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, 2006
Commission File
AMERICAN FINANCIAL GROUP, INC.
Incorporated underthe Laws of Ohio
IRS Employer I.D.No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirementsfor the past 90 days. Yes X No
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer: Large Accelerated Filer X Accelerated Filer Non-Accelerated Filer
Indicate by check mark whether the Registrant is a shell company. Yes No X
As of November 1, 2006, there were 79,153,318 shares of the Registrant's Common Stock outstanding, excluding9,953,392 shares owned by a subsidiary.
TABLE OF CONTENTS
Page
AMERICAN FINANCIAL GROUP, INC. 10-Q
PART I
ITEM I - FINANCIAL STATEMENTS
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (unaudited)
(Dollars In Thousands)
September 30,
December 31,
2006
2005
Assets:
Cash and cash equivalents
$ 1,139,818
$ 471,849
Investments:
Fixed maturities:
Available for sale - at fair value
(amortized cost - $14,450,880 and $14,272,314)
14,401,580
14,326,614
Trading - at fair value
279,779
271,851
Other stocks - at fair value
(cost - $635,510 and $501,459)
716,010
556,659
Policy loans
264,930
258,744
Real estate and other investments
502,741
338,254
Total cash and investments
17,304,858
16,223,971
Recoverables from reinsurers and prepaid
reinsurance premiums
3,881,564
3,263,128
Agents' balances and premiums receivable
797,714
574,882
Deferred policy acquisition costs
1,233,613
1,139,515
Other receivables
434,094
388,078
Variable annuity assets (separate accounts)
663,533
643,506
Prepaid expenses, deferred charges and other assets
575,945
416,030
Goodwill
178,807
166,882
$25,070,128
$22,815,992
Liabilities and Capital:
Unpaid losses and loss adjustment expenses
$ 6,117,648
$ 5,790,709
Unearned premiums
1,850,042
1,643,954
Annuity benefits accumulated
9,180,740
8,417,298
Life, accident and health reserves
1,396,303
1,088,016
Payable to reinsurers
480,004
298,664
Long-term debt
923,720
999,703
Variable annuity liabilities (separate accounts)
Accounts payable, accrued expenses and other
liabilities
1,417,358
1,215,490
Total liabilities
22,029,348
20,097,340
Minority interest
280,557
261,110
Shareholders' Equity:
Common Stock, no par value
- 200,000,000 shares authorized
- 79,115,424 and 78,067,514 shares outstanding
79,115
78,068
Capital surplus
1,245,175
1,194,600
Retained earnings
1,415,833
1,134,074
Unrealized gain on marketable securities, net
20,100
50,800
Total shareholders' equity
2,760,223
2,457,542
2
CONSOLIDATED STATEMENT OF OPERATIONS (unaudited)
(In Thousands, Except Per Share Data)
Three months ended
Nine months ended
Income:
Property and casualty insurance premiums
$ 730,859
$ 651,361
$1,924,965
$1,775,795
Life, accident and health premiums
91,742
91,811
249,291
276,256
Investment income
233,148
214,076
698,512
640,734
Realized gains (losses) on securities
(2,454)
10,748
19,876
27,303
Other income
83,216
107,837
234,956
265,904
1,136,511
1,075,833
3,127,600
2,985,992
Costs and Expenses:
Property and casualty insurance:
Losses and loss adjustment expenses
424,801
604,433
1,135,269
1,311,613
Commissions and other underwriting
expenses
225,276
181,283
567,232
497,589
Annuity benefits
88,331
81,122
255,142
244,950
Life, accident and health benefits
69,136
72,962
203,330
212,593
Annuity and supplemental insurance
acquisition expenses
38,281
31,592
102,041
99,835
Interest charges on borrowed money
18,324
20,004
53,931
59,637
Other operating and general expenses
115,035
112,749
336,903
335,345
979,184
1,104,145
2,653,848
2,761,562
Operating earnings (loss) before
income taxes
157,327
(28,312)
473,752
224,430
Provision (credit) for income taxes
56,482
(6,506
157,771
82,830
Net operating earnings (loss)
100,845
(21,806)
315,981
141,600
Minority interest expense
(6,668)
(6,772)
(21,712)
(21,453)
Equity in net losses of investee,
net of tax
(627
(66
(1,605
(4,904
Earnings (loss) from continuing operations
93,550
(28,644)
292,664
115,243
Discontinued operations, net of tax
-
2,214
25,246
2,827
Net Earnings (Loss)
$ 93,550
($ 26,430)
$ 317,910
$ 118,070
Basic earnings (loss) per Common Share:
Continuing operations
$1.19
($0.37)
$3.73
$1.49
Discontinued operations
.03
.32
.04
Net earnings (loss) available to
Common Shares
($0.34)
$4.05
$1.53
Diluted earnings (loss) per Common Share:
$1.16
$3.64
$1.47
$3.96
$1.51
Average number of Common Shares:
Basic
78,760
77,335
78,519
77,060
Diluted
80,400
78,702
80,043
78,267
Cash dividends per Common Share
$.1375
$.125
$.4125
$.375
3
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (unaudited)
(Dollars in Thousands)
Common Stock
Unrealized
Common
and Capital
Retained
Gain on
Shares
Surplus
Earnings
Securities
Total
Balance at January 1, 2006
78,067,514
$1,272,668
$1,134,074
$ 50,800
$2,457,542
Net earnings
317,910
Change in unrealized
(30,700)
(30,700
Comprehensive income
287,210
Dividends on Common Stock
(32,338)
Shares issued:
Exercise of stock options
1,027,618
35,823
Dividend reinvestment plan
96,829
3,787
Employee stock purchase plan
18,137
757
Deferred compensation distributions
42,108
1,646
Directors fees paid in stock
8,520
365
Shares tendered in option exercises
(145,302)
(2,386)
(3,813)
(6,199)
Stock-based compensation expense
5,135
Capital transactions of subsidiaries
1,919
Other
4,576
Balance at September 30, 2006
79,115,424
$1,324,290
$1,415,833
$ 20,100
$2,760,223
Balance at January 1, 2005
76,634,204
$1,222,507
$ 976,340
$231,700
$2,430,547
118,070
(138,000)
(138,000
Comprehensive loss
(19,930)
(28,859)
947,138
25,518
144,303
4,214
19,873
633
Retirement plan contributions
113,414
3,622
7,374
222
9,320
300
(401,784)
(6,415)
(6,015)
(12,430)
(7,850)
6,995
Balance at September 30, 2005
77,473,842
$1,249,746
$1,059,536
$ 93,700
$2,402,982
4
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Thousands)
Operating Activities:
Adjustments:
Equity in net losses of investee
1,605
4,904
27,481
22,075
Depreciation and amortization
120,670
148,442
246,529
Realized gains on investing activities
(82,783)
(68,320)
Net purchases/sales of trading securities
(10,767)
12,047
Deferred annuity and life policy acquisition costs
(114,612)
(94,021)
Increase in reinsurance and other receivables
(503,585)
(38,456)
Decrease (increase) in other assets
48,832
(5,053)
Increase in insurance claims and reserves
546,213
753,862
Increase (decrease) in payable to reinsurers
181,037
(251,267)
Decrease in other liabilities
(6,848)
(12,626)
Other, net
17,358
18,395
Net cash provided by operating activities
797,653
854,581
Investing Activities
Purchases of and additional investments in:
Fixed maturity investments
(1,871,990)
(3,258,133)
Equity securities
(264,665)
(181,606)
Subsidiaries
(206,996)
(17,500)
Real estate, property and equipment
(36,895)
(69,327)
Maturities and redemptions of fixed maturity
investments
708,482
864,715
Sales of:
1,176,870
1,331,269
185,907
202,968
Subsidiary
37,500
36,219
44,727
Cash and cash equivalents of businesses
acquired or sold, net
201,936
52,556
Increase in other investments
(38,766
(9,615
Net cash used in investing activities
(72,398
(1,039,946
Financing Activities
Fixed annuity receipts
914,292
632,465
Annuity surrenders, benefits and withdrawals
(898,561)
(688,416)
Net transfers from variable annuity assets
17,801
10,127
Additional long-term borrowings
117,513
14,716
Reductions of long-term debt
(206,993)
(28,342)
Issuances of Common Stock
27,899
11,558
Subsidiary's issuance of stock in public offering
40,391
Cash dividends paid on Common Stock
(28,551)
(24,645)
(686
(2,923
Net cash used in financing activities
(57,286
(35,069
Net Increase (Decrease) in Cash and Cash Equivalents
667,969
(220,434)
Cash and cash equivalents at beginning of period
471,849
861,742
Cash and cash equivalents at end of period
$1,139,818
$ 641,308
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
_________________________________________________________________________________
INDEX TO NOTES
A.
E.
B.
F.
G.
C.
H.
D.
________________________________________________________________________________
Basis of Presentation
Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
Investments
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced.
Certain AFG subsidiaries loan fixed maturity and equity securities to other institutions for short periods of time. The borrower is required to provide collateral on which AFG earns investment income, net of a fee to the lending agent. AFG records the collateral held (included in other assets) and the liability to return the collateral (included in other liabilities) in its Balance Sheet. The securities loaned remain a recorded asset on AFG's Balance Sheet. At September 30, 2006, the amount of collateral held was approximately $159 million and the fair value of the securities lent was approximately $156 million. There were no securities loaned at December 31, 2005.
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Derivatives
The terms of the interest rate swaps match those of the debt; therefore, the swaps are considered to be (and are accounted for as) 100% effective fair value hedges. Both the swaps and the hedged debt are adjusted for changes in fair value by offsetting amounts. Accordingly, since the swaps are included with long-term debt in the Balance Sheet, the only effect on AFG's financial statements is that the interest expense on the hedged debt is recorded based on the variable rate.
Insurance
Reinsurance
Subsidiaries of AFG's 81%-owned subsidiary, Great American Financial Resources, Inc. ("GAFRI"), cede life insurance policies to a third party on a funds withheld basis whereby GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. GAFRI classifies the securities related to these transactions as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income record ed on the adjustment to fair value of the related trading portfolios.
7
Deferred Policy Acquisition Costs ("DPAC")
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in "Unrealized gain on marketable securities, net" in the shareholders' equity section of the Balance Sheet.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues. DPAC includes the present value of future profits on business in force of insurance companies acquired by GAFRI, which represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The present value of future profits is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
Annuity and Supplemental Insurance 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 Operations in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
8
Annuity Benefits Accumulated
Life, Accident and Health Reserves
Variable Annuity Assets and Liabilities
Premium Recognition
Payable to Subsidiary Trusts
Minority Interest
Income Taxes
Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on 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.
9
Stock-Based Compensation
Prior to the implementation of SFAS No. 123(R), AFG accounted for stock options and other stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under this method, no compensation expense for stock option grants was recognized because options were granted at exercise prices equal to the fair value of the shares at the dates of grant. See Note F - "Shareholders' Equity" for further information on stock options.
Benefit Plans
AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.
Earnings Per Share
Statement of Cash Flows
Ceres Group, Inc.
10
has exited the major medical business. Following the acquisition, Ceres paid a $60 million return of capital distribution to GAFRI. GAFRI expects the retained Ceres business to generate at least $120 million in life, accident and health premiums in 2007. The preliminary allocation of purchase price for the Ceres acquisition resulted in an increase in goodwill of $11.9 million. Pro forma results of operations for the three and nine months ended September 30, 2006, assuming the acquisition of Ceres had taken place at the beginning of 2006 would not differ significantly from actual reported results.
Chatham Bars Inn
Old Standard Life Fixed Annuity Business
Great American Life Assurance Company of Puerto Rico
Farmers Crop Insurance Alliance, Inc.
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes inland and ocean marine, agricultural-related business and commercial automobile, (ii) Specialty casualty, which includes executive and professional liability, umbrella and excess liability and excess and surplus, (iii) Specialty financial, which includes fidelity and surety bonds and collateral protection, and (iv) California workers' compensation. AFG's annuity and supplemental insurance business markets primarily retirement annuities and various forms of supplemental insurance. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
11
The following tables (in thousands) show AFG's revenues and operating earnings (loss) before income taxes by significant business segment and sub-segment.
Revenues (a)
Premiums earned:
Specialty
Property and transportation
$ 322,419
$ 270,662
$ 747,528
$ 640,319
Specialty casualty
207,557
183,794
593,075
550,858
Specialty financial
110,545
91,586
304,236
270,008
California workers' compensation
69,640
88,128
222,767
262,029
20,338
16,496
55,895
49,507
Other lines
360
695
1,464
3,074
730,859
651,361
1,924,965
1,775,795
79,835
71,336
240,471
209,821
Realized gains
1,431
7,561
28,754
16,857
45,878
76,636
143,776
179,666
858,003
806,894
2,337,966
2,182,139
Annuities and supplemental insurance:
151,667
141,951
452,468
428,685
Realized gains (losses)
(2,812)
3,008
(7,887)
16,635
33,019
22,020
79,278
63,816
273,616
258,790
773,150
785,392
4,892
10,149
16,484
18,461
$1,136,511
$1,075,833
$3,127,600
$2,985,992
Operating Earnings (Loss) Before
Underwriting:
$ 40,386
$ 5,242
$ 113,551
$ 72,701
44,040
19,475
87,014
33,709
(24,091)
(9,253)
(22,676)
(21,159)
25,275
29,406
54,115
63,970
(3,378)
(1,738)
(3,049)
(2,295)
Other lines (b)
(1,450
(177,487
(6,491
(180,333
80,782
(134,355)
222,464
(33,407)
Investment income, realized gains
and other
70,942
98,397
244,100
230,560
151,724
(35,958)
466,564
197,153
Annuities and supplemental
insurance (c)
30,804
22,721
78,887
89,311
Other (d)
(25,201
(15,075)
(71,699
(62,034
$ 157,327
($ 28,312)
$ 473,752
$ 224,430
(a) Revenues include sales of products and services as well as other income
earned by the respective segments.
(b) Includes a third quarter 2005 charge of $179.3 million to increase
asbestos, environmental and other mass tort reserves.
(c) Includes a third quarter 2005 charge of $9.5 million related to
environmental liabilities at GAFRI's former manufacturing operatons.
(d) Includes holding company expenses.
12
Included in deferred policy acquisition costs in AFG's Balance Sheet are $94.4 million and $54.1 million at September 30, 2006, and December 31, 2005, respectively, representing the present value of future profits ("PVFP") related to acquisitions by AFG's annuity and supplemental insurance business. The PVFP amounts are net of $67.5 million and $82.5 million of accumulated amortization. The change in PVFP and related accumulated amortization reflects the August 2006 acquisition of Ceres, partially offset by the January 2006 sale of GAPR. Amortization of the PVFP was $2.8 million in the third quarter and $6.1 million in the first nine months of 2006 and $1.6 million in the third quarter and $7.5 million in the first nine months of 2005, respectively.
Holding Company:
AFG 7-1/8% Senior Debentures due April 2009
$182,814
$226,052
AFG Senior Convertible Notes due June 2033
189,825
189,857
AFG 7-1/8% Senior Debentures due February 2034
115,000
AFG 7-1/8% Senior Debentures due December 2007
59,493
3,783
3,768
550,915
594,170
GAFRI 7-1/2% Senior Debentures due November 2033
112,500
GAFRI 7-1/4% Senior Debentures due January 2034
86,250
GAFRI 6-7/8% Senior Notes due June 2008
33,590
100,000
Notes payable secured by real estate
67,925
33,112
American Premier Underwriters 10-7/8% Subordinated
Notes due May 2011
8,079
8,125
7,501
8,586
315,845
348,573
Payable to Subsidiary Trusts:
GAFRI 8-7/8% Subordinated Debentures due
January 2027
21,960
GAFRI 7.35% Subordinated Debentures due May 2033
20,000
National Interstate Variable Rate Subordinated
Debentures due May 2033
15,000
56,960
$923,720
$999,703
At September 30, 2006, scheduled principal payments on debt for the balance of 2006 and the subsequent five years were as follows: 2006 - $.1 million; 2007 - $60.8 million; 2008 - $34.4 million; 2009 - $184.5 million; 2010 - $3.0 million; and 2011 - $9.1 million.
During the first nine months of 2006, AFG repurchased $43.5 million of its 7-1/8% Debentures due 2009 for $45.6 million in cash and GAFRI repurchased $66.4 million of its 6-7/8% Notes for $68.7 million in cash. In July 2006, an AFG subsidiary borrowed $42 million under a 6.3% 10-year mortgage loan secured by one of its hotel properties.
13
In March 2006, AFG and GAFRI replaced their existing credit agreements with a new five-year revolving credit facility under which they can borrow a combined $500 million. AFG and GAFRI have agreed not to borrow more than $325 million and $200 million, respectively, under the credit facility and AFG has agreed to guarantee amounts borrowed by GAFRI. Amounts borrowed bear interest at rates ranging from 0.5% to 1.25% over LIBOR based on AFG's credit rating. No amounts were borrowed under these agreements at September 30, 2006 or December 31, 2005.
To achieve a desired balance between fixed and variable rate debt, GAFRI has entered into interest rate swaps that effectively convert its 6-7/8% fixed rate Senior Notes to a floating rate of 3-month LIBOR plus 2.9%. In connection with the 2006 debt repurchases discussed above, GAFRI paid an additional $2 million to effectively terminate the portion of the interest rate swaps that covered the repurchased debt.
AFG's Senior Convertible Notes were issued at a price of 37.153% of the principal amount due at maturity. Interest is payable semiannually at a rate of 4% of issue price per year through June 2008, after which interest at 4% annually will be accrued and added to the carrying value of the Notes. The Notes are redeemable at AFG's option at any time on or after June 2, 2008, at accreted value ranging from $371.53 per Note 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) for a specified period, (ii) if the credit rating of the Notes is significantly lowered, or, (iii) if AFG calls the notes for redemption. Based on the market price of AFG's Common Stock during the quarter ended September 30, 2006, the Notes are currently convertible through D ecember 31, 2006. AFG has delivered cash in lieu of Common Stock upon conversion of the Notes and intends to continue to do so. Accordingly, shares issuable upon conversion of the Notes are not treated as dilutive.
Stock Incentive Plans
14
At September 30, 2006, there were 10.6 million shares of AFG Common Stock reserved for issuance under AFG's stock incentive plan. Options generally become exercisable at the rate of 20% per year commencing one year after grant; those granted to non-employee directors of AFG are fully exercisable upon grant. Options expire ten years after the date of grant. Data for stock options issued under AFG's stock incentive plans is presented below:
Average
Aggregate
Remaining
Intrinsic
Exercise
Contractual
Value
Price
Term
(in millions)
Outstanding at January 1, 2006
6,389,288
$28.14
Granted
971,450
$40.51
Exercised
(1,027,618)
$30.97
Forfeited/Cancelled
(22,700
$35.56
Outstanding at September 30, 2006
6,310,420
$29.56
5.9 years
$109.6
Options exercisable at
September 30, 2006
3,656,430
$27.57
4.2 years
$ 70.8
Options and other awards available
for grant at September 30, 2006
4,298,366
The total intrinsic value of options exercised during the nine months ended September 30, 2006 and 2005 was $13.2 million and $6.6 million, respectively. During the nine months ended September 30, 2006, AFG received $25.6 million in cash and recognized a $4.0 million tax benefit from the exercise of stock options.
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility (after consideration of other factors). AFG began using the SEC's simplified method of calculating expected term with its 2006 grants. The fair value of options granted in the first nine months of 2006 and 2005 was $10.03 per share and $9.66 per share, respectively, based on the following assumptions:
Expected dividend yield
1-1/2%
2%
Expected volatility
19%
28%
Expected term (in years)
6.5
8.4
Risk-free rate
4.6%
4.3%
Total compensation expense related to stock incentive plans for the third quarter and first nine months of 2006 was $2.6 million and $7.4 million, respectively. Related tax benefits totaled $520,000 for the quarter and $1.5 million for the nine months. Included in these totals are $777,000 for the quarter and $2.2 million for the nine months in compensation expense and $112,000 for the quarter and $347,000 for the nine months in tax benefits related to stock incentive plans of two AFG subsidiaries. As of September 30, 2006, there was a total of $19.5 million of total unrecognized compensation expense related to nonvested stock options granted under AFG's plans. That cost is expected to be recognized over a weighted average of 3.5 years.
15
The following table illustrates the effect on net earnings (loss) (in thousands) and earnings (loss) per share for the third quarter and first nine months of 2005, had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the method used beginning in 2006.
Third
Nine
Quarter
Months
Net earnings (loss), as reported
($26,430)
$118,070
Pro forma stock option expense, net of tax
(1,875
(5,614
Adjusted net earnings (loss)
($28,305)
$112,456
Earnings (loss) per share (as reported):
Earnings (loss) per share (adjusted):
$1.46
($0.36)
$1.45
A summary of the hotel operations sold follows (in millions):
Operations:
Revenue
$ -
$16.9
$ 3.9
$33.4
Pretax earnings (loss)
4.0
(1.0)
5.2
Provision (benefit) for income taxes
1.3
(.3)
1.8
(.5
.1
(.6
Earnings (loss) from discontinued
operations
2.2
(.6)
2.8
Gain on sale, net of tax (*)
25.8
$ 2.2
$25.2
$ 2.8
(*) After transaction costs, contingencies, the write-off of certain
deferred annuity acquisition costs associated with the gain recognition
and minority interest.
16
ITEM 2
Management's Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
Forward-Looking Statements
17
Results of Operations
23
Overview
General
Critical Accounting Policies
18
Income Items
Liquidity and Capital Resources
19
Expense Items
27
Sources of Funds
Recent Accounting Standard
28
20
Proposed Accounting Standard
29
Uncertainties
_____________________________________________________________________________________________________
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Some of the forward-looking statements can be identified by the use of words such as "anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks", "could", "may", "should", "will" or the negative version of those words or other comparable terminology. Such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate increases; and improved loss experience.
Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:
The forward-looking statements herein are made only as of the date of this report. The Company assumes no obligation to publicly update any forward-looking statements.
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings,
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, because most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
At September 30, 2006, AFG (parent) had approximately $110 million in cash and securities and no amounts borrowed under its bank line of credit.
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 products.
AFG's net earnings for the third quarter and first nine months of 2006 were $93.6 million ($1.16 per share, diluted) and $317.9 million ($3.96 per share), respectively. These results include significantly higher earnings from AFG's insurance operations compared to the same periods a year earlier. AFG reported a net loss for the third quarter of 2005 of $26.4 million ($.34 per share), which included an aftertax charge of $121.6 million ($1.55 per share) to increase asbestos and environmental reserves ("A&E") within AFG's run-off operations. Net earnings for the first nine months of 2005 were $118.1 million ($1.51 per share).
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. The areas where management believes the degree of judgment required to determine amounts recorded in the financial statements make accounting policies critical are as follows:
For a discussion of these policies, see Management's Discussion and Analysis - "Critical Accounting Policies" in AFG's 2005 Form 10-K.
LIQUIDITY AND CAPITAL RESOURCES
Ratios
2004
$ 924
$1,000
$1,106
Total capital (*)
3,996
3,703
3,575
Ratio of debt to total capital
23.1%
27.0%
30.9%
(*) Includes long-term debt, minority interest and
shareholders' equity (excluding unrealized gains (losses)
related to fixed maturity investments).
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.49 for the nine months ended September 30, 2006 and 1.77 (2.20 excluding A&E and other mass tort charges) for the entire year of 2005. Excluding annuity benefits, this ratio was 8.53 and 4.58 (6.60 excluding the A&E and other mass tort charges), respectively. Although the ratio excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
Parent Holding Company Liquidity
In March 2006, AFG and GAFRI replaced their existing credit agreements with a new five-year revolving credit facility under which they can borrow a combined $500 million. AFG and GAFRI have agreed not to borrow more than $325 million and $200 million, respectively, under the credit facility and AFG has agreed to guarantee amounts borrowed by GAFRI. Amounts borrowed bear interest at rates ranging from 0.5% to 1.25% over LIBOR based on AFG's credit rating. No amounts were outstanding under this agreement at September 30, 2006.
Under a currently effective shelf registration statement, AFG can offer additional equity or debt securities, including 2.3 million shares of common stock under an equity distribution agreement with UBS Securities LLC. The shelf registration provides AFG with greater flexibility to access the capital markets from time to time as market and other conditions permit.
During the first nine months of 2006, AFG repurchased $43.5 million of its 7-1/8% Debentures due 2009 for $45.6 million in cash.
Subsidiary Liquidity
During the first nine months of 2006, GAFRI repurchased $66.4 million of its 6-7/8% Senior Notes due 2008 for $68.7 million in cash.
The liquidity requirements of AFG's insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In GAFRI's annuity business, where profitability is largely dependent on earning a "spread" between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on GAFRI's annuity products. With declining rates, GAFRI receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums.
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, 2006, were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and noninvestment grade. Management believes that a high quality investment portfolio should generate a stable and predictable investment return.
Since fixed maturities and stocks are carried at fair value in the balance sheet, there is virtually no effect on financial condition upon the sale and ultimate realization of unrealized gains and losses.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at September 30, 2006, is shown in the following table (dollars in millions). Approximately $154 million of available for sale "Fixed maturities" had no unrealized gains or losses at September 30, 2006.
With
Gains
Losses
Available for sale Fixed Maturities
Fair value of securities
$5,086
$9,162
Amortized cost of securities
$4,940
$9,357
Gross unrealized gain (loss)
$ 146
($ 195)
Fair value as % of amortized cost
103%
98%
Number of security positions
1,284
1,461
Number individually exceeding
$2 million gain or loss
1
Concentration of gains (losses) by type or
industry (exceeding 5% of unrealized):
Mortgage-backed securities
$21.6
($84.2)
Banks, savings and credit institutions
16.4
(18.0)
U.S. Government and government agencies
3.0
(16.1)
Insurance companies
8.9
(10.8)
State and municipal
7.1
(10.1)
Gas and electric services
16.5
Air transportation and courier services
12.0
(0.4)
Percentage rated investment grade
91%
96%
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at September 30, 2006, based on their fair values. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Maturity
One year or less
5%
1%
After one year through five years
25
After five years through ten years
39
After ten years
83
59
41
100
21
AFG realized aggregate losses of $6.6 million during the first nine months of 2006 on $149.1 million in sales of fixed maturity securities (five issues/issuers) that had individual unrealized losses greater than $500,000 at December 31, 2005. These securities were "AAA" rated mortgage-backed securities that decreased in fair value by an aggregate of $3.0 million from year-end 2005 to the sale date due to an increase in the general level of interest rates.
Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains.
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
Fair
Value as
% of Cost
Gain (Loss)
Basis
Fixed Maturities at September 30, 2006
Securities with unrealized gains:
Exceeding $500,000 (64 issues)
$ 617
$ 54
110%
Less than $500,000 (1,220 issues)
4,469
92
102
$146
Securities with unrealized losses:
Exceeding $500,000 (84 issues)
$1,868
($ 70)
Less than $500,000 (1,377 issues)
7,294
(125
98
($195)
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, 2006
Investment grade with losses for:
One year or less (582 issues)
$3,381
($ 40)
99%
Greater than one year (787 issues)
5,372
(143
97
$8,753
($183)
Non-investment grade with losses for:
One year or less (58 issues)
$ 200
($ 7)
97%
Greater than one year (34 issues)
209
( 5)
$ 409
($ 12)
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 2005 Form 10-K.
22
Based on its analysis, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they mature or recover in value. Should either of these beliefs change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
RESULTS OF OPERATIONS
AFG reported operating earnings before income taxes of $157.3 million for the third quarter of 2006 compared to an operating loss before income taxes of $28.3 million in the 2005 third quarter. Results for the 2005 quarter included $189 million in pretax charges resulting from strengthening A&E and other mass tort reserves within AFG's runoff operations, partially offset by a $30.9 million pretax gain on the sale of coal assets. Excluding these items, a $35.8 million improvement in property and casualty underwriting results and a $19.1 million increase in investment income were partially offset by a $13.2 million decline in realized gains on securities.
Excluding the third quarter 2005 A&E charge and gain on the sale of coal assets, nine-month pretax operating earnings improved $91.4 million compared to 2005 as a $76.6 million improvement in property and casualty underwriting results and a $57.8 million increase in investment income were partially offset by lower realized gains and lower earnings in GAFRI's supplemental insurance operations during the first half of the year.
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 and underwriting expenses to premiums. A combined ratio under 100% is indicative of an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.
Premiums and combined ratios for AFG's Specialty property and casualty insurance operations were as follows (dollars in millions):
Gross Written Premiums (GAAP)
Specialty:
$ 637.3
$ 496.8
$1,355.7
$1,087.1
371.3
359.6
1,113.3
1,080.7
142.8
133.1
396.4
367.6
69.7
93.5
229.9
289.8
.3
(2.5
1.2
Total Specialty
$1,221.4
$1,080.5
$3,095.3
$2,826.4
Net Written Premiums (GAAP)
$ 332.1
$ 291.0
$ 830.9
$ 728.8
237.6
192.3
645.6
567.4
115.7
107.9
313.1
294.7
65.8
84.2
217.0
260.5
17.7
57.3
48.4
$ 768.9
$ 691.8
$2,063.9
$1,899.8
Combined Ratios (GAAP)
Property and transportation (b)
87.4%
98.1%
84.7%
88.7%
78.7
89.4
85.3
93.9
Specialty financial (c)
121.8
110.1
107.5
107.8
63.6
66.7
75.7
75.5
116.6
110.6
105.5
104.6
Total Specialty (d)
93.3%
88.1%
91.8%
(a)
AFG's aggregate combined ratio, including other (primarily runoff) lines, was 88.9% and 120.6% for the quarter ended September 30, 2006 and 2005 and 88.4% and 101.8% for the nine months ended September 30, 2006 and 2005, respectively. The aggregate ratio includes 27.5 points and 10.1 points, respectively, for the three and nine month periods of 2005 relating to the A&E charge.
(b)
Includes the effect of hurricane losses for the 2005 three and nine month periods of 10.8 points and 4.6 points, respectively.
(c)
Includes the effect of hurricane losses for the 2005 three and nine month periods of 7.1 points and 2.4 points, respectively.
(d)
Includes the effect of hurricane losses of 6.2% and 2.3%, respectively, for the three and nine month periods of 2005.
Net written premiums for the specialty insurance operations increased 11% for the third quarter and 9% for the nine months compared to the same periods in 2005. Significant premium growth from the Property and transportation and Specialty casualty groups were partially offset by a decline in the California workers' compensation premiums. The specialty insurance operations generated an underwriting profit of $82.2 million in the 2006 third quarter, $39.1 million higher than the 2005 quarter. The combined ratio was 88.7%, 4.6 points better than in the 2005 third quarter, which included approximately $40.6 million (6.2 points) of catastrophe losses principally from hurricanes Katrina and Rita.
24
Underwriting profit for the first nine months of 2006 was $229 million, 56% above the 2005 period, reflecting premium growth, lower catastrophe losses, and the positive impact of favorable reserve development. These 2006 results include $22.6 million (1.2 points) of catastrophe losses compared to $48.4 million (2.7 points) in the same 2005 period. Net written premiums were 9% above the 2005 period.
Due to recent upward revisions in industry models of correlated catastrophe exposure associated with writing both workers' compensation and excess property coverage in California, AFG decided to stop writing most of its earthquake-exposed excess property coverage in California beginning in April 2006. This excess property business had net written premiums of $17 million in 2005. Prior to this action, AFG's excess property exposure to a catastrophic earthquake that models indicate could occur once in every 500 years (a "500-year event") was approximately 10% of AFG's shareholders' equity. Once the existing excess property policies expire in 2007, AFG's excess property exposure to a California earthquake 500-year event will be reduced to less than 1% of AFG's equity.
Specialty casualty net written premiums for the 2006 third quarter and nine-month period were 24% and 14% higher than in the respective 2005 periods due primarily to volume growth and higher premium retention within several of the group's businesses as well as third quarter 2006 changes to reinsurance agreements within the specialized program business line, which resulted in the recapture of $26 million in premiums previously ceded to reinsurers. This group's combined ratio improved 10.7 points for the third quarter, reflecting improvement across all businesses in the group. Results for the 2006 quarter included about 4.8 points of favorable reserve development whereas the prior year period included 1.4 points of unfavorable reserve development. Through the first nine months of this year, this group's combined ratio has improved 8.6 points compared with the same prior year period.
Specialty financial net written premiums for the three and nine month periods of 2006 increased 7% and 6%, respectively, above the 2005 periods reflecting premium growth principally in the surety and financial institutions businesses. The group experienced disappointing results in the 2006 third quarter resulting from losses within the automobile residual value business ("RVI"), which is in run-off. These losses were primarily attributable to lower than expected proceeds from the sale (at auction) of certain luxury cars and sport utility
vehicles at lease-end. Excluding the effect of the RVI business, this group's third quarter combined ratio was 88%, as the group's other operations are generating underwriting profits.
California workers' compensation net written premiums for the third quarter and first nine months of 2006 were 22% and 17% below the 2005 periods, reflecting the effect of significantly lower rates, partly offset by new volume growth. This business continued to report excellent profitability in the 2006 third quarter with a 3.1 point improvement in the combined ratio compared to the 2005 quarter. This business experienced $16 million of favorable prior year reserve development in the quarter, compared to $9 million in the 2005 third quarter. The underwriting results reflect the effects of the California workers' compensation reforms that have resulted in lower workers' compensation costs for employers and lower premium levels. However, due to the long-tail nature of this business, reserving is somewhat conservative until a higher percentage of claims have been paid and the ultimate impact of reforms can be determined.
Asbestos and Environmental and Other Mass Tort Reserve Charges
Life, Accident and Health Premiums and Benefits
Investment Income
26
Realized Gains (Losses)
Realized gains (losses) on securities include provisions for other than temporary impairment of securities still held as follows: third quarter of 2006 and 2005 - $7.1 million and $3.9 million; nine months of 2006 and 2005 - $12.9 million and $11.5 million, respectively.
Real Estate Operations
$20.7
$48.9
$65.8
$91.1
18.7
14.9
50.2
43.8
.9
.4
1.6
1.4
Minority interest expense, net
2.3
1.0
Income from real estate operations for 2005 includes a third quarter pretax gain of $30.9 million on the sale of coal reserves. Other income also includes net pretax gains on the sale of other real estate assets of $1.1 million in the third quarter and $14.2 million in the first nine months of 2006 and $1.1 million and $10.1 million for the 2005 periods.
Real Estate Operations - Discontinued
Fourth Quarter Real Estate Sales
Annuity Benefits
Annuity benefits for the third quarter and nine months of 2006 increased compared to the 2005 periods as the effect of internal growth and the acquisition of Old Standard Life fixed annuity business were partially offset by lower average effective crediting rates and the sale of GAPR.
Significant changes in projected investment yields could result in charges (or credits) to earnings in the period the projections are modified.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and run-off life insurance lines of business. Unanticipated spread compression, decreases in the stock market, and adverse mortality experience could lead to write-offs of DPAC in the future.
Interest Expense
Interest expense decreased $1.7 million (8%) for the third quarter and $5.7 million (10%) for the nine months due primarily to the retirement of debt during the first nine months of 2006 and late 2005.
Other Operating and General Expenses
Recent Account Standards
Convertible Notes
_____________________________________________________________
ITEM 3
Quantitative and Qualitative Disclosure of Market Risk
As of September 30, 2006, there were no material changes to the information provided in Item 7A - "Quantitative and Qualitative Disclosure of Market Risk" of AFG's 2005 Form 10-K.
ITEM 4
Controls and Procedures
AFG's management, with participation of its Co-Chief Executive Officers and its principal financial officer, has evaluated AFG's disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG's Co-CEOs and principal financial officer concluded that these disclosure controls and procedures were effective. On August 7, 2006, Great American Financial Resources acquired Ceres Group, Inc. Ceres has been excluded from management's assessment of internal control over financial reporting.
In the ordinary course of business, AFG and its subsidiaries routinely enhance their information systems by either upgrading current systems or implementing new systems. There has been no change in AFG's business processes and procedures during the third fiscal quarter of 2006 that has materially affected, or is reasonably likely to materially affect, AFG's internal controls over financial reporting.
PART II
OTHER INFORMATION
Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
ITEM 6
Exhibits
Number
Exhibit Description
Computation of ratios of earnings to fixed charges.
Certification of the Co-Chief Executive Officer pursuant
to section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to
section 302(a) of the Sarbanes-Oxley Act of 2002.
Certification of the Co-Chief Executive Officers and Chief
Financial Officer pursuant to section 906 of the Sarbanes-
Oxley Act of 2002.
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, American Financial Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned duly authorized.
American Financial Group, Inc.
November 8, 2006
BY: s/Keith A. Jensen
Keith A. Jensen
Senior Vice President
(principal financial and
accounting officer)
30