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AFG > SEC Filings for AFG > Form 10-Q on 9-May-2014All Recent SEC Filings




Quarterly Report

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


Page Page
Statements 29 Managed Investment Entities 37 Overview 30 Results of Operations 40 Critical Accounting
Policies 30 General 40 Liquidity and Capital Segmented Statement of Resources 30 Earnings 41 Property and Casualty Ratios 30 Insurance 42 Condensed Consolidated
Cash Flows 31 Annuity 50 Parent and Subsidiary Run-off Long-Term Care and Liquidity 32 Life 54 Holding Company, Other and Investments 33 Unallocated 55 Uncertainties 37


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;

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

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.

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


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 most meaningfully presented 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 first three months of 2014 were $103 million ($1.13 per share, diluted) compared to $120 million ($1.32 per share, diluted) for the comparable 2013 period. Higher underwriting profits in the property and casualty insurance segment were more than offset by lower realized gains on securities and slightly lower earnings in the annuity 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 2013 Form 10-K.


Ratios  AFG's debt to total capital ratio on a consolidated basis is shown below
(dollars in millions):
                                         March 31,       December 31,
                                           2014         2013       2012
Long-term debt                          $     913     $  913     $  953
Total capital                               5,281      5,192      4,907
Ratio of debt to total capital:
Including debt secured by real estate        17.3 %     17.6 %     19.4 %
Excluding debt secured by real estate        16.3 %     16.6 %     18.4 %

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

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

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 1.81 for the three months ended March 31, 2014 and 2.15 for the year ended December 31, 2013. Excluding annuity benefits, this ratio was 7.74 and 8.86, 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 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 and corporate expenses, and to provide returns to shareholders through share repurchases and dividends. AFG's cash flows from operating, investing and financing activities as detailed in its Consolidated Statement of Cash Flows are shown below (in millions):

                                              Three months ended March 31,
                                               2014                 2013
Net cash provided by operating activities $       204         $           59
Net cash used in investing activities            (426 )                 (470 )
Net cash provided by financing activities         459                    235
Net change in cash and cash equivalents   $       237         $         (176 )

Net Cash Provided by Operating Activities 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. Net cash provided by operating activities was $204 million for the first three months of 2014 compared to $59 million in the first three months of 2013, an increase of $145 million. The $145 million increase in net cash provided by operating activities is due primarily to the timing of claims payments and reinsurance recoveries in the property and casualty insurance operations.

Net Cash Used in Investing Activities AFG's investing activities consist primarily of the investment of funds provided by its property and casualty and annuity products. Net cash used in investing activities was $426 million for the first three months of 2014 compared to $470 million in the first three months of 2013, a decrease of $44 million. The $323 million increase in net cash flows from annuity policyholders in the first three months of 2014 as compared to the 2013 period (discussed below under net cash provided by financing activities) increased the amount of cash available for investment in the first three months of 2014 compared to the 2013 period. However, cash on hand in the annuity and run-off long-term care and life segments increased by $243 million during the first three months of 2014 as net cash flows from annuity policyholders outpaced the investment of the funds received. The change in net cash used in investing activities also reflects the impact of investing the property and casualty segment's cash flows from operating activities, which were higher in the first three months of 2014 as compared to the 2013 period. 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 $198 million source of cash in the first three months of 2014 compared to a $138 million source of cash in the 2013 period. See Note A - "Accounting Policies - Managed Investment Entities" and Note H - "Managed Investment Entities" to the financial statements.

Net Cash Provided by Financing Activities 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. Net cash provided by financing activities was $459 million for the first three months of 2014 compared to $235 million in the first three months of 2013, an increase of $224 million. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $578 million in the first three months of 2014 compared to $255 million in the first three months of 2013, resulting in a

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

$323 million increase in net cash provided by financing activities in the 2014 period compared to the 2013 period. During the first three months of 2014, AFG repurchased $24 million of its Common Stock compared to $3 million repurchased in the first three months of 2013, which accounted for a $21 million decrease in net cash provided by financing activities in the 2014 period compared to the 2013 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 $88 million in the first three months of 2014 compared to $18 million in the first three months of 2013, representing a $70 million decrease in net cash provided by financing activities in the 2014 period compared to the 2013 period. See Managed Investment Entities in Note A - "Accounting Policies" and Note H - "Managed Investment Entities" to the financial statements.

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.

AFG can borrow up to $500 million under its revolving credit facility which expires in December 2016. 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 2013 or the first three months of 2014.

In April 2014, AFG completed the previously announced purchase of Summit Holding Southeast, Inc. and its related companies ("Summit") from Liberty Mutual Insurance using cash on hand at the parent company. AFG paid Liberty Mutual Insurance approximately $260 million at closing. In addition, AFG made a capital contribution of approximately $140 million, bringing its capital investment in the Summit business to approximately $400 million, pending post-closing adjustments. Summit's results of operations will be included in AFG's consolidated results commencing with the beginning of the 2014 second quarter.

During the first three months of 2014, AFG repurchased 419,938 shares of its Common Stock for $24 million. In April 2014, AFG repurchased 151,266 additional shares of its Common Stock for $8 million. During 2013, AFG repurchased 1.4 million shares of its Common Stock for $70 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. At March 31, 2014, GALIC had $440 million in outstanding advances from the FHLB (included in annuity benefits accumulated), bearing interest at rates ranging from 0.02% to 0.23% over LIBOR (average rate of 0.31% at March 31, 2014). 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.

National Interstate Corporation, a 51%-owned property and casualty insurance subsidiary, can borrow up to $100 million under its unsecured credit agreement, which expires in November 2017. There was $12 million borrowed under this agreement at March 31, 2014, bearing interest at 1.07% (two-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.

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

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 March 31, 2014, AFG could reduce the average crediting rate of its $16 billion of traditional fixed and fixed-indexed deferred annuities without guaranteed withdrawal benefits by approximately 51 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.

Supplemental Catastrophe Reinsurance On March 31, 2014, AFG's property and casualty insurance operations entered into a reinsurance agreement to obtain additional catastrophe protection through a catastrophe bond structure with Riverfront Re Ltd. ("Riverfront"). The reinsurance agreement provides supplemental reinsurance coverage up to $95 million (fully collateralized) for catastrophe losses in excess of $100 million occurring during the period from April 1, 2014 through December 31, 2016. In connection with the reinsurance agreement, Riverfront issued notes to unrelated investors for the full $95 million of coverage provided under the reinsurance agreement. At the time of the agreement, AFG concluded that Riverfront is a variable interest entity, but that it does not have a variable interest in the entity because the variability in Riverfront's results is expected to be absorbed entirely by the investors in Riverfront. Accordingly, Riverfront is not consolidated in AFG's financial statements and the reinsurance agreement is accounted for as ceded reinsurance. AFG's cost for this coverage will be approximately $5 million per year.

Investments AFG's investment portfolio at March 31, 2014, contained $27.39 billion in fixed maturity securities classified as available for sale and $1.30 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, $297 million in fixed maturities were classified as trading with changes in unrealized holding gains or losses included in net 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 26% 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 85% 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.

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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 March 31, 2014 (dollars in millions). Effects of increases or decreases from the 100 basis points illustrated would be approximately proportional.

Fair value of fixed maturity portfolio                            $ 27,687
Pretax impact on fair value of 100 bps increase in interest rates $ (1,246 )
Pretax impact as % of total fixed maturity portfolio                  (4.5 %)

Approximately 86% of the fixed maturities held by AFG at March 31, 2014, 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, tighter lending standards 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 March 31, 2014, is shown (dollars 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 5 years and 4 years, respectively.

                                                                                       % Rated
                    Amortized                      Fair Value as      Unrealized      Investment
                       Cost        Fair Value        % of Cost       Gain (Loss)        Grade
Collateral type
Agency-backed      $       310    $        315           102 %      $           5         100 %
Non-agency prime         1,996           2,209           111 %                213          44 %
Alt-A                      989           1,091           110 %                102          22 %
. . .
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