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AFG > SEC Filings for AFG > Form 10-Q on 8-Aug-2013All Recent SEC Filings

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Quarterly Report

Management's Discussion and Analysis of Financial Condition and Results of Operations


Page Page
Statements 31 Annuity 53 Run-off Long-Term Care and Overview 32 Life 58 Critical Accounting Medicare Supplement and Policies 32 Critical Illness 59 Liquidity and Capital Holding Company, Other and Resources 33 Unallocated 59 Ratios 33 Other - Consolidated 60 Condensed Consolidated Results of Operations - First Cash Flows 33 Six Months 62 Parent and Subsidiary Segmented Statement of Liquidity 34 Earnings 62 Property and Casualty Investments 35 Insurance 63 Uncertainties 39 Annuity 71 Managed Investment Run-off Long-Term Care and Entities 39 Life 75 Medicare Supplement and Results of Operations 43 Critical Illness 76 Holding Company, Other and General 43 Unallocated 76 Results of Operations -
Second Quarter 44 Other - Consolidated 77 Segmented Statement of
Earnings 44 New Accounting Standards 78 Property and Casualty
Insurance 45


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", "projects", "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 long-term care, asbestos, environmental pollution and mass tort claims; rate changes; and improved loss experience.

Actual results and/or financial condition could differ materially from those contained in or implied by such forward-looking statements for a variety of reasons including but not limited to:
changes in financial, political and economic conditions, including changes in interest and inflation rates, currency fluctuations and extended economic recessions or expansions in the U.S. and/or abroad;

performance of securities markets;

AFG's ability to estimate accurately the likelihood, magnitude and timing of any losses in connection with investments in the non-agency residential mortgage market;

new legislation or declines in credit quality or credit ratings that could have a material impact on the valuation of securities in AFG's investment portfolio;

the availability of capital;

regulatory actions (including changes in statutory accounting rules);

changes in the legal environment affecting AFG or its customers;

tax law and accounting changes;

levels of natural catastrophes and severe weather, terrorist activities (including any nuclear, biological, chemical or radiological events), incidents of war or losses resulting from civil unrest and other major losses;

development of insurance loss reserves and establishment of other reserves, particularly with respect to amounts associated with asbestos and environmental claims and AFG's run-off long-term care business;

availability of reinsurance and ability of reinsurers to pay their obligations;

the unpredictability of possible future litigation if certain settlements of current litigation do not become effective;

trends in persistency, mortality and morbidity;

competitive pressures, including those in the annuity distribution channels;

the ability to obtain adequate rates and policy terms; and

Table of Contents
Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued

changes in AFG's credit ratings or the financial strength ratings assigned by major ratings agencies to AFG's operating subsidiaries.

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.


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, 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.

Results of Operations

Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance, focusing on specialized commercial products for businesses and in the sale of fixed and fixed-indexed annuities in the retail, financial institutions and education markets.

Net earnings attributable to AFG's shareholders for the second quarter and first six months of 2013 were $110 million ($1.20 per share, diluted) and $230 million ($2.52 per share, diluted), respectively, compared to $99 million ($1.01 per share, diluted) and $212 million ($2.15 per share, diluted) reported in the same periods of 2012. Significantly higher profits in the annuity segment and higher realized gains on sales of securities were partially offset by the absence of earnings from the Medicare supplement and critical illness businesses that were sold in August 2012, and lower underwriting profits and investment income in AFG's property and casualty insurance segment.


Significant accounting policies are summarized in Note A - "Accounting Policies" to the financial statements. The preparation of financial statements in conformity with U.S. generally accepted accounting principles ("GAAP") 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 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:

the establishment of insurance reserves, especially asbestos and environmental-related reserves and reserves for AFG's closed block of long-term care insurance,

the recoverability of reinsurance,

the recoverability of deferred acquisition costs,

the establishment of asbestos and environmental reserves of former railroad and manufacturing operations, and

the valuation of investments, including the determination of "other-than-temporary" impairments.

For a discussion of these policies, see Management's Discussion and Analysis - "Critical Accounting Policies" in AFG's 2012 Form 10-K.

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                      AMERICAN FINANCIAL GROUP, INC. 10-Q
   Management's Discussion and Analysis of Financial Condition and Results of
                             Operations - Continued


Ratios  AFG's debt to total capital ratio on a consolidated basis is shown below
(dollars in millions):
                                         June 30,       December 31,
                                           2013        2012       2011
Long-term debt                          $    949     $  953     $  934
Total capital                              5,092      4,907      4,860
Ratio of debt to total capital:
Including debt secured by real estate       18.6 %     19.4 %     19.2 %
Excluding debt secured by real estate       17.6 %     18.4 %     18.2 %

The ratio of debt to total capital is a non-GAAP measure that management believes is useful for investors, analysts and independent ratings agencies to evaluate AFG's financial strength and liquidity and to provide insight into how AFG finances its operations. The ratio is calculated by dividing AFG's long-term debt by its total capital, which includes long-term debt, noncontrolling interests and shareholders' equity (excluding unrealized gains (losses) related to fixed maturity investments and appropriated retained earnings related to managed investment entities).

AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.14 for the six months ended June 30, 2013 and 1.98 for the year ended December 31, 2012. Excluding annuity benefits, this ratio was 8.46 and 7.16, respectively. Although the ratio excluding annuity benefits 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.

Condensed Consolidated Cash Flows
AFG's cash flows from operating, investing and financing activities as detailed
in its Consolidated Statement of Cash Flows are shown below (in millions):
                                             Six months ended June 30,
                                                2013              2012
Net cash provided by operating activities $         196         $   226
Net cash used in investing activities            (1,192 )          (826 )
Net cash provided by financing activities           562             799
Net change in cash and cash equivalents   $        (434 )       $   199

AFG's principal sources of cash include insurance premiums, income from its investment portfolio and proceeds from the maturities, redemptions and sales of investments. Insurance premiums in excess of acquisition expenses and operating costs are invested until they are needed to meet policyholder obligations or made available to the parent company through dividends to cover debt obligations, corporate expenses, and to provide returns to shareholders through share repurchases and dividends.

Net cash provided by operating activities was $196 million for the first six months of 2013 compared to $226 million in the first six months of 2012, a decrease of $30 million. AFG's property and casualty insurance operations typically produce positive net operating cash flows as premiums collected and investment income exceed policy acquisition costs, claims payments and operating expenses. AFG's net cash provided by operating activities is impacted by the level and timing of property and casualty premiums, claim and expense payments and recoveries from reinsurers. AFG's annuity operations typically produce positive net operating cash flows as investment income exceeds acquisition costs and operating expenses. Interest credited on annuity policyholder funds is a non-cash increase in AFG's annuity benefits accumulated liability and annuity premiums, benefits and withdrawals are considered financing activities due to the deposit-type nature of annuities. The $30 million decrease in net cash provided by operating activities reflects the payment of a $124 million asbestos claim settlement in the property and casualty operations, which had been accrued for in prior years.

Net cash used in investing activities was $1.19 billion for the first six months of 2013 compared to $826 million in the first six months of 2012, an increase of $366 million. AFG's investing activities consist primarily of the investment of funds provided by its property and casualty and annuity products. The $75 million decline in net cash flows from annuity policyholders in the first six months of 2013 as compared to the 2012 period (discussed below under net cash provided by financing activities)

Table of Contents
Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued

reduced the amount of cash available for investment in the first six months of 2013 compared to the 2012 period. However, during the first six months of 2013, AFG reduced cash on hand by $164 million through the purchase of investments in the annuity and run-off long-term care and life segments. During the first six months of 2012, cash on hand in the annuity and run-off long-term care and life segments increased by $135 million from year-end 2011 as net cash flows from annuity policyholders outpaced the investment of the funds received. The increase in net cash used in investing activities also reflects the use of cash and cash equivalents held in the property and casualty operations to purchase fixed maturity and equity securities during the second quarter of 2013. Investing activities also include the purchase and disposal of managed investment entity investments (collateralized loan obligations), which are presented separately in AFG's Balance Sheet. Net investment activity in the managed investment entities was a $386 million source of cash in the first six months of 2013 compared to a $181 million source of cash in the 2012 period. See Managed Investment Entities in Note A - "Accounting Policies" and Note H - "Managed Investment Entities".

Net cash provided by financing activities was $562 million for the first six months of 2013 compared to $799 million in the first six months of 2012, a decrease of $237 million. AFG's financing activities consist primarily of transactions with annuity policyholders, issuances and retirements of long-term debt, repurchases of common stock and dividend payments. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $948 million in the first six months of 2013 compared to $1.02 billion in the 2012 period, resulting in a $75 million decrease in net cash provided by financing activities in the 2013 period compared to the 2012 period. Cash flows from financing activities for the first six months of 2012 include $223 million in net proceeds from the issuance of long-term debt in June 2012. The proceeds from the June debt offering were used primarily to retire higher interest rate debt in July 2012. During the first six months of 2013, AFG repurchased 1.4 million shares of its Common Stock for $70 million compared to 4.0 million shares repurchased in the first six months of 2012 for $153 million, which accounted for an $83 million increase in net cash provided by financing activities in the 2013 period compared to the 2012 period. Financing activities also include the issuance and retirement of managed investment entity liabilities, which are nonrecourse to AFG and presented separately in AFG's Balance Sheet. The retirement of managed investment entity liabilities exceed issuances by $308 million in the first six months of 2013 compared to $274 million in the first six months of 2012, accounting for $34 million of the decrease in net cash provided by financing activities in the 2013 period compared to the 2012 period. See Managed Investment Entities in Note A - "Accounting Policies" and Note H - "Managed Investment Entities".

Parent and Subsidiary Liquidity

Parent Holding Company Liquidity Management believes AFG has sufficient resources to meet its liquidity requirements. If funds generated from operations, including dividends, tax payments and borrowings from subsidiaries, are insufficient to meet fixed charges in any period, AFG would be required to utilize parent company cash and marketable securities or to generate cash through borrowings, sales of other assets, or similar transactions.

In December 2012, AFG replaced its bank credit facility with a four-year, $500 million revolving credit line. Amounts borrowed under this agreement bear interest at rates ranging from 1.00% to 1.875% (currently 1.375%) over LIBOR based on AFG's credit rating. There were no borrowings under the agreement, or under any other parent company short-term borrowing arrangements, during 2012 or the first six months of 2013.

During the first six months of 2013, AFG repurchased 1.4 million shares of its Common Stock for $70 million (primarily in the second quarter). During 2012, AFG repurchased 10.9 million shares of its Common Stock for $415 million.

Under tax allocation agreements with AFG, its 80%-owned U.S. subsidiaries generally pay taxes to (or recover taxes from) AFG based on each subsidiary's contribution to amounts due under AFG's consolidated tax return.

Subsidiary Liquidity Great American Life Insurance Company ("GALIC"), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati ("FHLB"). The FHLB makes advances and provides other banking services to member institutions, which provides the annuity operations with a substantial additional source of liquidity. These advances further the FHLB's mission of improving access to housing by increasing liquidity in the residential mortgage-backed securities market. In the second quarter of 2013, the FHLB advanced GALIC $200 million, increasing the total amount advanced to $440 million at June 30, 2013 (included in annuity benefits accumulated). The interest rates on the advances range from 0.02% to 0.23% over LIBOR (average rate of 0.35% at June 30, 2013). While these advances must be repaid between 2016 and 2018, GALIC has the option to prepay all or a portion of the advances. GALIC has invested the proceeds from the advances in fixed maturity securities for the purpose of earning a spread over the interest payments due to the FHLB.

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Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued

In November 2012, National Interstate Corporation ("NATL"), a 52%-owned property and casualty insurance subsidiary, replaced its $50 million bank credit facility with a five-year, $100 million unsecured credit agreement. There was $12 million borrowed under this agreement at June 30, 2013, bearing interest at 1.34% (six-month LIBOR plus 0.875%).

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 generally provided more than sufficient funds to meet these requirements. 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 the 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 AFG's annuity products. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to contractually guaranteed minimum interest rates ("GMIRs"). AFG began selling policies with GMIRs below 2% in 2003; almost all new business since late 2010 has been issued with a 1% GMIR. At June 30, 2013, AFG could reduce the average crediting rate of its $14 billion of traditional and fixed-indexed deferred annuities without guaranteed withdrawal benefits by approximately 41 basis points (on a weighted average basis).

AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses. In addition, these subsidiaries have sufficient capital to meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies. Nonetheless, changes in statutory accounting rules, significant declines in the fair value of the insurance subsidiaries' investment portfolios or significant ratings downgrades on these investments, could create a need for additional capital.

Investments AFG's investment portfolio at June 30, 2013, contained $25.04 billion in "Fixed maturities" classified as available for sale and $1.20 billion in "Equity securities," all carried at fair value with unrealized gains and losses included in a separate component of shareholders' equity on an after-tax basis. In addition, $293 million in fixed maturities were classified as trading with changes in unrealized holding gains or losses included in investment income.

Fair values for AFG's portfolio are determined by AFG's internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on closing prices obtained from the pricing services. For mortgage-backed securities ("MBS"), which comprise approximately 27% of AFG's fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the remainder of AFG's fixed maturity portfolio, approximately 86% are priced using pricing services and the balance is priced primarily by using non-binding broker quotes. When prices obtained for the same security vary, AFG's internal investment professionals select the price they believe is most indicative of an exit price.

The pricing services use a variety of observable inputs to estimate fair value of fixed maturities that do not trade on a daily basis. Based upon information provided by the pricing services, these inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data, and measures of volatility. Included in the pricing of MBS are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Due to the lack of transparency in the process that brokers use to develop prices, valuations that are based on brokers' prices are classified as Level 3 in the GAAP hierarchy unless the price can be corroborated, for example, by comparison to similar securities priced using observable inputs.

Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG's internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. In addition, AFG communicates directly with pricing services regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the services to value specific securities.

Table of Contents
Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued

In general, the fair value of AFG's fixed maturity investments is inversely correlated to changes in interest rates. The following table demonstrates the sensitivity of such fair values to reasonably likely changes in interest rates by illustrating the estimated effect on AFG's fixed maturity portfolio that an immediate increase of 100 basis points in the interest rate yield curve would have at June 30, 2013 (dollars in millions). Increases or decreases from the 100 basis points illustrated would be approximately proportional.

Fair value of fixed maturity portfolio                            $ 25,328
Pretax impact on fair value of 100 bps increase in interest rates $ (1,140 )
Pretax impact as % of total fixed maturity portfolio                  (4.5 %)

Approximately 86% of the fixed maturities held by AFG at June 30, 2013, 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 non-investment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return.

MBS are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates. Although interest rates have been low for the last few years, a weak housing market and uncertain economic conditions have led to tighter lending standards, which have resulted in fewer buyers being able to refinance the mortgages underlying much of AFG's non-agency residential MBS portfolio.

Summarized information for AFG's MBS (including those classified as trading) at June 30, 2013, is shown (in millions) in the table below. Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The majority of the Alt-A securities and substantially all of the subprime securities are backed by fixed-rate mortgages. The average life of the residential and commercial MBS is approximately 3 years and 4 years, respectively.

                                                                                       % Rated
                    Amortized                      Fair Value as      Unrealized      Investment
                       Cost        Fair Value       % of  Cost       Gain (Loss)        Grade
Collateral type
Agency-backed      $       226    $        232           103 %      $           6         100 %
Non-agency prime         1,922           2,094           109 %                172          44 %
Alt-A                      828             895           108 %                 67          23 %
Subprime                   886             945           107 %                 59          16 %
Commercial               2,631           2,858           109 %                227          97 %
                   $     6,493    $      7,024           108 %      $         531          61 %

. . .

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