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, 2003
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, 2003, there were 69,700,572 shares of the Registrant's Common Stock outstanding, excluding 18,666,614 shares owned by subsidiaries.
TABLE OF CONTENTS
Page
Exhibit Index
Section 302(a) of the Sarbanes-Oxley Act of 2002
Chief Financial Officer Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
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,
2003
2002
Assets:
Cash and short-term investments
$ 801,668
$ 871,103
Investments:
Fixed maturities - at market
(amortized cost - $11,717,287 and $11,549,710)
12,209,187
12,006,910
Other stocks - at market
(cost - $245,279 and $174,645)
402,779
300,445
Investment in investee corporations
169,996
-
Policy loans
215,349
214,852
Real estate and other investments
264,649
257,731
Total investments
13,261,960
12,779,938
Recoverables from reinsurers and prepaid
reinsurance premiums
3,003,316
2,866,780
Agents' balances and premiums receivable
571,680
708,327
Deferred acquisition costs
850,906
842,070
Other receivables
383,698
307,008
Variable annuity assets (separate accounts)
509,036
455,142
Prepaid expenses, deferred charges and other assets
312,368
425,775
Goodwill
169,331
248,683
$19,863,963
$19,504,826
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 4,793,333
$ 5,203,831
Unearned premiums
1,670,324
1,847,924
Annuity benefits accumulated
6,866,953
6,453,881
Life, accident and health reserves
964,925
902,393
Payable to reinsurers
404,760
508,718
Long-term debt:
Holding companies
586,171
648,410
Subsidiaries
229,277
296,771
Variable annuity liabilities (separate accounts)
Amounts due brokers for securities purchased
505,192
23,616
Accounts payable, accrued expenses and other
liabilities
999,009
967,268
Total liabilities
17,528,980
17,307,954
Minority interest
498,778
471,024
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 69,688,005 and 69,129,352 shares outstanding
69,688
69,129
Capital surplus
931,049
923,042
Retained earnings
480,968
409,777
Unrealized gain on marketable securities, net
354,500
323,900
Total shareholders' equity
1,836,205
1,725,848
2
CONSOLIDATED STATEMENT OF EARNINGS
(In Thousands, Except Per Share Data)
Three months ended
Nine months ended
Income:
Property and casualty insurance
premiums
$478,009
$605,012
$1,433,294
$1,827,855
Life, accident and health premiums
83,887
80,972
246,615
224,616
Investment income
189,866
215,607
578,881
647,635
Realized gains (losses) on:
Securities
21,792
(23,096)
41,929
(88,530)
(10,769)
(31,682)
Other investments
9,253
Other income
75,865
66,450
200,028
177,175
849,419
943,429
2,469,065
2,787,235
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
325,014
443,625
1,014,823
1,345,575
Commissions and other underwriting
expenses
132,850
158,848
413,158
495,803
Annuity benefits
71,523
68,685
227,230
215,226
Life, accident and health benefits
62,964
69,579
185,367
184,891
Annuity and life acquisition expenses
27,457
31,112
87,026
81,124
Interest charges on borrowed money
14,613
15,647
42,595
44,486
Other operating and general expenses
142,667
104,530
338,014
293,952
777,088
892,026
2,308,213
2,661,057
Operating earnings before income taxes
72,331
51,403
160,852
126,178
Provision for income taxes
22,546
15,447
42,368
19,376
Net operating earnings
49,785
35,956
118,484
106,802
Minority interest expense, net of tax
(11,094)
(6,330)
(27,137)
(18,189)
Equity in net earnings (losses)
of investees, net of tax
2,909
(2,746
5,883
(7,833
Earnings before cumulative effect
of accounting change
41,600
26,880
97,230
80,780
Cumulative effect of accounting change
(40,360
Net Earnings
$ 41,600
$ 26,880
$ 97,230
$ 40,420
Basic earnings per Common Share:
Before accounting change
$.60
$.39
$1.40
$1.18
(.59
Net earnings available to Common Shares
$.59
Diluted earnings per Common Share:
$1.39
$1.17
$.58
Average number of Common Shares:
Basic
69,651
68,873
69,507
68,717
Diluted
70,019
69,155
69,785
69,177
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, 2003
69,129,352
$ 992,171
$409,777
$323,900
$1,725,848
Net earnings
Change in unrealized
30,600
Comprehensive income
127,830
Dividends on Common Stock
(26,039)
Shares issued:
Exercise of stock options
14,400
303
Dividend reinvestment plan
159,429
3,284
Employee stock purchase plan
32,577
701
Retirement plan contributions
345,434
6,925
Deferred compensation distributions
3,300
71
Directors fees paid in stock
3,517
76
Shares acquired and retired
(4)
Other
(2,794
Balance at September 30, 2003
69,688,005
$1,000,737
$480,968
$354,500
$1,836,205
Balance at January 1, 2002
68,491,610
$ 979,566
$359,513
$159,300
$1,498,379
40,420
161,600
202,020
(25,744)
26,537
608
201,051
4,410
33,699
858
216,740
5,599
2,875
72
1,809
45
(789)
(11)
(9)
(20)
Tax effect of intercompany dividends
(2,400)
244
Balance at September 30, 2002
68,973,532
$ 988,991
$374,180
$320,900
$1,684,071
4
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)
Operating Activities:
Adjustments:
40,360
Equity in net (earnings) losses of investees
(5,883)
7,833
12,025
3,149
Depreciation and amortization
135,023
132,007
Realized (gains) losses on investing activities
(19,672)
82,206
Deferred annuity and life policy acquisition costs
(118,765)
(121,160)
Increase in reinsurance and other receivables
(404,718)
(514,206)
Decrease (increase) in other assets
30,155
(56,465)
Increase in insurance claims and reserves
620,421
561,134
Increase (decrease) in payable to reinsurers
(25,156)
168,987
Increase in other liabilities
56,818
100,615
Dividends from investees
864
Other, net
8,909
1,280
614,481
661,386
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(5,901,447)
(3,718,410)
Equity securities
(113,409)
(9,217)
Subsidiary
(48,500)
Real estate, property and equipment
(22,994)
(37,870)
Maturities and redemptions of fixed maturity
investments
1,428,014
1,256,037
Sales of:
3,615,671
2,057,781
36,464
20,144
247,380
14,236
12,731
Cash and short-term investments of acquired
(former) subsidiaries, net
(112,666)
4,392
Collection of receivable from investee
55,000
Decrease in other investments
531
26,432
(753,220
(436,480
Financing Activities
Fixed annuity receipts
592,806
599,174
Annuity surrenders, benefits and withdrawals
(417,590)
(410,561)
Net transfers from variable annuity assets
4,061
12,318
Additional long-term borrowings
228,715
79,000
Reductions of long-term debt
(363,405)
(145,655)
Issuances of trust preferred securities
33,943
Issuances of Common Stock
881
1,317
Subsidiary's issuance of stock in rights offering
10,632
Cash dividends paid
(22,755)
(21,374)
2,016
(96
69,304
114,123
Net Increase (Decrease) in Cash and Short-term Investments
(69,435)
339,029
Cash and short-term investments at beginning
of period
871,103
544,173
Cash and short-term investments at end of period
$ 883,202
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
Accounting Policies
F.
Long-Term Debt
B.
Acquisitions and Sales of Subsidiaries
G.
Minority Interest
C.
Segments of Operations
H.
Shareholders' Equity
D.
Investment in Investees
I.
Commitments and Contingencies
E.
J.
Subsequent Events
________________________________________________________________________________
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.
Proposed Merger with AFC
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.
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Derivatives
Investment in Investee Corporations
Insurance
Reinsurance
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.
7
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.
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
Premium Recognition
8
from policyholders. For interest-sensitive life and universal life products, premiums are recorded in a policyholder account which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses.
Policyholder Dividends
Under current guidance provided by Financial Accounting Standards Board Interpretation No. 46 ("FIN 46"), AFG believes it will be required to deconsolidate three wholly-owned subsidiary trusts because they are "variable interest entities" ("VIEs") in which AFG is not considered to be the primary beneficiary. These subsidiary trusts were formed to issue preferred securities and, in turn, purchase a like amount of subordinated debt from their parent company which provides interest and principal payments to fund the respective trust obligations. Accordingly, the subordinated debt due the trusts would be shown as a liability in the Balance Sheet and the related interest expense would be shown in the Statement of Earnings as interest on subsidiary trust obligations. The FASB has deferred implementation of FIN 46 for VIEs created before February 1, 2003, until periods ending after December 15, 2003. See Note G - "Minority Interest."
Income Taxes
Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized.
Stock-Based Compensation
9
shares at the dates of grant. No compensation expense is recognized for stock option grants.
The following table illustrates the effect on net earnings (in thousands) and earnings per share had compensation cost been recognized and determined based on "fair values" at grant dates consistent with the method prescribed by SFAS No. 123. For SFAS No. 123 purposes, the "fair value" of $5.62 per option granted in 2003 and $8.52 in 2002 was calculated using the Black-Scholes option pricing model and the following assumptions: dividend yield of 2%; expected volatility of 30%; risk-free interest rate of 3.6% for 2003 and 4.9% for 2002; and expected option life of 7.4 years. 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
$41,600
$26,880
$97,230
$40,420
Pro forma stock option expense,
net of tax
(1,619
(1,868
(4,744
(4,114
Adjusted net earnings
$39,981
$25,012
$92,486
$36,306
Earnings per share (as reported):
$0.60
$0.39
$0.59
$0.58
Earnings per share (adjusted):
$0.57
$0.36
$1.33
$0.53
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
10
Statement of Cash Flows
Fidelity Excess and Surplus Insurance Company
Direct automobile insurance business
Infinity Property and Casualty Corporation
New Jersey private passenger automobile insurance business
Manhattan National Life Insurance
11
The following table (in thousands) shows AFG's revenues and operating profit (loss) by significant business segment. Operating profit (loss) represents total revenues less operating expenses.
Revenues (a)
Premiums earned:
Specialty
$462,798
$403,738
$1,282,104
$1,130,439
Personal
15,201
201,290
151,182
697,110
Other lines
(16
306
478,009
605,012
1,433,294
1,827,855
59,619
82,380
189,055
249,139
Realized gains (losses)
19,995
(15,785)
63,868
(55,565)
45,291
32,601
123,929
81,559
602,914
704,208
1,810,146
2,102,988
Annuities, life and health (b)
241,400
225,787
690,949
650,829
Other (c)
5,105
13,434
(32,030
33,418
$849,419
$943,429
$2,469,065
$2,787,235
Operating Profit (Loss)
Underwriting:
$ 23,963
$ 4,706
$ 50,657
$ 17,377
(2,697)
(2,223)
1,083
(10,116)
Other lines (d)
(1,121
56
(46,427
(20,784
20,145
2,539
5,313
(13,523)
Investment and other income (e)
35,354
45,259
190,040
141,433
55,499
47,798
195,353
127,910
Annuities, life and health
34,047
7,387
62,851
40,476
(17,215
(3,782
(97,352
(42,208
$ 72,331
$ 51,403
$ 160,852
$ 126,178
(a) Revenues include sales of products and services as well as other
income earned by the respective segments.
(b) Investment income comprises approximately three-fifths of these revenues. Includes
impairment charges of $27.7 million and $68.7 million for the quarter and nine months
ended September 30, 2002.
(c) Other revenues and operating profit (loss) for the nine months ended September 30,
2003, include a loss of $45.9 million on the public offering of Infinity.
Operating profit (loss) includes holding company expenses.
(d) Represents development of lines in "run-off" and includes a pretax charge
of $43.8 million in the first nine months of 2003 for an arbitration
decision relating to a 1995 property claim from a discontinued business;
AFG has ceased underwriting new business in these operations.
(e) Includes a third quarter 2003 pretax charge of $35.5 million related to
the settlement of litigation. See Legal Proceedings in Item 1 of Part II.
12
Equity in Infinity's net earnings was $3.8 million for the third quarter and $8.3 million for the first nine months of 2003. Summarized financial information for Infinity is shown below for the nine months ended September 30, 2003 (in millions).
Earned premiums
$504.2
Total revenues
551.3
38.8
Equity in net earnings (losses) of investees for the first nine months of 2002 represents AFG's share of the losses from two start-up manufacturing businesses that were formerly subsidiaries. One of these businesses was sold in the fourth quarter of 2002; equity in the net loss of the remaining business was $855,000 for the third quarter and $2.4 million for the first nine months of 2003.
Substantially all of the $79.4 million decrease in goodwill during the first nine months of 2003 related to the sale of subsidiaries in AFG's Personal segment.
Included in deferred acquisition costs in AFG's Balance Sheet are $64.4 million and $66.8 million at September 30, 2003, and December 31, 2002, respectively, representing the present value of future profits ("PVFP") related to acquisitions by AFG's annuity and life business. The PVFP amounts are net of $63.5 million and $57.3 million of accumulated amortization. Amortization of the PVFP was $1.9 million in the third quarter and $6.2 million in the first nine months of 2003 and $4.9 million in the third quarter and $8.5 million in the first nine months of 2002. During each of the next five years, the PVFP is expected to decrease at a rate of approximately 13% of the balance at the beginning of each respective year.
13
Holding Companies:
AFG 7-1/8% Senior Debentures due April 2009
$301,451
$301,298
AFG 7-1/8% Senior Debentures due December 2007
75,100
79,600
AFG Senior Convertible Notes due June 2033
189,857
AFC notes payable under bank line
248,000
APU 10-7/8% Subordinated Notes due May 2011
11,449
11,498
8,314
8,014
$586,171
$648,410
GAFRI 6-7/8% Senior Notes due June 2008
$100,000
GAFRI notes payable under bank line
90,600
148,600
Notes payable secured by real estate
27,205
35,610
11,472
12,561
$229,277
$296,771
At September 30, 2003, scheduled principal payments on debt for the balance of 2003 and the subsequent five years (adjusted to reflect GAFRI's paydown of its bank line in November) were as follows (in millions):
Holding
Companies
$ -
$ .4
2004
2.0
2005
11.2
2006
19.4
2007
80.5
.1
80.6
2008
100.1
In June 2003, AFG issued Senior Convertible Notes due in 2033 at an issue price of 37.153% of the principal amount due at maturity. AFG received $189.9 million before issue costs of $4.5 million. 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. In addition, contingent cash interest will be paid if the average market price of a Note for an applicable five-day trading period equals 120% or more of the accreted value. The Notes are redeemable at AFG's option at any time on or after June 2, 2008, at prices ranging from $371.53 per Note to $1,000 per Note at maturity. Holders may require AFG to purchase all or a portion of their Notes on five year anniversaries beginning in 2008, at the accreted value. Generally, holders may convert each Note into 11.5016 shares of AFG Common Stock (i) during any quarter after September 30, 2003, if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value, (ii) if the credit rating of the Notes is significantly lowered, or (iii) if AFG calls the notes for redemption.
AFC's credit line provides up to $280 million of availability. The line consists of two facilities: a 364-day revolving facility, extendable annually, for one-third of the total line and a three-year revolving facility for the remaining two-thirds with a final maturity in November 2005. Amounts borrowed bear interest at rates ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. In addition, GAFRI has an unsecured credit agreement under which it can borrow up to $155 million at floating rates based on prime or Eurodollar rates through December 2004. See Note J - "Subsequent Events - GAFRI Debt Offering."
14
Interest of noncontrolling shareholders
in subsidiaries' common stock
$184,961
$157,207
Preferred securities issued by consolidated
subsidiary trusts
241,663
AFC preferred stock
72,154
$498,778
$471,024
Preferred Securities
The preferred securities consisted of the following at September 30, 2003 (in thousands):
Date of
Amount
Optional
Issuance
Issue (Maturity Date)
Outstanding
Redemption Dates
October 1996
AFCH 9-1/8% TOPrS (2026)
$98,750
Currently redeemable
November 1996
GAFRI 9-1/4% TOPrS (2026)
72,913
March 1997
GAFRI 8-7/8% Pfd (2027)
70,000
On or after 3/1/2007
In May 2003, a GAFRI subsidiary and a 68%-owned subsidiary of Great American Insurance issued an aggregate of $35 million in trust preferred securities maturing in 2033. In accordance with FIN 46, variable interest entities that issue preferred securities subsequent to January 31, 2003, are not consolidated for reporting purposes. The $35 million in subordinated debt due these trusts is included in "Accounts payable, accrued expenses and other liabilities".
AFC Preferred Stock
Series J,
Minority Interest Expense
in earnings of subsidiaries
$12,025
$ 3,149
Accrued distributions by consolidated
subsidiaries on preferred securities:
Trust issued securities, net of tax
10,783
10,711
4,329
$27,137
$18,189
15
The Senior Convertible Notes issued in June 2003 could be converted under certain conditions into 5.9 million shares of AFG Common Stock. See Note F - "Long-Term Debt."
Stock Options
Sale of Transport
GAFRI Debt Offering
Planned Sale of Remaining Infinity Shares
16
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
General
17
Results of Operations
23
Forward-Looking Statements
Critical Accounting Policies
18
Income Items
Liquidity and Capital Resources
Expense Items
26
Ratios
Other Items
27
Sources of Funds
Recent Accounting Standards
28
Uncertainties
21
_____________________________________________________________________________________________________
GENERAL
AFG and its subsidiaries, AFC and American Premier, are organized as holding companies with almost all of their operations being conducted by subsidiaries. These parent corporations, however, have continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, 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.
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.
of Financial Condition and Results of Operations - Continued
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 1.45 for the nine months ended September 30, 2003, and 1.37 for the entire year of 2002. Excluding annuity benefits, this ratio was 2.73 and 2.42, 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.
AFC's bank credit line consists of two facilities: a 364-day revolving facility, extendable annually, for one-third of the total line and a three-year revolving facility for the remaining two-thirds. Amounts borrowed bear interest at rates ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. This credit agreement provides ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent companies. About half of the net proceeds from the issuance of Senior Convertible Notes in June 2003 were used to repay borrowings under AFC's bank line. While the credit line provides up to $280 million of availability, there were no borrowings outstanding at September 30, 2003. Under a shelf registration, AFG has the flexibility to issue up to $600 million in additional equity or debt securities as market and other conditions permit.
Approximately 93% of the fixed maturities held by AFG at September 30, 2003, 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 is more likely to 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, 2003, is shown in the following table (dollars in millions). Approximately $138 million of "Fixed maturities" and $34 million of "Other stocks" had no unrealized gains or losses at September 30, 2003.
With
Gains
Losses
Fixed Maturities
Market value of securities
$9,494
$2,577
Amortized cost of securities
$8,934
$2,645
Gross unrealized gain (loss)
$ 560
($ 68)
Market value as % of amortized cost
106%
97%
Number of security positions
1,801
286
Number individually exceeding
$2 million gain or loss
19
Concentration of gains (losses) by
type or industry (exceeding 5% of
unrealized):
Mortgage-backed securities
$ 69.3
($ 22.3)
Electric services
53.9
(1.6)
Banks and savings institutions
48.8
(.4)
U.S. government and government agencies
35.8
(2.5)
State and municipal
34.7
(5.0)
Telephone communications
28.4
Asset-backed securities
15.7
(7.3)
Air transportation (generally collateralized)
5.5
(13.2)
Percentage rated investment grade
94%
91%
Other Stocks
$ 324
$ 45
Cost of securities
$ 163
$ 48
$ 161
($ 3)
Market value as % of cost
199%
AFG's investment in equity securities of Provident Financial Group, a Cincinnati-based commercial banking and financial services company, represents $131 million of the $161 million in unrealized gains on other stocks at September 30, 2003.
The table below sets forth the scheduled maturities of fixed maturity securities at September 30, 2003, 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
24
22
After five years through ten years
36
After ten years
44
100
AFG realized aggregate losses of $4 million during the first nine months of 2003 on $36.1 million in sales of fixed maturity securities (7 issues/issuers) that had individual unrealized losses greater than $500,000 at December 31, 2002. Market values of five of the issues increased an aggregate of $4.7 million from December 31 to date of sale. The market value of the remaining two securities decreased $316,000 from December 31 to the sale date.
Although AFG had the ability to continue holding these investments, its intent to hold them changed due primarily to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular credit or industry, or to modify asset allocation within the portfolio.
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Market
Aggregate
Value as
% of Cost
Value
Gain (Loss)
Basis
Fixed Maturities at September 30, 2003
Securities with unrealized gains:
Exceeding $500,000 (372 issues)
$4,490
$378
109.2%
Less than $500,000 (1,429 issues)
5,004
182
103.8
$560
106.3%
Securities with unrealized losses:
Exceeding $500,000 (40 issues)
$ 772
($ 45)
94.5%
Less than $500,000 (246 issues)
1,805
(23
98.7
97.4%
20
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, 2003
Investment grade with losses for:
Less than 6 months (169 issues)
$2,156
($27)
98.8%
7 to 12 months (25 issues)
130
(7)
94.9
Greater than 12 months (20 issues)
66
(7
90.4
$2,352
($41)
98.3%
Non-investment grade with losses for:
Less than 6 months (20 issues)
$ 55
($ 1)
98.2%
7 to 12 months (9 issues)
( 1)
96.0
Greater than 12 months (43 issues)
146
( 25)
85.4
$ 225
89.3%
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 2002 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, AFG actuaries determine a single or "point" estimate which management utilizes in recording its best estimate of the liabilities. Ranges of loss reserves are not developed by AFG 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 13 of AFG's 2002 Form 10-K, the original estimates of AFG's liability for losses and loss adjustment expenses, net of reinsurance, over the past 10 years has developed through December 31, 2002, to be deficient (for two years) by as much as 4.3% and redundant (for 8 years) by as much as 8.0% (excluding the effect of special charges for asbestos and environmental exposures). AFG 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: Case Incurred Development Method; Paid Development Method; Bornhuetter-Ferguson Method; and Incremental Paid LAE to Paid Loss Methods. Generally, data is segmented by major product or coverage within product using countrywide data; however, in some situations data may be reviewed by state for large volume states.
Asbestos and Environmental-related ("A&E") Reserves
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.
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 of a plan of reorganization by the bankruptcy court 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. This process should be completed in 2004. 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 $20.9 million in the third quarter of 2003 compared to the same period in 2002 due primarily to a $46.4 million improvement in realized gains and $17.6 million improvement in property and casualty underwriting results, which more than offset a third quarter $35.5 million pretax charge related to a litigation settlement and a $25.7 million decrease in investment income due primarily to the sale of Infinity and lower yields on fixed maturity securities.
Nine-month pretax operating earnings improved $34.7 million compared to 2002 reflecting a $100.3 million increase in realized gains and $62.6 million increase in property and casualty underwriting results (excluding a second quarter arbitration charge), which more than offset the third quarter litigation settlement charge, a second quarter $43.8 million arbitration charge relating to a 1995 property claim, a $68.8 million decrease in investment income and a second quarter $12.5 million charge related to the narrowing of spreads on fixed annuities.
Property and Casualty Insurance - Underwriting
The Specialty group includes a highly diversified group of business lines. Some of the more significant areas are inland and ocean marine, California workers' compensation, agricultural-related coverages, executive and professional
liability, fidelity and surety bonds, collateral protection, and umbrella and excess coverages.
The Personal group wrote nonstandard and preferred/standard private passenger auto insurance and, to a lesser extent, homeowners' insurance. Nonstandard automobile insurance covers risk not typically accepted for standard automobile coverage because of an applicant's driving record, type of vehicle, age or other criteria.
Performance measures such as segment 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 property and casualty insurance subsidiaries were as follows (dollars in millions):
Gross Written Premiums (GAAP)
$1,006.0
$ 839.5
$2,479.0
$2,050.8
Personal (a)
51.1
280.7
289.8
956.6
.3
$1,057.1
$1,120.2
$2,768.8
$3,007.7
Net Written Premiums (GAAP)
$ 523.7
$ 474.2
$1,412.9
$1,254.7
12.7
150.9
149.0
652.2
$ 536.4
$ 625.1
$1,561.9
$1,907.2
Combined Ratios (GAAP)
Specialty (b)
94.8%
96.1%
98.4%
117.7
101.2
99.3
101.5
Aggregate (including
discontinued lines)(c)
95.8
99.6
99.7
100.8
(a) Includes the operations of Infinity through the sale date in mid- February 2003 and the direct auto business through its sale at the end of April 2003. In 2003, gross written premiums includes personal lines business written by Great American Insurance and ceded to Infinity.
(b) Favorably impacted by 2.2 points and 0.8 points for the third quarter and nine months of 2003, respectively, for the effect of a benefit related to recently enacted California workers' compensation legislation.
(c) Includes 3.1 points for the nine months of 2003 for the effect of an arbitration decision relating to a claim arising from a discontinued business.
The Specialty group reported an underwriting profit of $24.0 million for the 2003 third quarter with a combined ratio of 94.8% and $50.7 million for the first nine months with a combined ratio of 96.1%, improvements of 4.0 and 2.3 points, respectively, over the comparable 2002 periods. The group's third quarter underwriting results include a pretax benefit of $10 million related to recently enacted California workers' compensation legislation.
Arbitration Settlement
Investment Income
Realized Gains
Gains (Losses) on Securities
Realized losses on securities include net gains of $1.9 million in the third quarter of 2003 and net losses of $1.9 million in the first nine months of 2003 compared to losses of $7.5 million (third quarter) and $6.9 million (nine months) in the 2002 periods to adjust the carrying value of AFG's investment in warrants to market value.
25
Gains (Losses) on Sales of Subsidiaries
Gain on Other Investments
Real Estate Operations
$32.3
$26.0
$74.7
$70.9
21.0
19.8
55.8
52.0
.5
.6
1.8
1.9
Minority interest expense, net
1.6
1.0
Other income includes net pretax gains on the sale of real estate assets of $4.7 million in the third quarter and $9.4 million in the first nine months of 2003 compared to $87,000 and $7.7 million for the 2002 periods.
Other Income
Annuity Benefits
The majority of GAFRI's fixed annuity products permit GAFRI to change the crediting rate at any time subject to minimum interest rate guarantees (as determined by applicable law). Approximately 45% of the annuity benefits accumulated relate to policies that have a minimum guarantee of 3%; the balance have a guarantee of 4%. In states where required approvals have been received, GAFRI has begun issuing products with guaranteed minimum crediting rates of 1.5% beginning in the fourth quarter of 2003. Historically, management has been able to react to changes in market interest rates and maintain a desired interest rate spread.
The increase in annuity and life acquisition expenses in the first nine months of 2003 compared to 2002 reflects an increase in in-force policies, primarily in the annuities and supplemental insurance operations.
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. However, absent significant deterioration in those factors, GAFRI does not anticipate any material write-offs in the foreseeable future.
Interest on Borrowed Money
Other Operating and General Expenses
Investee Corporations
Start-up Manufacturing Businesses
Cumulative Effect of Accounting Change
RECENT ACCOUNTING STANDARDS
Interpretation No. 46
See Note A - "Accounting Policies - Minority Interest" and Note G - "Minority Interest" for the effect of implementing FIN 46 with respect to AFG's trust preferred securities.
While AFG continues to assess the application of FIN 46 and the FASB continues to issue additional guidance, management believes AFG will be required to consolidate its investments in two collateralized debt obligations ("CDOs"), for which AFG also acts as investment manager. Under the CDOs, securities were issued in various senior and subordinate classes and the proceeds were invested primarily in bank loans, and to a lesser extent, high yield bonds, all of which serve as collateral for the securities issued by the CDOs. None of the
collateral was purchased from AFG. The market value of the collateral at September 30, 2003, was approximately $850 million.
AFG's investments in the two CDOs are subordinate to the senior classes (approximately 92% of the total securities) issued by the CDOs. 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. Holders of the CDO debt securities have no recourse against AFG for the liabilities of the CDOs; accordingly, AFG's exposure to loss on these investments is limited to its investment. AFG's investments in the CDOs are carried at estimated market value of $10.1 million at September 30, 2003, which is included in fixed maturities in AFG's balance sheet.
SOP 03-1
GAFRI's variable annuity contracts contain a guaranteed minimum death benefit ("GMDB") (which may exceed the value of the policyholder's account) to be paid if the annuityholder dies before the annuity payout period commences. Liabilities for any difference between the GMDB and the related account balance is borne by GAFRI and expensed when paid. In periods of declining equity markets, the GMDB difference increases as the variable annuity account value decreases. At September 30, 2003, the aggregate GMDB values (assuming every policyholder died on that date) exceeded the market value of the underlying variable annuities by $181 million. Industry practice varies, but GAFRI does not establish GAAP reserves for this mortality risk. Under SOP 03-1, GAFRI would be required to record a liability for the present value of expected GMDB payments. Initial recognition of a GAAP liability is estimated to be less than $5 million at September 30, 2003. D eath benefits paid in excess of the variable annuity account balances were about $1.1 million in both the first nine months of 2003 and in all of 2002.
The impact of SOP 03-1 on accounting for GAFRI's fixed annuities has not yet been determined.
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
Fixed Maturity Portfolio
Debt Securities
As of September 30, 2003, there were no other material changes to the information provided in AFG's Form 10-K for 2002 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 Chief Executive Officer and Chief Financial Officer, with assistance from management, have 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, they 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.
29
PART II
OTHER INFORMATION
ITEM 1
Legal Proceedings
Please refer to Item 3 "Legal Proceedings" of the AFG 2002 Form 10-K. In February 2003, Great American Insurance Company entered into an agreement for the settlement of litigation brought by certain parties referred to as A.P. Green. During the third quarter of 2003, a revised settlement agreement was approved by the Bankruptcy Court supervising the A.P. Green reorganization shortly after its execution. The revised settlement agreement is conditioned upon confirmation 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. No assurance can be made that all conditions will be met; no payments are required until completion of the process. If the conditions are not met, the outcome of this litigation will again be subject to the complexities and uncertainties associated with a Chapter 11 proce eding and asbestos coverage litigation.
In October 2003, Republic Insurance Company of America, a wholly-owned subsidiary of AFG, entered into an agreement for the settlement of litigation brought in late 1994 by several medical groups. The lawsuit (NPI Medical Group, a California professional corporation, et al., v. State Compensation Insurance Fund, et al., Superior Court of California, County of Los Angeles) alleged antitrust violations by a number of California workers' compensation insurers, including Republic. While Republic believed it had significant defenses to these antitrust claims, in light of the risks resulting from certain recent adverse pretrial rulings, it was concluded that a settlement was in the company's best interest. The settlement is for $37.5 million, a portion of which will be covered by reserves established through September 30, 2003. As of September 30, 2003, Republic recorded a $35.5 million charge to cover the balance of the settlement and remaining legal costs.
ITEM 6
Exhibits and Reports on Form 8-K
(a) Exhibit 12 - Computation of ratios of earnings to fixed charges.
Exhibit 31(a) - Certification of the Chief Executive Officer pursuant to section 302(a) of the Sarbanes-Oxley Act of 2002.
Exhibit 31(b) - Certification of the Chief Financial Officer pursuant to section 302(a) of the Sarbanes-Oxley Act of 2002.
Exhibit 32 - Certification of the Chief Executive Officer and Chief Financial Officer pursuant to section 906 of the Sarbanes- Oxley Act of 2002.
(b) Reports on Form 8-K:
Date of Report
Item Reported
July 7, 2003
Press Release regarding AFC/AFG Merger Agreement.
July 31, 2003
Second Quarter 2003 Earnings Release.
October 7, 2003
October 29, 2003
Third Quarter 2003 Earnings Release.
30
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 10, 2003
BY: s/Fred J. Runk
Fred J. Runk
Senior Vice President and Treasurer
31