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, 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 August 1, 2005, there were 77,302,138 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)
June 30,
December 31,
2005
2004
Assets:
Cash and short-term investments
$ 797,488
$ 861,742
Investments:
Fixed maturities:
Available for sale - at market
(amortized cost - $13,579,305 and $13,035,165)
13,987,305
13,411,365
Trading - at market
285,968
292,233
Other stocks - at market
(cost - $505,227 and $456,053)
553,727
537,153
Policy loans
251,985
250,211
Real estate and other investments
326,682
283,929
Total cash and investments
16,203,155
15,636,633
Recoverables from reinsurers and prepaid
reinsurance premiums
3,170,674
3,440,592
Agents' balances and premiums receivable
651,458
518,464
Deferred policy acquisition costs
1,150,059
1,114,433
Other receivables
280,878
359,746
Investments of managed investment entity
-
392,624
Variable annuity assets (separate accounts)
610,011
620,007
Prepaid expenses, deferred charges and other assets
281,842
311,146
Goodwill
165,882
$22,513,959
$22,559,527
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 5,296,531
$ 5,337,270
Unearned premiums
1,700,515
1,612,035
Annuity benefits accumulated
8,312,383
8,132,106
Life, accident and health reserves
1,055,775
1,021,986
Payable to reinsurers
284,169
513,565
Long-term debt:
Holding company
670,003
685,083
Subsidiaries
342,447
343,590
Payable to subsidiary trusts
77,800
Debt of managed investment entity
371,368
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,333,362
1,194,584
Total liabilities
19,682,996
19,909,394
Minority interest
272,731
219,586
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 77,229,688 and 76,634,204 shares outstanding
77,230
76,634
Capital surplus
1,159,179
1,145,873
Retained earnings
1,095,623
976,340
Unrealized gain on marketable securities, net
226,200
231,700
Total shareholders' equity
2,558,232
2,430,547
2
CONSOLIDATED STATEMENT OF EARNINGS
(In Thousands, Except Per Share Data)
Three months ended
Six months ended
Income:
Property and casualty insurance premiums
$575,335
$529,520
$1,124,434
$1,016,321
Life, accident and health premiums
92,389
87,553
184,445
177,878
Investment income
212,451
195,895
426,658
387,982
Realized gains on securities
22,094
687
16,555
36,903
Revenues of managed investment entity
4,546
651
9,437
Other income
92,380
83,212
173,889
147,185
994,649
901,413
1,926,632
1,775,706
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
358,802
338,144
707,180
647,774
Commissions and other underwriting
expenses
157,415
161,781
316,306
308,778
Annuity benefits
84,119
73,765
164,881
146,031
Life, accident and health benefits
69,607
65,905
138,578
135,219
Annuity, supplemental insurance and
life acquisition expenses
33,798
32,699
69,070
62,853
Interest charges on borrowed money
18,414
18,097
36,422
35,185
Interest on subsidiary trust obligations
1,639
1,545
3,211
6,006
Expenses of managed investment entity
3,146
774
6,528
Other operating and general expenses
121,249
113,661
236,282
216,394
845,043
808,743
1,672,704
1,564,768
Operating earnings before income taxes
149,606
92,670
253,928
210,938
Provision for income taxes
54,645
29,260
89,776
66,642
Net operating earnings
94,961
63,410
164,152
144,296
Minority interest expense
(8,942)
(6,160)
(14,814)
(11,664)
Equity in net losses of investee, net of tax
(4,394
(882
(4,838
(1,800
Earnings from continuing operations
81,625
56,368
144,500
130,832
Discontinued operations
(428)
145
Cumulative effect of accounting change
(1,837
Net Earnings
$ 81,625
$ 55,940
$ 144,500
$ 129,140
Basic earnings per Common Share:
Continuing operations
$1.06
$.77
$1.88
$1.79
(.01)
(.03
Net earnings available to Common Shares
$.76
$1.76
Diluted earnings per Common Share:
$1.04
$1.85
$1.75
(.02
$.75
$1.73
Average number of Common Shares:
Basic
77,102
73,388
76,920
73,280
Diluted
78,230
74,671
78,031
74,509
Cash dividends per Common Share
$.125
$.25
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
(5,500)
(5,500
Comprehensive income
139,000
Dividends on Common Stock
(19,202)
Shares issued:
Exercise of stock options
783,988
20,538
Dividend reinvestment plan
106,050
2,982
Employee stock purchase plan
14,105
438
Retirement plan contributions
76,431
2,373
Deferred compensation distributions
7,374
222
Directors fees paid in stock
9,320
300
Shares tendered in option exercises
(401,784)
(6,415)
(6,015)
(12,430)
Capital transactions of subsidiaries
(7,315)
Other
779
Balance at June 30, 2005
77,229,688
$1,236,409
$1,095,623
$226,200
$2,558,232
Balance at January 1, 2004
73,056,085
$1,108,840
$ 664,721
$302,600
$2,076,161
129,140
(102,500)
(102,500
26,640
(18,303)
250,499
5,986
5,170
140
14,506
425
76,274
2,269
33,620
959
11,666
339
(955)
(15)
(13)
(28)
(447
Balance at June 30, 2004
73,446,865
$1,118,496
$ 775,545
$200,100
$2,094,141
4
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)
Operating Activities:
Adjustments:
1,837
Equity in net losses of investee
4,838
1,800
14,814
11,664
Depreciation and amortization
100,240
89,116
Realized gains on investing activities
(25,607)
(45,308)
Net purchases/sales of trading securities
9,596
(58,734)
Deferred annuity and life policy acquisition costs
(62,719)
(63,616)
Decrease in reinsurance and other receivables
233,269
135,491
Decrease (increase)in other assets
(17,521)
30,221
Increase in insurance claims and reserves
82,467
117,782
Decrease in payable to reinsurers
(229,396)
(27,427)
Increase (decrease) in other liabilities
75,181
(4,260)
Other, net
17,035
4,503
511,578
468,240
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(2,287,028)
(3,021,929)
Equity securities
(124,173)
(73,185)
Subsidiary
(10,382)
Real estate, property and equipment
(62,566)
(12,192)
Maturities and redemptions of fixed maturity
investments
620,182
694,147
Sales of:
1,161,516
1,940,941
86,422
31,055
11,783
9,562
Cash and short-term investments of business
acquired or sold, net
27,857
Increase in other investments
(2,330
(22,291
(596,194
(436,417
Financing Activities
Fixed annuity receipts
452,401
340,259
Annuity surrenders, benefits and withdrawals
(446,860)
(353,921)
Net transfers from (to) variable annuity assets
4,668
(3,766)
Additional long-term borrowings
100
195,007
Reductions of long-term debt
(17,717)
(7,897)
Repurchases of trust preferred securities
(188,961)
Issuances of Common Stock
6,683
5,830
Subsidiary's issuance of stock in public offering
40,391
Cash dividends paid on Common Stock
(16,220)
(18,163)
(3,084
973
20,362
(30,639
Net Increase (Decrease) in Cash and Short-term Investments
(64,254)
1,184
Cash and short-term investments at beginning of period
861,742
593,552
Cash and short-term investments at end of period
$ 594,736
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
G.
B.
H.
I.
C.
J.
D.
E.
K.
F.
L.
________________________________________________________________________________
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
current mortgage loan rates and the structure of the security. Other factors affecting prepayments include the size, type and age of underlying mortgages, the geographic location of the mortgaged properties and the creditworthiness of the borrowers. Variations from anticipated prepayments will affect the life and yield of these securities.
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings (included in realized gains (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
Reinsurance
7
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. 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 "trading." The mark to market on the embedded derivatives offsets the investment income recorded on the mark to market of the related trading portfolios.
Deferred Policy Acquisition Costs ("DPAC")
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of expected gross profits on the policies. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in "Unrealized gain on marketable securities, net" in the shareholders' equity section of the Balance Sheet.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
DPAC includes the present value of future profits on business in force of insurance companies acquired by GAFRI, which represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The present value of future profits is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
Annuity, Supplemental Insurance and Life Acquisition Expenses
Unpaid Losses and Loss Adjustment Expenses
8
received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims; and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos and environmental claims involves considerably more judgment than other types of 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. 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
Payable to Subsidiary Trusts
9
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
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 six months of 2005 and $8.92 in the first six months 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
$81,625
$55,940
$144,500
$129,140
Pro forma stock option expense,
net of tax
(1,784
(2,143
(3,433
(3,360
Adjusted net earnings
$79,841
$53,797
$141,067
$125,780
Earnings per share (as reported):
$0.76
$0.75
Earnings per share (adjusted):
$0.73
$1.83
$1.72
$1.03
$1.82
$1.70
10
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
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
11
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
$201,586
$144,942
$ 369,657
$ 269,858
Specialty casualty
182,897
181,014
367,064
355,508
Specialty financial
86,652
99,488
178,422
183,850
California workers' compensation
86,577
82,798
173,901
160,227
16,604
17,180
33,011
37,797
Other lines
1,019
4,098
2,379
9,081
575,335
529,520
1,124,434
1,016,321
70,116
63,702
138,485
127,427
Realized gains
8,449
3,958
9,296
29,953
51,462
51,070
103,030
93,675
705,362
648,250
1,375,245
1,267,376
Annuities, supplemental insurance
and life (b)
280,260
243,777
543,075
490,789
9,027
9,386
8,312
17,541
$994,649
$901,413
$1,926,632
$1,775,706
Operating Profit (Loss)
Underwriting:
$ 38,518
$ 22,216
$ 67,459
$ 42,875
7,666
877
14,234
11,670
(7,838)
(1,506)
(11,906)
(2,260)
21,542
8,333
34,564
12,072
612
1,934
(557)
118
(1,382
(2,259
(2,846
(4,706
59,118
29,595
100,948
59,769
Investment income, realized gains
and other
66,277
60,940
132,163
141,888
125,395
90,535
233,111
201,657
42,075
22,733
67,776
51,820
Other (c)
(17,864
(20,598
(46,959
(42,539
$149,606
$ 92,670
$ 253,928
$ 210,938
(a) Revenues include sales of products and services as well as other income
earned by the respective segments.
(b) Includes realized gains (losses) of $13.6 million and ($3.3) million for the 2005 and 2004 quarters, and $13.6 million and $6.9 million for the six months, respectively. Excluding realized gains, investment income comprises approximately 54% of the revenues and premiums represent about 35%.
(c) Includes holding company expenses.
13
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$296,958
$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
6,195
8,283
$670,003
$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
26,158
26,471
APU 10-7/8% Subordinated Notes due May 2011
8,153
8,181
10,188
$342,447
$343,590
At June 30, 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
$ -
$ 8.5
2006
19.5
2007
65.3
.1
65.4
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 6.3% at June 30, 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)
6/30/05
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.
Stock Incentive Plans
The American Jobs Creation Act of 2004 provides a special one-time dividends received deduction on the repatriation of certain foreign earnings. In June 2005, Great American Life Assurance Company of Puerto Rico paid a $30 million dividend to GAFRI. Deferred taxes had previously been accrued on these earnings. While AFG is still evaluating whether it will remit any additional qualified foreign earnings under this provision in 2005, it does not believe the impact of any such election will be material to its results of operations.
15
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
19
Other Items
27
Sources of Funds
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 second quarter of 2005 were $81.6 million or $1.04 per share (diluted), compared to $55.9 million or $0.75 per share recorded in the comparable period in 2004. The results reflect continued improvement in property and casualty underwriting results and higher realized gains on securities.
Net earnings for the first six months of 2005 were $144.5 million or $1.85 per share, compared to $129.1 million or $1.73 per share recorded in the comparable period in 2004. The improvement results from higher earnings from insurance operations, partially offset by lower realized gains on securities.
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)
$1,090
$1,106
$1,102
Total capital (2)
3,725
3,575
3,187
Ratio of debt to total capital
29%
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 2.20 for the six months ended June 30, 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 6.44 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. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on AFG's credit rating. No amounts have been borrowed under this agreement. 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. No amounts have been borrowed under this agreement. 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 June 30, 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 June 30, 2005, is shown in the following table (dollars in millions). Approximately $113 million of available for sale "Fixed maturities" and $17 million of "Other stocks" had no unrealized gains or losses at June 30, 2005.
With
Gains
Losses
Available for sale Fixed Maturities
Market value of securities
$10,777
$3,097
Amortized cost of securities
$10,332
$3,134
Gross unrealized gain (loss)
$ 445
($ 37)
Market value as % of amortized cost
104%
99%
Number of security positions
1,727
472
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
$83.8
($ 1.4)
Gas and electric services
55.2
(1.5)
Mortgage-backed securities
49.2
(11.8)
U.S. Government and government agencies
23.7
(7.5)
State and municipal
23.6
(2.9)
Percentage rated investment grade
95%
92%
Other Stocks
$258
$279
Cost of securities
$199
$289
$ 59
($ 10)
Market value as % of cost
130%
97%
1
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at June 30, 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
3%
2%
After one year through five years
37
After five years through ten years
39
After ten years
71
59
29
41
21
AFG realized aggregate losses of $4.3 million during the first six months of 2005 on $111.2 million in sales of fixed maturity securities (four 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 June 30, 2005
Securities with unrealized gains:
Exceeding $500,000 (271 issues)
$ 3,962
$272
107%
Less than $500,000 (1,456 issues)
6,815
173
103
$445
Securities with unrealized losses:
Exceeding $500,000 (13 issues)
$ 422
($ 11)
Less than $500,000 (459 issues)
2,675
( 26)
99
$ 3,097
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 June 30, 2005
Investment grade with losses for:
One year or less (295 issues)
$1,725
($12)
Greater than one year (127 issues)
1,121
( 19)
98
$2,846
($31)
Non-investment grade with losses for:
One year or less (33 issues)
$ 196
($ 4)
98%
Greater than one year (17 issues)
55
( 2)
96
$ 251
($ 6)
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.
22
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, management plans to complete an independent review of its A&E reserves by the end of 2005. In addition, GAFRI will be reviewing the environmental liabilities at its former manufacturing operations (which were discontinued prior to 1993).
RESULTS OF OPERATIONS
Operating earnings before income taxes improved $56.9 million in the second quarter of 2005 compared to the same period in 2004. The results reflect a $29.5 million improvement in property and casualty underwriting results and a $21.4 million increase in realized gains.
Six-month pretax operating earnings improved $43 million compared to 2004 reflecting a $52.1 million improvement in property and casualty operating earnings (excluding realized gains) and a $9.3 million increase in the operating earnings of the annuity, supplemental insurance and life business, partially offset by a $20.3 million decrease in realized gains.
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:
$312.9
$338.2
$ 590.3
$ 578.1
363.6
388.3
721.1
751.6
118.8
121.2
234.5
227.8
92.3
90.2
196.3
186.4
2.4
(2.2
3.7
(1.5
Total Specialty
$890.0
$935.7
$1,745.9
$1,742.4
Net Written Premiums (GAAP)
$235.3
$206.0
$ 437.8
$ 352.9
189.4
193.8
375.1
392.1
90.7
95.4
186.8
186.0
82.8
80.6
176.3
164.6
17.0
13.1
32.0
30.4
$615.2
$588.9
$1,208.0
$1,126.0
Combined Ratios (GAAP)
80.9%
84.6%
81.8%
84.1%
95.8
99.4
96.1
96.8
109.0
101.5
106.6
101.2
75.1
90.0
80.1
92.5
96.3
88.7
101.7
99.7
89.4%
94.0%
90.8%
93.6%
(a) AFG's aggregate combined ratio, including other (primarily discontinued) lines, was 89.7% and 94.5% for the three months ended June 30, 2005 and 2004 and 91.0% and 94.1% for the six months ended June 30, 2005 and 2004, respectively.
24
Property and transportation gross written premiums decreased 7% for the second quarter compared to the 2004 quarter, due primarily to the effect of lower commodity prices earlier in the year which were used to establish the insured value of crop insurance coverages and lower volume resulting from competitive pricing within the excess property insurance operations. Through the first half of the year, however, such premiums were 2% higher than 2004 due to strong volume growth in the transportation and inland marine businesses. Net written premiums increased 14% and 24% during the second quarter and six months compared to the 2004 periods reflecting a reduction in reinsurance ceded, principally in the inland marine and crop insurance operations. The combined ratio for the second quarter and six months improved by 3.7 points and 2.3 points, respectively, over the 2004 periods reflecting favorable development of prior year loss reserves.
Investment Income
Realized Gains
Realized gains on securities include provisions for other than temporary impairment of securities still held as follows: second quarter of 2005 and 2004 - $5.7 million and $6.1 million; six months of 2005 and 2004 - $7.6 million and $8.1 million, respectively.
25
Real Estate Operations
$35.4
$28.8
$58.7
$45.8
22.7
20.1
43.3
36.2
.5
1.0
Minority interest expense, net
.7
.9
1.1
The increase in income and expenses from real estate operations reflects acquisitions of new properties. Other income also includes net pretax gains on the sale of real estate assets of $6.4 million in the second quarter and $9.0 million for the first six months of 2005 and $4.9 million and $6.5 million for the 2004 periods.
Anticipated Real Estate Sales
Other Income
Annuity Benefits
Historically, GAFRI has been able to react to changes in market interest rates and maintain a desired interest rate spread. Significant changes in projected investment yields could result in charges (or credits) to earnings in the period the projections are modified.
The increase in annuity benefits in the 2005 periods 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 on Subsidiary Trust Obligations Interest charges decreased $2.8 million for the first six months of 2005 compared to 2004 due to the retirement of trust preferred securities in the 2004 first quarter.
Other Operating and General Expenses
Minority Interest Expense
Cumulative Effect of Accounting Change
Convertible Notes
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
As of June 30, 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 second fiscal quarter of 2005 that has materially affected, or is reasonably likely to materially affect, AFG's internal controls over financial reporting.
28
PART II
OTHER INFORMATION
Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
Submission of Matters to a Vote of Security Holders
AFG's Annual Meeting of Shareholders was held on May 19, 2005; there were three matters voted upon: (Item 1) election of nine directors, (Item 2) approval of AFG 2005 Stock Incentive Plan and (Item 3) ratifying Ernst & Young as independent registered public accounting firm.
The votes cast for, against, withheld and the number of abstentions and brokernon-votes as to each matter voted on at the 2005 Annual Meeting is set forth below:
Broker
Name
For
Against
Withheld
Abstain
Non-Votes
Item 1
Theodore H. Emmerich
69,197,944
N/A
3,058,270
James E. Evans
67,572,600
4,683,614
Terry S. Jacobs
62,913,325
9,342,889
Carl H. Lindner
68,787,473
3,468,741
Carl H. Lindner III
68,678,696
3,577,518
S. Craig Lindner
68,679,170
3,577,044
William R. Martin
68,052,705
4,203,509
Kenneth C. Ambrecht
66,807,280
5,448,934
William W. Verity
67,187,238
5,068,976
Item 2
57,476,663
9,025,195
702,108
5,052,248
Item 3
71,306,014
273,860
676,288
52
N/A - Not Applicable
OTHER INFORMATION - CONTINUED
ITEM 6
Exhibits
Number
Exhibit Description
Computation of ratios of earnings to fixed charges.
Certification of the Co-Chief Executive Officer pursuant
to section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to
section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Co-Chief Executive Officers and Chief
Financial Officer pursuant to section 906 of the Sarbanes-
Oxley Act of 2002.
_________________________________________________________
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 5, 2005
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)
30