American Financial Group, Inc., (NYSE:AFG)
Q2 2010 Earnings Call
August 3, 2010
Carl Lindner III - President & Co-Chief Executive Officer
Keith Jensen – Senior Vice President & Chief Financial Officer
Jay Cohen – Bank of America
Welcome to the American Financial Group 2010 second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question and answer session. (Operator instructions). Thank you. I will now like to turn the call over to Keith Jensen, senior vice president of American Financial Group. Please go ahead sir.
Thank you. Good morning and welcome to American Financial Group's 2010 second quarter earnings results conference call. I'm joined this morning by Carl Lindner III and Craig Lindner, the Co-CEO's of American Financial Group. If you are viewing the webcast from our website, you can follow along with the slide presentation if you'd like.
Certain statements made during this call are not historical facts and may be considered forward-looking statements because and are based on estimates, assumptions and projections, which management believes are reasonable, but by their nature subject to risks and uncertainties.
The factors which could cause actual results and/or financial conditions to differ materially from those suggested by such forward-looking statements include, but are not limited to those that are discussed or identified from time to time in AFG's filings with the Securities and Exchange Commission, including the report on Form 10-K and Quarterly Reports on Form 10-Q.
We do not promise to update such forward-looking statements to reflect actual results or changes in assumptions or other factors that could affect these statements. Core net operating earnings is a non-GAAP financial measure, which sets aside items that are generally not considered to be part of ongoing operations, such as net realized gains and losses on investments, the effects of accounting changes, discontinued operations, significant asbestos and environmental charges and other certain other non-recurring items.
AFG believes this non-GAAP measure to be a useful tool for analysts and investors in analyzing ongoing operating trends and will be discussed for various periods during this call. A reconciliation of net earnings attributable to shareholders to core net operating earnings is included in our earnings release.
Now, I am pleased to turn the call over to Carl Lindner III to discuss our results.
Carl Lindner III
Good morning and thank you for joining us. We released our 2010 second quarter results yesterday afternoon reporting quarter earnings that were in line with our expectations. Despite increased catastrophe activity, decreased commercial demand resulting from a depressed economy and soft pricing, we’re making solid progress towards our operational goals for 2010. I’m assuming that the participants on today’s call reviewed our earnings release and the supplemental materials posted on our website. A review of Q2 highlights and focus today’s discussion on key issues in our outlook for the remainder of 2010.
Let’s start by looking at our 2010 2nd quarter results summarized on slides 3 and 4 of the webscast. Our 2nd quarter core net operating earnings were $102 million or $.91 per share, about 13% below the prior year period. These results reflect improved results in our duly and supplemental insurance operations which were more than offset by lower property and casualty underwriting profit and lower investment income.
Results for the 2nd quarter and first 6 months include increased borrowing costs associated with a $350 million debt issuance in 2009 which were more than offset by reduced expenses associated with the company stock portion, our employee retirement plans and higher earnings from our managed investment annuities.
Net earnings were $0.97 per share for the 2010 2nd quarter, a decrease of 11%. Annualized 6 months quarter operating return on equity for 2010 was approximately 10%. One of our important strategic objectives is to deploy our excess capital in a way that enhances shareholder value. To that end, we purchased 2.7 million shares of our common stock at an average price of $27.82 per share during the 2010 2nd quarter.
To put this in context, the total shares repurchased in the 1st 6 months of 2010 represent about 5% of AFG’s outstanding shares at the beginning of the year. We believe the purchase of shares below book value is an appropriate means of increasing shareholder value. There are approximately 2 million shares remaining under our current repurchase authorization. We plan to seek an additional authorization at the next meeting of our board of directors as we anticipate continued share repurchases through the end of the year, subject to market conditions and other capital needs.
We also continue to seek opportunities to grow our specialty niche business, particularly when expected investment returns provide the potential to enhance long term shareholder value. The acquisition of Vanliner Insurance Company by our National Interstate Sub is an excellent example of this type of investment. Vanliner’s expertise in providing insurance for the moving and storage industry serves as a natural, strategic extension to the tracking and transportation business.
Yesterday we renewed our $500 million bank line which strengthens our financial flexibility to respond when opportunities arise. In all these capital allocation decisions, we keep in mind our need to keep sufficient dry powder enable us to respond appropriately to unforeseen needs as well as opportunities. As you’ll see on slide 4, AFG’s book value per share including all unrealized gains and losses on investments but excluding appropriated retained earnings increased to $37.48 as a result of AFG's earnings performance, continued improvement in the market value of our investment portfolio and a share repurchase activity. This represents an increase of 12% from the $33.35 per share reported at the end of last year.
Tangible book value was $35.08 at June 30th 2010, up 13% from year end 2009. Growth in AFG’s book value per share is a key strategic benchmark in measuring value creation for our shareholders. Since the end of 2007 AFG has grown its book value per share, excluding appropriated retained earnings, by 40%.
Our capital adequacy, financial condition and liquidity remained strong in our key areas of focus for us, especially as economic uncertainty continues. We’ve maintain capital on our insurance businesses at levels that support our operations and are consistent with amounts required for rating levels. At the end of the quarter, available cash at the parent company was approximately $125 million with excess capital more than $400 million. We anticipate continuing to generate additional capital and cash through operations during this year.
Keith and I are proud that Great American was recently named 2010 Ward’s 50 list of top performing property and casualty companies. Each Ward’s 50 company has passed various safety and consistency screens and achieved superior performance over the 5 years analyzed. Considering that over 3,000 PNC companies were evaluated by Ward’s, we’re pleased that our performance has been recognized in this manner for the 4th consecutive year.
In addition, in May, A.M Best once again awarded Great American with an A rating, one that we’ve held since 1908, making Great American one of only 4 property and casualty companies rated A or better by A.M Best for over 100 years. Great American is one of only 2 insurance companies that have earned both of these distinctions, something that we’re both extremely proud of. We also think that this recognition highlights our commitment for underwriting excellence and operational discipline.
Now let’s turn our discussion to our specialty property and casualty business. On slide 5, you’ll see summary results for these operations. Overall underwriting profits in the 2010 second quarter were solid, generating a combined ration of 88%, six points higher than the prior year period. Severe storms that brought flooding, hail and tornados primarily in Oklahoma contributed to catastrophe losses that were $23 million higher than in the 2nd quarter of last year, though our favorable reserve development was also a factor driving the increase in the combined ratio.
We continue to focus on pricing our business to achieve appropriate returns. Reduced top line growth in some of our lines is evidence of our commitment to walk away from business that won’t generate appropriate returns. We know that we’ll see the results of today’s pricing decisions for a lot of years to come and believe our disciplined approach will allow us to provide quality products to insureds at competitive rates over the long run. Average renewal rates in specialty operations during the first half of 2010 were flat when compared to the prior year.
A continuing soft market, competitive pressures, depressed economic conditions and lower commodity prices contributed to declines in gross and net written premiums during the first of this year. Sessions under our crop quota share agreement returned to historical levels resulting in higher levels of retained crop premium that partially offsets the declines in the net written premium. Gross investment, income related to our property and casualty operations was down approximately 17% for the second quarter of 2010 when compared to the same period last year, primarily as a result of decreased holdings and higher yielding investments and generally lower reinvestment rates.
Now let’s discuss a few highlights from each of our specialty business groups on slide six and seven. Property and transportation group reported low underwriting results during the 2nd quarter. The decline in underwriting profit was driven primarily by higher catastrophe losses. These were somewhat offset by higher favorable reserve development. Current growing conditions are favorable for the 3 main crops in our major producing states in our crop business.
As of July 30th, commodity prices for corn were about 2% higher than the February discovery prices and soybean pricing is up about 9%. The Risk Management Agency and Federal Crop Insurance Corporation issued the 3rd and final draft of the 2011 standard reinsurance agreement, commonly called the SRA in June this year. Great American signed a new agreement in July along with 15 other approved insurance providers that participate in the program.
The new SRA includes several changes that reduced revenue for participating insurers. We estimate that the new provisions in the 2011 SRA will reduce AFG’s operating income by about $15 million annually. We’re closely examining our business model to make the necessary adjustments to align delivery costs with underwriting margins. First policy covered by the new SRA terms will be effective for _ insurance year beginning July 1st 2010.
Though the results we report in this calendar year will be subject to the current and more favorable SRA terms. Average renewal rates in our property and transportation group for the 1st half were flat compared to the prior year period. Our specialty casualty group reported lower underwriting profits for the 2nd quarter of 2010 primarily due to continued challenging underwriting environment and slightly lower favorable development. General economic conditions have dampened demand for coverages in some markets particularly our general liability business that serves home builders and our California Workers Comp business.
We firmly believe that more rates needed to achieve appropriate returns in our California Comp business, especially as we’re seeing some increases in severity trends particularly related to increases in medical costs. Our average renewal rates in California were up 9% for the first six months, which is encouraging but still not where we need to be from a rate perspective.
Although second quarter 2010 underwriting profits for most of the businesses in this group were at levels lower than the prior year, the vast majorities businesses produced satisfactory underwriting profit margins.
Average renewal rates for the specialty casualty group were flat compared to the prior year period. Moving on to specialty financial, this group lower underwriting profits in the second quarter, primarily due to lower favorable reserve development in our run-off automobile residual value business. The remaining $23 million of Canadian RVI reserves relating to leases that terminate through the end of this year.
All the businesses of this group produced excellent underwriting profits that lower levels than the prior year. Average renewal rates for this group were flat in the 1st half of 2010. Now let’s move on to a review of our annuity and supplemental insurance group on slide 8. The annuity and supplemental insurance group generated pretax core net operating earnings for the second quarter of 2010 that were approximately 10% than the comparable period last year.
These results are principally the result of higher earnings in our fixed annuity and supplemental insurance businesses which were partially offset by lower earnings in our variable annuity operations. Second quarter and six month statutory premiums were up about a third due to increased sales of single premium annuities and higher sales in the bank market, primarily as a result of our distribution through PNC bank.
The single premium annuities and bank market sales were offset somewhat by lower sales in the 403 B annuity market.
We were pleased to see a final resolution to the industry’s regulatory issues related to equity indexed annuities. These annuities will continue to be treated just like other fixed annuities. We think this approach should allow consistency in our product distribution. We continue to experience strong persistency in our annuity businesses. We continue to move toward product designs that reward policy holders and agents for long-term persistency.
We recently completed an internal review of AFG’s asbestos and environmental exposures relating to the runoff operations of our PMC Group and exposures related to a former railroad and manufacturing operations and sites. We conduct similar studies with the assistance of outside actuaries, especially outside council every two years and perform in-depth internal review in the intervening years. As a result of this review there were no newly identified emerging trends or issues that significantly impact the adequacy of our reserves.
We recorded less than $5 million in after tax increases in AFG’s asbestos environmental reserves. At June 30th, 2010 the group’s A & E reserves of $360 million net of reassurance recoverables as outlined on slide nine.
Our survival ratio for property and casualty asbestos reserves is 9.6 times eight losses and for A & E reserves it's 8.5 times paid losses. As you can see these ratios compare favorably with industry A & E data published by Conning Research and Consulting in May of this year. According to Conning’s report, previous survival ratios were 8.2 for asbestos reserves and 7.7 for total earnings reserves at the end of ‘09.
Consistent with our current practice we plan to perform an external study next year and an internal review in 2012.
Now if you turn to slide 10 I will talk about a few highlights regarding our investment portfolio. During the second quarter of 2010 we recorded after tax realized gains on investments of $6 million, $4 million less than in the comparable period last year.
After tax unrealized gains were $403 million at June 30th, 2010. This number reflects an after tax unrealized gain on fixed maturities of $287 million. The vast majority of our portfolios held in fixed maturities was approximately 91% being rated investment grade and 95% with a designation of NAIC 1 or 2.
We have provided additional detailed information on the various segments of our investment portfolio in the investment supplement on our website.
Now I’d like to cover our outlook for 2010 on slides 11 and 12. Based on the results through the first half of this year, our 2010 core net operating earnings guidance has been increased to $3.55 to $3.85 a share up from our original estimate of $3.30 to $3.70 per share. We do expect to maintain adequate rates on our specialty property and casualty operations because of our strong underwriting culture. We expect to achieve a combined ratio of about 87% to 89%. That said, we’re targeting modest increases in overall
average renewal rates this year due to competitive conditions in certain markets.
We expect net written premiums in our specialty property and casualty operations to be flat at 3% higher than 2009 levels. We’re currently negotiating the sale of the unarmed premium for certain of our non-RBI automotive-related lines of business which is reflected in our guidance and completes our planned exit from these businesses. The sale will result in a decrease in specialty property and casualty net written premiums. This decrease will partially offset additional net written premiums resulting from increased retention in our op business.
Guidance assumes action year crop earnings at a more normal run rate therefore lower than our record 2009 results. We expect this group’s net rate premiums to increase by approximately 20% to 24% primarily as a result of higher retention in our crop business and National Interstates acquisition of Vanliner.
We expect the specialty casualty group to generate solid underwriting profit with a combined ratio in the 91% to 95% range. We anticipate net written premiums will be down 3% to 7%. We look for specialty financial groups combined ratio to be between 77% and 81%. Because of the anticipated sale of the unearned premium associated with certain of our non-RBI automotive-related lines of business, we project net written premiums to be down 28% to 32%. We also expect to record a gain from the sale during the third quarter.
Based on recent market conditions and trends, we expect 2010 full year core pre-tax earnings – operating earnings for our annuity and supplemental insurance group to be 15% to 20% higher than last year
These 2010 expected results exclude the potential for significant catastrophe in crop losses, significant adjustments to A & E reserves, large gains or losses from assets sales or impairments and unlocking adjustments related to annuity deferred acquisition funds.
Now we’d like to open the lines for any questions; thank you.
We’ll pause for just a moment to compile the Q&A roster. (Operator Instructions) We have a question from Joe Cohen from Bank of America.
Jay Cohen – Bank of America
Yeah, it's actually Jay Cohen and a couple of questions. The first is you suggested that the 2Q numbers were basically in line with your expectations. What then accounts for the increased guidance? Let me start there then I’ll ask the other one.
Yeah, Jay this is Carl. I think…it's probably a couple of things; I think the condition of our…the crops and the crop pricing and then also I think I alluded to…we’ve built in the sale of the unearned premium on that runoff automotive business that would add to operating earnings at the point that we would complete that. And I think we – in our own internal modeling, our second quarter was above kind of what our internal modeling was; probably the combination of those three things caused us to increase our guidance.
Jay Cohen – Bank of America
Got it and then the second question has to do with the specialties financial proposed transaction. So I guess your recorded gain which you will run through your core earnings, any estimates of what that gain is going to be?
Yes, we expect that gain is going to be probably plus or minus about $10 million.
Jay Cohen – Bank of America
Okay, and then the last question, I understand you don’t break out the California Comp business but there was at least one other competitor that had a pretty rough quarter in California Comp and you obviously suggested you need rate there. Can you give us at least a qualitative feel for how that business is doing from a combined ratio stand point?
Yeah, I think you can check me on those but I think the on a calendar year basis we reported around 110ish…
Yeah, 109, 110ish and on an accident year basis, I think we feel that that business is probably 118ish today. We’ve got about 9% in rate through the first six months, we could use another 8% to 10% on top of that to get that business at least to a point where we could get low teens returns. At 104 that’s, about 15% return on equity so we need about – we need another additional 8% to 10% to get that business to a reasonable return. The market is more competitive than what it should be, for the accident year results that we see and it doesn’t surprise me, I think the industry numbers out there are 120 or 120 plus. I’ve been saying all along but I think there is going to be some surprises unfavorably at a certain competitors that have been extremely aggressive there. Our businesses have been coming down and dropping pretty significantly for the last couple of years in that competitive environment. So it doesn’t surprise me that there is a few surprises out there.
Jay Cohen – Bank of America
Yeah, at this point fortunately they’re a relatively small piece of your business given those margins. That’s helpful Carl; I appreciate that, thank you.
(Operator Instructions) There are no further questions at this time.
Alright, thank you very much for joining us today, we appreciate your time and we look forward to reporting to you in three months.
Thank you, have a good day.
This concludes today’s conference call, you may now disconnect.
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