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, 2006
Commission File
AMERICAN FINANCIAL GROUP, INC.
Incorporated underthe Laws of Ohio
IRS Employer I.D.No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirementsfor the past 90 days. Yes X No
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer: Large Accelerated Filer X Accelerated Filer Non-Accelerated Filer
Indicate by check mark whether the Registrant is a shell company. Yes No X
As of May 1, 2006, there were 78,541,477 shares of the Registrant's Common Stock outstanding, excluding9,953,392 shares owned by a subsidiary.
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 Thousands)
March 31,
December 31,
2006
2005
Assets:
Cash and cash equivalents
$ 565,232
$ 471,849
Investments:
Fixed maturities:
Available for sale - at fair value
(amortized cost - $14,617,054 and $14,272,314)
14,407,454
14,326,614
Trading - at fair value
279,649
271,851
Other stocks - at fair value
(cost - $521,286 and $501,459)
595,186
556,659
Policy loans
254,567
258,744
Real estate and other investments
345,914
338,254
Total cash and investments
16,448,002
16,223,971
Recoverables from reinsurers and prepaid
reinsurance premiums
3,130,473
3,263,128
Agents' balances and premiums receivable
554,337
574,882
Deferred policy acquisition costs
1,166,357
1,139,515
Other receivables
370,205
388,078
Variable annuity assets (separate accounts)
673,441
643,506
Prepaid expenses, deferred charges and other assets
399,566
416,030
Goodwill
166,882
$22,909,263
$22,815,992
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 5,794,333
$ 5,790,709
Unearned premiums
1,699,158
1,643,954
Annuity benefits accumulated
8,706,174
8,417,298
Life, accident and health reserves
922,949
1,088,016
Payable to reinsurers
294,637
298,664
Long-term debt
914,455
999,703
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,202,273
1,215,490
Total liabilities
20,207,420
20,097,340
Minority interest
252,818
261,110
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 78,482,208 and 78,067,514 shares outstanding
78,482
78,068
Capital surplus
1,208,901
1,194,600
Retained earnings
1,224,842
1,134,074
Unrealized gain (loss) on marketable securities, net
(63,200
50,800
Total shareholders' equity
2,449,025
2,457,542
2
CONSOLIDATED STATEMENT OF EARNINGS (unaudited)
(In Thousands, Except Per Share Data)
Three months ended
Income:
Property and casualty insurance premiums
$579,084
$549,099
Life, accident and health premiums
82,043
92,056
Investment income
231,903
214,207
Realized gains (losses) on securities
29,812
(5,539)
Other income
74,769
82,160
997,611
931,983
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
337,111
348,378
Commissions and other underwriting expenses
173,336
158,891
Annuity benefits
83,275
80,762
Life, accident and health benefits
67,164
68,971
Annuity and supplemental insurance acquisition expenses
33,024
35,272
Interest charges on borrowed money
18,500
19,580
Other operating and general expenses
116,131
115,807
828,541
827,661
Operating earnings before income taxes
169,070
104,322
Provision for income taxes
59,332
35,131
Net operating earnings
109,738
69,191
Minority interest expense
(7,778)
(5,872)
Equity in net losses of investee, net of tax
(450
(444
Net Earnings
$101,510
$ 62,875
Earnings per Common Share:
Basic
$1.30
$.82
Diluted
$1.27
$.81
Average number of Common Shares:
78,251
76,738
79,599
77,824
Cash dividends per Common Share
$.1375
$.125
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (unaudited)
(Dollars in Thousands)
Common Stock
Unrealized
Common
and Capital
Retained
Gain (Loss)
Shares
Surplus
Earnings
on Securities
Total
Balance at January 1, 2006
78,067,514
$1,272,668
$1,134,074
$ 50,800
$2,457,542
Net earnings
-
101,510
Change in unrealized
(114,000)
(114,000
Comprehensive income (loss)
(12,490)
Dividends on Common Stock
(10,742)
Shares issued:
Exercise of stock options
331,770
10,555
Dividend reinvestment plan
35,051
1,275
Employee stock purchase plan
5,765
225
Deferred compensation distributions
42,108
1,646
Stock-based compensation expense
1,455
Capital transactions of subsidiaries
209
Other
(650
Balance at March 31, 2006
78,482,208
$1,287,383
$1,224,842
($ 63,200)
$2,449,025
Balance at January 1, 2005
76,634,204
$1,222,507
$ 976,340
$231,700
$2,430,547
62,875
(131,400)
(131,400
(68,525)
(9,580)
571,308
14,906
49,902
1,438
6,432
198
Retirement plan contributions
35,896
1,104
7,374
222
Shares tendered in option exercises
(339,411)
(5,414)
(4,999)
(10,413)
(724)
(210
Balance at March 31, 2005
76,965,705
$1,234,027
$1,024,636
$100,300
$2,358,963
4
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Thousands)
Operating Activities:
$ 101,510
Adjustments:
Equity in net losses of investee
450
444
7,778
5,872
Depreciation and amortization
35,145
49,120
Realized (gains) losses on investing activities
(36,811)
2,941
Net purchases/sales of trading securities
(14,287)
5,020
Deferred annuity and life policy acquisition costs
(27,277)
(33,760)
Decrease in reinsurance and other receivables
213,347
333,603
Decrease in other assets
68,300
17,334
Increase (decrease) in insurance claims and reserves
62,828
(56,501)
Decrease in payable to reinsurers
(4,330)
(201,744)
Increase (decrease) in other liabilities
(47,667)
19,822
Other, net
4,963
4,833
Net cash provided by operating activities
447,224
290,621
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(1,063,005)
(1,710,026)
Equity securities
(63,693)
(63,643)
Subsidiary
(1,246)
Real estate, property and equipment
(6,615)
(4,233)
Maturities and redemptions of fixed maturity
investments
291,436
241,082
Sales of:
409,231
820,199
55,075
26,493
37,500
23,854
3,856
Cash and cash equivalents of businesses
acquired or sold, net
99,960
Decrease (increase) in other investments
21,733
(796
Net cash used in investing activities
(195,770
(687,068
Financing Activities
Fixed annuity receipts
220,261
266,521
Annuity surrenders, benefits and withdrawals
(294,286)
(224,260)
Net transfers from variable annuity assets
4,056
256
Additional long-term borrowings
26,197
100
Reductions of long-term debt
(116,771)
(14,626)
Issuances of Common Stock
10,506
3,351
Subsidiary's issuance of stock in public offering
40,444
Cash dividends paid on Common Stock
(9,467)
(8,142)
1,433
(1,548
Net cash provided by (used in) financing activities
(158,071
62,096
Net Increase (Decrease) in Cash and Cash Equivalents
93,383
(334,351)
Cash and cash equivalents at beginning of period
471,849
861,742
Cash and cash equivalents at end of period
$ 527,391
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
E.
B.
F.
G.
C.
H.
D.
________________________________________________________________________________
Basis of Presentation
Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
Investments
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced.
Derivatives
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
The terms of the interest rate swaps match those of the debt; therefore, the swaps are considered to be (and are accounted for as) 100% effective fair value hedges. Both the swaps and the hedged debt are adjusted for changes in fair value by offsetting amounts. Accordingly, since the swaps are included with long-term debt in the Balance Sheet, the only effect on AFG's financial statements is that the interest expense on the hedged debt is recorded based on the variable rate.
Insurance
Reinsurance
Subsidiaries of AFG's 81%-owned subsidiary, Great American Financial Resources, Inc. ("GAFRI"), cede life insurance policies to a third party on a funds withheld basis whereby GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. GAFRI classifies the securities related to these transactions as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of t he related trading portfolios.
Deferred Policy Acquisition Costs ("DPAC")
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the
7
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 (loss) on marketable securities, net" in the shareholders' equity section of the Balance Sheet.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
DPAC includes the present value of future profits on business in force of insurance companies acquired by GAFRI, which represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The present value of future profits is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
Annuity and Supplemental Insurance 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. 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
8
Variable Annuity Assets and Liabilities
Premium Recognition
Payable to Subsidiary Trusts
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
Prior to the implementation of SFAS No. 123(R), AFG accounted for stock options and other stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under this method, no compensation expense
9
for stock option grants was recognized because options are granted at exercise prices equal to the fair value of the shares at the dates of grant. See Note F - "Shareholders' Equity" for further information on stock options.
Benefit Plans
AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.
Earnings Per Share
Statement of Cash Flows
Old Standard Life Fixed Annuity Business
Great American Life Assurance Company of Puerto Rico
Farmers Crop Insurance Alliance, Inc.
10
the initial Farmers Crop purchase price was recorded as intangible renewal rights and is being amortized over an estimated retention period of four years on a straight-line basis. Any future payments (not expected to exceed $15 million) based on customer retention will also be recorded as intangible renewal rights. While there is uncertainty as to the amount of premiums that ultimately will be retained due to the departure of several Farmers' employees in the months preceding the acquisition, AFG expects this acquired business will generate gross written premiums of $130 million to $180 million in 2006.
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes inland and ocean marine, agricultural-related business and commercial automobile, (ii) Specialty casualty, which includes executive and professional liability, umbrella and excess liability and excess and surplus, (iii) Specialty financial, which includes fidelity and surety bonds and collateral protection, and (iv) California workers' compensation. AFG's annuity and supplemental insurance business markets primarily retirement annuities and various forms of supplemental insurance. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
The following tables (in thousands) show AFG's revenues and operating earnings before income taxes by significant business segment and sub-segment.
Revenues (a)
Premiums earned:
Specialty
Property and transportation
$200,003
$168,071
Specialty casualty
188,215
184,167
Specialty financial
96,223
91,770
California workers' compensation
77,315
87,324
16,731
16,407
Other lines
597
1,360
579,084
549,099
79,529
68,369
Realized gains
26,053
847
47,034
51,568
731,700
669,883
Annuity and supplemental insurance:
150,394
145,160
3,721
45
26,057
25,554
262,215
262,815
3,696
(715
$997,611
$931,983
11
Operating Earnings Before Income Taxes
Underwriting:
$ 42,051
$ 28,941
14,619
6,568
812
(4,068)
12,514
13,022
(159)
(1,169)
(1,200
(1,464
68,637
41,830
Investment income, realized gains and other
97,853
65,886
166,490
107,716
Annuity and supplemental insurance
28,750
25,701
Other (b)
(26,170
(29,095
$169,070
$104,322
(a) Revenues include sales of products and services as well as other income
earned by the respective segments.
(b) Includes holding company expenses.
12
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$203,365
$226,052
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
59,493
3,773
3,768
571,488
594,170
Subsidiaries
GAFRI 7-1/2% Senior Debentures due November 2033
112,500
GAFRI 7-1/4% Senior Debentures due January 2034
86,250
GAFRI 6-7/8% Senior Notes due June 2008
45,175
100,000
Notes payable secured by real estate
26,071
33,112
APU 10-7/8% Subordinated Notes due May 2011
8,110
8,125
7,901
8,586
286,007
348,573
Payable to Subsidiary Trusts:
GAFRI 8-7/8% Subordinated Debentures due
January 2027
21,960
GAFRI 7.35% Subordinated Debentures due May 2033
20,000
National Interstate Variable Rate Subordinated
Debentures due May 2033
15,000
56,960
$914,455
$999,703
At March 31, 2006, sinking fund and other scheduled principal payments on debt for the balance of 2006 and the subsequent five years were as follows: 2006 - $.9 million; 2007 - $60.8 million; 2008 - $45.6 million; 2009 - $204.4 million; 2010 - $2.2 million; and 2011 - $8.2 million.
During the first quarter of 2006, AFG repurchased $22.8 million of its 7-1/8% Debentures due 2009 for $24.2 million in cash and GAFRI repurchased $54.8 million of its 6-7/8% Notes for $56.8 million in cash.
In March 2006, AFG and GAFRI replaced their existing credit agreements with a new five-year revolving credit facility under which they can borrow a combined $500 million. AFG and GAFRI have agreed not to borrow more than $325 million and $200 million, respectively, under the credit facility and AFG has agreed to guarantee amounts borrowed by GAFRI. Amounts borrowed bear interest at rates ranging from 0.5% to 1.25% over LIBOR based on AFG's credit rating.
To achieve a desired balance between fixed and variable rate debt, GAFRI has entered into interest rate swaps that effectively convert its 6-7/8% fixed rate Senior Notes to a floating rate of 3-month LIBOR plus 2.9%. In connection with the 2006 debt repurchases discussed above, GAFRI paid an additional $1.6 million to effectively terminate the portion of the interest rate swaps that covered the repurchased debt.
AFG's Senior Convertible Notes were issued at a price of 37.153% of the principal amount due at maturity. Interest is payable semiannually at a rate of 4% of issue price per year through June 2008, after which interest at 4% annually will be accrued and added to the carrying value of the Notes. The Notes are redeemable at AFG's option at any time on or after June 2, 2008, at
13
accreted value ranging from $371.53 per Note to $1,000 per Note at maturity. Generally, holders may convert each Note into 11.5016 shares of AFG Common Stock (at $32.30 per share currently) (i) if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value ($38.76 per share currently) for a specified period, (ii) if the credit rating of the Notes is significantly lowered, or, (iii) if AFG calls the notes for redemption. Based on the market price of AFG's Common Stock during the quarter ended March 31, 2006, the Notes are currently convertible through June 30, 2006. AFG intends to deliver cash in lieu of Common Stock upon conversion of the Notes; accordingly, shares issuable upon conversion of the Notes are not treated as dilutive.
Stock Incentive Plans
At March 31, 2006, there were 11.3 million shares of AFG Common Stock reserved for issuance under AFG's stock incentive plan. Options generally become exercisable at the rate of 20% per year commencing one year after grant; those granted to non-employee directors of AFG are fully exercisable upon grant. Options expire ten years after the date of grant. Data for stock options issued under AFG's stock incentive plans is presented below:
Average
Aggregate
Remaining
Intrinsic
Exercise
Contractual
Value
Price
Term
(in millions)
Outstanding at January 1, 2006
6,389,288
$28.14
Granted
936,450
$40.31
Exercised
(331,770)
$29.40
Forfeited/Cancelled
(16,900
$36.03
Outstanding at March 31, 2006
6,977,068
$29.70
6.1 years
$83.3
Options exercisable March 31, 2006
4,351,678
$28.24
4.5 years
$58.4
Options and other awards available
for grant at March 31, 2006
4,327,566
The total intrinsic value of options exercised during the three months ended March 31, 2006 and 2005 was $3.6 million and $4.0 million, respectively. During the three months ended March 31, 2006, AFG received $9.8 million from the exercise of stock options. The total tax deduction related to the exercises was $2.3 million.
14
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility (after consideration of other factors). AFG began using the SEC's simplified method of calculating expected term with its 2006 grants. The fair value of options granted in the first three months of 2006 and 2005 was $9.98 and $9.66, respectively, based on the following assumptions:
Expected dividend yield
1-1/2%
2%
Expected volatility
19%
28%
Expected term (in years)
6.5
8.4
Risk-free rate
4.6%
4.3%
Total compensation expense related to stock incentive plans for the three months ended March 31, 2006 was $2.2 million. Related tax benefits totaled $443,000. Included in these totals are $744,000 in compensation expense and $119,000 in tax benefits related to stock incentive plans of two AFG subsidiaries. As of March 31, 2006, there was a total of $22.7 million of total unrecognized compensation expense related to nonvested stock options granted under AFG's plan. That cost is expected to be recognized over a weighted average of 3.8 years.
The following table illustrates the effect on net earnings (in thousands) and earnings per share for the three months ended March 31, 2005, had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the method used beginning in 2006.
Net earnings, as reported
$62,875
Pro forma stock option expense, net of tax
(1,650
Adjusted net earnings
$61,225
Earnings per share (as reported):
$0.82
$0.81
Earnings per share (adjusted):
$0.80
$0.79
Chatham Bars Inn
Ceres Group, Inc.
15
segments and had assets of approximately $770 million at December 31, 2005. Ceres' medical segment includes major medical health insurance for individuals, families, associations and small businesses. The senior segment includes senior health, life and annuity products for Americans age 55 and over. The transaction, which GAFRI expects to be completed in the third quarter of 2006, is subject to the approval of Ceres' stockholders, regulatory approval and other customary conditions.
16
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
17
Results of Operations
23
Overview
General
Critical Accounting Policies
18
Income Items
Liquidity and Capital Resources
19
Expense Items
26
Ratios
Proposed Accounting Standard
27
Sources of Funds
20
Uncertainties
_____________________________________________________________________________________________________
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Some of the forward-looking statements can be identified by the use of words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate increases; and improved loss experience.
Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:
The forward-looking statements herein are made only as of the date of this report. The Company assumes no obligation to publicly update any forward-looking statements.
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings,
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, because most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
At March 31, 2006, AFG (parent) had over $120 million in cash and securities and no amounts borrowed under its bank line of credit.
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 products.
AFG's net earnings for the first three months of 2006 were $101.5 million or $1.27 per share (diluted), compared to $62.9 million or $.81 per share reported in the first quarter of 2005. The results reflect continued improvement in property and casualty underwriting results and net realized gains on investments in the 2006 quarter compared to net realized losses in the 2005 quarter.
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. 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 2005 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
2004
$ 914
$1,000
$1,106
Total capital (*)
3,726
3,703
3,575
Ratio of debt to total capital
24.5%
27.0%
30.9%
(*) 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 2.61 for the quarter ended March 31, 2006 and 1.82 (2.25 excluding A&E and other mass tort charges) for the entire year of 2005. Excluding annuity benefits, this ratio was 8.88 and 4.81 (6.83 excluding the A&E and other mass tort charges), 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
Under a currently effective shelf registration statement, AFG can offer additional equity or debt securities, including 2.3 million shares of common stock under an equity distribution agreement with UBS Securities LLC. The shelf registration provides AFG with greater flexibility to access the capital markets from time to time as market and other conditions permit.
During the first quarter of 2006, AFG repurchased $22.8 million of its 7-1/8% Debentures due 2009 for $24.2 million in cash.
Subsidiary Liquidity
During the first quarter of 2006, GAFRI repurchased $54.8 million of its 6-7/8% Senior Notes due 2008 for $56.8 million in cash.
The liquidity requirements of AFG's insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In GAFRI's annuity business, where profitability is largely dependent on earning a "spread" between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on GAFRI's annuity products. With declining rates, GAFRI receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies.
Approximately 94% of the fixed maturities held by AFG at March 31, 2006, 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 fair 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, 2006, is shown in the following table (dollars in millions). Approximately $159 million of available for sale "Fixed maturities" had no unrealized gains or losses at March 31, 2006.
Securities
With
Gains
Losses
Available for sale Fixed Maturities
Fair value of securities
$3,226
$11,022
Amortized cost of securities
$3,113
$11,345
Gross unrealized gain (loss)
$ 113
($ 323)
Market value as % of amortized cost
104%
97%
Number of security positions
883
1,670
Number individually exceeding
$2 million gain or loss
1
Concentration of gains (losses) by type or
industry (exceeding 5% of unrealized):
Mortgage-backed securities
$10.1
($141.5)
Banks, savings and credit institutions
10.6
(31.7)
U.S. Government and government agencies
1.8
(24.7)
Insurance companies
5.7
(21.1)
State and municipal
(19.4)
Gas and electric services
16.3
(16.2)
Air transportation and courier services
10.5
(0.4)
Percentage rated investment grade
83%
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at March 31, 2006, 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
7%
After one year through five years
34
22
After five years through ten years
37
32
After ten years
89
61
39
21
AFG realized aggregate losses of $5.1 million during the first quarter of 2006 on $129.3 million in sales of fixed maturity securities (four issues/issuers) that had individual unrealized losses greater than $500,000 at December 31, 2005. These securities were "AAA" rated mortgage-backed securities that decreased in fair value by an aggregate of $2.2 million from year-end 2005 to the sale date due to an increase in the general level of interest rates.
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.
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Fair
Value as
% of Cost
Basis
Fixed Maturities at March 31, 2006
Securities with unrealized gains:
Exceeding $500,000 (49 issues)
$ 450
$ 41
110%
Less than $500,000 (834 issues)
2,776
72
103
$ 3,226
$113
Securities with unrealized losses:
Exceeding $500,000 (179 issues)
$ 3,683
($160)
96%
Less than $500,000 (1,491 issues)
7,339
(163
98
($323)
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, 2006
Investment grade with losses for:
One year or less (1,260 issues)
$ 8,675
($232)
Greater than one year (342 issues)
2,013
(84
96
$10,688
($316)
Non-investment grade with losses for:
One year or less (47 issues)
$ 264
($ 4)
99%
Greater than one year (21 issues)
70
(3
$ 334
($ 7)
98%
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 2005 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.
RESULTS OF OPERATIONS
AFG reported operating earnings before income taxes of $169 million for the first quarter of 2006 compared to $104 million for the 2005 quarter. The increase reflects a $26.8 million improvement in property and casualty underwriting results and net realized gains of $29.8 million for the 2006 quarter compared to net realized losses of $5.5 million for the 2005 quarter. Realized gains for the 2006 quarter includes a pretax gain of $23.6 million on the sale of AFG's interest in The Cincinnati Reds.
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 underwriting losses, loss adjustment expenses and underwriting expenses to premiums. A combined ratio under 100% is indicative of an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.
Premiums and combined ratios for AFG's Specialty property and casualty insurance operations were as follows (dollars in millions):
Gross Written Premiums (GAAP)
Specialty:
$317.8
$277.4
375.1
357.5
119.1
115.7
84.6
104.0
(2.2
1.3
Total Specialty
$894.4
$855.9
Net Written Premiums (GAAP)
$230.7
$202.5
202.1
185.7
92.7
96.1
79.6
93.5
18.2
15.0
$623.3
$592.8
Combined Ratios (GAAP)
79.0%
82.8%
92.3
96.4
99.1
104.3
83.9
85.1
100.9
107.1
88.0%
92.1%
(a)
AFG's aggregate combined ratio, including other (primarily discontinued) lines, was 88.1% and 92.4% for the three months ended March 31, 2006 and 2005, respectively.
Net written premiums for the specialty insurance operations were 5% higher in the 2006 first quarter than the same period in 2005. Significant premium growth in the Property and Transportation group was partially offset by a decline in California workers' compensation premiums. The specialty operations generated an underwriting profit of $69.8 million in the first quarter of 2006, a $26.5 million (61%) increase over the 2005 first quarter. Favorable reserve development more than offset a $10.8 million (1.8 point) increase in catastrophe losses in 2006 compared to 2005, principally from severe storms in the Midwest.
Property and transportation net written premiums increased 14% over the 2005 quarter due primarily to new premium volume from the recently acquired Farmers Crop Insurance Alliance, higher commodity prices used to establish 2006 crop insurance coverages and growth in the inland marine businesses. Although the majority of the Midwest storm losses affected this group, those losses were offset by favorable prior year reserve development, particularly in the crop insurance operations. The combined ratio improvement of 3.8 points also reflects strong underwriting profits from the transportation, marine and equine operations.
Due to recent upward revisions in industry models of correlated catastrophe exposure associated with writing both workers' compensation and excess property
24
coverage in California, AFG has decided that it would stop writing most of its earthquake-exposed excess property coverage in California effective in April 2006. This excess property business had net written premiums of $17 million in 2005. AFG's excess property and California workers' compensation exposure to a catastrophic earthquake that models indicate could occur once in every 500 years was limited to less than 10% of equity. Excluding the excess property coverage to be non-renewed, AFG's exposure will be limited to less than 1% of equity for an earthquake that models indicate could occur once in 500 years.
Specialty casualty net written premiums were 9% higher than the 2005 quarter due primarily to volume growth as well as lower premiums ceded under reinsurance agreements, principally in the executive liability and excess and surplus lines. The 4.1 point improvement in the combined ratio compared to the 2005 quarter reflects a significant decrease in adverse reserve development in the executive liability operations. In addition, the excess and surplus lines and coverage for not-for-profit businesses continued to produce strong underwriting profits.
Specialty financial net written premiums were about 4% lower than the 2005 quarter as more premiums were ceded in the 2006 period under residual value reinsurance agreements. AFG is exiting the residual value business in 2006 as the remaining contracts expire. The 5.2 point improvement in the combined ratio compared to the 2005 quarter reflects a significant reduction in losses from the residual value business. In addition, the fidelity and crime, trade credit and financial institutions operations continued to generate strong profitability.
Life, Accident and Health Premiums and Benefits
Investment Income
Realized Gains (Losses)
Realized gains (losses) on securities include provisions for other than temporary impairment of securities still held of $3.0 million in the first quarter of 2006 and $1.9 million in the first quarter of 2005.
25
Real Estate Operations
$22.6
$23.3
16.9
20.6
.7
.5
Minority interest expense, net
1.5
.4
Sales of properties have reduced revenues and expenses from AFG's real estate operations. Other income includes net pretax gains on the sale of real estate assets of $7.0 million in the first quarter of 2006 and $2.6 million for the 2005 period. See Note H - "Subsequent Events."
Annuity Benefits
The increase in annuity benefits for the first quarter of 2006 compared to the 2005 period reflects higher reserves due primarily to new business.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and run-off 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 Expense
The $1.1 million (6%) decrease in interest expense is due primarily to the retirement of debt during the first quarter of 2006 and late 2005, partially offset by a higher effective interest rate on GAFRI's floating rate debt.
Other Operating and General Expenses
Convertible Notes
_________________________________________________
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
As of March 31, 2006, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2005 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 these disclosure controls and procedures were effective.
In the ordinary course of business, AFG and its subsidiaries routinely enhance their information systems by either upgrading current systems or implementing new systems. There has been no change in AFG's business processes and procedures during the first fiscal quarter of 2006 that has materially affected, or is reasonably likely to materially affect, AFG's internal controls over financial reporting.
PART II
OTHER INFORMATION
ITEM 6
Exhibits
Number
Exhibit Description
Computation of ratios of earnings to fixed charges.
Certification of the Co-Chief Executive Officer pursuant
to section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to
section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Co-Chief Executive Officers and Chief
Financial Officer pursuant to section 906 of the Sarbanes-
Oxley Act of 2002.
28
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 5, 2006
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)
29