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, 2007
Commission File
AMERICAN FINANCIAL GROUP, INC.
Incorporated underthe Laws of Ohio
IRS Employer I.D.No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirementsfor the past 90 days. Yes X No
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer: Large Accelerated Filer X Accelerated Filer Non-Accelerated Filer
Indicate by check mark whether the Registrant is a shell company. Yes No X
As of May 1, 2007, there were 119,552,269 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)
March 31,
December 31,
2007
2006
Assets:
Cash and cash equivalents
$ 1,102.9
$ 1,329.0
Investments:
Fixed maturities:
Available for sale - at fair value
(amortized cost - $15,044.5 and $14,663.0)
15,046.4
14,624.3
Trading - at fair value
277.4
276.4
Other stocks available for sale - at fair value
(cost - $671.9 and 606.4)
793.4
729.4
Mortgage loans
290.3
264.5
Policy loans
267.9
267.1
Real estate and other investments
248.7
248.3
Total cash and investments
18,027.0
17,739.0
Recoverables from reinsurers and prepaid
reinsurance premiums
3,613.1
3,625.2
Agents' balances and premiums receivable
623.3
599.4
Deferred policy acquisition costs
1,283.7
1,266.9
Other receivables
299.1
425.0
Variable annuity assets (separate accounts)
703.9
700.5
Prepaid expenses and other assets
667.2
577.3
Goodwill
167.7
167.8
$25,385.0
$25,101.1
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 5,987.7
$ 6,027.7
Unearned premiums
1,681.8
1,653.9
Annuity benefits accumulated
9,612.0
9,456.7
Life, accident and health reserves
1,451.2
1,414.7
Payable to reinsurers
322.7
314.9
Long-term debt
924.3
921.0
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,363.5
1,398.9
Total liabilities
22,047.1
21,888.3
Minority interest
296.9
283.9
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 119,437,645 and 119,303,928 shares outstanding
119.4
119.3
Capital surplus
1,231.8
1,220.5
Retained earnings
1,610.9
1,533.6
Accumulated other comprehensive income, net of tax
78.9
55.5
Total shareholders' equity
3,041.0
2,928.9
2
CONSOLIDATED STATEMENT OF EARNINGS (unaudited)
(In Millions, Except Per Share Data)
Three months ended
Income:
Property and casualty insurance premiums
$ 639.8
$ 579.1
Life, accident and health premiums
106.6
82.0
Investment income
245.8
231.9
Realized gains on securities
4.7
29.8
Other income
82.7
73.3
1,079.6
996.1
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
326.9
337.1
Commissions and other underwriting expenses
210.2
173.3
Annuity benefits
88.8
82.8
Life, accident and health benefits
85.5
67.6
Annuity and supplemental insurance
acquisition expenses
44.5
33.6
Interest charges on borrowed money
18.1
18.5
Other operating and general expenses
110.7
113.4
884.7
826.3
Operating earnings before income taxes
194.9
169.8
Provision for income taxes
72.3
59.6
Net operating earnings
122.6
110.2
Minority interest expense
(8.5)
(7.8)
Equity in net losses of investee, net of tax
(.5
Earnings from continuing operations
113.6
101.9
Discontinued operations, net of tax
-
(.4
Net Earnings
$ 113.6
$ 101.5
Basic earnings per Common Share:
Continuing operations
$0.95
$0.86
Discontinued operations
Net earnings available to Common Shares
Diluted earnings per Common Share:
$0.92
$0.85
Average number of Common Shares:
Basic
119,470
117,377
Diluted
122,445
119,399
Cash dividends per Common Share
$.10
$.092
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, 2006
119,303,928
$1,339.8
$1,533.6
$ 55.5
$2,928.9
Cumulative effect of accounting change
(14.9)
Net earnings
Other comprehensive income, net of tax:
Change in unrealized gains on securities
20.1
Change in foreign currency translation
.6
Change in unrealized pension and other
postretirement benefits
2.7
Total comprehensive income
137.0
Dividends on Common Stock
(11.9)
Shares issued:
Exercise of stock options
376,062
8.6
Dividend reinvestment plan
40,276
1.4
Employee stock purchase plan
7,991
.3
Deferred compensation distributions
31,863
1.1
Stock incentive plan
114,594
3.9
Other stock-based compensation expense
1.8
Shares acquired and retired
(411,639)
(4.5)
(8.9)
(13.4)
Shares tendered in option exercises
(25,430)
(.3)
(.6)
(.9)
Capital transactions of subsidiaries
(.9
Balance at March 31, 2007
119,437,645
$1,351.2
$1,610.9
$ 78.9
$3,041.0
Balance at December 31, 2005
117,101,271
$1,272.7
$1,134.1
$ 50.8
$2,457.6
101.5
Other comprehensive loss,
net of tax:
(114.0)
(114.0
Total comprehensive loss
(12.5)
(10.8)
497,654
10.6
52,577
1.3
8,648
.2
63,162
1.6
Stock-based compensation expense
1.5
(.7
Balance at March 31, 2006
117,723,312
$1,287.4
$1,224.8
($ 63.2)
$2,449.0
4
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
Operating Activities:
Adjustments:
Equity in net losses of investee
.5
8.5
7.8
Depreciation and amortization
49.0
35.1
Realized gains on investing activities
(10.7)
(36.8)
Net purchases/sales of trading securities
(14.3)
Deferred annuity and life policy acquisition costs
(49.7)
(27.3)
Decrease in reinsurance and other receivables
102.3
213.3
Decrease (increase) in other assets
(104.6)
68.3
Increase in insurance claims and reserves
24.6
63.3
Increase (decrease) in payable to reinsurers
(4.3)
Decrease in other liabilities
(58.1)
(47.7)
Other, net
7.7
5.0
Net cash provided by operating activities
179.9
447.2
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(1,031.1)
(1,063.0)
Equity securities
(101.7)
(63.7)
Subsidiary
(1.2)
Real estate, property and equipment
(6.2)
(6.6)
Maturities and redemptions of fixed maturity investments
324.5
291.4
Sales of:
335.1
409.2
46.2
55.1
37.5
14.3
23.9
Increase in securities lending collateral
(16.7)
Cash and cash equivalents of businesses
acquired or sold, net
100.0
Decrease (increase) in other investments
(32.8
21.7
Net cash used in investing activities
(468.4
(195.7
Financing Activities
Annuity receipts
378.8
220.3
Annuity surrenders, benefits and withdrawals
(329.7)
(294.3)
Net transfers from variable annuity assets
8.9
4.1
Additional long-term borrowings
92.0
26.2
Reductions of long-term debt
(90.0)
(116.8)
Increase in securities lending obligation
16.7
Issuances of Common Stock
10.5
Repurchases of Common Stock
Cash dividends paid on Common Stock
(10.5)
(9.5)
1.9
Net cash provided by (used in) financing activities
62.4
(158.1
Net Increase (Decrease) in Cash and Cash Equivalents
(226.1)
93.4
Cash and cash equivalents at beginning of period
1,329.0
471.8
Cash and cash equivalents at end of period
$1,102.9
$ 565.2
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
E.
B.
F.
G.
C.
H.
D.
________________________________________________________________________________
Basis of Presentation
Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
Stock Split
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) 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) and the liability to return the collateral (included in other liabilities) in its
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Balance Sheet. The securities loaned remain a recorded asset on AFG's Balance Sheet. The amount of collateral held was approximately $176 million at March 31, 2007 and approximately $159 million at December 31, 2006.
Derivatives
The terms of the interest rate swaps match those of the debt; therefore, the swaps are considered to be (and are accounted for as) 100% effective fair value hedges. Both the swaps and the hedged debt are adjusted for changes in fair value by offsetting amounts. Accordingly, since the swaps are included with long-term debt in the Balance Sheet, the only effect on AFG's financial statements is that the interest expense on the hedged debt is recorded based on the variable rate.
Reinsurance
Subsidiaries of AFG's 81%-owned subsidiary, Great American Financial Resources, Inc. ("GAFRI"), cede life insurance policies to a third party on a funds withheld basis whereby GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. GAFRI classifies the securities related to these transactions as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income record ed on the adjustment to fair value of the related trading portfolios.
7
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 on marketable securities, a component of "Accumulated Other Comprehensive Income, 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 insurance companies acquired by GAFRI, which represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The present value of future profits is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
Annuity and Supplemental Insurance Acquisition Expenses
Unpaid Losses and Loss Adjustment Expenses
8
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
Payable to Subsidiary Trusts
Minority Interest
Income Taxes
Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on
9
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.
AFG records a liability for the inherent uncertainty in quantifying its income tax provisions. Interest and penalties related to these unrecognized tax benefits 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 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. See Note G - "Income Taxes."
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
Statement of Cash Flows
10
Great American Financial Resources
Ceres Group, Inc.
Chatham Bars Inn
Old Standard Life Fixed Annuity Business
Great American Life Assurance Company of Puerto Rico
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
$ 228.6
$200.0
Specialty casualty
211.2
188.2
Specialty financial
114.4
96.2
California workers' compensation
62.8
77.3
22.6
16.8
Other lines
639.8
579.1
83.9
79.5
Realized gains
26.1
50.4
47.0
776.8
731.7
Annuity and supplemental insurance:
158.8
150.4
3.7
27.1
294.4
260.7
8.4
$1,079.6
$996.1
Operating Earnings (Losses) Before Income Taxes
Underwriting:
$ 38.6
$ 42.1
59.0
14.6
.8
13.5
12.5
Other (a)
(11.4)
(.2)
(1.2
102.7
68.6
Investment income, realized gains and other
84.6
97.9
187.3
166.5
31.1
29.5
Other (b)
(23.5
(26.2
$ 194.9
$169.8
(a) Includes a $13.5 million charge to adjust a retroactive reinsurance
gain in the first quarter of 2007.
(b) Includes holding company expenses.
D.Deferred Policy Acquisition Costs
Included in deferred policy acquisition costs in AFG's Balance Sheet are $89.8 million and $95.0 million at March 31, 2007, and December 31, 2006, respectively, representing the present value of future profits ("PVFP") related
12
to acquisitions by AFG's annuity and supplemental insurance business. The PVFP amounts are net of $75.7 million and $70.5 million of accumulated amortization. Amortization of the PVFP was $5.2 million and $1.6 million during the first three months of 2007 and 2006, respectively. The increase in amortization compared to the first quarter of 2006 reflects the acquisition of Ceres, including the effect of lapses in Medicare supplement products.
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$182.9
AFG Senior Convertible Notes due June 2033
189.7
AFG 7-1/8% Senior Debentures due February 2034
115.0
AFG 7-1/8% Senior Debentures due December 2007
59.5
3.8
550.8
550.9
Subsidiaries
GAFRI 7-1/2% Senior Debentures due November 2033
112.5
GAFRI 7-1/4% Senior Debentures due January 2034
86.3
GAFRI 6-7/8% Senior Notes due June 2008
28.5
31.5
GAFRI borrowings under AFG/GAFRI credit facility
33.0
Notes payable secured by real estate
67.8
American Premier Underwriters 10-7/8% Subordinated
Notes due May 2011
8.0
8.1
2.4
6.9
338.5
313.1
Payable to Subsidiary Trusts:
GAFRI 7.35% Subordinated Debentures due May 2033
20.0
GAFRI 8-7/8% Subordinated Debentures
22.0
National Interstate Variable Rate Subordinated
Debentures due May 2033
15.0
35.0
57.0
$924.3
$921.0
At March 31, 2007, scheduled principal payments on debt for the balance of 2007 and the subsequent five years were as follows: 2007 - $60.6 million; 2008 - $29.2 million; 2009 - $184.4 million; 2010 - $2.9 million; 2011 - $42.1 million; and 2012 - $1.4 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
$856.5
$853.2
Obligations secured by real estate
On March 1, 2007, GAFRI used funds borrowed under the AFG/GAFRI bank credit facility to redeem its $22 million in outstanding 8-7/8% Subordinated Debentures due 2027 for $22.9 million.
In March 2006, AFG and GAFRI replaced their existing credit agreements with a new five-year revolving credit facility under which they can borrow a combined $500 million. AFG and GAFRI have agreed not to borrow more than $325 million and $200 million, respectively, under the credit facility and AFG has agreed to
13
guarantee amounts borrowed by GAFRI. Amounts borrowed bear interest at rates ranging from 0.5% to 1.25% over LIBOR based on AFG's credit rating. At March 31, 2007, GAFRI had $33 million in borrowings outstanding under the credit facility (interest rate of 6.1% at March 31, 2007); there were no borrowings under this agreement at December 31, 2006.
To achieve a desired balance between fixed and variable rate debt, GAFRI has entered into interest rate swaps that effectively convert its 6-7/8% fixed rate Senior Notes to a floating rate of 3-month LIBOR plus 2.9%.
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 to $1,000 per Note at maturity. Generally, holders may convert each Note into 17.2524 shares of AFG Common Stock (at $21.53 per share currently) (i) if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value ($25.84 per share currently) for a specified period, (ii) if the credit rating of the Notes is significantly lowered, or, (iii) if AFG calls the notes for redemption. Based on the market price of AFG's Common Stock during the quarter ended March 31, 2007, the N otes are currently convertible through June 30, 2007. AFG has delivered cash in lieu of Common Stock upon conversion of the Notes and intends to continue to do so. Accordingly, shares issuable upon conversion of the Notes are not treated as dilutive.
Accumulated Other Comprehensive Income, Net of Tax
Net unrealized gains on securities
$70.8
$50.7
Foreign currency translation adjustment
4.9
4.3
Unrealized pension and other postretirement benefits
3.2
Total accumulated other comprehensive income
$78.9
$55.5
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 (after consideration of other factors). The fair value of options granted in the first quarter of 2007 was $10.46 per share based on the following assumptions: expected dividend yield - 1.2%; expected volatility - 21.5%; expected term - 6 1/2 years; risk-free rate - 4.7%.
14
Total compensation expense related to stock incentive plans of AFG and its two public subsidiaries was $6.6 million for the first quarter of 2007 compared to $2.2 million for the 2006 quarter. Stock-based compensation expense for the first three months of 2007 includes $3.9 million in non-deductible stock awards.
As of January 1, 2007, AFG's 2004, 2005 and 2006 tax years remain subject to examination by the IRS. In addition, AFG has several tax years for which there are ongoing disputes. AFG has subsidiaries in various states, cities and provinces that are currently under audit for years ranging from 1995 through 2004. In April 2007, AFG signed a settlement agreement with a municipality. As a result of this settlement, AFG anticipates that it will reduce its liability for unrecognized income tax benefits by approximately $5.5 million ($4.3 million net of federal tax effect) in the quarter ended June 30, 2007. No other significant changes to this liability are anticipated within the next 12 months.
15
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
16
Results of Operations
22
Overview
General
Critical Accounting Policies
17
Income Items
Liquidity and Capital Resources
Expense Items
25
Sources of Funds
19
Proposed Accounting Standard
26
Uncertainties
_____________________________________________________________________________________________________
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Some of the forward-looking statements can be identified by the use of words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate increases; and improved loss experience.
Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:
The forward-looking statements herein are made only as of the date of this report. The Company assumes no obligation to publicly update any forward-looking statements.
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, 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
of Financial Condition and Results of Operations - Continued
addition, because most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
At March 31, 2007, AFG (parent) had approximately $190 million in cash and securities and no amounts borrowed under the AFG/GAFRI bank line of credit. GAFRI had $33 million borrowed under this line at March 31, 2007.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance, and in the sale of traditional fixed, indexed and variable annuities and a variety of supplemental insurance products.
AFG's net earnings for the first three months of 2007 were $113.6 million or $.92 per share (diluted) compared to $101.5 million or $0.85 per share reported in the first quarter of 2006, reflecting significantly improved results within the specialty property and casualty insurance operations.
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 2006 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
Ratios
2005
$ 924
$ 921
$1,000
Total capital (*)
4,267
4,160
3,703
Ratio of debt to total capital
21.7%
22.1%
27.0%
(*) Includes long-term debt, minority interest and
shareholders' equity (excluding unrealized gains (losses)
related to fixed maturity investments).
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.77 for the three months ended March 31, 2007 and 2.62 for the entire year of 2006. Excluding annuity benefits, this ratio was 10.10 and 9.15, 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 March 2006, AFG and GAFRI replaced their existing credit agreements with a five-year revolving credit facility under which they can borrow a combined $500 million. AFG and GAFRI have agreed not to borrow more than $325 million and $200 million, respectively, under the credit facility and AFG has agreed to guarantee amounts borrowed by GAFRI. GAFRI had $33 million in borrowings outstanding under this agreement at March 31, 2007, bearing interest at a rate of 6.1% at March 31, 2007.
In addition to parent company cash and marketable securities of approximately $190 million, AFG can borrow approximately $200 million on its bank line and maintain its desired debt to total capital ratio of less than 25%.
Under a currently effective shelf registration statement, AFG can offer additional equity or debt securities, including 3.5 million shares of common stock under an equity distribution agreement with UBS Securities LLC. The shelf registration provides AFG with greater flexibility to access the capital markets from time to time as market and other conditions permit.
Subsidiary Liquidity
On March 1, 2007, GAFRI used funds borrowed under the AFG/GAFRI bank credit line to redeem its $22 million in outstanding 8-7/8% Subordinated Debentures for $22.9 million in cash.
The liquidity requirements of AFG's insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
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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. With declining rates, GAFRI 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 GAFRI'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.
Approximately 94% of the fixed maturities held by AFG at March 31, 2007, 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.
Since fixed maturities and stocks are carried at fair value in the balance sheet, there is virtually no effect on 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, 2007, is shown in the following table (dollars in millions). Approximately $174 million of available for sale "Fixed maturities" had no unrealized gains or losses at March 31, 2007.
Securities
With
Unrealized
Gains
Losses
Available for sale Fixed Maturities
Fair value of securities
$6,034
$8,838
Amortized cost of securities
$5,887
$8,983
Gross unrealized gain (loss)
$ 147
($ 145)
Fair value as % of amortized cost
102%
98%
Number of security positions
1,408
1,393
Number individually exceeding
$2 million gain or loss
1
Concentration of gains (losses) by type or
industry (exceeding 5% of unrealized):
Mortgage-backed securities
$26.0
($60.0)
Banks, savings and credit institutions
14.5
(16.6)
U.S. Government and government agencies
3.3
State and municipal
(9.9)
Insurance companies
10.0
(7.9)
Gas and electric services
17.7
(7.1)
Air transportation and courier services
(0.2)
Percentage rated investment grade
91%
97%
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at March 31, 2007, 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
3%
5%
After one year through five years
27
23
After five years through ten years
38
30
After ten years
78
62
100
20
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 March 31, 2007
Securities with unrealized gains:
Exceeding $500,000 (57 issues)
$ 604
$ 48
109%
Less than $500,000 (1,351 issues)
5,430
99
102
$147
Securities with unrealized losses:
Exceeding $500,000 (48 issues)
$1,118
($ 39)
Less than $500,000 (1,345 issues)
7,720
(106
($145)
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.
Loss
Fixed Maturities with Unrealized
Losses at March 31, 2007
Investment grade with losses for:
One year or less (205 issues)
$1,217
($ 7)
99%
Greater than one year (1,128 issues)
7,370
(134
98
$8,587
($141)
Non-investment grade with losses for:
One year or less (25 issues)
$ 77
($ 2)
Greater than one year (35 issues)
174
(2
$ 251
($ 4)
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 2006 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 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
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results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
RESULTS OF OPERATIONS
AFG reported operating earnings before income taxes of $194.9 million for the first quarter of 2007 compared to $169.8 million in the 2006 first quarter. The increase reflects a $34.0 million improvement in property and casualty underwriting results and a $13.9 million increase in investment income partially offset by a $25.1 million decline in realized gains on securities.
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 policy holder 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)
$323
$318
361
375
138
119
68
85
(1
$889
$895
Net Written Premiums (GAAP)
$245
$231
216
202
115
93
65
80
$657
$624
Combined Ratios (GAAP)
83.1%
79.0%
72.0
92.3
96.7
99.1
78.5
Total Specialty
83.8
88.0
Aggregate (including discontinued lines)
84.0%
88.1%
Net written premiums for the specialty insurance operations increased 5% for the 2007 first quarter compared to the same period in 2006. Premium growth from the Property and transportation, Specialty casualty and Specialty financial groups was partially offset by a decline in the California workers' compensation premiums. Overall average rates for the specialty insurance operations in the 2007 first quarter were down about 4% compared with the same prior year period. The specialty insurance operations generated an underwriting profit of $103.4 million in the 2007 first quarter, $33.6 million higher than the 2006 quarter. The improved results for the 2007 quarter reflect profitable earned premium growth, lower catastrophe losses, and the positive impact of favorable reserve development compared to the 2006 quarter. Catastrophe losses in the 2007 first quarter were approximately $1 million compared to about $13 million (2.2 points) of such losses in th e 2006 quarter. The specialty insurance operations recorded $54.0 million (8.4 points) of favorable reserve development in the first quarter of 2007 compared to $11.3 million (2.0 points) in the 2006 first quarter. The favorable development in 2007 is net of a $13.5 million charge to adjust a retroactive reinsurance gain.
Specialty casualty gross written premiums for the 2007 first quarter were 4% below the same period last year resulting primarily from volume reductions in the excess and surplus lines, reflecting stronger competition in those commercial casualty markets. Net written premiums for the 2007 quarter were 7% higher than in the 2006 quarter due primarily to lower premiums ceded under reinsurance agreements on policies covering groups, programs and events. The 20.3 point improvement in the combined ratio compared to the 2006 quarter reflects $41.5 million (19.7 points) of favorable reserve development due primarily to lower claim frequency compared to $1.2 million (.6 points) for the 2006 quarter. The excess and surplus lines and general liability operations produced the majority of this group's underwriting profit.
Specialty financial gross and net written premiums for the 2007 quarter were up 16% and 24%, respectively, over the same period last year. These increases were driven primarily by volume growth in the leasing and lending, financial institutions and surety operations as well as greater premium retention in some of the group's operations. The 2.4 point improvement in this group's combined ratio was driven primarily by significant improvement in the surety and fidelity and crime operations. The trade credit and financial institutions operations also continued to generate strong profitability. This group's combined ratio continued to be impacted by disappointing results in the automobile residual value business ("RVI"), which is in run-off. However, 2007 is the last year in which there are a meaningful number of automobiles with expiring leases covered by AFG's policies. Excluding the RVI business, this group's combined ratio was 88.6% for the first three months of 2007.
California workers' compensation gross and net written premiums for the 2007 quarter were 19% below the 2006 first quarter, reflecting the effect of lower rates. These rate reductions averaged about 21% for the 2007 first quarter and are continuing evidence of the positive effects of the reform legislation in lowering workers' compensation costs for employers. This business' underwriting margins continue to benefit from an improved claims environment resulting from workers' compensation reforms enacted in California. The 2007 results benefited from favorable prior year reserve development of $4.7 million (7.5 points) compared to less than $1 million of unfavorable development in the same 2006 period. Due to the long-tail nature of this business, AFG continues to be conservative in recognizing the benefits from the reform legislation until a higher percentage of claims are paid and the ultimate impact of reforms can be determined.
Life, Accident and Health Premiums and Benefits
Investment Income
24
Realized Gains
Realized gains on securities include provisions for other than temporary impairment of securities still held of $9.1 million in the first quarter of 2007 and $3.0 million in the first quarter of 2006.
Real Estate Operations
$20.9
$21.1
13.7
14.4
1.0
.4
Minority interest expense (benefit)
Income from real estate operations includes net pretax gains on the sale of real estate assets of $6.0 million in the first quarter of 2007 and $7.0 million for the 2006 quarter.
Real Estate Operations - Discontinued
Other Income
Annuity Benefits
Annuity benefits increased $6.0 million for the first quarter of 2007 compared to the 2006 period reflecting higher sales of fixed-indexed annuities, partially offset by a lower average crediting rate.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Unanticipated spread compression, decreases in the stock market and adverse mortality experience could lead to write-offs of DPAC or PVFP in the future.
Other Operating and General Expenses
Convertible Notes
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
As of March 31, 2007, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2006 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 first fiscal quarter of 2007 that materially affected, or are reasonably likely to materially affect, AFG's 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 first fiscal quarter of 2007 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
Under AFG's shareholder-approved Stock Option Plan, 25,430 shares of AFG Common Stock were tendered at $33.87 per share in connection with the exercise of stock options in March 2007.
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.
May 8, 2007
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)
28