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 EndedSeptember 30, 2004
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 November 1, 2004, there were 73,792,061 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)
September 30,
December 31,
2004
2003
Assets:
Cash and short-term investments
$ 837,085
$ 593,552
Investments:
Fixed maturities:
Available for sale - at market
(amortized cost - $12,785,672 and $11,724,181)
13,187,572
12,101,981
Trading - at market
282,878
195,390
Other stocks - at market
(cost - $573,928 and $258,466)
654,028
454,866
Policy loans
248,749
215,571
Real estate and other investments
292,945
266,435
Total cash and investments
15,503,257
13,827,795
Recoverables from reinsurers and prepaid
reinsurance premiums
3,280,111
3,131,775
Agents' balances and premiums receivable
645,870
502,458
Deferred acquisition costs
974,206
851,199
Other receivables
267,499
320,517
Investments of managed investment entity
393,216
424,669
Variable annuity assets (separate accounts)
569,155
568,434
Prepaid expenses, deferred charges and other assets
333,072
402,081
Goodwill
165,882
168,330
$22,132,268
$20,197,258
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 5,103,159
$ 4,909,109
Unearned premiums
1,762,414
1,594,839
Annuity benefits accumulated
8,015,535
6,974,629
Life, accident and health reserves
1,064,812
1,018,861
Payable to reinsurers
489,315
408,518
Long-term debt:
Holding company
684,995
574,618
Subsidiaries
345,934
262,244
Payable to subsidiary trusts (issuers of preferred
securities)
77,800
265,472
Debt of managed investment entity
374,622
406,547
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,174,209
950,267
Total liabilities
19,661,950
17,933,538
Minority interest
210,013
187,559
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 73,680,675 and 73,056,085 shares outstanding
73,681
73,056
Capital surplus
1,055,674
1,035,784
Retained earnings
897,950
664,721
Unrealized gain on marketable securities, net
233,000
302,600
Total shareholders' equity
2,260,305
2,076,161
2
CONSOLIDATED STATEMENT OF EARNINGS
(In Thousands, Except Per Share Data)
Three months ended
Nine months ended
Income:
Property and casualty insurance premiums
$ 549,296
$478,009
$1,565,617
$1,433,294
Life, accident and health premiums
85,929
83,887
263,807
246,615
Investment income
201,631
190,038
589,613
579,161
Realized gains (losses) on:
Securities
223,563
21,778
260,466
41,067
Subsidiary
-
(31,682)
Revenues of managed investment entity
3,302
12,739
Other income
89,800
74,566
236,985
196,352
1,153,521
848,278
2,929,227
2,464,807
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
397,746
324,564
1,045,520
1,012,812
Commissions and other underwriting
expenses
151,055
132,836
459,833
413,023
Annuity benefits
82,482
71,523
228,513
227,230
Life, accident and health benefits
63,981
62,964
199,200
185,367
Annuity and life acquisition expenses
29,439
27,457
92,292
87,026
Interest charges on borrowed money
18,050
14,613
53,235
42,595
Interest on subsidiary trust obligations
1,552
598
7,558
781
Expenses of managed investment entity
4,123
10,651
Other operating and general expenses
172,509
141,849
388,903
337,098
920,937
776,404
2,485,705
2,305,932
Operating earnings before income taxes
232,584
71,874
443,522
158,875
Provision for income taxes
78,031
22,354
144,673
41,651
Net operating earnings
154,553
49,520
298,849
117,224
Minority interest expense, net of tax
(10,987)
(11,213)
(22,651)
(27,137)
Equity in net earnings (losses)
of investees, net of tax
(668
2,909
(2,468
5,883
Earnings from continuing operations
142,898
41,216
273,730
95,970
Discontinued operations
(942)
384
(797)
1,260
Cumulative effect of accounting changes
(3,756
(5,593
Net Earnings
$ 138,200
$ 41,600
$ 267,340
$ 97,230
Basic earnings per Common Share:
Continuing operations
$1.94
$.59
$3.73
$1.38
(.01)
.01
.02
(.05
(.08
Net earnings available to Common Shares
$1.88
$.60
$3.64
$1.40
Diluted earnings per Common Share:
$1.91
$.58
$3.67
$1.37
$1.85
$3.58
$1.39
Average number of Common Shares:
Basic
73,626
69,651
73,396
69,507
Diluted
74,762
70,019
74,597
69,785
Cash dividends per Common Share
$.125
$.375
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in Thousands)
Common Stock
Unrealized
Common
and Capital
Retained
Gain on
Shares
Surplus
Earnings
Total
Balance at January 1, 2004
73,056,085
$1,108,840
$664,721
$302,600
$2,076,161
Net earnings
267,340
Change in unrealized
(69,600)
(69,600
Comprehensive income
197,740
Dividends on Common Stock
(27,506)
Shares issued:
Exercise of stock options
872,499
22,083
Dividend reinvestment plan
6,151
167
Employee stock purchase plan
20,908
616
Retirement plan contributions
107,898
3,212
Deferred compensation distributions
34,218
977
Directors fees paid in stock
11,666
339
Shares tendered in option exercises
(428,750)
(6,529)
(6,605)
(13,134)
Other
(350
Balance at September 30, 2004
73,680,675
$1,129,355
$897,950
$233,000
$2,260,305
Balance at January 1, 2003
69,129,352
$ 992,171
$409,777
$323,900
$1,725,848
97,230
30,600
127,830
(26,039)
14,400
303
159,429
3,284
32,577
701
345,434
6,925
3,300
71
3,517
76
Shares acquired and retired
(4)
(2,794
Balance at September 30, 2003
69,688,005
$1,000,737
$480,968
$354,500
$1,836,205
4
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)
Operating Activities:
Adjustments:
5,593
Equity in net (earnings) losses of investees
2,468
(5,883)
22,651
12,025
Depreciation and amortization
127,986
135,023
Realized gains on investing activities
(274,577)
(19,672)
Net purchases/sales of trading securities
(85,683)
1,534
Deferred annuity and life policy acquisition costs
(95,035)
(118,765)
Increase in reinsurance and other receivables
(125,520)
(404,718)
Decrease in other assets
70,936
30,155
Increase in insurance claims and reserves
409,598
620,421
Increase (decrease) in payable to reinsurers
80,797
(25,156)
Increase in other liabilities
127,035
56,818
Other, net
13,423
8,239
775,525
614,481
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(3,729,889)
(5,901,447)
Equity securities
(131,932)
(113,409)
(10,382)
Real estate, property and equipment
(46,887)
(22,994)
Maturities and redemptions of fixed maturity
investments
972,067
1,428,014
Sales of:
2,370,684
3,615,671
48,958
36,464
247,380
15,542
14,236
Cash and short-term investments of businesses
acquired or sold, net
27,857
(112,666)
Collection of receivable from investee
55,000
Decrease (increase) in other investments
(16,667
531
(500,649
(753,220
Financing Activities
Fixed annuity receipts
523,968
592,806
Annuity surrenders, benefits and withdrawals
(534,302)
(417,590)
Net transfers from variable annuity assets
1,996
4,061
Additional long-term borrowings
195,008
228,715
Reductions of long-term debt
(8,482)
(363,405)
Issuances of trust preferred securities
33,943
Repurchases of trust preferred securities
(188,961)
Issuances of Common Stock
7,411
881
Subsidiary's issuance of stock in rights offering
10,632
Cash dividends paid on Common Stock
(27,339)
(22,755)
(642
2,016
(31,343
69,304
Net Increase (Decrease) in Cash and Short-term Investments
243,533
(69,435)
Cash and short-term investments at beginning of period
593,552
871,103
Cash and short-term investments at end of period
$ 801,668
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
H.
B.
C.
I.
D.
J.
E.
K.
F.
L.
G.
M.
________________________________________________________________________________
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.
Subsidiary Realignment
Investments
current mortgage loan rates and the structure of the security. Other factors affecting prepayments include the size, type and age of underlying mortgages,
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
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) and the cost basis of that investment is reduced.
In March 2003, the Financial Accounting Standards Board's ("FASB's") 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." EITF 03-16 became effective for periods beginning after June 15, 2004. The cumulative effect of changing from the cost method to the equity method of accounting for an investment in an LLC is to be shown separately in the Statement of Earnings and can be determined as the proportional share of profits and losses over the ownership period or as the difference between the carrying value and the proportional share of the company's net assets. AFG used the latter method and wrote off its investment in an LLC that has a deficit in equity.
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
7
CDO are shown separately in the Statement of Earnings; related minority interest is shown in Note H under "Minority Interest Expense."
Insurance
Reinsurance
Subsidiaries of Great American Financial Resources, Inc. ("GAFRI"), an82%-owned subsidiary, 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. Effective October 1, 2003, GAFRI implemented Statement of Financial Accounting Standards ("SFAS") No. 133 Implementation Issue B36 ("B36"). Under 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. As permitted under B36, GAFRI reclassified the securities related to these transactions from "available for sale" to "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.
8
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 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
9
Premium Recognition
Policyholder Dividends
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.
10
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 $8.92 per option granted in the first nine months of 2004 and $5.62 in the first nine months of 2003 was calculated using the Black-Scholes option pricing model and the following assumptions: expected dividend yield of 2%; expected volatility of 29% in 2004 and 30% in 2003; risk-free interest rate of 3.7% for 2004 and 3.6% for 2003; and expected option life of 7.5 years in 2004 and 7.4 years in 2003. 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
$138,200
$41,600
$267,340
$97,230
Pro forma stock option expense,
net of tax
(1,602
(1,619
(4,810
(4,744
Adjusted net earnings
$136,598
$39,981
$262,530
$92,486
Earnings per share (as reported):
$0.60
$0.59
Earnings per share (adjusted):
$1.86
$0.57
$1.33
$1.84
$3.54
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.
11
Discontinued Operations
Earnings Per Share
Statement of Cash Flows
National Health Annuity Business
Fidelity Excess and Surplus Insurance Company
Direct automobile insurance business
Infinity Property and Casualty Corporation
12
Since AFG disposed of substantially all of its Personal insurance business in 2003, it has revised its reporting of the Specialty insurance business into the following components: (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.
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
$ 166,466
$125,845
$ 436,324
$ 344,639
Specialty casualty
181,781
164,994
537,289
481,071
Specialty financial
87,884
79,337
271,734
200,536
California workers' compensation
90,937
69,864
251,164
190,888
19,513
22,758
57,310
64,970
Personal (b)
15,201
151,182
Other lines
2,715
11,796
549,296
478,009
1,565,617
1,433,294
64,794
59,791
192,221
189,335
Realized gains
179,135
19,981
209,088
63,006
50,009
43,992
143,684
120,253
843,234
601,773
2,110,610
1,805,888
Annuities, life and health (c)
302,808
241,400
793,597
690,949
Other (d)
7,479
5,105
25,020
(32,030
$1,153,521
$848,278
$2,929,227
$2,464,807
13
Operating Profit (Loss)
Underwriting:
$ 769
$ 17,469
$ 43,644
$ 51,892
2,264
(2,189)
13,934
(2,657)
(4,566)
(1,363)
(6,826)
(15,373)
9,416
11,166
21,488
15,581
(4,289)
(1,120)
(4,171)
1,214
Personal (e)
(2,697)
1,083
Other lines (f)
(3,099
(657
(7,805
(44,281
495
20,609
60,264
7,459
Investment and other income (g)
232,931
34,250
374,819
185,917
233,426
54,859
435,083
193,376
Annuities, life and health
71,818
34,230
123,638
62,851
(72,660
(17,215
(115,199
(97,352
$ 232,584
$ 71,874
$ 443,522
$ 158,875
(a) Revenues include sales of products and services as well as other income
earned by the respective segments.
(b) There is no earned premium for the Personal group in 2004 due to the sale of Infinity and the direct auto business during 2003, and the transfer, beginning in 2004, of the remaining former Personal business to Specialty transportation (2004 premium of $6 million and $19 million) and Other lines (2004 premium of $3 million and $12 million).
(c) Includes realized gains (losses) of $44 million and $2 million for the 2004 and 2003
quarters, and $51 million and ($8 million) for the nine months. Excluding realized
gains (losses), investment income comprises approximately 53% of these revenues and
premiums represent about 35%.
(d) Operating profit (loss) for 2004 includes a third quarter pretax charge of
$52 million resulting from the settlement of litigation. Revenues and operating
profit (loss) for 2003 include the first quarter loss on the public offering of
Infinity. Operating profit (loss) includes holding company expenses.
(e) There is no underwriting profit for the Personal group in 2004 due to the sale of Infinity and the direct auto business during 2003, and the transfer, beginning in 2004, of the remaining former Personal business to Specialty transportation (2004 profit of $2 million and $3 million) and Other lines (2004 loss of $2 million and $1 million).
(f) Represents development of lines in "run-off" and includes a 2003 second
quarter pretax charge of $43.8 million for an arbitration decision relating
to a 1995 property claim from a discontinued business; AFG has ceased
underwriting new business in these operations.
(g) Includes a third quarter 2003 pretax charge of $35.5 million related to the
settlement of litigation.
14
manager for, three CDOs. The investments are primarily lowest tier securities (considered equity), credited with residual income of the CDO after it pays stated rates of interest on senior levels of securities. AFG is also paid management fees based on a percentage of the investments managed. Under FIN 46, AFG has been determined to be the "primary beneficiary" of one CDO and began consolidating it as of December 31, 2003. The two other CDOs (formed in 2000 and 2004) are not required to be consolidated and are included in fixed maturities. The following summarizes AFG's experience with the CDOs since inception (in millions):
Cons.
CDO
CDOs
Initial investment in CDOs
$ 21
$ 33
$ 54
Income earned on investments in CDOs
16
24
Distributions from CDOs
(12)
(31)
(43)
Impairment charges recorded before
consolidation under FIN 46
(14
Carrying values at September 30, 2004
$ 11
$ 10
Assets in CDOs at September 30, 2004
$393
$835
$1,228
Management fees earned
$ 7
$ 14
Upon formation in 1999, the consolidated CDO issued securities in various senior and subordinate classes and the proceeds were invested in primarily floating rate, secured bank loans, and to a lesser extent, high yield bonds, all of which serve as collateral for the securities issued by the CDO. None of the collateral was purchased from AFG. Income from the CDO's investments is used to service its debt and pay other operating expenses, including management fees to AFG. AFG's investment in this CDO is subordinate to the senior classes (approximately 92% of the total securities) issued by the CDO. To the extent there are defaults and unrecoverable losses on the underlying collateral resulting in reduced cash flows, AFG's class would bear losses first.
The assets (substantially all investments carried at market as "trading securities") of this managed investment entity are separately disclosed in the Balance Sheet because they are not available for use to satisfy AFG obligations. Likewise, the CDO liabilities (substantially all debt) are separately disclosed because they represent claims against only the CDO's assets and not against AFG's other assets. Accordingly, AFG's exposure to loss on this investment is limited to its investment (carrying value of $11.5 million at September 30, 2004).
Beginning in 2004, the operating results of the CDO are included in AFG's Statement of Earnings. However, due to the non-recourse nature of the instruments issued by the CDO, any excess losses included in AFG's results that are not absorbed by AFG's investment over the life of the CDO will ultimately reverse when the CDO is liquidated. Accordingly, while implementation of FIN 46 impacts the timing of income recognition, it does not impact the overall amount of income recognized over the life of this investment.
15
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$296,790
$301,501
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
75,100
8,248
8,160
$684,995
$574,618
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
26,624
27,063
APU 10-7/8% Subordinated Notes due May 2011
10,317
11,433
10,243
11,248
$345,934
$262,244
At September 30, 2004, sinking fund and other scheduled principal payments on debt for the balance of 2004 and the subsequent five years were as follows (in millions):
Holding
Company
$ -
$ 0.5
2005
11.4
2006
19.4
2007
80.4
.1
80.5
2008
100.1
2009
298.0
298.1
In the first quarter of 2004, AFG issued $115 million principal amount of 7-1/8% senior debentures due 2034 and GAFRI issued $86.3 million principal amount of7-1/4% senior debentures due 2034. Proceeds from both offerings were used primarily to redeem at face value a portion of their outstanding trust preferred securities.
GAFRI has entered into interest rate swaps which effectively convert its 6-7/8% 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 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 significantly lowered, or, (iii) if AFG calls the notes for redemption.
AFG has commitments from banks to replace its current credit agreement with a $300 million, four-year credit facility that is expected to be completed in November 2004. Amounts borrowed will bear interest at rates ranging from 1% to 2% over LIBOR based on AFG's credit rating. Under its current credit agreement, AFG may borrow up to $280 million through November 2005. In August 2004, GAFRI replaced its existing line of credit with a credit agreement under which it can borrow up to $150 million through August 2008 at interest rates ranging from 1% to 2% over LIBOR based on GAFRI's credit rating.
In accordance with FIN 46, variable interest entities that issued preferred securities subsequent to January 31, 2003, are not consolidated for reporting purposes. Beginning December 31, 2003, previously consolidated subsidiary trusts were deconsolidated for reporting purposes under FIN 46. Accordingly, the subordinated debt due the trusts is shown as a liability in AFG's Balance Sheet. The preferred securities supported by the payable to subsidiary trusts consisted of the following (in thousands):
Date of
Amount Outstanding
Optional
Issuance
Issue (Maturity Date)
9/30/04
12/31/03
Redemption Dates
October 1996
AFG 9-1/8% TOPrS (2026)
$95,459
Redeemed March 2004
November 1996
GAFRI 9-1/4% TOPrS (2026)
65,013
March 1997
GAFRI 8-7/8% Pfd (2027)
42,800
70,000
On or after 3/1/2007
May 2003
GAFRI 7.35% Pfd (2033)
20,000
On or after 5/15/2008
Variable Rate Pfd (2033)
15,000
On or after 5/23/2008
In 2003, a GAFRI subsidiary and a 68%-owned subsidiary of GAI issued an aggregate of $35 million in trust preferred securities maturing in 2033.
The AFG 9-1/8% trust preferred securities and the GAFRI 9-1/4% trust preferred securities were redeemed at face value in March 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
$203,363
$180,937
Managed investment entity
6,650
6,622
$210,013
$187,559
17
Minority Interest Expense
Interest of noncontrolling investors in earnings of:
$21,471
$12,025
1,180
Accrued distributions by consolidated
subsidiaries on preferred securities:
Trust issued securities, net of tax
10,783
AFC preferred stock
4,329
$22,651
$27,137
AFG is authorized to issue 12.5 million shares of Voting Preferred Stock and 12.5 million shares of Nonvoting Preferred Stock, each without par value.
The Senior Convertible Notes due in 2033 could be converted under certain conditions into 5.9 million shares of AFG Common Stock.
Stock Options
Included in equity in net earnings of investees for the third quarter and first nine months of 2003 was $3.8 million and $8.3 million, respectively, representing AFG's equity in net earnings from Infinity after the date of the initial sale of 61% of Infinity in mid-February 2003.
18
In November 2004, American Premier reached an agreement on the allocation of environmental clean-up costs at its former railroad site in Paoli, Pennsylvania. Based on the settlement, American Premier increased its liabilities for environmental exposures by $52 million. Because the settlement was reached prior to issuance of the third quarter financial statements, the charge (included in "Other operating and general expenses") was recorded as of September 30, 2004. Although American Premier has been advised by counsel that it should be able to recover a significant amount of these costs from a financially viable third party, no recovery asset has been recorded for its Paoli Yard costs. American Premier's liabilities for environmental and personal injury claims aggregated $109 million and $75 million at September 30, 2004, and December 31, 2003, respectively.
19
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
20
Results of Operations
28
Overview
General
Critical Accounting Policies
21
Income Items
Liquidity and Capital Resources
Expense Items
32
Ratios
Other Items
33
Sources of Funds
22
Proposed Accounting Standards
34
23
Uncertainties
25
_____________________________________________________________________________________________________
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.
In the first quarter of 2004, AFG and GAFRI issued just over $200 million in senior debentures and used approximately $189 million of the proceeds to retire higher coupon debt due unconsolidated subsidiary trusts that, in turn, retired preferred securities.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance and in the sale of retirement annuities and supplemental insurance and life products. With the sale of Infinity in 2003, AFG narrowed the focus of its property and casualty business to its specialized commercial products for businesses.
AFG's net earnings for the 2004 third quarter were $138.2 million or $1.85 per share (diluted), significantly above the $41.6 million or $.59 per share reported for the third quarter of last year. The increase is due primarily to a $134.4 million realized gain (net of tax and minority interest) on the sale of AFG's investment in Provident Financial Group, partially offset by losses associated with hurricanes in the Southeastern U.S. in the third quarter of 2004 and higher litigation settlement costs.
Net earnings for the first nine months of 2004 were $267.3 million or $3.58 per share (diluted), compared to $97.2 million or $1.39 per share recorded in the comparable period in 2003. In addition to the items affecting the third quarter (discussed above), this improvement reflects a second quarter 2003 charge for an arbitration settlement in the property and casualty group and a charge in the same quarter related to lower interest rates in the fixed annuity business.
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, and the determination of "other than temporary" impairment on investments are the two areas where the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical. For further discussion of these policies, see "Liquidity and Capital Resources - Investments" and "Liquidity and Capital Resources - Uncertainties."
LIQUIDITY AND CAPITAL RESOURCES
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.47 (1.74 excluding the Provident gain) for the nine months ended September 30, 2004, and 1.69 for the entire year of 2003. Excluding annuity benefits, this ratio was 7.11 (4.08 excluding the Provident gain) and 3.71, respectively. Although the ratio excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
Parent Holding Company Liquidity
AFG has commitments from banks to replace its existing credit line with a $300 million, four-year credit facility that is expected to be completed in November 2004. Amounts borrowed will bear interest at rates ranging from 1% to 2% over LIBOR based on AFG's credit rating. This credit agreement will provide ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent company. Under its current credit agreement, AFG may borrow up to $280 million through November 2005.
Subsidiary Liquidity
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In GAFRI's annuity business, however, 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 due to the ability to lower crediting rates, subject to guaranteed minimums.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies.
Approximately 94% of the fixed maturities held by AFG at September 30, 2004, 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 September 30, 2004, is shown in the following table (dollars in millions). Approximately $179 million of available-for-sale "Fixed maturities" and $19 million of "Other stocks" had no unrealized gains or losses at September 30, 2004.
With
Gains
Losses
Available-for-sale Fixed Maturities
Market value of securities
$10,072
$2,937
Amortized cost of securities
$ 9,624
$2,983
Gross unrealized gain (loss)
$ 448
($ 46)
Market value as % of amortized cost
105%
98%
Number of security positions
1,842
283
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
$ 69.1
($ 0.4)
Gas and electric services
60.2
(2.3)
Mortgage-backed securities
47.4
(25.6)
Insurance and related services
33.1
(2.1)
State and municipal
26.0
(1.2)
U.S. government and government agencies
21.2
(5.5)
Percentage rated investment grade
93%
96%
Other Stocks
$ 573
$ 62
Cost of securities
$ 489
$ 66
$ 84
($ 4)
Market value as % of cost
117%
94%
The table below sets forth the scheduled maturities of AFG's available-for-sale fixed maturity securities at September 30, 2004, 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%
1%
After one year through five years
After five years through ten years
38
After ten years
40
60
100
AFG realized aggregate losses of $2.1 million during the first nine months of 2004 on $14.6 million in sales of fixed maturity securities (2 issues/issuers) that had individual unrealized losses greater than $500,000 at December 31, 2003. Market values of both of the issues increased an aggregate of $1.7 million from December 31 to date of sale.
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 September 30, 2004
Securities with unrealized gains:
Exceeding $500,000 (268 issues)
$ 3,258
$257
108.6%
Less than $500,000 (1,574 issues)
6,814
191
102.9
$448
104.7%
Securities with unrealized losses:
Exceeding $500,000 (28 issues)
$ 840
($ 21)
97.6%
Less than $500,000 (255 issues)
2,097
(25
98.8
$ 2,937
98.5%
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 September 30, 2004
Investment grade with losses for:
One year or less (204 issues)
$2,174
($23)
99.0%
Greater than one year (47 issues)
642
(18
97.3%
$2,816
($41)
98.6%
Non-investment grade with losses for:
One year or less (19 issues)
$ 86
95.6%
Greater than one year (13 issues)
35
(1
97.2%
$ 121
($ 5)
96.0%
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 2003 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.
Property and Casualty Insurance Reserves
and other factors, management, including company actuaries, determines a single or "point" estimate which it records as its best estimate of the liabilities. Recorded amounts are analyzed and tested on a quarterly basis by company actuaries. Ranges of loss reserves are not developed by company actuaries.
Estimating the liability for unpaid losses and LAE is inherently judgmental and is influenced by factors which are subject to significant variation. Through the use of analytical reserve development techniques, management utilizes items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, general economic trends and the legal environment.
While current factors and reasonably likely changes in variable factors are considered in estimating the liability for unpaid losses, there is no method or system which can eliminate the risk of actual ultimate results differing from such estimates. As shown in the reserve development table (loss triangle) on page 11 of AFG's 2003 Form 10-K, the original estimates of AFG's liability for losses and loss adjustment expenses, net of reinsurance, over the past 10 years have developed through December 31, 2003, to be deficient (for three years) by as much as 10.4% and redundant (for 7 years) by as much as 7.2% (excluding the effect of special charges for asbestos and environmental exposures). The average of such redundancies and deficiencies has been slightly (less than 1%) redundant. Management believes this development illustrates the variability in factors considered in estimating its insurance reserves.
Quarterly reviews of unpaid loss and LAE reserves are prepared using standard actuarial techniques. These may include (but may not be limited to):
Supplementary statistical information is reviewed to determine which methods are most appropriate to use or if adjustments are needed to particular methods. Such information includes:
Within each line, AFG's actuaries review the results of individual tests, supplementary statistical information, and input from underwriting, operating and claim management, to select their point estimate of the ultimate liability. This estimate may be one test, or a weighted average of several tests, or a judgmental selection as the actuaries determine is appropriate. The actuarial review is performed each quarter as a test of the reasonableness of management's point estimate.
The level of detail in which data is analyzed varies among the different lines of business. Data is generally analyzed by major product or by coverage within product, using countrywide data; however, in some situations, data may be reviewed by state for a few large volume states. Appropriate segmentation of the data is determined based on data volume, data credibility, mix of business, and other actuarial considerations. Overall, AFG's actuaries review over 500 identified line components. Best estimates are selected based on test indications and judgment.
26
Asbestos and Environmental-related ("A&E") Reserves
Emerging trends, such as those named below, could impact AFG's reserves and payments:
While management believes that AFG's reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims and the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, whether claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims. Based on A&E reserves at December 31, 2003, a 1% variation in loss costs trends, caused by any of the factors previously described, would change net income by approximately $11 million.
From time to time, AFG has engaged independent firms to study the 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 this type of study every three or four years. Accordingly, absent legislative reforms eliminating the need for an independent review, management plans to conduct such a routine study within the next twelve months.
27
In February 2003, Great American Insurance Company entered into an agreement for the settlement of asbestos related coverage litigation under insurance polices issued during the 1970's and 1980's to Bigelow-Liptak Corporation and related companies, subsequently known as A.P. Green Industries, Inc. ("A.P. Green"). Management believes that this settlement will enhance financial certainty and provides resolution to litigation that represents AFG's largest known asbestos-related claim and the only such claim that management believes to be material.
The settlement is for $123.5 million (Great American has the option to pay in cash or over time with 5.25% interest), all of which is covered by reserves established prior to 2003 and anticipated reinsurance recoverables for this matter. The agreement allows up to 10% of the settlement to be paid in AFG Common Stock.
The settlement has received the approval of the bankruptcy court supervising the reorganization of A.P. Green. It remains subject to the confirmation by the bankruptcy court of a plan of reorganization that includes an injunction prohibiting the assertion against Great American of any present or future asbestos personal injury claims under policies issued to A.P. Green and related companies. Because no plan of reorganization has been filed, the earliest time for confirmation would be during the first quarter of 2005. No assurance can be made that a plan of reorganization will be confirmed; no payments are required until completion of the process. If there is no plan confirmation, the outcome of this litigation will again be subject to the complexities and uncertainties associated with a Chapter 11 proceeding and asbestos coverage litigation.
RESULTS OF OPERATIONS
Operating earnings before income taxes increased $161 million in the third quarter of 2004 compared to the same period in 2003. The improvement is due primarily to a $214 million pretax realized gain on Provident Financial Group securities. This item was partially offset by pretax losses of $35 million in the property and casualty operations associated with the four hurricanes that affected the Southeastern U.S. in the third quarter of 2004 and charges resulting from litigation of $52 million in the third quarter of 2004 compared to $35.5 million in the same 2003 period.
Nine-month pretax operating earnings improved $285 million compared to 2003. The increase reflects the items mentioned above as well as, (i) a $44 million improvement in property and casualty underwriting results (excluding the hurricane losses and the arbitration charge), (ii) a $44 million charge in the second quarter of 2003 for an arbitration decision relating to a 1995 property claim, and (iii) a $12.5 million charge in the 2003 second quarter related to the negative effect of lower interest rates on the fixed annuity business.
Property and Casualty Insurance - Underwriting
Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their financial statements better understand the company's performance. See Note C - "Segments of Operations" for the detail of AFG's operating profit by significant business segment.
Underwriting profitability is measured by the combined ratio which is a sum of the ratios of underwriting losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. 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:
$ 527.7
$ 444.1
$1,105.8
$ 923.3
364.8
371.7
1,116.4
1,065.4
114.7
115.7
342.5
277.4
97.3
73.7
283.7
211.8
1.7
.8
.2
1.1
Total Specialty
$1,106.2
$1,006.0
$2,848.6
$2,479.0
Net Written Premiums (GAAP)
$ 172.4
$ 146.7
$ 525.3
$ 399.3
189.4
181.3
581.5
519.3
91.5
100.6
277.5
228.3
87.4
68.8
252.0
198.1
19.8
26.3
50.2
67.9
$ 560.5
$ 523.7
$1,686.5
$1,412.9
Combined Ratios (GAAP)
99.5%(b)
86.1%
90.0%(b)
85.0%
98.7
101.3
97.4
100.7
105.2 (c)
101.7
102.5 (c)
107.7
89.7
84.0
91.8
122.0
104.9
107.3
98.1
99.4%
94.8%
96.1%
(a) AFG's aggregate combined ratio, including the former Personal group and other (primarily discontinued) lines was 99.9%, 95.7%, 96.2% and 99.5% in the four periods. The aggregate ratio for the nine months of 2003 includes 3.1 points for the effect of a $43.8 million second quarter charge for an arbitration decision relating to a claim arising from a discontinued business.
(b) For the 2004 three and nine month periods, includes 16.6 points and 6.3 points for the effect of hurricane losses.
(c) For the 2004 three and nine month periods, includes 2.9 points and 0.9 points for the effect of hurricane losses.
29
The Specialty group reported an underwriting profit of $3.6 million and $68.1 million for the third quarter and first nine months of 2004, including $35 million in third quarter hurricane losses. The combined ratios for these periods included 6.4 points and 2.3 points, respectively, for the effect of Southeastern U.S. hurricane losses. Excluding the effect of these losses, the combined ratios for the respective periods improved 1.8 points and 2.8 points over the comparable 2003 periods.
Property and transportation gross written premiums increased about 20% during the third quarter and first nine months of 2004 reflecting primarily volume increases in the crop, equine, truck, bus and recreational vehicle products, and to a lesser extent, rate increases. The majority of the growth in third quarter gross written premiums represents crop business that is subject to a 95% quota share reinsurance agreement. Net written premiums increased 17% for the third quarter and 32% for the nine months reflecting the items above, plus an overall reduction in reinsurance ceded. The combined ratios for these periods included 16.6 points and 6.3 points for the effect of the hurricane losses. Excluding the hurricane losses, the combined ratios for the respective periods improved 3.2 points and 1.3 points over the 2003 periods.
Specialty casualty net written premiums increased 5% in the third quarter and 12% for the first nine months compared to the same periods in 2003 while gross written premiums were relatively flat. The increase for the quarter is primarily a result of a decrease in reinsurance ceded and rate increases while the nine month increase also reflects the return of premium as a result of the cancellation of certain reinsurance agreements. Although both 2004 and 2003 contain significant amounts of adverse prior year development, the overall combined ratio improved 2.6 points for the quarter and 3.3 points for the nine months compared to 2003 due to less prior year development and rate increases.
Specialty financial gross written premiums for the third quarter were comparable to the 2003 period, but increased 23% for the nine months due to substantial volume growth in collateral protection products for financial institutions. The combined ratios for these periods included 2.9 points and 0.9 points for the effect of hurricane losses. Excluding the hurricane losses, the combined ratio for the nine months improved 6.1 points over the 2003 period due to the growth in the more profitable collateral protection products mentioned above.
California workers' compensation net written premiums grew 27% for both the third quarter and first nine months of 2004 reflecting an increase in volume and modest rate increases. The combined ratios for 2003 include 14.3 points in the third quarter (5.2 points for the nine months) related to the favorable impact of then newly enacted California workers' compensation legislation.
30
Investment Income
Realized Gains
Gains (Losses) on Securities
Realized gains (losses) on securities include provisions for other than temporary impairment of securities still held as follows: third quarter of 2004 and 2003 - $5.1 million and $5.0 million; nine months of 2004 and 2003 - $13.2 million and $55.5 million, respectively. Impairment charges in 2003 reflect primarily the downturn in the airline industry and writedowns of certain asset-backed securities.
Gains (Losses) on Sales of Subsidiaries
Real Estate Operations
$34.6
$32.3
$80.4
$74.7
24.3
21.0
60.5
55.8
.5
1.5
1.8
Minority interest expense, net
1.3
1.6
2.2
Other income includes net pretax gains on the sale of real estate assets of $3.9 million in the third quarter and $10.4 million for the first nine months of 2004 compared to $4.7 million and $9.4 million for the 2003 periods.
Other Income
31
Annuity Benefits
On its deferred annuities (annuities in the accumulation phase), GAFRI generally credits interest to policyholders' accounts at their current stated interest rates. Furthermore, for "two-tier" deferred annuities (annuities under which a higher interest amount can be earned if a policy is annuitized rather than surrendered), GAFRI accrues an additional liability to provide for expected deaths and annuitizations. Changes in crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect this accrual.
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 half of the annuity benefits accumulated relate to policies that have a minimum guarantee of 3%; the majority of the balance has a guarantee of 4%. In the fourth quarter of 2003, GAFRI began issuing products with guaranteed minimum crediting rates of less than 3% in states where required approvals have been received.
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 on Borrowed Money
Interest on Subsidiary Trust Obligations
Other Operating and General Expenses
Investee Corporations
Start-up Manufacturing Business
Cumulative Effect of Accounting Change
In July 2004, AFG recorded a $3.8 million after-tax charge resulting from implementation of EITF 03-16, "Accounting for Investments in Limited Liability Companies." This charge reflects the cumulative effect of changing from the cost method to the equity method of accounting for AFG's investment in a limited liability company. This charge reduced AFG's investment in this entity to zero. Management believes the fair value of this investment substantially exceeds its carrying value prior to the writedown.
Equity Compensation
Convertible Notes
______________________________________________________
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
Debt Securities
As of September 30, 2004, there were no other material changes to the information provided in AFG's Form 10-K for 2003 under the caption "Exposure to Market Risk" in Management's Discussion and Analysis of Financial Condition and Results of Operations.
ITEM 4
Controls and Procedures
AFG's management, with participation of its Chief Executive Officer and Chief 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 CEO and CFO concluded that the controls and procedures are effective. There have been no significant changes in AFG's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
PART II
OTHER INFORMATION
Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Under AFG's shareholder-approved Stock Option Plan, 427,795 shares of AFG Common Stock were tendered by employees to exercise stock options for a total of 561,272 shares in the third quarter of 2004 (423,437 @ $30.64 in July; 4,358 @ $26.44 in September).
_________________________________________________
ITEM 5
Other Information
In October 2004, the New York State Attorney General brought suit against Marsh & McClennan Companies, Inc. alleging, among other things, that the firm had manipulated the insurance market through specified conduct, including bid rigging and price fixing. The New York State Attorney General also stated that the evidence implicates certain insurance companies. As a result, the insurance departments and attorneys general of a number of states, including Ohio, have announced investigations and have begun to issue subpoenas and/or information requests to many insurance companies domiciled or licensed to do business in such states. While we are not a party to any of the litigation, we, along with other companies in our industry, will be (or have been) asked to provide information to the insurance departments in a number of states where we do business.
We have reviewed the allegations contained in the complaint against Marsh and have begun an internal review of our business arrangements with insurance producers. While our internal investigation will be ongoing, at this time we have found no evidence of the conduct that is the subject of the complaint. The Company cannot estimate the scope or breadth of the issues that may be investigated, their results, or timeframe in which the reviews might be completed. The Company also cannot predict the impact, if any, that these matters may have on its business or the property and casualty insurance industry generally.
ITEM 6
Exhibits
Number
Exhibit Description
Computation of ratios of earnings to fixed charges.
Certification of the Chief Executive Officer pursuant to
section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to
Certification of the Chief Executive Officer 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.
November 8, 2004
BY: s/Fred J. Runk
Fred J. Runk
Senior Vice President and Treasurer
36