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, 2005
Commission File
AMERICAN FINANCIAL GROUP, INC.
Incorporated underthe Laws of Ohio
IRS Employer I.D.No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes X No Indicate by check mark whether the Registrant is an accelerated filer. Yes X No As of May 1, 2005, there were 77,051,734 shares of the Registrant's Common Stock outstanding, excluding 9,953,392 shares owned by a subsidiary.
TABLE OF CONTENTS
Page
AMERICAN FINANCIAL GROUP, INC. 10-Q
PART I
FINANCIAL INFORMATION
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars In Thousands)
March 31,
December 31,
2005
2004
Assets:
Cash and short-term investments
$ 527,391
$ 861,742
Investments:
Fixed maturities:
Available for sale - at market
(amortized cost - $13,676,167 and $13,035,165)
13,834,667
13,411,365
Trading - at market
283,049
292,233
Other stocks - at market
(cost - $497,571 and $456,053)
544,671
537,153
Policy loans
250,289
250,211
Real estate and other investments
281,461
283,929
Total cash and investments
15,721,528
15,636,633
Recoverables from reinsurers and prepaid
reinsurance premiums
3,134,034
3,440,592
Agents' balances and premiums receivable
568,434
518,464
Deferred policy acquisition costs
1,166,172
1,114,433
Other receivables
280,055
359,746
Investments of managed investment entity
13,133
392,624
Variable annuity assets (separate accounts)
602,763
620,007
Prepaid expenses, deferred charges and other assets
355,572
311,146
Goodwill
165,882
$22,007,573
$22,559,527
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 5,247,322
$ 5,337,270
Unearned premiums
1,622,421
1,612,035
Annuity benefits accumulated
8,254,048
8,132,106
Life, accident and health reserves
1,044,557
1,021,986
Payable to reinsurers
311,821
513,565
Long-term debt:
Holding company
672,221
685,083
Subsidiaries
343,017
343,590
Payable to subsidiary trusts (issuers of preferred
securities)
77,800
Debt of managed investment entity
597
371,368
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,222,439
1,194,584
Total liabilities
19,399,006
19,909,394
Minority interest
249,604
219,586
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 76,965,705 and 76,634,204 shares outstanding
76,966
76,634
Capital surplus
1,157,061
1,145,873
Retained earnings
1,024,636
976,340
Unrealized gain on marketable securities, net
100,300
231,700
Total shareholders' equity
2,358,963
2,430,547
2
CONSOLIDATED STATEMENT OF EARNINGS
(In Thousands, Except Per Share Data)
Three months ended
Income:
Property and casualty insurance premiums
$549,099
$486,801
Life, accident and health premiums
92,056
90,325
Investment income
214,207
192,087
Realized gains (losses) on securities
(5,539)
36,216
Revenues of managed investment entity
651
4,891
Other income
81,509
63,973
931,983
874,293
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
348,378
309,630
Commissions and other underwriting expenses
158,891
146,997
Annuity benefits
80,762
72,266
Life, accident and health benefits
68,971
69,314
Annuity, supplemental insurance and
life acquisition expenses
35,272
30,154
Interest charges on borrowed money
18,008
17,088
Interest on subsidiary trust obligations
1,572
4,461
Expenses of managed investment entity
774
3,382
Other operating and general expenses
115,033
102,733
827,661
756,025
Operating earnings before income taxes
104,322
118,268
Provision for income taxes
35,131
37,382
Net operating earnings
69,191
80,886
Minority interest expense
(5,872)
(5,504)
Equity in net losses of investee, net of tax
(444
(918
Earnings from continuing operations
62,875
74,464
Discontinued operations
-
573
Cumulative effect of accounting change
(1,837
Net Earnings
$ 62,875
$ 73,200
Basic earnings per Common Share:
Continuing operations
$.82
$1.02
.01
(.03
Net earnings available to Common Shares
$1.00
Diluted earnings per Common Share:
$.81
$ .98
Average number of Common Shares:
Basic
76,738
73,172
Diluted
77,824
74,344
Cash dividends per Common Share
$.125
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in Thousands)
Common Stock
Unrealized
Common
and Capital
Retained
Gain on
Shares
Surplus
Earnings
Securities
Total
Balance at January 1, 2005
76,634,204
$1,222,507
$ 976,340
$231,700
$2,430,547
Net earnings
Change in unrealized
(131,400)
(131,400
Comprehensive income (loss)
(68,525)
Dividends on Common Stock
(9,580)
Shares issued:
Exercise of stock options
571,308
14,906
Dividend reinvestment plan
49,902
1,438
Employee stock purchase plan
6,432
198
Retirement plan contributions
35,896
1,104
Deferred compensation distributions
7,374
222
Shares tendered in option exercises
(339,411)
(5,414)
(4,999)
(10,413)
Capital transactions of subsidiaries
(724)
Other
(210
Balance at March 31, 2005
76,965,705
$1,234,027
$1,024,636
$100,300
$2,358,963
Balance at January 1, 2004
73,056,085
$1,108,840
$ 664,721
$302,600
$2,076,161
73,200
124,700
Comprehensive income
197,900
(9,134)
173,950
4,028
4,233
112
6,683
189
37,468
1,095
33,620
959
Directors fees paid in stock
1,506
39
15
Balance at March 31, 2004
73,313,545
$1,115,277
$ 728,787
$427,300
$2,271,364
4
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)
Operating Activities:
Adjustments:
1,837
Equity in net losses of investee
444
918
5,872
5,504
Depreciation and amortization
49,120
39,075
Realized (gains) losses on investing activities
2,941
(39,764)
Net purchases/sales of trading securities
5,020
(23,673)
Deferred annuity and life policy acquisition costs
(33,760)
(30,756)
Decrease in reinsurance and other receivables
333,603
324,344
Decrease in other assets
17,334
28,958
Decrease in insurance claims and reserves
(56,501)
(58,608)
Decrease in payable to reinsurers
(201,744)
(105,603)
Increase (decrease) in other liabilities
19,822
(19,849)
Other, net
4,833
2,822
290,621
270,671
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(1,710,026)
(1,686,323)
Equity securities
(63,643)
(44,584)
Subsidiary
(10,382)
Real estate, property and equipment
(4,233)
(3,277)
Maturities and redemptions of fixed maturity
investments
241,082
276,096
Sales of:
820,199
1,095,928
26,493
14,662
3,856
2,768
Cash and short-term investments of business acquired
1,295
Increase in other investments
(796
(9,596
(687,068
(363,413
Financing Activities
Fixed annuity receipts
266,521
152,932
Annuity surrenders, benefits and withdrawals
(224,260)
(159,367)
Net transfers from (to) variable annuity assets
256
(3,698)
Additional long-term borrowings
100
194,733
Reductions of long-term debt
(14,626)
(6,114)
Repurchases of trust preferred securities
(188,961)
Issuances of Common Stock
3,351
3,891
Subsidiary's issuance of stock in public offering
40,444
Cash dividends paid on Common Stock
(8,142)
(9,022)
(1,548
212
62,096
(15,394
Net Decrease in Cash and Short-term Investments
(334,351)
(108,136)
Cash and short-term investments at beginning of period
861,742
593,552
Cash and short-term investments at end of period
$ 485,416
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
H.
B.
I.
C.
J.
D.
K.
E.
F.
L.
G.
________________________________________________________________________________
Basis of Presentation
Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
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) on securities) and the cost basis of that investment is reduced.
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
In 2003, the Financial Accounting Standards Board's ("FASB") Emerging Issues Task Force ("EITF") reached a final consensus on Issue 03-16, "Accounting for Investments in Limited Liability Companies" under which limited liability companies ("LLCs") are deemed to be the same as limited partnerships for which the equity method of accounting is generally required for ownership levels of "more than 3 to 5 percent." In accordance with EITF 03-16, the cumulative effect of changing from the cost to the equity method of accounting for AFG's investment in an LLC was recorded in the third quarter of 2004.
Derivatives
The terms of the interest rate swaps match those of the hedged 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.
Managed Investment Entity
Insurance
7
Reinsurance
Subsidiaries of AFG's 82%-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 (including realized gains and losses) of the retained assets. Under Statement of Financial Accounting Standards ("SFAS") No. 133 Implementation Issue B36 ("B36"), these reinsurance contracts are considered to contain embedded derivatives (that must be marked to market) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. GAFRI classifies the securities related to these transactions as "tradi ng." The mark to market on the embedded derivatives offsets the investment income recorded on the mark to market of the related trading portfolios.
Deferred Policy Acquisition Costs ("DPAC")
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of expected gross profits on the policies. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in "Unrealized gain on marketable securities, net" in the shareholders' equity section of the Balance Sheet.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
DPAC includes the present value of future profits on business in force of insurance companies acquired by GAFRI, which represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The present value of future profits is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
8
Annuity, Supplemental Insurance and Life Acquisition Expenses
Unpaid Losses and Loss Adjustment Expenses
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. In spite of the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Annuity Benefits Accumulated
Life, Accident and Health Reserves
Variable Annuity Assets and Liabilities
Premium Recognition
9
Payable to Subsidiary Trusts (Issuers of Preferred Securities)
Minority Interest
Income Taxes
Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized.
Stock-Based Compensation
10
The following table illustrates the effect on net earnings (in thousands) and earnings per share had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the method prescribed by SFAS No. 123.
For SFAS No. 123 purposes, the "fair value" of $9.66 per option granted in the first quarter of 2005 and $8.92 in the first quarter of 2004 was calculated using the Black-Scholes option pricing model and the following assumptions: expected dividend yield of 2%; expected volatility of 28% in 2005 and 29% in 2004; risk-free interest rate of 4.3% for 2005 and 3.7% for 2004; and expected option life of 8.4 years in 2005 and 7.5 years in 2004. There is no single reliable method to determine the actual value of options at grant date. Accordingly, actual value of the option grants may be higher or lower than the SFAS No. 123 "fair value."
Net earnings, as reported
$62,875
$73,200
Pro forma stock option expense, net of tax
(1,650
(1,217
Adjusted net earnings
$61,225
$71,983
Earnings per share (as reported):
$0.82
$0.81
$0.98
Earnings per share (adjusted):
$0.80
$0.79
$0.97
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment." SFAS 123(R) revises SFAS 123 and eliminates the use of the intrinsic value method prescribed by APB 25. Under SFAS 123(R), companies must recognize compensation expense for all new share-based awards (including employee stock options), and the nonvested portions of prior awards, based on their fair value at the date of grant. AFG expects to implement the new standard on January 1, 2006, on a prospective basis. After that date, all share-based grants will be recognized as compensation expense over their respective vesting periods. While AFG currently uses the Black-Scholes pricing model to measure the fair value of employee stock options for purposes of disclosing pro forma earnings, the use of other models will also be permitted. AFG has not yet determined which model it will use to measure the fair value of future stock option grants.
Benefit Plans
11
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
Transport Insurance Company
National Health Annuity Business
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, supplemental insurance and life business markets primarily retirement annuities and various forms of supplemental insurance and life products. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
12
The following tables (in thousands) show AFG's revenues and operating profit (loss) by significant business segment and sub-segment. Operating profit (loss) represents total revenues less operating expenses.
Revenues (a)
Premiums earned:
Specialty
Property and transportation
$168,071
$124,916
Specialty casualty
184,167
174,494
Specialty financial
91,770
84,362
California workers' compensation
87,324
77,429
16,407
20,617
Other lines
1,360
4,983
549,099
486,801
68,369
63,725
Realized gains
847
25,995
51,568
42,605
669,883
619,126
Annuities, supplemental insurance and life (b)
262,815
247,012
(715
8,155
$931,983
$874,293
Operating Profit (Loss)
Underwriting:
$ 28,941
$ 20,659
6,568
10,793
(4,068)
(754)
13,022
3,739
(1,169)
(1,816)
(1,464
(2,447
41,830
30,174
Investment and other income
65,886
80,948
107,716
111,122
Annuities, supplemental insurance and life
25,701
29,087
Other (c)
(29,095
(21,941
$104,322
$118,268
(a) Revenues include sales of products and services as well as other income
earned by the respective segments.
(b) Includes realized gains of $45,000 and $10.2 million for the first quarter of 2005 and 2004, respectively. Excluding realized gains, investment income comprises approximately 55% of these revenues and premiums represent about 35%.
(c) Operating profit (loss) includes holding company expenses.
13
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$296,901
$296,843
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
61,993
75,100
8,470
8,283
$672,221
$685,083
GAFRI 7-1/2% Senior Debentures due November 2033
$112,500
GAFRI 6-7/8% Senior Notes due June 2008
100,000
GAFRI 7-1/4% Senior Debentures due January 2034
86,250
Notes payable secured by real estate
26,316
26,471
APU 10-7/8% Subordinated Notes due May 2011
8,167
8,181
9,784
10,188
$343,017
$343,590
At March 31, 2005, sinking fund and other scheduled principal payments on debt for the balance of 2005 and the subsequent five years were as follows (in millions):
Holding
Company
$ -
$ 9.1
2006
19.5
2007
67.5
.1
67.6
2008
100.1
2009
298.0
298.1
2010
1.9
GAFRI has entered into interest rate swaps that effectively convert its 6-7/8% Senior Notes to a floating rate of 3-month LIBOR plus 2.9% (effective rate of approximately 6% at March 31, 2005). The swaps realign GAFRI's mix of floating and fixed rate 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 accreted value ranging from $371.53 per Note at June 2, 2008 to $1,000 per Note at maturity. Generally, holders may convert each Note into 11.5016 shares of AFG Common Stock (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), (ii) if the credit rating of the Notes is
14
significantly lowered, or, (iii) if AFG calls the notes for redemption. 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.
In the second half of 2004, AFG and GAFRI replaced their existing credit agreements with four-year revolving credit facilities under which they can borrow up to $300 million and $165 million, respectively. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on the respective borrower's credit ratings.
Date of
Amount Outstanding
Optional
Issuance
Issue (Maturity Date)
3/31/05
12/31/04
Redemption Dates
March 1997
GAFRI 8-7/8% Pfd (2027)
$42,800
On or after 3/1/2007
May 2003
GAFRI 7.35% Pfd (2033)
20,000
On or after 5/15/2008
NIC Variable Pfd (2033)
15,000
On or after 5/23/2008
NIC and GAFRI effectively provide unconditional guarantees of their respective trusts' obligations. AFG's $95.5 million in 9-1/8% trust preferred securities and GAFRI's $65 million in 9-1/4% trust preferred securities were redeemed at face value in the first quarter of 2004. In addition, during the first quarter of 2004, GAFRI repurchased $27.2 million of its 8-7/8% preferred securities for $28.5 million in cash.
Subsidiaries' common stock
$245,019
$214,292
Managed investment entity
4,585
5,294
$249,604
$219,586
Minority Interest Expense
$5,917
$4,827
(45
677
$5,872
$5,504
Stock Options
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
Expense Items
26
Ratios
Other Items
27
Sources of Funds
19
Proposed Accounting Standard
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 forward-looking words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Examples of such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate increases; and improved loss experience.
Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:
The forward-looking statements herein are made only as of the date of this report. AFG assumes no obligation to publicly update any forward-looking statements.
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings,
of Financial Condition and Results of Operations - Continued
shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, since most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
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 retirement annuities and supplemental insurance and life products.
AFG's net earnings for the first three months of 2005 were $62.9 million or $0.81 per share (diluted), compared to $73.2 million or $0.98 per share recorded in the comparable period in 2004. The results reflect continued improvement in property and casualty underwriting results and higher operating earnings in the annuity, supplemental insurance and life operations. Additionally, AFG reported significant realized gains in the 2004 period compared to realized losses in the 2005 period.
CRITICAL ACCOUNTING POLICIES
Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. Management believes that the establishment of insurance reserves, especially asbestos and environmental-related reserves, the recoverability of annuity and life deferred policy acquisition costs, and the determination of "other than temporary" impairment on investments are the areas where the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical. For a discussion of these policies, see Management's Discussion and Analysis - "Critical Accounting Policies" in AFG's 2004 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
AFG's debt to total capital ratio on a consolidated basis is shown below (dollars in millions).
2003
Consolidated debt (1)
$1,093
$1,106
$1,102
Total capital (2)
3,631
3,575
3,187
Ratio of debt to total capital
30%
31%
35%
(1) Includes payable to subsidiary trusts.
(2) Includes consolidated 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 2.01 for the quarter ended March 31, 2005 and 2.43 (1.91 excluding the $214.3 million third quarter gain on the sale of Provident Financial Group) for the entire year of 2004. Excluding annuity benefits, this ratio was 5.53 and 7.07 (4.85 excluding the Provident gain), respectively. Although the ratio excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
Parent Holding Company Liquidity
In November 2004, AFG replaced its existing credit line with a $300 million, four-year revolving credit facility. No amounts had been borrowed through March 31, 2005. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on AFG's credit rating. This credit agreement provides ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent company.
Under a currently effective shelf registration statement, AFG can offer up to an aggregate of $517 million in additional equity or debt securities. The shelf registration provides AFG with greater flexibility to access the capital markets from time to time as market and other conditions permit.
Subsidiary Liquidity
The liquidity requirements of AFG's insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without resorting to sales 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.
As discussed in Note C, National Interstate Corporation issued 3.4 million shares of its common stock in a February 2005 initial public offering for net proceeds of $40.4 million.
In August 2004, GAFRI replaced its existing credit agreement with a $150 million four-year revolving credit facility; this facility was increased to $165 million in April 2005. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on GAFRI's credit rating. There were no amounts borrowed under this agreement at March 31, 2005. In addition, GAFRI can offer approximately $250 million in additional equity or debt securities under a currently effective shelf registration.
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.
Approximately 94% of the fixed maturities held by AFG at March 31, 2005, were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and noninvestment grade. Management believes that a high quality investment portfolio should generate a stable and predictable investment return.
Individual portfolio securities are sold creating gains or losses as market opportunities exist. Since all of these securities are carried at market value in the balance sheet, there is virtually no effect on liquidity or financial condition upon the sale and ultimate realization of unrealized gains and losses.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at March 31, 2005, is shown in the following table (dollars in millions). Approximately $243 million of available for sale "Fixed maturities" and $21 million of "Other stocks" had no unrealized gains or losses at March 31, 2005.
With
Gains
Losses
Available for sale Fixed Maturities
Market value of securities
$6,946
$6,646
Amortized cost of securities
$6,668
$6,765
Gross unrealized gain (loss)
$ 278
($ 119)
Market value as % of amortized cost
104%
98%
Number of security positions
1,347
833
Number individually exceeding
$2 million gain or loss
Concentration of gains (losses) by
type or industry (exceeding 5% of
unrealized):
Banks, savings and credit institutions
$39.2
($ 6.3)
Gas and electric services
37.8
(4.1)
Mortgage-backed securities
24.1
(49.1)
Telephone communications
17.1
(1.8)
State and municipal
13.4
(9.8)
U.S. Government and government agencies
13.8
(19.8)
Percentage rated investment grade
91%
Other Stocks
$249
$275
Cost of securities
$188
$289
$ 61
($ 14)
Market value as % of cost
132%
95%
1
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at March 31, 2005, based on their market values. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Maturity
One year or less
4%
1%
After one year through five years
22
After five years through ten years
40
After ten years
81
55
45
21
AFG realized aggregate losses of $4.3 million during the first quarter of 2005 on $111.2 million in sales of fixed maturity securities (4 issues/issuers) that had individual unrealized losses greater than $500,000 at December 31, 2004. The market value of one of the securities increased $389,000 from December 31 to the sale date. The market value of the other three securities decreased an aggregate of $652,000 from December 31 to the sale date.
Although AFG had the ability to continue holding these investments, its intent to hold them changed due primarily to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular credit or industry, or to modify asset allocation within the portfolio.
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Market
Aggregate
Value as
% of Cost
Value
Gain (Loss)
Basis
Fixed Maturities at March 31, 2005
Securities with unrealized gains:
Exceeding $500,000 (153 issues)
$1,854
$142
108%
Less than $500,000 (1,194 issues)
5,092
136
103
$278
Securities with unrealized losses:
Exceeding $500,000 (52 issues)
$1,583
($ 46)
97%
Less than $500,000 (781 issues)
5,063
( 73)
99
($119)
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, 2005
Investment grade with losses for:
One year or less (729 issues)
$5,897
($ 91)
Greater than one year (59 issues)
586
( 23)
96%
$6,483
($114)
Non-investment grade with losses for:
One year or less (30 issues)
$ 117
($ 3)
Greater than one year (15 issues)
46
( 2)
$ 163
($ 5)
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 2004 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.
As discussed in AFG's 2004 Form 10-K, from time to time, AFG has engaged independent experts to work closely with its claims staff to study the asbestos and environmental ("A&E") reserves of its insurance company subsidiaries. The most recent study was completed in the third quarter of 2001 and resulted in AFG recording a pretax charge of $100 million to increase its A&E reserves. Management believes that current practice of the property and casualty insurance industry is to commission a comprehensive study every three or four years. Accordingly, absent legislative reforms, which may alter the need for an independent review, management plans to conduct such a routine study during 2005.
RESULTS OF OPERATIONS
Operating earnings before income taxes decreased $13.9 million in the first quarter of 2005 compared to the same period in 2004. The results reflect an $11.7 million improvement in property and casualty underwriting results and a $6.8 million increase in the operating earnings of the annuity, supplemental insurance and life business. Results for the 2004 quarter included $36.2 million in realized gains compared to realized losses of $5.5 million in the 2005 quarter.
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 D - "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:
$277.4
$239.9
357.5
363.3
115.7
106.6
104.0
96.2
1.3
.7
Total Specialty
$855.9
$806.7
Net Written Premiums (GAAP)
$202.5
$146.9
185.7
198.3
96.1
90.6
93.5
84.0
15.0
17.3
$592.8
$537.1
Combined Ratios (GAAP)
82.8%
83.5%
96.4
93.8
104.3
100.9
85.1
95.2
107.1
108.8
92.1%
93.3%
(a) AFG's aggregate combined ratio, including other (primarily discontinued) lines, was 92.4% and 93.8% for the three months ended March 31, 2005 and 2004, respectively.
The Specialty group reported an underwriting profit of $43.3 million for the first quarter of 2005, an improvement of 33% over the comparable 2004 period.
Property and transportation gross written premiums increased about 16% during the first quarter of 2005 reflecting primarily volume increases in the truck and bus products. Net written premiums increased 38% for the first quarter, reflecting a reduction in reinsurance ceded principally within the inland marine operations. The combined ratio improved 0.7 points over the 2004 period.
24
Specialty casualty net written premiums declined 6% in the first quarter compared to the same period in 2004 while gross written premiums were relatively flat, reflecting the return of premiums from the cancellation of certain reinsurance agreements during the first quarter of 2004. The combined ratio was 2.6 points higher than the comparable 2004 period but considerably better than the last two quarters of 2004. The underwriting profits of the excess and surplus businesses were partly offset by $12.7 million of unfavorable prior year development in the executive and professional liability operations.
Specialty financial gross and net written premiums grew 9% and 6%, respectively, over the 2004 period driven primarily by growth in the dealer services and fidelity and crime businesses. The combined ratio was 3.4 points above the comparable 2004 period but improved significantly over the last quarter of 2004.
California workers' compensation gross and net written premiums grew 8% and 11%, respectively, over the 2004 period reflecting solid volume growth offset by lower rates. Rate decreases averaged about 6% for the 2005 quarter. This group's claim results continued to benefit from the California workers' compensation reforms enacted in 2003 and 2004.
Investment Income
Realized Gains (Losses)
Realized gains (losses) on securities include provisions for other than temporary impairment of securities still held of $1.9 million in the first quarter of 2005 and $2.0 million in the first quarter of 2004.
Real Estate Operations
$23.3
$17.0
20.6
16.1
.5
Minority interest expense, net
.4
Other income includes net pretax gains on the sale of real estate assets of $2.6 million in the first quarter of 2005 compared to $1.6 million for the 2004 period.
Other Income
25
Annuity Benefits
The majority of GAFRI's fixed annuity products permit GAFRI to change the crediting rate at any time subject to minimum interest rate guarantees (as determined by applicable law). Approximately 4% of annuity benefits accumulated relate to policies that have a minimum guarantee of less than 3%. The remaining balance is split almost evenly between policies with minimum guarantee rates of 3% and 4%.
The increase in annuity benefits in 2005 compared to 2004 reflects the May 2004 acquisition of a block of annuity business.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Continued spread compression, decreases in the stock market and adverse mortality could lead to write-offs of DPAC in the future.
Interest Expense
Interest Charges on Borrowed Money Interest expense for the first quarter of 2005 increased by less than $1 million compared to the 2004 period due primarily to higher average indebtedness. The majority of the proceeds from debt issued in the first quarter of 2004 was used to retire higher coupon trust preferred securities.
Interest on Subsidiary Trust Obligations Interest charges decreased $2.9 million for the first quarter of 2005 compared to the 2004 period due to the retirement of trust preferred securities in the 2004 first quarter.
Other Operating and General Expenses
Cumulative Effect of Accounting Change
Convertible Notes
______________________________________________________
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
As of March 31, 2005, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2004 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(e)) 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. Examples include subsidiary implementation of a new general ledger system and payroll system during the first quarter of 2005. There has been no change in AFG's business processes and procedures during the first fiscal quarter of 2005 that has materially affected, or is reasonably likely to materially affect, AFG's internal controls over financial reporting.
PART II
OTHER INFORMATION
Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
_________________________________________________
ITEM 6
Exhibits
Number
Exhibit Description
10(a)
2005 Co-CEO and Co-President Bonus Plan.
10(b)
2005 Senior Executive Bonus Plan.
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 6, 2005
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)
29