no borrowings outstanding during the first quarter of 2004. Under a currently effective shelf registration, AFG has the flexibility to issue up to $485 million in additional equity or debt securities as market and other conditions permit.
Approximately 93% of the fixed maturities held by AFG at March 31, 2004, were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and noninvestment grade. Management believes that a high quality investment portfolio should generate a stable and predictable investment return.
Individual portfolio securities are sold creating gains or losses as market opportunities exist. Since all of these securities are carried at market value in the balance sheet, there is virtually no effect on liquidity or financial condition upon the sale and ultimate realization of unrealized gains and losses.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at March 31, 2004, is shown in the following table (dollars in millions). Approximately $108 million of available-for-sale "Fixed maturities" and $22 million of "Other stocks" had no unrealized gains or losses at March 31, 2004.
With
Gains
Losses
Available-for-sale Fixed Maturities
Market value of securities
$11,311
$1,234
Amortized cost of securities
$10,714
$1,260
Gross unrealized gain (loss)
$ 597
($ 26)
Market value as % of amortized cost
106%
98%
Number of security positions
1,738
144
Number individually exceeding
$2 million gain or loss
Concentration of gains (losses) by
type or industry (exceeding 5% of
unrealized):
Banks, savings and credit institutions
$ 80.8
($ 0.4)
Gas and electric services
73.5
(3.7)
Mortgage-backed securities
72.5
(6.7)
U.S. government and government agencies
38.5
(1.5)
State and municipal
35.4
(1.9)
Asset-backed securities
19.3
(2.9)
Air transportation (generally collateralized)
8.2
(3.4)
Percentage rated investment grade
94%
91%
Other Stocks
$ 475
$ 53
Cost of securities
$ 216
$ 55
$ 259
($ 2)
Market value as % of cost
220%
97%
AFG's investment in equity securities of Provident Financial Group, a Cincinnati-based commercial banking and financial services company, represents $217 million of the $259 million in unrealized gains on other stocks at March 31, 2004. In the first quarter of 2004, Provident announced it was being acquired by National City Corporation. If this transaction is completed, AFG will receive 8.1 million shares ($280 million market value at April 30, 2004) of National City in exchange for its investment in Provident.
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The table below sets forth the scheduled maturities of AFG's available-for-sale fixed maturity securities at March 31, 2004, based on their market values. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Maturity
One year or less
2%
3%
After one year through five years
After five years through ten years
33
After ten years
73
46
27
54
100
AFG realized aggregate losses of $2.2 million during the first quarter of 2004 on $13.5 million in sales of fixed maturity securities (2 issues/issuers) that had individual unrealized losses greater than $500,000 at December 31, 2003. Market values of both of the issues increased an aggregate of $1.7 million from December 31 to date of sale.
Although AFG had the ability to continue holding these investments, its intent to hold them changed due primarily to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular credit or industry, or to modify asset allocation within the portfolio.
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Market
Aggregate
Value as
% of Cost
Value
Gain (Loss)
Basis
Fixed Maturities at March 31, 2004
Securities with unrealized gains:
Exceeding $500,000 (407 issues)
$ 5,101
$409
108.7%
Less than $500,000 (1,331 issues)
6,210
188
103.1
$597
105.6%
Securities with unrealized losses:
Exceeding $500,000 (16 issues)
$ 184
($ 14)
92.9%
Less than $500,000 (128 issues)
(12
98.9
$ 1,234
97.9%
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The following table summarizes (dollars in millions) the unrealized loss for all fixed maturity securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
Fixed Maturities with Unrealized
Losses at March 31, 2004
Investment grade with losses for:
One year or less (92 issues)
$1,043
($11)
99.0%
Greater than one year (15 issues)
77
(4
95.1%
$1,120
($15)
98.7%
Non-investment grade with losses for:
One year or less (15 issues)
$ 44
($ 3)
93.6%
Greater than one year (22 issues)
70
(8
89.7%
$ 114
91.2%
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 2003 Form 10-K.
Based on its analysis, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they mature or recover in value. Should either of these beliefs change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
Property and Casualty Insurance Reserves
and other factors, AFG actuaries determine a single or "point" estimate which management utilizes in recording its best estimate of the liabilities. Ranges of loss reserves are not developed by AFG actuaries.
Estimating the liability for unpaid losses and LAE is inherently judgmental and is influenced by factors which are subject to significant variation. Through the use of analytical reserve development techniques, management utilizes items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, general economic trends and the legal environment.
While current factors and reasonably likely changes in variable factors are considered in estimating the liability for unpaid losses, there is no method or system which can eliminate the risk of actual ultimate results differing from such estimates. As shown in the reserve development table (loss triangle) on page 11 of AFG's 2003 Form 10-K, the original estimates of AFG's liability for losses and loss adjustment expenses, net of reinsurance, over the past 10 years have developed through December 31, 2003, to be deficient (for three years) by as much as 10.4% and redundant (for 7 years) by as much as 7.2% (excluding the effect of special charges for asbestos and environmental exposures). AFG believes this development illustrates the variability in factors considered in estimating its insurance reserves.
Quarterly reviews of unpaid loss and LAE reserves are prepared using standard actuarial techniques. These may include: Case Incurred Development Method; Paid Development Method; Bornhuetter-Ferguson Method; and Incremental Paid LAE to Paid Loss Methods. Generally, data is segmented by major product or coverage within product using countrywide data; however, in some situations data may be reviewed by state or region.
Asbestos and Environmental-related ("A&E") Reserves
While management believes that AFG's reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims and the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, whether claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims.
In February 2003, Great American Insurance Company entered into an agreement for the settlement of asbestos related coverage litigation under insurance polices issued during the 1970's and 1980's to Bigelow-Liptak Corporation and related companies, subsequently known as A.P. Green Industries, Inc. ("A.P. Green"). Management believes that this settlement will enhance financial certainty and provides resolution to litigation that represents AFG's largest known asbestos-related claim and the only such claim that management believes to be material.
The settlement is for $123.5 million (Great American has the option to pay in cash or over time with 5.25% interest), all of which is covered by reserves established prior to 2003, and anticipated reinsurance recoverables for this matter. The agreement allows up to 10% of the settlement to be paid in AFG Common Stock.
The settlement has received the approval of the bankruptcy court supervising the reorganization of A.P. Green. It remains subject to the confirmation by the bankruptcy court of a plan of reorganization that includes an injunction prohibiting the assertion against Great American of any present or future asbestos personal injury claims under policies issued to A.P. Green and related companies. This process should be completed in 2004. No assurance can be made that a plan of reorganization will be confirmed; no payments are required until completion of the process. If there is no plan confirmation, the outcome of this litigation will again be subject to the complexities and uncertainties associated with a Chapter 11 proceeding and asbestos coverage litigation.
RESULTS OF OPERATIONS
Operating earnings before income taxes increased $80.8 million in the first quarter of 2004 compared to the same period in 2003 due primarily to a $34.5 million improvement in realized gains on securities, a first quarter 2003 $39.4 million pretax loss on the sale of 61% of Infinity and a $14.7 million improvement in property and casualty underwriting results. These items more than offset a $9.8 million decrease in investment income due primarily to lower yields on fixed maturity securities.
Property and Casualty Insurance - Underwriting
The Personal group wrote nonstandard and preferred/standard private passenger auto insurance and, to a lesser extent, homeowners' insurance. Nonstandard automobile insurance covers risks not typically accepted for standard automobile coverage because of an applicant's driving record, type of vehicle, age or other criteria.
Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their financial statements better understand the company's performance. See Note C - "Segments of Operations" for the detail of AFG's operating profit by significant business segment.
Underwriting profitability is measured by the combined ratio which is a sum of the ratios of underwriting losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. When the combined ratio is
under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. 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)
Specialty:
$239.9
$191.6
363.3
339.9
106.6
74.2
96.2
69.6
.7
1.5
Total Specialty
806.7
676.8
Personal (a)
2.0
181.1
$808.7
$857.9
Net Written Premiums (GAAP)
$146.9
$124.9
198.3
165.7
90.6
57.5
84.0
66.0
17.3
24.7
537.1
438.8
117.9
$539.1
$556.7
Combined Ratios (GAAP)
83.5%
96.0%
93.8
100.8
100.9
109.6
95.2
92.0
108.8
70.6
93.3
97.9
95.5
Aggregate (including discontinued lines)
93.8%
97.1%
(a) Includes the operations of Infinity through the sale date in mid-February 2003.
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The Specialty group reported an underwriting profit of $32.6 million for the 2004 first quarter with a combined ratio of 93.3%, an improvement of 4.6 points over the 2003 first quarter, respectively, reflecting less prior year development in 2004 and the impact of rate increases.
Property and transportation gross written premiums increased 25% during the first quarter of 2004 reflecting primarily volume increases in truck, bus and recreational vehicle products and to a lesser extent rate increases. Net written premiums increased 18% as the growth in gross written premiums was partially offset by increased reinsurance coverage. Combined ratios for property and transportation improved to 83.5% in 2004 from 96% in 2003 reflecting a favorable change in prior year development, the effect of a reinsurance profit-sharing agreement and rate increases.
Specialty casualty net written premiums increased 20% in the first quarter of 2004 compared to the same period in 2003 reflecting return premiums from cancellation of certain reinsurance agreements during the first quarter of 2004 and to a lesser extent rate increases. The 7.0 point improvement in the Specialty casualty combined ratio reflects primarily a favorable change in prior year development.
Specialty financial gross written premiums increased 44% during the first quarter of 2004 reflecting substantial volume growth in financial institutions collateral protection products. In addition, net written premiums increased 58% as less reinsurance was in place during the first quarter of 2004 compared to the first quarter of 2003. The combined ratio for Specialty financial improved 8.7 points in the first quarter of 2004 reflecting growth in more profitable products.
The 27% net written premiums growth in California workers' compensation during the first quarter of 2004 is due primarily to rate increases. The 3.2 point deterioration in the combined ratio reflects prior year development in 2004 partially offset by rate increases.
Investment Income
Realized Gains
Gains (Losses) on Securities
Loss on Sale of Subsidiary
Real Estate Operations
$17.0
$16.0
16.1
.5
.6
Other income includes net pretax gains on the sale of real estate assets of $1.6 million in the first quarter of 2004 compared to $33,000 for the 2003 period.
Other Income
Annuity Benefits
The majority of GAFRI's fixed annuity products permit GAFRI to change the crediting rate at any time subject to minimum interest rate guarantees (as determined by applicable law). Approximately half of the annuity benefits accumulated relate to policies that have a minimum guarantee of 3%; the majority of the balance has a guarantee of 4%. Beginning in the fourth quarter of 2003, in states where required approvals have been received, GAFRI began issuing products with guaranteed minimum crediting rates of less than 3%.
insurance products. Annuity and life acquisition expenses also include amortization of the present value of future profits of businesses acquired.
The increase in annuity and life acquisition expenses in the first quarter of 2004 compared to 2003 reflects an increase in in-force policies, primarily in the annuities and supplemental insurance business.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Continued spread compression, decreases in the stock market and adverse mortality could lead to write-offs of DPAC in the future.
Interest on Borrowed Money
Interest on Subsidiary Trust Obligations
Other Operating and General Expenses
Investee Corporations
Start-up Manufacturing Business
Cumulative Effect of Accounting Change
Proposed Standard on Equity Compensation
______________________________________________
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
Debt Securities
As of March 31, 2004, there were no other material changes to the information provided in AFG's Form 10-K for 2003 under the caption "Exposure to Market Risk" in Management's Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 4
Controls and Procedures
AFG's management, with participation of its Chief Executive Officer and Chief 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 CEO and CFO concluded that the controls and procedures are effective. There have been no significant changes in AFG's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
PART II
OTHER INFORMATION
ITEM 6
Exhibits and Reports on Form 8-K
(a) Exhibits:
Number
Exhibit Description
2004 CEO and Co-President Bonus Plan.
2004 Senior Executive Bonus Plan.
Keith E. Lindner Salary Continuation Agreement.
Computation of ratios of earnings to fixed charges.
Certification of the Chief Executive Officer pursuant to
section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to
Certification of the Chief Executive Officer and Chief
Financial Officer pursuant to section 906 of the Sarbanes-
Oxley Act of 2002.
(b) Reports on Form 8-K:
Date of Report
Item Reported
January 30, 2004
Press Release regarding Sale of 7-1/8% Senior Debentures
due 2034.
February 2, 2004
Correction of Press Release regarding Sale of 7-1/8%
Senior Debentures due 2034.
February 12, 2004
Fourth Quarter and Full Year 2003 Earnings Release.
February 17, 2004
Press Release regarding Potential Effect of a Proposed
Merger Agreement between Provident Financial Group, Inc.
and National City Corporation.
April 26, 2004
First Quarter 2004 Earnings Release.
31
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, American Financial Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned duly authorized.
American Financial Group, Inc.
May 7, 2004
BY: s/Fred J. Runk
Fred J. Runk
Senior Vice President and Treasurer
32