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American Financial Group Inc. (NYSE:AFG)

Bank of America Merrill Lynch Insurance Conference Call

February 13, 2013 11:10 am ET


Carl H. Lindner III – Co-President and Co-Chief Executive Officer

S. Craig Lindner – Co-President and Co-Chief Executive Officer

Keith A. Jensen – Senior Vice President


Jay A. Cohen – Bank of America Merrill Lynch

Jay A. Cohen

We are very pleased to once again have the management of American Financial Group at our conference. Presenting for the company will be the co-CEO’s Carl and Craig Lindner. Also of the company, Keith Jensen is here, and Diane Weidner, who is Head of Investor Relations.

AFG has a very unique business mix, a unique approach to the business. It’s obvious all our specialty focus and it’s always a pleasure to have the company here to go to the story. Carl?

Carl H. Lindner III

Thanks Jim. Well good morning and thanks for giving us an opportunity to share our story. We’re certainly enthusiastic about it, about AFG, which we feel is one of the premier specialty insurance groups in the world. So why invest in American Financial Group. Here are the reasons we’re going to talk about a little bit today. Craig and I are going to spend a little time on each of these subjects.

We’re a strong diversified specialty niche insurance business with strong brand leadership. We’ve got pricing momentum and premium growth momentum, and we’re excited about that in our property and causality business. Our annuity business is coming on. We have a combination of superior underwriting talent and our culture and our superior investing talent will show you good things in the property and casualty business. Intelligent use of excess capital, growth and book value, our shareholder returns and if there was a number 9, it would probably be our stocks undervalued compared to our peers.

So as you can see we have a great spread and diversity of business. None of the 23 Specialty Property and Casualty exceed 16% of net return premium. Results of large specialties like our crop-hail business, equine business, national and states captive part of our business, and our Annuity business aren’t really correlated to the rest of our Specialty Property and Casualty businesses.

In an year of drought, in an year of super storm Sandy, it was really nice that our Specialty Casualty and our Specialty Financial segments stepped up with good years. And our Annuity business moved on, we’ve had record earnings. So we like our business model.

Nearly half of our Property and Casualty gross return premium is produced by businesses with top 10 market ratings. And we are top five in fixed annuity sales through bank and independent producer channels. We’re number one in fixed annuity sales, through P&C and Regions Bank. And we’re top five in several other banks.

We’re continuing to see good momentum in Property and Casualty pricing and in premium growth. I am probably more excited than I have been for a while moving into this year. We achieved a 4% renewal price increase overall in our Property and Casualty book in the fourth quarter. That’s a sequential improvement and as we kind of moved through all of 2012 and we’re targeting overall increases of about 4% to 6% in this year.

In the fourth quarter, for instance, our California Workers Comp business we had the first double digit price increase that we’ve had all year, at about 11%. In our D&O related minds we had about a 9% pricing increase in the fourth quarter. So I am enthusiastic again going into 2013 as far as pricing opportunities and opportunities to grow the business and here little later you will see a growth range of 6% to 10%, probably the highest range that we paid out there for a while.

Craig is going to talk about annuity momentum a little later on, so I am going to skip over that.

We’re proud of our stellar underwriting performance that comes from our superior underwriting talent. Our culture puts a priority on underwriting profit before growth for growth stake. Craig again will talk more about our superior investment talent and our fixed income results are track record there. But here’s what happens in the property and causality business if you have superior investment results in talent and superior underwriting, you can end up on top. This is against what we consider to be, this is a downlink exhibit, it get’s pretax returns on – overall pretax returns on stat capital and that. So we’re very proud of that. We too work hard at staying there.

We feel that we are intelligent in using our excess capital, which is about $625 million at year-end. After keeping about a $100 million to $200 million of powder dry or dry powder, we’re deploying excess capital in a number of different ways, opportunistic share repurchases. As I mentioned before, I think we have an opportunity for greater organic growth in the Property and Casualty side in particular. We’ve had a consistent increase in our dividends.

I think our five year compound annual growth and dividends is about 12.5%. That will continue to be a focus, and we’ll always been very prolific on doing new startups and doing small to medium sized acquisitions, and starting new products.

Here is one of our favorite slides. You can see over five years $1.5 billion has been returned to shareholders, mostly through repurchases, but through a growing dividend stream also. And when you look over that five years, that’s about 31% of our outstanding shares that when repurchased and we repurchased then about 86% of average book value. We think that’s a pretty wise use of capital.

So adding intelligent utilization of excess capital to superior underwriting talent and superior investment talent, leads to strong compounded growth and book value per share as you can see surpassing our peers. AFG achieved about 10% growth in book value in 2012 that we were proud of despite some headwinds. You'll notice that the book value numbers exclude unrealized gains; we think that's the right way to look at things.

And you can see our 5 and 10 year compounded shareholder returns including dividend has surpassed the overall market and Property & Casualty stocks overall. We feel AFG stock is undervalued particularly against our peers. I think because annuity companies are valued a little bit below, below the Property & Casualty in general, I think that accounts were a little bit of the overall discount but we still are at a discount particularly to our specialty peers.

Here’s a few financial highlights. As you can see, we really performed – our business model performed pretty well in 2011, which was a disaster year for Property & Casualty industry in general. Add even a tough year 2012, we ended up despite Sandy and drought with pretty solid results. Our goal is to be back on an upward trajectory on earnings driven again by improving pricing in the Property & Casualty part of our business and continued growth in our annuity earnings.

You can see that we also had record net earnings. We're not against growing book value, whether it's taking gains or you know investing and taking gains or resolving tax matters. We’ll take it whatever way we can get it in that.

In 2013 and forward, Craig and I, and our team would like to continue to exceed book value post dividends growth, 10% plus. Let me just talk a little bit about our Specialty Property and Casualty here for a minute. Here is a snapshot of the mix of our Specialty Property and Casualty business as you can see, some 23 different niches that are categorized into three main groups, with property and transportation being the greatest at 53%. One important fact to us is our Specialty Property and Casualty business comes from over 8000 agents and brokers, with only 9% about coming from the top three national producers. We like that spread and we like that – I think the national producer driven businesses definitely more price sensitive.

Here is our Specialty Property and Casualty strategic focus. I already talked about pricing increases, I don't need to repeat that, improving our market position in our existing businesses and adding new niches globally, that will be an important part of continuing to increase our franchise value over time. We’ve begun aligning annual bonuses and long-term incentives compensation for the guys running our businesses based off of their results in particular off of accident year underwriting profitability paid out over time, with look backs and call backs and where there is direct accountability, the guy are running the property in the range.

They have long-term incentives and annual incentives, they are tied to accident year profitability in one year and over five years and it does influence behavior. I can tell you that. But I think that's a crucial part of our strategy. We feel good about our reserve position today and we're capitalizing our subsidiaries towards the upper end of the rating ranges that for the ratings we have.

One thing unique about our company is generally we have a lower catastrophe volatility than our peers and that's on purpose. I just don’t think, I think it's very difficult, I'm a Christian, if you believe there is a sovereign God that can do whatever he wants, whenever he wants, it's hard to price coastal property. So we do it but I think we try to write less catastrophe exposed business than most companies.

One in 500 year event on a hurricane, would probably be $127 million after-tax or about 3.3% of equity. So that's not by chance, that's kind of our philosophy. With the exception of our Specialty Property and Transportation segment, 2012 we’ve had strong underwriting results last couple of years in each of our three main segments. I mentioned Sandy and the drought were the reasons this past year on that segment '12, our guidance for 2013 for a strong underwriting profitability in each of the three. If there is any part of our business where I think we need to focus a bit more price increase and underwriting focus it would be on the – some of the property businesses excluding our crop business, and that I think we need to be a bit more aggressive there and improve our returns there.

Our overall Specialty Property and Casualty guidance is 91:95 combined ratio, with a firming Property and Casualty marketplace, 2013 looks like it's going to provide the opportunity for strong organic growth as I mentioned before and that's driven by price increase, a improving economy and I think again in lines that we feel real good about, which are a lot of our businesses and opportunity may be to pick up a little bit of share in that, particularly in Specialty Casualty, as you can see.

With that I'm going to turn things over to Craig, to talk about our annuity business and investments.

S. Craig Lindner

Thank you, Carl. We are pretty pleased with the performance of our annuity business in 2012. We reported record operating earnings, actually reported 36% growth in our pre-tax quarter earnings and record levels of capital at the end of the year. Over the last couple of years, we’ve generated after-tax returns on new business in the low to mid teens. We made a decision to exit the health insurance business; it was a business that was not one of our core businesses, we were pretty small player there and decided to exit the business.

We sold our med supp and critical illness business to Cigna closed in August of 2012 and reported a gain of $114 million after-tax on that sale. Unfortunately, Cigna was not interested in the long-term care block. So we ended up with a one-off long-term care block and at year-end, did a thorough evaluation of that block of business with the help of an outside actuarial firm and that resulted in a $99 million after-tax charge. The biggest part of that charge was driven by a change in assumptions on reinvestment rates with the smaller impact from changes in expected claims, persistency, and expenses.

We have a very strong position in the back-end indexed annuity markets. We’re top five or six in each of these markets. The interest rate environment is a bit challenging with interest rates where they are today. It’s a bit challenging for fixed annuity writers. We would very much like to see a rise in rates and I think that we are very well positioned for that.

Here’s a three year look at our results; you can see we had a very strong growth in premiums from 2010 to 2011 and the premiums flattened out in 2012. We would expect 2013 premiums to be flattish. We do have some new competition. There are some new players in our space specifically. The fixed indexed annuity business are very, very aggressive in the pricing and we're going to have discipline in our pricing and demand, the right returns on product and that's resulting in a flattening out of the sales. You can see that the operating earnings have grown at a very healthy cliff.

This is a five-year picture of premium growth and earnings growth. You can see that we had very substantial growth in premiums over that period of time, for a period of time when a lot of companies in the industry were really retrenching. Fortunately we had adequate capital. We did not receive a ratings downgrade during that period, as a matter of fact we received an increase in our ratings and it gave us a great opportunity when other companies were retrenching to grow our business at pretty attractive rates of return.

You can see that operating earnings over that five-year period of time due to strong growth and new premiums and maintenance spreads operating earnings grew from $105 million in 2008, to $256 million in 2012. This might just give a breakdown of annuity premiums and annuity assets. You can see the indexed annuities are becoming a much more important product for us and really responsible for the biggest part of the growth in the last couple of years.

I'd like to talk about the consolidated investment portfolio of American Financial Group, in other words for annuities and P&C portfolios combined.

We invest principally in high quality fixed income maturity securities. 86% is weighted investment grade, 96% weighted NAIC 1 and 2. We’ve been very opportunistic investors over the last four to five years in surplus segments. When the residential mortgage backed securities will look at ways in (inaudible) we did take an outsized position principally in the senior most position in the securitizations. And we did it at a very larger discount to par, didn’t rely upon the ratings agencies, ratings we had a credit staff that did their own analysis at the underlying value at the collateral, and we felt we had tremendous subordination given the position that we’re in, the senior position and given the entry price and I think our average cost was $1.80 or something like that, and that’s worked very, very well for us. We did the same thing in the commercial mortgaged backed securities, when that market hit the fan.

We were also opportunistic investors in (inaudible) market, when it got hit several years ago. We had almost no exposure in (inaudible) and it became pretty significant investors. What we thought was a pretty goodtime.

This next chart wind up we’re pretty proud of, shows a five year picture of total return under portfolio compared to our peers we put a custom composite together of I think 40 or 45 companies in the annuity business as well as the P&C business, and we did it kind of in proportion to the mix of our businesses and as you can see, we outperformed over that five year period on a total return basis by 1.6% or 160 basis points that amounted to 1.6 billion in pre-tax dollars of outperformance on the investment side. So we’re pretty proud of that thing that our talents on the investment side give us a real competitive advantage.

With that Cohen, I’d be happy to answer any questions you’d have.

Question-and-Answer Session

Jay A. Cohen – Bank of America Merrill Lynch

There are a couple. The first one is, when you talk about excess capital you also mentioned wanting to hold some dry powder. Should I take that number away from the quote excess capital or is that in addition to the 625?

Keith A. Jensen

That’s a part of the 625 and that you can look at it anyway you want it. Let’s say, we look at that as – you can have changes in the rating agency models that can change your requirements in a given year by $100 million; it’s an ongoing type. The thing are sensibly maybe an acquisition that maybe a little larger or there maybe something that we need to extraordinary that we step up for. So right now our focus is going to be after kind of keeping that powder dry, as I said before on opportunistic share repurchases, dividends. I am hoping we might see some organic growth opportunities maybe that come in this marketplace that may not have been there in the last couple of years.

Jay A. Cohen – Bank of America Merrill Lynch

Great, the other question I have is on the business that you probably don't get a lot of questions about, it’s the Specialty finance business. The margins have been very good, but I don't really get chance to see is how much equity is allocated to that business and that’s the kind of return in that business you are generating. In addition if you could spend a little time on some of the lender services businesses, exactly what you're doing there?

Carl H. Lindner III

Yes, generally at those ranges we're operating at double-digit plus returns in Specialty Casualty, Specialty Financial and that crop business is a great business in a normal crop year. As I mentioned we want to improve the returns in some of the other than crop businesses, especially financial businesses we're the fifth largest rider of fidelity in crime. Some of the specialties within that would be things like casinos, armored cars, we're expanding that business globally and have been a good profitable, good returning business over a long period of time.

The export credit business generally over 20 years you read a small book that, some more one off kind of larger transactions versus kind of the consumer, smaller big volume kind of transaction in that. And generally that business has been good over 20 years with some of the volatility, I think we had our first underwriting loss, it was either maybe two years ago in 20 years and part of it had to do with some of the credit volatility throughout the world. But we like that business and would like to have opportunities to grow out there. Then we do some lender, we do some – there is some $130 million of mortgage place business.

There’s been quite a bit of buzz around that because of the (inaudible) some of the soybean and we’ve had no soybean we generally operate with a cleaner model in that and that said California’s and generally we got operated not as higher rates competitors or model has been more to work with a producer and have a sliding scale condition, and more lock in a good profit margin rather than try to take exorbitant profit margins and spit all the goodies around.

Our approach is to try to lock in a healthy margin and if it’s, we do better than we should some of that. So I mean, California for instance, I think rates are going down 28%. We [wrote] $4.5 million, I mean that’s like $1.3 million and I haven’t had a chance to figure out how it would impact on the sliding scale commission, but we probably don’t loose all that $1.3 million, on the profit side. And that there is probably some offset in that.

We were at $130 million of that on that part, we write some business in New York and may be a few other states that may get aggressive and take rates down. But the bottom line is I think that will continue to be a business that will have a good solid return for us. I could get surprised in that because we haven’t been on the headlines as much, we might end up taking up a few clients that may be tired of being in the headlines in that. So that would be a unexpected but a positive thing that might happen.

Now those are the supported main businesses there?

Jay A. Cohen – Bank of America Merrill Lynch

So the question on the annuity business, you talked about expecting flat premiums this year there and the aggressive new competition you’re seeing in index annuities. This one and why you wouldn’t want to shrink that business competition that aggressive, good growth on the P&C side, but maybe there is other pieces that are offsetting there?

Carl H. Lindner III

If we can’t achieve what we think are the right returns, then we will shrink the business. So we’re going to rebuild price to hit a certain premium volume. We price to get a return that is satisfactory to us and so I am just taking a guess of what the premium result is going to be, but I mean it is possible that it can shrink a bit. I’d sure rather see it, not shrink if we can get the right rate of return.

S. Craig Lindner

And again he is targeting 10% to 13% return on new business, that’s pretty healthy with rates where they are in.

Jay A. Cohen – Bank of America Merrill Lynch

I have one other question. I am getting asked these days about the crop season coming out and people mentioned to me that like it was in certain areas, I (inaudible) suburban Connecticut, I don’t know much about real agriculture, but in regard to my backyard that was about it. Is it simply too early to form any conclusions?

Carl H. Lindner III

But I would say this, the majority of our corn and soybean business is in the eastern states and that’s and those seem to be staged that seem to be coming out of the drought with more moisture.

It's kind of the plains and the Western kind of growing states, it still seem to be in a drought condition. We write some business there, but when our wheat is not in the – it's kind of do or not and we don't know where that will all end up, but that may or may not be in great shape, that's 10% of our business and frankly that's a part of our business. We always see more to the government, in the government bucket. So our net position, even though our gross percentage would be 10% of our business on a net basis, it would probably be 5% or approximately there. So there is a private data point that would be most meaningful, at least to me right now. It looks like the prices that are being averaged as we speak during this month that will determine kind of the premium and the strike prices, spring discovery prices and all that, don't seem to be in corn and they are a whole lot different than last years. And soybeans maybe up a little bit, but our premiums are going to be flat down a couple of points I think it would be my best guess. The part that’s the most – the hardest part to figure is after a drought like we had last year, were more farmers buy than have bought in the past and well the ones that have bought last year will they buy more, that's the part you don't know until you kind of go through.

Jay A. Cohen – Bank of America Merrill Lynch

Well that's great, please join me in thanking the management of AFG.

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