UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Quarterly Period EndedJune 30, 2008
Commission File
AMERICAN FINANCIAL GROUP, INC.
Incorporated underthe Laws of Ohio
IRS Employer I.D.No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirementsfor the past 90 days. Yes X No
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or asmaller reporting company: Large Accelerated Filer X Accelerated Filer Non-Accelerated Filer Smaller Reporting Company
Indicate by check mark whether the Registrant is a shell company. Yes No X
As of August 1, 2008, there were 115,193,710 shares of the Registrant's Common Stock outstanding, excluding14.9 million shares owned by subsidiaries.
TABLE OF CONTENTS
Page
AMERICAN FINANCIAL GROUP, INC. 10-Q
PART I
ITEM I - FINANCIAL STATEMENTS
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (unaudited)
(Dollars In Millions)
June 30,
December 31,
2008
2007
Assets:
Cash and cash equivalents
$ 843.1
$ 815.9
Investments:
Fixed maturities:
Available for sale - at fair value
(amortized cost - $15,767.3 and $15,188.1)
15,295.7
15,140.7
Trading - at fair value
326.3
274.1
Equity securities - at fair value
(cost - $734.6 and $914.5)
732.7
923.3
Mortgage loans
348.9
358.8
Policy loans
277.2
273.2
Real estate and other investments
299.0
268.1
Total cash and investments
18,122.9
18,054.1
Recoverables from reinsurers and prepaid
reinsurance premiums
3,677.0
3,664.1
Agents' balances and premiums receivable
751.6
560.6
Deferred policy acquisition costs
1,460.9
1,394.4
Other receivables
324.8
475.4
Variable annuity assets (separate accounts)
601.5
692.5
Prepaid expenses and other assets
1,009.2
762.0
Goodwill
209.7
204.4
$26,157.6
$25,807.5
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 6,221.7
$ 6,168.4
Unearned premiums
1,812.4
1,668.2
Annuity benefits accumulated
10,387.1
10,096.6
Life, accident and health reserves
1,531.5
1,483.7
Payable to reinsurers
354.3
363.8
Long-term debt
997.5
936.9
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,254.2
1,251.4
Total liabilities
23,160.2
22,661.5
Minority interest
122.6
99.9
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 115,066,902 and 113,499,080 shares outstanding
115.1
113.5
Capital surplus
1,219.6
1,186.5
Retained earnings
1,811.2
1,733.5
Accumulated other comprehensive income (loss),
net of tax
(271.1
12.6
Total shareholders' equity
2,874.8
3,046.1
2
CONSOLIDATED STATEMENT OF EARNINGS (unaudited)
(In Millions, Except Per Share Data)
Three months ended
Six months ended
Income:
Property and casualty insurance premiums
$ 618.8
$ 633.5
$1,253.8
$1,273.3
Life, accident and health premiums
107.9
103.4
216.6
210.0
Investment income
270.9
249.0
537.2
494.8
Realized gains (losses) on securities
(63.1)
14.0
(143.4)
18.7
Other income
96.2
92.0
180.7
174.7
1,030.7
1,091.9
2,044.9
2,171.5
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
343.1
354.8
634.0
681.7
Commissions and other underwriting
expenses
211.0
208.5
433.0
418.7
Annuity benefits
81.8
90.4
186.7
179.2
Life, accident and health benefits
85.3
85.4
172.7
170.9
Annuity and supplemental insurance
acquisition expenses
54.7
40.7
94.8
85.2
Interest charges on borrowed money
17.3
17.7
36.0
35.8
Other operating and general expenses
137.5
182.4
261.7
293.9
930.7
979.9
1,818.9
1,865.4
Operating earnings before income taxes
100.0
112.0
226.0
306.1
Provision for income taxes
37.0
36.6
81.9
108.6
Net operating earnings
63.0
75.4
144.1
197.5
Minority interest expense
(2.7
(10.1
(7.8
(18.6
Earnings from continuing operations
60.3
65.3
136.3
178.9
Discontinued operations, net of tax
-
1.7
Net Earnings
$ 60.3
$ 67.0
$ 136.3
$ 180.6
Basic earnings per Common Share:
Continuing operations
$.53
$.55
$1.20
$1.50
Discontinued operations
.01
Net earnings available to Common Shares
$.56
$1.51
Diluted earnings per Common Share:
$.52
$1.16
$1.46
$.54
$1.47
Average number of Common Shares:
Basic
113.3
119.6
113.4
119.5
Diluted
116.3
122.4
116.9
Cash dividends per Common Share
$.125
$.10
$.25
$.20
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (unaudited)
(Dollars in Millions)
Accumulated
Common Stock
Other
Common
and Capital
Retained
Comprehensive
Shares
Surplus
Earnings
Income (Loss)
Total
Balance at December 31, 2007
113,499,080
$1,300.0
$1,733.5
$ 12.6
$3,046.1
Net earnings
Other comprehensive income, net of tax:
Change in unrealized gain (loss)
on securities
(281.9)
Change in foreign currency translation
(1.9)
Change in unrealized pension and other
Postretirement benefits
.1
Total comprehensive income (loss)
(147.4)
Dividends on Common Stock
(28.3)
Shares issued:
Redemption of convertible notes
2,364,640
24.4
Exercise of stock options
943,514
19.1
Other benefits plans
167,541
4.7
Dividend reinvestment plan
142,759
3.7
Other stock-based compensation expense
5.1
Shares acquired and retired
(1,803,000)
(20.7)
(26.7)
(47.4)
Shares tendered in option exercises
(247,632)
(2.8)
(3.6)
(6.4)
Capital transactions of subsidiaries
1.2
Balance at June 30, 2008
115,066,902
$1,334.7
$1,811.2
($271.1)
$2,874.8
Balance at December 31, 2006
119,303,928
$1,339.8
$1,533.6
$ 55.5
$2,928.9
Cumulative effect of accounting change
(14.9)
180.6
(112.7)
12.7
2.8
Total comprehensive income
83.4
(23.9)
590,784
13.9
Other benefit plans
173,910
6.0
80,224
2.7
(855,939)
(9.6)
(19.1)
(28.7)
(26,498)
(.3)
(.6)
(.9)
(1.5
Balance at June 30, 2007
119,266,409
$1,356.1
$1,655.7
($ 41.7)
$2,970.1
4
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
Operating Activities:
Adjustments:
7.8
18.9
Depreciation and amortization
124.9
95.2
Realized (gains) losses on investing activities
137.6
(35.1)
Net purchases/sales of trading securities
27.5
(41.0)
Deferred annuity and life policy acquisition costs
(95.6)
(103.2)
Decrease
56.6
(19.7)
Increase in other assets
(43.8)
(195.6)
Increase in insurance claims and reserves
78.1
209.2
Decrease in payable to reinsurers
(11.1)
(12.0)
Decrease in other liabilities
(59.5)
(15.6)
Other, net
9.7
11.0
Net cash provided by operating activities
555.2
271.9
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(3,722.6)
(1,946.4)
Equity securities
(116.6)
(224.4)
Subsidiaries
(112.2)
(1.7)
Real estate, property and equipment
(25.0)
(13.8)
Maturities and redemptions of fixed maturity investments
1,253.9
667.3
Sales of:
1,876.6
433.4
155.3
97.6
6.5
22.9
Decrease in securities lending collateral
26.0
5.2
Cash and cash equivalents of businesses acquired
44.3
Increase in other investments
(14.3
(54.8
Net cash used in investing activities
(628.1
(1,014.7
Financing Activities
Annuity receipts
789.6
817.4
Annuity surrenders, benefits and withdrawals
(693.9)
(691.7)
Net transfers from variable annuity assets
27.7
31.9
Additional long-term borrowings
530.0
Reductions of long-term debt
(469.5)
(117.3)
Decrease in securities lending obligation
(26.0)
(5.2)
Issuances of Common Stock
14.3
13.3
Repurchases of Common Stock
Cash dividends paid on Common Stock
(24.6)
(21.2)
(.1
Net cash provided by financing activities
100.1
93.3
Net Increase (Decrease) in Cash and Cash Equivalents
27.2
(649.5)
Cash and cash equivalents at beginning of period
815.9
1,329.0
Cash and cash equivalents at end of period
$ 679.5
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
F.
B.
G.
C.
H.
D.
I.
E.
________________________________________________________________________________
Basis of Presentation
Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
Fair Value Measurements
Investments
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced.
Certain AFG subsidiaries loan fixed maturity and equity securities to other institutions for short periods of time. The borrower is required to provide collateral on which AFG earns investment income, net of a fee to the lending agent. AFG records the collateral held (included in other assets) in its Balance Sheet at fair value. The obligation to return the collateral is included in other liabilities. The securities loaned remain a recorded asset on AFG's Balance Sheet. The fair value of collateral held was approximately $108 million at June 30, 2008, and $139 million at December 31, 2007. The fair value of securities loaned plus accrued interest was approximately $113 million and $139 million at those dates.
Derivatives
Reinsurance
Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaries retain the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies'
7
assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to these transactions are classified as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of the related trading portfolios.
Deferred Policy Acquisition Costs ("DPAC")
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of "Accumulated Other Comprehensive Income (Loss), net of tax" in the shareholders' equity section of the Balance Sheet.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
DPAC includes the present value of future profits on business in force of annuity and supplemental insurance companies acquired ("PVFP"). PVFP represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. PVFP is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
Unpaid Losses and Loss Adjustment Expenses
8
claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Annuity Benefits Accumulated
Life, Accident and Health Reserves
Variable Annuity Assets and Liabilities
Premium Recognition
Minority Interest
Income Taxes
AFG records a liability for the inherent uncertainty in quantifying its income tax provisions. Related interest and penalties are recognized as a component of tax expense.
AFG implemented FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)" ("FIN 48") on
9
January 1, 2007. FIN 48 sets forth criteria for recognition and measurement of tax positions taken or expected to be taken in a tax return. FIN 48 requires that companies recognize the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest, penalties, accounting in interim periods and disclosure. The cumulative effect of applying FIN 48 was recorded as a reduction to retained earnings at January 1, 2007 and is shown separately in the Statement of Changes in Shareholders' Equity.
Stock-Based Compensation
Benefit Plans
AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.
Earnings Per Share
Adjustments to net earnings:
Dilution of majority-owned subsidiaries
($.4)
($.1)
($.9)
Assumed issuance of shares under
deferred compensation plan
(.2)
(.1)
Adjustments to weighted average
common shares:
Stock-based compensation plans
1.9
2.9
Convertible notes
1.3
1.6
AFG's weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: second quarter of 2008 and 2007 - 4.4 million and 1.3 million; six months of 2008 and 2007 - 4.1 million and .9 million, respectively.
Statement of Cash Flows
10
Marketform Group
Strategic Comp Holdings
Great American Financial Resources
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive and professional liability and customized programs for small to mid-sized businesses, (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions, surety and fidelity products and trade credit insurance, and (iv) California workers' compensation. AFG's annuity and supplemental insurance business markets traditional fixed, indexed and variable annuities and a variety of supplemental insurance products. AFG's reportable segments and their components were determined based primarily upon si milar economic characteristics, products and services.
11
The following tables (in millions) show AFG's revenues and operating earnings before income taxes by significant business segment and sub-segment.
Revenues
Premiums earned:
Specialty
Property and transportation
$ 222.2
$ 238.8
$ 458.3
$ 467.4
Specialty casualty
200.4
212.2
412.2
423.4
Specialty financial
126.6
112.4
246.2
226.8
California workers' compensation
52.3
58.7
103.7
121.5
11.3
33.2
33.9
Other lines
.2
.3
618.8
633.5
1,253.8
1,273.3
98.2
86.8
198.2
170.7
Realized gains (losses)
(41.9)
7.0
(75.4)
55.9
48.9
99.3
731.0
776.2
1,484.5
1,553.0
Annuity and supplemental insurance:
172.6
159.5
340.7
318.3
(21.0)
8.1
(64.8)
10.0
31.5
31.8
60.6
58.9
291.0
302.8
553.1
597.2
8.7
12.9
7.3
21.3
$1,030.7
$1,091.9
$2,044.9
$2,171.5
Operating Earnings Before Income Taxes
Underwriting:
$ 12.9
$ 26.1
$ 51.6
$ 64.7
43.2
67.3
96.5
126.3
5.0
10.6
21.7
13.0
11.6
23.2
25.1
Other (a)
1.4
(1.0)
2.6
(12.4)
Other lines (b)
(10.8
(44.4
(8.8
(45.1
64.7
70.2
186.8
172.9
Investment and other operating income
81.5
65.2
169.1
147.1
(41.9
(75.4
104.3
142.4
280.5
329.7
Operations (c)
44.6
34.2
71.1
69.1
Other (c)(d)
(27.9
(72.7
(60.8
(102.7
$ 100.0
$ 112.0
$ 226.0
$ 306.1
(a) Includes a benefit of $6.0 million in the first six months of 2008 and a charge of $14.2 million in the 2007 first quarter to adjust retroactive reinsurance gains.
(b) Includes a second quarter 2008 charge of $12.0 million and a second quarter 2007 charge of $44.2 million to increase asbestos and environmental reserves.
(c) GAFRI's $2.0 million second quarter 2007 environmental liabilities charge and holding company interest and debt expense of $5.3 million for the 2007 second quarter and $11.0 million for the first six months of 2007 were reclassified from "Annuity and supplemental insurance" to "Other" to be consistent with the current year presentation.
(d) Includes second quarter charges of $3.0 million in 2008 and $43.0 million in 2007 related to asbestos and environmental liabilities at former railroad and manufacturing operations.
12
D.Fair Value Measurements
Level 1 - Quoted prices for identical assets or liabilities in active markets (markets in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis).
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets.
Level 3 - Valuations derived from valuation techniques in which one or more significant inputs are unobservable. The unobservable inputs may include management's own assumptions about the assumptions market participants would use based on the best information available in the circumstances.
AFG's Level 1 financial instruments consist primarily of publicly traded equity securities, highly liquid government bonds and separate account assets and liabilities for which quoted market prices in active markets are available. AFG's Level 2 financial instruments include primarily corporate and municipal fixed maturity securities and mortgage-backed securities priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, broker/dealer quotes, issuer spreads and benchmark securities. AFG's Level 3 is comprised of financial instruments whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, readily available market information. AFG's management is responsible for the valuation process and uses data from outside sources in establishing fair value. This data is reviewed by internal investment professionals who determine appropriate fair value me asurements.
Assets and liabilities measured at fair value on June 30, 2008, are summarized below (in millions):
Level 1
Level 2
Level 3
Available for sale ("AFS")
$ 341
$14,273
$682
$15,296
Trading
316
326
499
174
60
733
Separate account assets (a)
602
Other investments
Other assets
42
63
108
Total assets accounted for at fair value
$1,484
$14,838
$755
$17,077
Liabilities:
Derivatives embedded in annuity
benefits accumulated
$ -
$124
$ 124
(a) Separate account liabilities equal the fair value for separate account assets.
Approximately 4% of the total assets measured at fair value were Level 3 assets measured using unobservable market inputs. Approximately 40% of these assets were mortgage-backed securities whose fair values were determined primarily using non-binding broker quotes; the balance was primarily private placement debt and equity securities whose fair values were determined internally using
13
significant unobservable inputs, including the evaluation of underlying collateral and issuer creditworthiness, as well as certain Level 2 inputs such as comparable yields and multiples on similar publicly traded issues.
Changes in balances of Level 3 financial assets and liabilities during the second quarter and first six months of 2008 are presented below (in millions). Transfers into (out of) Level 3 are due to a change in the availability of market observable inputs for individual securities.
Fixed Maturities
Equity
Embedded
AFS
Securities
Assets
Balance at April 1, 2008
$665
$10
$46
$4
$146
Total realized/unrealized gains (losses):
Included in net income
(5)
1
(29)
Included in other comprehensive
income (loss)
(17)
Purchases, sales, issuances and settlements
(1)
Transfers into (out of) Level 3
36
14
$60
$3
Balance at January 1, 2008
$527
$11
$56
$5
$155
18
(45)
(19)
120
(10)
Included in other assets in AFG's Balance Sheet at June 30, 2008, is $88.5 million in amortizable intangible assets (net of accumulated amortization of $26.0 million) related to property and casualty insurance acquisitions, primarily the 2008 acquisitions of Marketform and Strategic Comp. Amortization of these intangibles was $6.9 million in the second quarter and $12.1 million during the first six months of 2008 compared to $1.4 million in the second quarter and $2.8 million in the first six months of 2007.
Direct obligations of AFG:
7-1/8% Senior Debentures due April 2009
$173.3
$173.2
7-1/8% Senior Debentures due February 2034
115.0
Senior Convertible Notes
189.7
Borrowings under bank credit facility
395.0
95.0
686.2
575.8
Obligations of AAG Holding (guaranteed by AFG):
7-1/2% Senior Debentures due November 2033
112.5
7-1/4% Senior Debentures due January 2034
86.3
6-7/8% Senior Notes
28.5
21.0
Notes payable secured by real estate
due 2008 through 2016
67.5
National Interstate bank credit facility
15.0
American Premier Underwriters 10-7/8% Subordinated
Notes due May 2011
8.0
2.2
2.3
291.3
326.1
Payable to Subsidiary Trusts:
AAG Holding 7.35% Subordinated Debentures due May 2033
20.0
National Interstate Subordinated Debentures
35.0
$997.5
$936.9
At June 30, 2008, scheduled principal payments on debt for the balance of 2008 and the subsequent five years were as follows: 2008 - $.5 million; 2009 - $174.6 million; 2010 - $2.8 million; 2011 - $404.1 million; 2012 - $16.4 million; and 2013 - $1.5 million.
As shown below (in millions), the majority of AFG's long-term debt is unsecured obligations of the holding company and its subsidiaries:
Unsecured obligations
$930.2
$869.4
Obligations secured by real estate
AFG has a revolving credit facility under which it can borrow up to $500 million through March 2011. Amounts borrowed bear interest at rates ranging from .5% to 1.25% (currently .75%) over LIBOR based on AFG's credit rating. At June 30, 2008, AFG had $395 million in borrowings outstanding under the credit facility (interest rate of 3.4% at June 30, 2008).
In July 2008, AFG entered into a 364 day revolving credit facility under which it can borrow up to $120 million at an interest rate of 2.25% over LIBOR. No amounts have been borrowed under this credit facility.
In the second quarter of 2008, AFG paid $189.7 million in cash and issued 2.4 million shares of Common Stock to redeem its Senior Convertible Notes. AFG paid cash in lieu of Common Stock for all conversions of the Notes prior to the redemption. Since AFG had previously expressed its intent to use cash for the accreted value of the Notes and the option to use stock for the conversion premium, shares issuable for amounts in excess of the accreted value of the Notes are included in AFG's calculation of diluted earnings per share for the first six months of 2008.
In May 2008, National Interstate borrowed $15 million under its credit facility to redeem its $15 million in outstanding variable rate Subordinated Debentures due May 2033. In June 2008, GAFRI paid $28.5 million to redeem its outstanding6-7/8% Senior Notes at maturity.
15
In the first six months of 2008, AFG repurchased approximately 1.8 million shares of its Common Stock for $47.4 million. In the second quarter of 2008, AFG issued 2.4 million shares of Common Stock in connection with the redemption of its Senior Convertible Notes.
Accumulated Other Comprehensive Income (Loss), Net of Tax
Net unrealized loss on securities
($300.3)
($18.4)
Foreign currency translation adjustment
27.9
Unrealized pension and other postretirement benefits
3.2
3.1
Total accumulated other comprehensive income (loss)
$12.6
Stock Incentive Plans
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility over a period equal to the expected term. The expected term was estimated based on historical exercise patterns and post vesting cancellations. The fair value of options granted during 2008 was $7.92 per share based on the following assumptions: expected dividend yield - 1.8%; expected volatility - 28%; expected term - 7.5 years; risk-free rate - 3.2%.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries was as follows: second quarter of 2008 and 2007 - $3.4 million and $4.1 million, respectively; six months of 2008 and 2007 - $8.5 million and $10.7 million, respectively. Stock-based compensation expense for the first six months of 2008 and 2007 includes $2.0 million and $3.9 million, respectively, in first quarter non-deductible stock awards.
16
CONDENSED CONSOLIDATING BALANCE SHEET
(In millions)
AAG
All Other
Consol.
June 30, 2008
AFG
GAFRI
Holding
Subs
Entries
Consolidated
Cash and investments
$ 63.0
$ 11.6
$18,049.9
($ 1.6)
$18,122.9
Recoverables from reinsurers and
prepaid reinsurance premiums
18.5
6.4
1,960.7
148.3
2,145.2
Investment in subsidiaries and
affiliates
3,641.7
1,016.6
1,093.3
723.5
(6,475.1
$3,716.0
$1,046.7
$1,099.7
$26,623.6
($6,328.4)
Unpaid losses, loss adjustment expenses
and unearned premiums
$ 8,034.1
Annuity, life, accident and health
benefits and reserves
11,920.3
11,918.6
.7
219.4
91.6
(.4)
Other liabilities
155.0
74.6
108.1
2,153.2
(158.3
2,332.6
841.2
75.3
327.5
22,199.2
(160.4)
23,282.8
971.4
772.2
4,424.4
(6,168.0
December 31, 2007
$ 52.8
$ 4.6
$17,998.5
($ 1.8)
$18,054.1
18.4
2,003.4
2,134.3
3,764.5
1,168.5
1,316.6
1,111.9
(7,361.5
$3,831.3
$1,191.5
$1,323.1
$26,732.9
($7,271.3)
$ 7,836.6
11,582.1
(1.8)
11,580.3
.8
340.4
91.7
(71.8)
209.4
75.5
108.9
2,269.0
(255.2
2,407.6
785.2
76.3
449.3
21,779.4
(328.8)
22,761.4
1,115.2
873.8
4,953.5
(6,942.5
17
CONDENSED CONSOLIDATING INCOME STATEMENT
FOR THE THREE MONTHS ENDED
JUNE 30, 2008
Income
(63.0)
Investment and other income
3.3
371.7
(8.0)
367.1
Equity in earnings of subsidiaries
122.1
18.8
23.5
(164.4
122.0
22.1
1,035.4
(172.3)
Insurance benefits and expenses
775.9
14.8
3.4
(8.3)
Other expenses
9.9
6.7
122.7
(.5
140.2
24.7
6.8
902.0
933.4
Earnings before income taxes
97.3
15.3
133.4
(163.5)
5.9
5.3
50.1
(61.3
$ 9.4
$ 9.5
$ 83.3
($102.2)
JUNE 30, 2007
(1.2)
12.5
2.4
4.1
350.4
(15.9)
341.0
130.8
36.7
45.8
15.1
(228.4
132.0
40.8
1,114.9
(241.6)
779.8
8.8
3.9
(14.0)
11.2
172.0
2.5
192.5
30.1
6.1
9.6
955.7
(11.5
990.0
101.9
34.7
36.2
159.2
(230.1)
11.8
12.3
47.5
(71.6
23.9
111.7
(158.5)
(3.8
$24.8
$23.9
$ 113.6
($162.3)
FOR THE SIX MONTHS ENDED
(3.2)
(140.1)
733.2
(20.2)
717.9
271.7
(3.6
10.3
(278.4
266.6
2,063.5
(298.7)
1,521.2
32.8
15.8
7.9
(20.6)
15.6
10.4
241.8
(.9
269.5
48.4
10.5
1,770.9
(21.5
1,826.7
Earnings (loss) before income taxes
218.2
(7.3)
(8.1)
292.6
(277.2)
Provision (credit) for income taxes
(2.1
(3.1
107.3
(102.1
Net Earnings (Loss)
$136.3
($ 5.2)
($ 5.0)
$ 185.3
($175.1)
(1.1)
17.2
5.4
10.1
(3.4)
685.1
(27.7)
669.5
345.1
61.1
80.7
26.8
(513.7
349.4
77.3
2,212.4
(538.7)
1,535.7
37.7
24.2
6.6
1.8
272.8
7.1
312.5
61.9
20.6
1,816.4
(21.6
1,884.0
287.5
64.4
56.7
396.0
(517.1)
21.5
19.3
130.4
(171.2
42.9
37.4
265.6
(345.9)
$180.6
$44.8
$37.4
$ 267.5
($349.7)
19
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
Net earnings (loss)
Equity in net (earnings) loss
of subsidiaries
(170.8)
2.0
(7.2)
176.0
Dividends from subsidiaries
143.0
72.5
(215.8)
Other adjustments, net
11.4
(5.6
412.1
418.9
Net cash provided by (used in)
operating activities
119.9
(8.5
62.2
597.4
(215.8
Investing Activities:
Purchase of investments, property and
equipment
(3,816.8)
(3,864.2)
Purchase of subsidiaries
Capital contributions to subsidiaries
(158.2)
(67.3)
(60.0)
285.5
Maturities and redemptions of fixed
maturity investments
5.8
1,268.0
(20.0)
Sale of investments, property and
3.8
37.9
1,996.7
2,038.4
.4
(1.8
57.4
56.0
investing activities
(157.5
(69.2
(60.0
(606.9
265.5
Financing Activities:
Annuity surrenders, benefits and
withdrawals
515.0
(404.8)
(69.5)
(15.1)
13.5
Capital contribution from parent
83.0
135.2
(285.5)
Cash dividends paid
215.8
(26.1
financing activities
51.7
82.9
(2.2
17.4
(49.7
Net increase in cash and cash equivalents
14.1
Cash and cash equivalents at beginning
of period
797.7
$ 29.7
$ 7.8
$ 805.6
20
$ 44.8
$ 37.4
Equity in net earnings of subsidiaries
(221.9)
(42.3)
(53.0)
(26.8)
344.0
4.0
137.3
30.0
(171.3)
(9.0
(.6
96.9
91.3
(46.3
138.0
13.8
337.6
(2,204.3)
20.3
(2,184.6)
(4.0)
(185.4)
189.4
32.2
686.4
(55.4)
21.8
532.1
(17.3)
553.9
(49.6
(135.9
(1,037.1
137.0
(10.4)
(154.2)
(4.9)
12.4
.9
Capital contributions from parent
185.4
(189.4)
(137.0)
(34.3)
171.3
(5.8
(2.4
(47.9
(13.8
117.5
Net increase (decrease) in cash and
cash equivalents
(72.9)
(582.0)
146.0
1,180.2
$ 73.1
$ 8.2
$ 598.2
21
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
22
Uncertainties
29
Overview
23
Results of Operations
Critical Accounting Policies
General
Liquidity and Capital Resources
24
Income Items
Sources of Funds
Expense Items
34
25
Recent Accounting Standards
35
_____________________________________________________________________________________________________
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Some of the forward-looking statements can be identified by the use of words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate changes; and improved loss experience.
Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:
The forward-looking statements herein are made only as of the date of this report. The Company assumes no obligation to publicly update any forward-looking statements.
of Financial Condition and Results of Operations - Continued
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, because most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
At June 30, 2008, AFG (parent) had approximately $60 million in cash and securities and had borrowed $395 million under the bank line of credit.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance, focusing on specialized commercial products for businesses and in the sale of traditional fixed, indexed and variable annuities and a variety of supplemental insurance products.
AFG's net earnings for the second quarter and first six months of 2008 were $60.3 million ($.52 per share, diluted) and $136.3 million ($1.16 per share, diluted), respectively, compared to $67.0 million ($.54 per share, diluted) and $180.6 million ($1.47 per share, diluted) reported in the same periods of 2007. These results reflect net realized losses on investments in 2008 partially offset by substantially lower charges for asbestos and other environmental exposures. In addition, improved earnings in AFG's annuity and supplemental insurance operations and increased investment income were offset by lower property and casualty underwriting profits due in part to an increase in catastrophe losses.
CRITICAL ACCOUNTING POLICIES
Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions change and thus impact amounts reported in the future. The areas where management believes the degree of judgment required to determine amounts recorded in the financial statements make accounting policies critical are as follows:
For a discussion of these policies, see Management's Discussion and Analysis - "Critical Accounting Policies" in AFG's 2007 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
Ratios
2006
$ 998
$ 937
$ 921
Total capital (*)
4,295
4,108
4,160
Ratio of debt to total capital:
Including debt secured by real estate
23.2%
22.8%
22.1%
Excluding debt secured by real estate
22.0%
21.5%
20.9%
(*) Includes long-term debt, minority interest and
shareholders' equity (excluding unrealized gains (losses)
related to fixed maturity investments).
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.99 for the six months ended June 30, 2008 and 2.40 for the entire year of 2007. Excluding annuity benefits, this ratio was 6.27 and 8.49, respectively. Although the ratio excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
Parent Holding Company Liquidity
AFG can borrow up to $500 million under its revolving credit facility, which expires in 2011. AFG had $395 million in borrowings outstanding under this agreement at June 30, 2008, bearing interest at a rate of 3.4%.
In July 2008, AFG entered into a 364 day credit facility under which it can borrow up to $120 million at an interest rate of 2.25% over LIBOR. No amounts have been borrowed under this credit facility.
In the second quarter of 2008, AFG paid $189.7 million in cash and issued 2.4 million shares of Common Stock to redeem its Senior Convertible Notes. The cash used in the redemption was funded primarily with borrowings under AFG's revolving credit facility.
Through the first six months of 2008, AFG repurchased approximately 1.8 million shares of its Common Stock for $47.4 million.
Under tax allocation agreements with AFG, its 80%-owned U.S. subsidiaries generally pay taxes to (or recover taxes from) AFG based on each subsidiary's contribution to amounts due under AFG's consolidated tax return.
Subsidiary Liquidity
In June 2008, GAFRI used cash on hand to redeem its $28.5 million in 6-7/8% notes at maturity.
The liquidity requirements of AFG's insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In the annuity business, where profitability is largely dependent on earning a "spread" between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG's annuity products.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies.
$15.3 billion in "Fixed maturities" classified as available for sale and $732.7 million in "Equity securities," all carried at fair value with unrealized gains and losses included in a separate component of shareholders' equity on an after-tax basis. At June 30, 2008, AFG had a pretax net unrealized loss of $471.6 million on fixed maturities and $1.9 million on equity securities. The $308.4 million increase in unrealized losses in fixed maturities since March 31, 2008, was primarily due to an increase in market interest rates.
Approximately 94% of the fixed maturities held by AFG at June 30, 2008, were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and noninvestment grade. Management believes that a high quality investment portfolio should generate a stable and predictable investment return.
AFG's $5.6 billion investment in mortgage-backed securities ("MBSs") represented approximately one-third of its fixed maturities at June 30, 2008. MBSs are subject to significant prepayment risk due to the fact that, in periods of
declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates.
Approximately 97% of AFG's mortgage-backed securities are rated "AAA." At June 30, 2008, AFG owned approximately $460 million (representing 3% of AFG's total fixed maturity portfolio) of mortgage-backed securities in which the underlying collateral is subprime mortgages. At that date, the net unrealized loss on these securities was approximately $43 million. The securities are collateralized by fixed-rate mortgages and have an overall average life of approximately 4 years. At June 30, 2008, AFG owned approximately $930 million in Alt-A securities (risk profile between prime and subprime) with an average life of approximately 5 years, the vast majority of which are backed by fixed rate mortgages. The unrealized loss on Alt-A securities was $38 million at June 30, 2008. Based on current information, management does not believe that AFG's risk of loss on the subprime or Alt-A securities is material to its financial condition.
At June 30, 2008, AFG owned approximately $850 million in securities with credit enhancement provided by bond insurers, including $601 million of insured municipal bonds, $138 million in insured subprime securities (included in the $460 million in total subprime exposure discussed above) and $99 million in insured corporate bonds. Approximately 91% of the insured municipal bonds carry an explicit underlying rating (i.e. without credit enhancement) with an average of A+, and 55% of the corporate bonds carry an explicit underlying rating with an average of A-. None of the insured subprime securities carry an explicit underlying rating. Management does not believe the risk of loss on the securities without underlying credit ratings is material to AFG's financial condition.
26
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at June 30, 2008, is shown in the following table (dollars in millions). Approximately $398 million of available for sale "Fixed maturities" and $129 million of "Equity securities" had no unrealized gains or losses at June 30, 2008.
With
Unrealized
Gains
Losses
Available for Sale Fixed Maturities
Fair value of securities
$4,861
$10,037
Amortized cost of securities
$4,739
$10,630
Gross unrealized gain (loss)
$ 122
($ 593)
Fair value as % of amortized cost
103%
94%
Number of security positions
1,266
1,568
Number individually exceeding
$2 million gain or loss
52
Concentration of gains (losses) by type or
industry (exceeding 5% of unrealized):
Mortgage-backed securities
$ 45.1
($ 255.9)
Banks, savings and credit institutions
(130.8)
Insurance companies
4.5
(30.5)
Gas and electric services
(16.5)
Direct obligations of the U.S. Government
8.9
(.7)
Percentage rated investment grade
96%
93%
Equity Securities
$ 241
$ 363
Cost of securities
$ 128
$ 478
$ 113
($ 115)
Fair value as % of cost
188%
76%
56
150
Number of individually exceeding
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at June 30, 2008, based on their fair values. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Maturity
One year or less
7%
2%
After one year through five years
44
After five years through ten years
After ten years
79
58
Mortgage-backed securities (average
life of 5-1/2 years)
100
27
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Fair
Aggregate
Value as
% of Cost
Value
Gain (Loss)
Basis
Fixed Maturities at June 30, 2008
Securities with unrealized gains:
Exceeding $500,000 (43 issues)
$ 519
$ 39
108%
Less than $500,000 (1,223 issues)
4,342
83
102
$ 4,861
$122
Securities with unrealized losses:
Exceeding $500,000 (341 issues)
$ 4,414
($452)
91%
Less than $500,000 (1,227 issues)
5,623
(141
98
($593)
The following table summarizes (dollars in millions) the unrealized loss for all securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
Loss
Securities with Unrealized
Losses at June 30, 2008
Investment grade fixed maturities with losses for:
Less than one year (1,096 issues)
$ 7,117
($293)
One year or longer (288 issues)
2,263
(228
91
$ 9,380
($521)
95%
Non-investment grade fixed maturities with losses for:
Less than one year (131 issues)
$ 441
($ 41)
One year or longer (53 issues)
216
(31
87
$ 657
($ 72)
90%
Equity securities with losses for:
Less than one year (110 issues)
$ 332
($104)
One year or longer (40 issues)
31
(11
74
($115)
When a decline in the value of a specific investment is considered to be "other than temporary," a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced. The determination of whether unrealized losses are "other than temporary" requires judgment based on subjective as well as objective factors. A listing of factors considered and resources used is contained in the discussion of "Investments" under Management's Discussion and Analysis in AFG's 2007 Form 10-K.
Based on its analysis, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they mature or recover in value. Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG's ability or intent change with regard to a particular
28
security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to results of operations in future periods. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
RESULTS OF OPERATIONS
AFG reported operating earnings before income taxes of $100.0 million for the second quarter of 2008 compared to $112.0 million for the 2007 second quarter.
Results for the second quarter of 2008 include (i) $63.1 million in realized losses on securities compared to $14.0 million in gains in the comparable 2007 quarter and (ii) a $39.1 million decline in Specialty property and casualty underwriting results due largely to catastrophe losses. These items were partially offset by a reduction of $72.2 million in asbestos and environmental charges and a $21.9 million increase in investment income.
Six month pretax operating earnings decreased $80.1 million in 2008 compared to 2007 reflecting a $162.1 million decline in realized gains (losses) on securities and a $22.4 million decline in Specialty property and casualty underwriting results which more than offset a $42.4 million increase in investment income and the lower A&E charges discussed above.
Property and Casualty Insurance - Underwriting
Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their financial statements better understand the company's performance. See Note C - "Segments of Operations" for the detail of AFG's operating profit by significant business segment.
Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. A combined ratio under 100% is indicative of an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.
Premiums and combined ratios for AFG's property and casualty insurance operations were as follows (dollars in millions):
Gross Written Premiums (GAAP)
$425
$421
$ 743
$ 744
321
350
660
711
154
139
290
277
54
61
122
129
(1
$955
$972
$1,814
$1,861
Net Written Premiums (GAAP)
$261
$277
$ 508
$ 522
204
209
426
425
128
121
239
236
49
57
112
32
$661
$681
$1,319
$1,337
Combined Ratios (GAAP)
94.2%
89.1%
88.7%
86.2%
78.4
68.3
76.5
70.1
96.1
90.6
91.2
93.8
75.0
80.2
77.6
79.4
Total Specialty
87.8
84.3
Aggregate (including
discontinued lines)
89.5%
88.9%
85.1%
86.4%
Favorable (Unfavorable) Prior Year
Development
$18
$ 1
$ 38
$21
30
39
80
Other specialty
(3
(15
70
45
135
99
Special A&E charges
(12)
(44)
$59
$126
$55
Premium growth for the Specialty insurance operations has been impacted primarily by competitive pressures in the commercial general liability and excess and surplus markets. These declines have been offset by additional premiums from AFG's Marketform acquisition in January 2008. Apart from rate decreases in the California workers' compensation business, average renewal rate levels in AFG's other specialty operations were down about 3% through the first half of the year.
The Specialty insurance operations generated an underwriting profit of $75.5 million in the 2008 second quarter, $39.1 million lower than the same quarter a year earlier, resulting primarily from the effects of a softer market and higher catastrophe losses.
Catastrophe losses, principally from tornados in the Midwestern part of the United States, totaled $25.1 million (4.1 points) for the quarter, compared to $5.0 million (.8 points) in the comparable 2007 period. Underwriting profit of the specialty insurance operations for the first half of 2008 was $195.6 million, 10% below the 2007 period. Results for the first half of 2008 include $27.4 million (2.2 points) in catastrophe losses compared to $6.1 million (.5 points) in the same 2007 period.
California workers' compensation gross and net written premiums decreased from the comparable 2007 periods, reflecting the effect of significantly lower rates due to the continuing impact of the state's reform legislation partly offset by this group's expansion of its excess workers' compensation products. The improved claims environment resulting from the California workers' compensation reform legislation has continued to benefit AFG's results as well as those of the industry. The California renewal rate reductions averaged about 16 percent through the first half of this year and indicate some moderation in rate reductions compared to the last several years. The favorable reserve development in California workers' compensation in the first half of 2008 and 2007 reflects the continuing impact of the reform legislation passed in 2003 and 2004.
Due to the long-tail nature of this business, AFG has been conservative in reserving for the favorable effects of the reform legislation until a higher percentage of claims are paid and the ultimate impact of reforms can be estimated with more precision.
Asbestos and Environmental Reserve Charges During the second quarter of 2008, AFG completed the previously announced comprehensive internal review of its asbestos and environmental exposures relating to the run-off operations of its property and casualty group and its exposures related to former railroad and manufacturing operations and sites. Previous studies, which were done with the aid of outside actuarial and engineering firms and specialty outside counsel, were completed in 2007, 2005 and 2003, respectively.
As a result of the internal review, AFG recorded a $12 million charge (net of reinsurance recoverables) to increase the property and casualty group's asbestos and environmental reserves. At June 30, 2008, the property and casualty group's A&E reserves were $413.2 million, net of reinsurance recoverables. At that date, AFG's three year survival ratio was 9.5 times paid losses for the asbestos reserves and 9.0 times paid losses for the total A&E reserves. These ratios compare favorably with A.M. Best's most recent report (published in 2007) on A&E survival ratios which were 8.6 for asbestos and 7.9 for total industry A&E reserves. During the course of this review, there were no newly identified emerging trends or issues that management believes significantly impact the overall adequacy of AFG's A&E reserves. The modest increases were primarily due to reassessments of the potential loss on certain outstanding cases.
The review relied on a comprehensive exposure analysis by AFG's internal A&E claims specialists in consultation with in-house actuaries and outside specialty counsel. It considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development, as appropriate. As has been observed by others, the asbestos legal climate remains very difficult to predict. While progress continues to be made in state asbestos tort reform and judicial rulings, that progress has been somewhat offset by the lack of reform in certain jurisdictions, increased claims costs, increased defense costs, the assertion of non-products theories and an expanding pool of plaintiffs and defendants. Environmental claims likewise present challenges in prediction, due to uncertainty regarding the interpretation of insurance policies, complexities regarding multi-party involvements at sites, evolving clean up standards and protracted time periods required to assess the level of c lean up required at contaminated sites.
The 2007 A&E study resulted in a second quarter 2007 pretax charge of $44.2 million (net of reinsurance) to increase the property and casualty group's A&E reserves.
Statutory Annuity Premiums
403(b) Fixed and Indexed Annuities:
First Year
$ 12
$ 17
$ 24
$ 33
Renewal
85
Single Sum
Subtotal
92
88
169
167
Non-403(b) Indexed Annuities
160
259
300
472
Non-403(b) Fixed Annuities
104
72
151
136
Bank Annuities
153
Variable Annuities
43
Total Annuity Premiums
$530
$439
$817
$818
The increase in annuity premiums for the second quarter of 2008 compared to the 2007 quarter reflects increased annuity sales through the new bank annuity distribution channel, as well as increased sales of traditional fixed annuities. These increases were partly offset by lower sales of indexed annuities in the single premium market.
Life, Accident and Health Premiums and Benefits
Premiums
Supplemental insurance operations
First year
$ 20
$ 16
$ 40
$ 29
161
164
Life operations (in run-off)
$108
$103
$217
$210
Benefits
$ 72
$147
$145
$ 86
$173
$171
Investment Income
33
Realized Gains (Losses) on Securities
Net realized gains (losses)
on disposals
($11.3)
$16.2
($ 18.1)
$30.0
Charges for impairment
(61.3)
(2.2)
(170.4)
(11.3)
Changes in the fair value of
derivatives
4.9
Other(*)
4.6
10.9
($63.1)
$14.0
($143.4)
$18.7
(*) Adjustments to the amortization of annuity deferred policy
acquisition costs are included in realized gains (losses).
Approximately $109 million of the other than temporary impairments in the first half of 2008 were attributable to equity investments, primarily in financial institutions including $43 million for National City Corporation. Charges of approximately $28 million on mortgage-backed securities in the first half of 2008 resulted primarily from the recent downgrade of Financial Guaranty Insurance Company, which provides credit guarantees for those securities.
Real Estate Operations
$24.1
$26.6
$40.7
$47.5
16.4
16.5
32.5
31.7
1.1
2.1
Income from real estate operations includes net pretax gains on the sale of real estate assets of $5.5 million in the second quarter and $5.9 million in the first six months of 2008 compared to $7.5 million and $13.5 million for the 2007 periods.
Annuity Benefits
The $8.6 million decrease in annuity benefits for the second quarter of 2008 compared to the 2007 quarter reflects changes in the fair value of derivatives
related to the indexed annuity business. The $7.5 million increase in annuity benefits for the six months of 2008 compared to the 2007 period is due primarily to growth in the annuity business.
Annuity and Supplemental Insurance Acquisition Expenses
The vast majority of the annuity and supplemental insurance group's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Unanticipated spread compression, decreases in the stock market, adverse mortality experience and higher than expected lapse rates could lead to write-offs of DPAC or PVFP in the future.
Other Operating and General Expenses
Discontinued Operations
In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements," which is effective January 1, 2009, for calendar year companies. Under SFAS No. 160, noncontrolling (minority) interest ($122.6 million at June 30, 2008) will be reported in AFG's Balance Sheet as a separate component of shareholders' equity; net earnings attributable to noncontrolling (minority) interests will be reported in AFG's Statement of Earnings as a deduction from net income (instead of as an expense) in deriving net income attributable to AFG. In addition, SFAS No. 160 requires that purchases and sales of equity interests in less than 100%-owned subsidiaries that do not result in a change of control be accounted for as equity transactions and, upon loss of control, requires any interest retained to be recorded at fair value with a gain or loss recognized in earnings.
In December 2007, the FASB issued SFAS No. 141(R), "Business Combinations," which requires the recognition of assets acquired, liabilities assumed and any noncontrolling interests at fair value as of the acquisition date, and the
immediate expense recognition of acquisition-related transaction and restructuring costs. SFAS No. 141(R) is to be applied prospectively to business combinations after January 1, 2009, except that adjustments to an acquired company's valuation allowance on deferred tax assets and tax contingency liability are to be recorded as a component of income tax expense for all business combinations, regardless of the consummation date.
In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities," which is effective January 1, 2009, for calendar year companies. SFAS No. 161 amends and expands the disclosure requirements of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and disclosures about credit-risk-related contingent features in derivative agreements.
In May 2008, the FASB issued FSP No. APB 14-1, "Accounting for Convertible Debt Instruments That May be Settled in Cash upon Conversion (Including Partial Cash Settlement)." FSP APB 14-1 requires an issuer of convertible debt instruments that may be settled for cash (including partial cash settlements) to separately account for the liability and equity components in a manner that reflects the issuer's nonconvertible debt borrowing rate at the date of issuance. The difference between the fair value of the debt component and the initial proceeds from issuance is recorded as a component of equity. The resulting debt discount would be amortized as additional interest expense over the period the debt is outstanding. FSP APB 14-1 is effective for fiscal years beginning after December 15, 2008 and shall be applied retrospectively to all periods presented. Accordingly, the new rule would change the accounting for AFG's Senior Convertible Notes which were redeemed in June 2008. AFG does not believe that the adoption of the new rule will result in material changes to its previously issued financial statements.
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
As of June 30, 2008, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2007 Form 10-K.
ITEM 4
Controls and Procedures
AFG's management, with participation of its Co-Chief Executive Officers and its principal financial officer, has evaluated AFG's disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG's Co-CEOs and principal financial officer concluded that the controls and procedures are effective. There have been no changes in AFG's internal control over financial reporting during the second fiscal quarter of 2008 that materially affected, or are reasonably likely to materially affect, AFG's internal control over financial reporting. AFG acquired Marketform Group Limited and Strategic Comp Holdings, LLC effective January 1, 2008. These companies have been excluded from management's assessment of internal control over financial reporting.
In the ordinary course of business, AFG and its subsidiaries routinely enhance their information systems by either upgrading current systems or implementing new systems. There has been no change in AFG's business processes and procedures during the second fiscal quarter of 2008 that has materially affected, or is reasonably likely to materially affect, AFG's internal controls over financial reporting.
37
PART II
OTHER INFORMATION
Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
Total Number
Maximum Number
of Shares
Purchased as
that May
Number
Average
Part of Publicly
Yet be Purchased
Price Paid
Announced Plans
Under the Plans
Purchased
Per Share
or Programs
Or Programs (a)
1st quarter
1,003,000
$26.37
2,059,100
2nd quarter
April
800,000
$26.22
1,259,100
May
June
(a)
Represents the remaining shares that may be repurchased under the Plan authorized by AFG's Board of Directors in 2007.
Submission of Matters to a Vote of Security Holders
AFG's Annual Meeting of Shareholders was held on May 15, 2008; there were three matters voted upon: (Item 1) election of nine directors, (Item 2) ratifying Ernst & Young LLP as independent registered public accounting firm and (Item 3) shareholder proposal regarding certain employment matters.
The votes cast for, against, withheld and the number of abstentions and brokernon-votes as to each matter voted on at the 2008 Annual Meeting is set forth below:
Broker
Name
For
Against
Withheld
Abstain
Non-Votes
Item 1
Kenneth C. Ambrecht
98,700,705
N/A
1,135,224
Theodore H. Emmerich
98,548,096
1,287,833
James E. Evans
94,161,236
5,674,693
Terry S. Jacobs
98,693,354
1,142,576
Gregory G. Joseph
99,003,944
831,986
Carl H. Lindner
95,629,001
4,206,928
Carl H. Lindner III
97,377,291
2,458,638
S. Craig Lindner
97,373,762
2,462,168
William W. Verity
96,808,893
3,027,036
Item 2
99,719,554
68,803
47,579
Item 3
32,284,514
55,841,921
2,161,689
9,547,812
N/A - Not Applicable
38
OTHER INFORMATION - CONTINUED
ITEM 6
Exhibits
Exhibit Description
Computation of ratios of earnings to fixed charges.
Certification of the Co-Chief Executive Officer pursuant
to section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to
section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Co-Chief Executive Officers and Chief
Financial Officer pursuant to section 906 of the Sarbanes-
Oxley Act of 2002.
_____________________________________________________________
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, American Financial Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned duly authorized.
American Financial Group, Inc.
August 7, 2008
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)