Jay Cohen – Bank of America/Merrill Lynch
We have with us the team from American Financial Group. We’ve got co-CEOs; Carl and Craig Lindner; and CFO, Jeff Consolino. I mentioned this morning when I was introducing Bill Berkley, that his name is on the door, and he acts like an owner of the business. Well, here is another company that for years has acted like owners in everything they do, from underwriting to capital management. So their bread and butter is at the same place to everyone else is. Let me turn it over to Carl, to do some introductory comments.
Good morning. We appreciate the opportunity to talk about AFG, a subject we enjoy talking about. Here is what Craig and I are going to talk about today. Key question is to why invest in AFG? Few things that we’re going to be talking about are core values, corporate culture, diversified specialty niches, the momentum in the premium growth side and the property and casualty side, the strong annuity performance, superior underwriting talent and culture, superior investing talent, what we’ve been doing intelligently to use excess capital. And talk about some good things, the growth in the book value and our compounded shareholder return.
Let me just a little bit about our corporate values. We have 30 separate specialized entrepreneurial insurance units, which have full responsibility and full accountability for their businesses. We think it’s a good model. They are fun jobs. I like to tell our employees that we have 30 CEOs, and we have very little turnover in those positions. I think we probably lost one of those presidents in probably last 10 years.
And we have a culture that people enjoy working with it and to write incentives. And we have a very cohesive deep management team. The environment and culture itself starting with integrity, which is where things need to start. That’s clearly at the top of our values in our corporate culture. We do have a strong work ethic, but interestingly enough, we’ve been a company that’s been at balance with the family and work for about 25 plus years. And again adds to an environment where the average employee that works for us, not just our management team who likes our culture, who likes what we’re doing and we’re an exciting place to work.
We’ve got great spread in diversity of our business. None other business exceed 18% of net written premium. We like that. It means more consistent results overtime. Results of the large specialties of businesses like our crop hail, government multi-peril, National Interstate's captive business, our annuity business, the lender-placed mortgage property insurances. Those businesses don't really correlate to our other property and casualty businesses. Again we like that. We think it means more consistent results.
This past year as we didn’t get to the right returns in our specialty property and transportation, property and casualty business, the annuity business outperformed in that. And we ended up getting across the finish line with a good year and good healthy growth and book value. As you can see, we have strong fixed annuity sales position last year.
We continue to focus on what we know best in that specialty lines. As you can see, we've really been prolific in doing start-ups and acquisitions over a long period of time, back to National Interstate where we started that we were talking about earlier this morning – stated as a $0.5 million investment for 51%, 52% of the company in 1989. And that’s the way we build our business.
We’re off to an exciting start this year with the announced acquisition of Summit Southeast. Well, it’s a specialist workers’ comp carrier that actually have the number one market position in the southeastern part of the United States. Good fit with our other specialist workers comp businesses. And many of you know just recently, we commenced a tender offer to acquire the public minority stake in National Interstate.
We are continuing to see good opportunities to grow our property and casualty business and continue to get some price increase. Our net written premium was up 13% last year in our property and casualty business, and the 2014 outlook is for 17% to 21% growth. That includes Summit. Excluding Summit, there would be about 5% to 9% growth.
We’re proud of our stellar underwriting performance over many years that comes from our superior management team and underwriting talent. We have a culture that clearly puts underwriting profit before growth for just for growth sake.
So in a few minutes, Craig is going to talk about superior investing talent and superior our track record, but here is what happens in the property and casualty business if you combine superior underwriting results and superior investing results in one company. And we’re very proud. And you can see that over the past five years – this is a Dowling report, we were number one in pre-tax returns for the last few years against our peers.
Let's talk about intelligent use of excess capital. One of our favorite slides. We obviously feel we’ve been intelligently using excess capital. You can see over the last five years, between dividends paid and repurchases, we’ve spent about $1.6 billion. And I believe over that time, we probably repurchased close to 30%, third of the company’s shares below book value in our prices below book.
You can see nice 2013. Last year, we paid $161 million in dividends. We increased our ordinary dividend by 13%. We’ve had a five-year compounded annual growth rate in our dividends through last year of about 10%.
With about $1 billion of excess capital at year-end 2013, I have to say we’re excited to have two good opportunities early this year to put between those two deals about $676 million to work with the Summit and the National Interstate announcements. It still leaves us room to do opportunistic share repurchases, to continue our dividend increase track record and frankly to start other businesses or look at other acquisitions. So we’re very excited.
So when you add intelligent use of excess capital to superior underwriting, to superior investing, at least the strong compounded growth in book value per share, surpassing our peers.
And when you look on a total value creation basis over the last five years, you can see we came in second, which we’re very happy with. All in line, we thank god. We thank our talented management team and we thank our talented employees for great results.
And when you look at over a five and 10-year compounded shareholder returns, this includes dividends, you can see that we have surpassed the overall market and property and casualty stocks in general.
Let me talk just a little bit about our property and casualty business. Here is a snapshot of the mix of our business. You can see that with the acquisition of Summit, there the pro forma chart on the right, specialty property and transportation, specialty casualty will be roughly the same percentages at 45% and 43% of gross written premium respectively.
Currently our business comes from over 8,000 agents and brokers. Interesting little fact is that only 7% of our gross written premiums come from the top four national producers. We kind of like that. It’s probably less price sensitive business, and less of our business has the potential to be leveraged against this going forward.
Let me talk a little bit about our strategic focus. We’re going to continue to secure price increases to support continued strong underwriting profitability. In our guidance, we said – we’re shooting for 3% to 4% price increase. We want to continue to improve the market position in our existing 28 specialty businesses. And we want to continue to add new niches globally, aligning significant annual and long-term incentive compensation for our guys that run those 28 some units, with strong underwriting profitability and good solid returns, continues to be a core part of our strategy.
Our guys don’t have many incentives to grow unless it’s at the right returns and at the right underwriting profitability. We’re continuing a strong adequate reserve or a good adequate reserve position as we have today. It’s important also to us. One thing that’s a little different about our company is that we have a low relative exposure to windstorm and quake compared to most competitors.
For instance, there are one in 500 exposure to hurricane. It’s about $110 million after-tax or around 2.5% of equity. We’re going to continue to try to grow opportunistically through the cycles.
So with an improving economy, rate increase, and our acquisition of Summit as I mentioned before, we’re projecting healthy growth of 17% to 21% this year. Stronger growth opportunities come in the specialty casualty part of our business, where excluding Summit we’re going to grow 12% to 16%, that’s what we think. Including Summit, you can see, it would be 45% to 49%.
And in the property side, if you exclude our crop business, which because of fall in prices, we’re projecting to be down some in premium this year. Our property and transportation business, the outlook excluding crop would be more in the 5% to 10% range.
You can see we’ve had strong underwriting results overall, particularly in the specialty casualty and financial. Our outlook for this year is for the same. Mediocre specialty property and transportation results have been driven by disappointing results at National Interstate and disappointing results in our property in the marine business. As well as in 2012, we made a little money in crop, but that was a drought year.
We’ve been taking high single-digit price increases last year at National Interstate and in property in inland marine. We’re going to continue to focus on improving increasing rates this year. We’ll probably be targeting mid-single-digit price increase for both those businesses. And you can see guidance is forward improvement there with a combined ratio of 94% to 98%.
With that, I am going to turn things over to my brother.
Thank you, Carl. American Financial Group acquired our annuity business in 1974 as part of a larger acquisition. At that time, the annuity business had assets of $30 million, and since then the assets have grown at an 18% compound annual rate.
Company is focused on fixed and fixed-indexed annuities. 2013 was another record year of operating earnings. In 2013, we had 28% growth in pre-tax core annuity operating earnings. The average assets and reserves grew by about 15%. And a significant increase in interest rates had a favorable impact on the accounting for indexed annuities. I’ll talk about that a little bit more in a minute.
We price to achieve 12% return on capital. In the last couple of years, we’re able to do a little bit better than that on new sales.
In 2013, we had premiums of a little over $4 billion, an increase of 33% over the previous year.
The next slide shows the growth over a long period of time of the business. When we acquired our annuity business, we had $30 million of assets, and we ended last year with a little over $24 billion of assets, a pretty – as you can see very steady growth over a long period of time.
This is a five-year picture of premiums and earnings. Frankly the challenges and ratings downgrades that some of our competitors experienced in the ’08, ’09 period created a lot of opportunities for us, especially in the bank market. You can see that over the five-year period of time, our earnings have little bit more than tripled.
As I mentioned, our focus is on fixed and fixed-indexed annuities, actually a very good fit. They are spread businesses and fit very well with the investment skills that we have.
We are focusing on consumer-centric products, lower up-front commissions, shorter surrender charge periods. It puts us in a position to offer more value to our customers. We were never a significant issuer of variable annuities. They account for about 4% of our reserves. The only place that we sold variable annuities was in the 403(b) market. And frankly, we never offered the exotic writers that some of the competition was offering.
This shows our three-year record and guidance for 2014. You can see we had a great premium year last year, a little over $4 billion. We’re expecting premiums this year 2014 to be flattish. It’s too early to know for sure, but our expectation would be flat premiums. We’re expecting that the fixed annuity investments and reserves will grow at 15% to 18%.
If you take a look at our net interest spread, you can see in 2013, the spread declined by about 18 basis points, principally a result of higher yielding investments running off the books. You can see though that our net spread earned actually increased by 12 basis points. We’re projecting that to decline a bit in 2014.
I’ll talk in a minute about the accounting for indexed-annuities that really drove the increase in the net spread earned, even though the net interest spread declined a bit.
Core pre-tax operating earnings last year increased by 28%. Certainly the big move in interest rates was a positive thing for us. We also had exceptionally strong investment results last year. We’re expecting the operating earnings this year to be flattish with 2013.
And let's talk a little bit about the impact of interest rates on our earnings. Under FAS 133 accounting, a portion of fixed-indexed annuity reserves are discounted using current market rates. In our case, we discount these reserves at the corporate A2 market rate.
As a result in general, an increase in interest rates would have a positive impact on reported earnings and vice-versa. To size the impact of that for you, in 2013, the 10-year corporate A2 rate increased by 110 basis points, and resulted in $18 million of additional earnings.
In 2012, the 10-year A2 rate declined by 72 basis points, which actually reduced our earnings by $12 million. This accounting really affects the timing. It really doesn’t affect the amount of earnings that we’ll book over the lifetime of the policies.
We’re positioned very well for rising interest rates. We think that gradually rising interest rates would be a very healthy thing for our annuity business. Our asset duration is about half year shorter than the liabilities. 13% of the portfolio is invested in floating rate securities. And the lower GMIR or guaranteed minimum interest rate business is protected by sticky product features like market value adjustments, FIA riders or surrender charges.
Let's talk for a minute about our investments. We have a very high quality portfolio. 86% of the portfolio is invested in fixed maturity investments, of which 86% are rated investment grade, and 97% with NAIC ratings of 1 or 2. We take a small part of the portfolio and invest more opportunistically in little bit in private equity, a little bit in equities, a little bit in real estate, but the bulk of the portfolio is in high quality fixed maturity investments.
This is something that we’re pretty proud of. You can see that over the last five years, our fixed income total return has outperformed our industry peers by 160 basis points, which actually created a $1.6 billion of pre-tax value.
Let's talk about financial highlights at American Financial Group. Core net operating earnings from 2013 increased by 23%, and the core net operating earnings per share increased by 29% on fewer shares outstanding because of some repurchases.
Book value per share excluding appropriated retained earnings and unrealized gains on fixed maturities increased by 8%. The tangible book value per share, again excluding appropriated retained earnings and unrealized gains on fixed maturities, increased by 9%. In addition, we paid a $1 a share special dividend as Carl talked about, and paid our regular dividend.
We have a very strong capital position. At year-end 2013, we had a $1 billion of excess capital.
2014 outlook. We announced guidance on core operating earnings of $4.50 to $4.90 per share. That assumes that we owned Summit for nine months. Carl and I have already talked about most of the assumptions that go into this guidance. So a couple of things that we didn’t talk about that I’ll mention here. We’re assuming that the P&C investment income will be approximately 10% higher than last year that really is driven by the Summit acquisition, bigger assets that we’re investing.
We’re also assuming that the run-off in long-term care and life segment will have no material earnings or losses.
And with that, we’d be happy to answer any questions you have.
[Inaudible - Microphone Inaccessible] the logic behind the acquisition of National Interstate and also the price that you are paying for it. I think you might be overpaying?
Sure. Can you hear me? The logic behind the offer for National Interstate is pretty straight forward and it’s laid out in offer to purchase that we published on February 5. Since we’re in offer period, I prudently will check myself to comment that are in that offer to purchase. And it’s fairly complete.
National Interstate is a business that we’ve considered before. It’s a specialty property and casualty business operating in a niche, like where there are other specialty property and casualty niche operations. The earnings of the company have been under pressure as a result at this market, and it’s our feeling that National Interstate might fully complete its corrective action plans more appropriately as a private company wholly-owned by AFJ. And that outcome will be determined by the shareholders potentially tangible or not [ph].
In terms of the price of $28 and the offer to purchase Interstate that we consider to be appropriate, we looked a premiums paid and now that’s going private type transaction and in 2013 [indiscernible] offer. We think it’s a fair opportunity for shareholders to know National Interstate and convert their ownership in cash that attracts a premium, have the certainty of that value in invested capital [Technical Difficulty].
In addition to the National Interstate acquisition, how about the Summit acquisition. Can you comment on that a bit considering others particularly Liberty Mutual strategically reducing its workers’ comp exposure? Why you see it as a strong strategic fit?
I think number one, Liberty Mutual. They have a Liberty brand which was – which competes against Summit. I think that they are focused on a multi-line approach including comp. And I think Summit might have been kind of non-core to their brand building and their approach to things over time. So it makes sense for them.
For us, we’re in the specialty workers’ comp business through a public indemnity in California, and have done well over a long period of time. And we have a large deductible niche business in comp, what we call strategic comp. Both of our workers’ comp businesses are in good order.
We feel that this year, Republic is moving towards action here underwriting profitability. Our strategic comp large deductible business is profitable and both those businesses have good returns. We have our house in order. And Summit was an opportunity to acquire another specialty workers’ comp rider that has great market position. They are the number one in the southeastern United States. So it fits very well geographically with what we’re doing. And has a good management team. And we’re very excited to be making that investment.
Jay Cohen – Bank of America/Merrill Lynch
We have time for another question. I’ll grab the mike and ask it. The crop business, specifically the farm bill, it seems part of the change occurring is to make crop insurance a more important part of the help they give to farmers, you play an important role there obviously, this has to be good for your business. Can you talk about the impact that it could have?
Yes, I think we agree with your assessment, Jay. We think the farm bill is a net positive. It makes the government multi-peril program more important as really the cuts were done in food stamps and direct aid to farmers in that.
I think it really reinforced the importance of the program. So we had good market position. We're the fourth largest rider in that business. So we are very pleased that the farm bill has passed, and think it will be positive.
Jay Cohen – Bank of America/Merrill Lynch
So we can't quantify yet at this point what it could mean for you?
That’s probably right. I think one interesting little twist I think is that Congress, I think will have the authority to set the economics rather than the RMA or the government agency is our understanding.
So it’s really two, three, four year negotiations and that type of thing that happen ever so many years that probably more congress that will set the economics versus the RMA. I think it had some poor flexibility in changing things on an ongoing basis. So I think that could be a positive, but creates more certainty.
Jay Cohen – Bank of America/Merrill Lynch
That’s great. That’s all the time we have. Before we let you go, so just to make sure you guys know that there are box lunches available. The next presentation starts at 12:35. It’s kind of a working lunch. So grab some lunch, you can bring it back in here and join me in thanking the team from AFJ.
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