American Financial Group Inc (AFG) 2006 Q2 法說會逐字稿

Good day, ladies and gentlemen. Welcome to your Second Quarter 2006 American Financial Group earnings conference call. My name is Jean. I'll be your conference coordinator today.

At this time, I'll turn the call over to your host, Mr. Keith Jensen, Senior Vice President.

Thank you. I'm joined today by Carl Linder III and Craig Lindner, Co-CEOs of American Financial Group. I'm happy to welcome you to American Financial Group's 2006 second quarter earnings results conference call.

If you're 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 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 to differ from those suggested by such forward-looking statements include, but are not limited to, those discussed or identified from time to time in AFG's filings with the Securities and Exchange Commission, including the annual report on Form 10-K and the quarterly report only Form 10-Q. We do not promise to update such forward-looking statements to reflect actual results or changes, 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 not considered to be part of ongoing operations, such as net realized gains or losses on investments, effects of accounting changes, discontinued operations, and certain nonrecurring items. AFG believes it to be a useful tool for investors and analysts in analyzing ongoing operating trends. As such, core net operating earnings for various periods will be discussed during this call, including the results of Great American Financial Resources, our 81%-owned subsidiary, listed on the New York Stock Exchange. A reconciliation of net earnings to core net operating earnings is included in our earnings release.

Now I'm happy to turn the call over to Carl Linder III, Co-Chief Executive Officer of American Financial Group.

Good morning, and thank you for joining us.

Please turn to slide 3 of the webcast. Yesterday afternoon, we released the 2006 second quarter results for American Financial Group, as well as for our 81%-owned subsidiary, Great American Financial Resources.

Our results for the quarter and through the first half of the year of excellent. I'd like to review a few highlights.

Net earnings for the 2006 second quarter were 50% higher than the 2005 second quarter, due primarily to higher insurance operating earnings, a $26 million after-tax gain from the previously announced sale of the Chatham Bars Inn, and the favorable resolution of tax issues.

We again achieved record core net operating earnings of $1.16 per share in the second quarter, 29% higher than the same period a year earlier. This significant increase was driven by improved underwriting profits in the Specialty, Property, and Casualty operations, and higher investment income.

We maintained our strong balance sheet and liquidity at the end of the 2006 second quarter. Our debt-to-capital ratio was below 24%, and shareholders' equity, excluding unrealized gains and losses on fixed maturities, was up 10% from the 2005 year end.

Turning to slide 4, let's cover some second quarter highlights of the Specialty, Property, and Casualty group.

Net written premiums in the 2006 second quarter were 9% higher than the same period a year earlier. Growth in the Property and Transportation group and Specialty Casualty groups more than offset a decline in California Workers Comp business, due to significant rate decreases.

Overall average rates were down about 2% from the prior year period. Excluding the effect of California Workers Comp rate decreases, average rate levels were up about 1%, though. Our year-to-date growth is at the top end of our previously announced expectations of between 5 and 7%.

Specialty Property and Casualty operations achieved another best in AFG history, with a combined ratio of 87.5%. Underwriting profit of nearly 77 million was up 27% compared to the 2005 second quarter.

The 2006 second quarter results benefited from about $12 million, or two points of favorable reserve development, compared to $9 million of unfavorable development in the 2005 period. The 2006 favorable development was primarily in our Property and Transportation group. The other groups had no significant development in the quarter.

These 2006 results also included $11.6 million, or 1.9 points, of catastrophe losses, principally from tornadoes in the Midwest. The 2005 second quarter included about one point from catastrophe losses.

Now I'd like to review the results for each of our specialty business groups on slides 5 and 6.

Property and Transportation group has continued its trend of excellent growth and profitability through the second quarter of 2006. Net written premiums for the three- and six-month periods were 14% above the same 2005 periods. The primary growth areas are the Inland Marine Operations, Crop Insurance, and the Transportation businesses.

New premium volume resulting from the recent acquisition of Farmers Crop Insurance Alliance has continued to contribute to growth in our Crop business. Rate increases for this group of businesses have averaged about 2% through the 2006 second quarter. This group's 2006 second quarter combined ratio included about four points of catastrophe losses, primarily from the tornadoes in the Midwest, compared to about 2 points in the 2005 period. It has continued to experience very favorable prior year reserve development, principally in our Crop operations, offsetting the storm losses. Even though this group's combined ratio to the first half of 2006 is a point higher than the 2005 period, its underwriting profit improved 8%, resulting from the effect of strong premium growth.

Our Specialty Casualty group has experienced significant improvement in its underwriting profitability and solid premium growth through the first half of the year. It's combined ratio for the 2006 second quarter was over 10 points better than the 2005 second quarter, and through the first six months it's improved seven points.

2006 results include modest favorable prior year reserve development versus unfavorable development last year, particularly in the Executive Liability operations. The excess in surplus and targeted markets lines are also contributing to this group's profitability with ongoing favorable results.

The 9% growth in first quarter and year-to-date net written premiums is driven primarily by greater premium retention in the Executive Liability and excess and surplus lines. Gross written premium growth of 1% in the quarter and 3% for the first half is primarily as a result of volume growth and rate increases of approximately 1%.

Specially Financial group has achieved modest underwriting profitability through the first six months of 2006. The combined ratio for the second quarter was comparable with the first quarter of 2006 and was nearly 10 points better, though, than in the 2005 second quarter. This improvement primarily reflects the reduction in losses from the residual value business, which has been placed in runoff this year.

Our Fidelity and crime, trade credit, and financial institution businesses have continued to generate excellent underwriting profits.

The increase in net written premiums for the 2006 second quarter was driven largely by the surety and financial institutions operations. Rates in this group were down about 2% in the 2006 second quarter and first six months compared to the 2005 periods.

Our California workers comp business has continued to produce outstanding profitability through the first half of the year, with a combined ratio of 81.2%. The 2006 results have benefited from some favorable prior-year reserve development, but at a lower level than in the same 2005 period. We continue to monitor the impact of changes in the California workers comp environment and to evaluate the impact of those changes on business written during the past few years.

Net written premiums declined 14% for the 2006 three- and six-month periods compared to the same prior-year periods, reflecting a lower rate environment resulting from the California workers comp reform legislation. This reform continues to benefit California industry results and is producing the intended effect of lowering workers comp costs for employers. We're pleased to be in a position to help provide these benefits to businesses in California.

However, due to the long-tail nature of this business, we continue to be somewhat conservative in our pricing and reserving until we've experienced a higher percent of paid claims and see more certainty about the ultimate impact of reform.

Now let's review our annuity and supplemental insurance group, managed by Great American Financial Resources, as shown on slide 7.

Statutory premiums for the 2006 second quarter were 43% above the 2005 second quarter. Excluding the effect of $100 million of fixed annuities transferred to us from policyholders of an unaffiliated company in the rehabilitation, premiums were up 34% for the first half of 2006 compared to the same prior year period.

We've reentered the indexed annuity market in the second quarter of 2005, and have experienced significant growth since then. This demonstrates our ability to successfully introduce new products through both new and existing distribution. We've also seen a substantial increase in the 403 B annuity segment.

Core net operating earnings from continuing operations for the 2006 three- and six-month periods as reported in Great American Financial Resources' earnings release, were 13% and 21% above the comparable prior year periods. These increases reflect improvements in the fixed annuity operations as a result of a recent acquisition; higher investment income and a higher first quarter real estate income; higher earnings in the runoff life operations resulting from an improvement in mortality experience and lower expenses; the investment of dividends received in 2005 from the Puerto Rican sub; and the investment of the proceeds related to its 2006 sale.

These increases more than offset an earnings decrease in the supplemental insurance operations that resulted from the effects of lower first year premiums, higher lapses, and higher loss experience.

As previously announced, Great American Financial Resources has a definitive agreement to acquire all the outstanding shares of the Ceres Group for $205 million in cash. As of July 31st, 2006, Great American Financial Resources had more than $250 million of excess capital, including $180 million of parent company cash and investments.

Great American financial resources will fund the Ceres acquisition primarily with cash on hand. Taking into account the planned disposition of Ceres' medical insurance business and 50% reinsurance of its in-force supplemental business, we expect to commit about $100 million of capital to this acquisition.

Now, on slide 8, I'd like to highlight some key aspects of our strategic focus and our outlook for the remainder of the year.

Our operational focus on specialty niche markets within the property and casualty, annuity, and supplemental insurance industries will continue. Our results show that this strategy is working. We're seeking acquisition and start-up opportunities that follow that strategy.

We're also pursuing internal growth opportunities for our existing specialty insurance businesses, in particular, within the transportation and inland marine operations and for our annuity operations.

Our goal is to grow profitably. We remain committed to our strong underwriting culture and pricing discipline and continually monitor the adequacy of our rates in all markets. Our investment group targets achieving investment returns that outperform the market.

Now, for the remainder of 2006, we expect high single- to low double-digit growth in net written premiums and sustained strong underwriting profits in our specialty, property, and casualty operations.

Double-digit premium growth and excellent underwriting margins in our property and transportation businesses are expected to continue. We expect the specialty casualty group's underwriting margins to remain strong, with a moderate increase in premiums. We continue to expect California workers comp premiums to decline about 15% year-over-year as a result of the significant rate reductions. And we still expect a calendar year combined ratio for the year of about 80% in this business.

We expect the underwriting margins of the specialty financial group to remain stable and its gross premiums to grow profitably -- or moderately.

We will continue to monitor the impact of running off our residual value business. We expect operating earnings improvement within the annuity and run-off life operations to continue for the remainder of the year. We expect the decrease in earnings from the existing supplemental insurance operations to continue through at least year end.

We plan to further penetrate the indexed annuity market as well as introduce several new products during the balance of 2006. And as I mentioned earlier, we expect to complete the Ceres acquisition in the third quarter of this year.

Based on our results through the first half of the year, we've increased our 2006 core operating earnings guidance for AFG to between $4.35 and $4.65 per share. We continue to plan to maintain our strong balance sheet with a debt-to-capital ratio of 25% or below. Our long-term objective is to achieve returns on equity between 12 and 15%, with consistent growth in book value.

Now we'd be pleased to open the lines for any questions.

[OPERATOR INSTRUCTIONS] I'll take a question from Charles Gates of Credit Suisse.

Good morning. Congratulations on a real fine quarter, guys.

Here is the question -- I have two in number. I guess question number one, if you look at the midpoint of what guidance was before and the midpoint of what guidance is now, what would be the two principal reasons for the much increased guidance?

I think the key things, Charlie -- this is Keith Jensen. The key things is that we are certainly experiencing a continuation of strong underwriting results and, at least as we look at prior year, we are not incurring the development that we had in previous years and we didn't want to get out ahead of ourselves in our guidance, assuming that we'd had favorable development.

Secondly, we are enjoying the benefits of increasing yields in our investment portfolio, and that has meaningful impact on us.

My second question: after the first quarter, you guesstimated what the unrealized gain in real estate was. You helped us figure what that number was. That wouldn't be materially different three months later, would it?

Not materially, except that we've sold Chatham Bar. I think the numbers we gave you --

Excluded Chatham Bar.

-- excluded Chatham Bar. And just, our view right now is that that unrealized depreciation would be in 150 to 220 range.

I guess my third question, if you could simply drill down a little further on pricing in your specialty casualty markets as you currently assess them. That would be my only other question.

This is Carl, Charlie.

We're real pleased with where we are from an overall pricing standpoint through the first six months. You know, our pricing was up about 1%, excluding what's going on in California. And the casualty side, pricing's, as I mentioned, up 1%. Generally pretty stable. There are probably soft places, might be in some of the larger umbrella counts. There might be some price declines. Some of our business produced coming out of some of the larger national producers, there seems to be a little bit more renewal pricing pressure.

But for the most part, I am very pleased with where we are.

At the Ohio seminar, you said that potentially, under the worst case, you might lose $3 million when -- if Barbaro passes away. Is that pretty much the largest policy that you would write on any animal?

With reinsurance, that would be probably -- within a reasonable range, probably one of our larger exposures that we'd take on a Thoroughbred. Keep in mind, the Thoroughbred part of our equine mortality business or the racing part is not -- is a significant part, but most of our business really are show horses, pleasure horses, Arabians, Western horses, hunters and jumpers, that are more show and pleasure type of horses versus racing horses.

We are the largest equine mortality insurer in the United States and probably in the world, at this point. We cover the whole gamut of types of horses and, in the Thoroughbred side, naturally, the values get a little bit larger.

What portion of the market do you think you have in the United States? That is my last question.

Charlie, our estimate is we think we're probably about 40% of the market in the U.S.

Again, nice quarter, guys.

One thing, Charlie, I just want to make clear. You mentioned Barbaro and 3 million. At the time that we disclosed that, we were in our preliminary investigation. It looks like, now that we've got all our facts in, if Barbaro were to go down, it would be about a 4 million net loss.

Thank you.

I'll take your next question from Jay Cohen of Merrill Lynch.

Yes, thanks. Just a couple of questions. One was a numbers question that I missed on the call. You mentioned the average price decrease in California comp. What was that number again?

It's about 15%.

That's kind of consistent with what you saw last year?

Probably a little lighter than last year. Last year I think declined more significantly than that.

Okay. And then, in the specialty financial business, obviously underwriting profit is a lot better than underwriting loss, but within that business what's the drag still from the run-off of the residual value business? Is that holding back the underwriting profitability in that unit still?

It is, Jay. If we looked at that unit X, the residual value, you'd be between 85 and 90%, combined.

And what's kind of the natural run-off evolution of this? For example, when should we expect to see this drag go away, basically?

The next year to maybe 16, 17 months, there will continue to be a drag. It will be on a decline curve during that period. By the time we get out into '08 and '09, it'll be pretty modest.

Great. Thanks a lot.

And I will take our next question from [inaudible].

Good morning. First of all, congratulations on a superb quarter.

My question has, really, two parts. How many shares of National City do we still own? And in relation to that, I'm looking at your goals on return on equity, and I'm sure it's a lot higher than the return we're getting on our position in National City. So why don't we sell NCC and have you guys put the money to work?

We own about 1% of Nat City's outstanding shares. That's about 3.5 million shares, roughly.

Abe, you have to understand that you can't compare the return on a portfolio investment with our expected return on shareholders' equity. I don't think you're looking at that the right way.

The expected return on the National City stock is higher than -- our expected return would be higher than if we reinvested that in a fixed income security or the type of investments that we have that make up the bulk of the portfolio. But you really can't equate a return on any segment of the investment portfolio with return on equity. The two -- we're not using parent company cash to hold that investment. It's an insurance company portfolio investment.

And one other question. On our convertible outstanding, how many shares -- how large is the issue, and how many shares have been converted so far?

No shares have been converted so far, and the equivalent shares would be about 5.5 million, if I remember correctly.

Is this convertible callable?

It is in 2008.

Thank you very much, and congratulations again.

We'll take our next question from John Gwynn of Morgan Keegan.

Good morning.

Carl, a number of your competitors in the California market are talking about the fact that they -- at least their perception is that work comp pricing there is bottoming out. Would that be your observation also?

You mean flattening out at this point?

Yes. Right.

I think we expect pricing for the year to be down about 15%. You know, we see the market as being pretty competitive with state fund not really being -- really being more of an insurer of last resort, which is a good thing, in the way that they're acting. But companies like the Berkshire companies, some of the newer companies, some of the national companies, even companies like Chubb have come back and have been pretty competitive. So we see the market as very vibrant, very competitive today, and we'd expect, again, to see, for the rest of the year, probably our pricing decline by about 15%.

It's frankly hard for me to really gauge whether I feel that there's a bottoming happening there right now, but I think it's -- we seem to be doing fine around our pricing levels. It's maybe a little bit difficult to give you a straight-up answer on that today.

All right. One heck of an improvement from five or six years ago, though.

Oh, definitely, yes.

Keith, on crops --

The most important thing, John, is that the pricing, we feel, is very adequate in light of what's happening, the real impact of the reform there. Industry or the insureds are happy and the business continues to be and is projected to be very profitable. That's the key thing that we look at.

Thanks a lot.

Keith, on crop, obviously commodity prices have helped premium levels, but are we in the midst of a drought or not?

Well, there's been a lot in the press about droughts and much of it has focused on the Dakotas because they've been the most severely hit. I think it really depends on what geographic area you're talking about. Most of our writings -- our penetration in the Dakotas is relatively light -- the majority of our writings would be in the corn and soybean crops in Illinois, Indiana, Nebraska, Kansas, sort of the bread basket states. So there clearly are some parts of the country that there's a drought taking place.

We've looked at this recently, John, and found that the crops, at least as industry observers in the agricultural industry are looking at it -- the crops look like they are on a normal trend on an overall basis. Obviously, if drought conditions continued through the remainder of the summer, that would be somewhat of an issue, although the harvest of this year's crop is getting fairly close so it's more of a 2007 issue if it were to continue in any severe way through the remainder of the summer.

Right. And in crop, the profitability there is heavily rear-ended. Is that right?

That's correct. We take the approach that says, really, until you know what yield ten pricing is, you're ill-advised to try and up-front any profitability. So that's really a late third quarter and fourth quarter analysis for us.

Does that mean in the first two quarters you booked, like, 100 combined on that business? Or --

For the calendar year, yes, we did have favorable development in our '05 year that was booked in the first two quarters. But on a calendar year basis, we do book it at 100.

Okay. And you may have already covered this, but what was holding company cash at 6/30?

123 million. That's for American Financial Group. As Carl indicated, there's about 180 million at the holding company and Great American Financial Resources.

Okay. And that's prior to the Ceres amount. Right?

Correct.

Okay. Thanks a lot.

Now we'll take our next question from Dan Baransky of FPK.

Hi. Thanks.

I was curious: your guidance for this year, what type of crop expectations are built into there or lack thereof?

What we've built in is an expectation that would look back over the last five or ten years and look at an average profitability level. So we have not assumed, as we've reported earlier, both last year and the year before, '04 and '05, the profitability was substantially above what a normal profit rate would be. And so, as we look into '06, we have not assumed at those rates.

Okay. And is there more volatility now in that book of business, given that the pricing was set on higher commodity prices so the profitability could be higher, but the loss levels, if there are any, could also be higher as well? Or --

Somewhat, but that's not really dramatic. That --

I think actually, higher -- this is Carl -- actually prices, when all is said and done, probably is helpful versus the spring prices.

Okay. And I guess on the capital front, it seems like -- can you perhaps list off your order of preference of what uses of capital would be? And what do you think about stock buybacks at these levels?

Sure. Now that our debt to capital is where we want it to be, continuing to look for internal growth opportunities for almost all of our businesses, as we like what we have today. We continue to seek the right kinds of acquisitions, do the right type of startup type of businesses.

We just, for instance, decided to leverage our truck physical damage operations into writing some trucking liability for owner type of vehicles and that. So we look for ways to expand what we're doing in that and do some startups of new lines.

Certainly, opportunistically, stock buybacks could be -- would be a part of our strategy also.

Do you have a current authorization or do you need one?

I believe we have a current authorization.

Do you know how much that's for?

5million.

5 million shares?

5 million shares.

Okay. Last question. The WCIRB puts out their thought processes on what the loss ratios in California workers comp are going to be. Do you have any thought process on what your book of business is shaping up to versus what they think California is looking like? And I know that the experience has -- the long-tail line experience hasn't fully flowed through yet.

Well, I'm not sure we feel that the WCIRB combined ratio estimates in that, as low as they are, are going to end up being that way. We feel -- I mean, Republic's one of the better underwriters out there over a long period of time, so naturally we feel that we should always end up better comparably with the WCIRB, whatever their ultimates are in that. And -- Keith, do you have any other --

I think that's fair. Our perspective has been that, as a result, we would expect to have results probably a little more moderate than what they're projecting. We think they're probably being overly aggressive for a variety of reasons.

Our inflation factors would be higher than probably what WCIRB are using.

Great. And on the commercial trucking side, how is that at commercial auto in general? We've heard some people say it's getting more competitive. What are you seeing there?

I think that's true. I think there's definitely more competition in that whole arena. But, again, some price decreases here and there on accounts, but overall, we're pleased with kind of where we are in our pricing.

Do you have a sense of how big that book of business is or what percent of your premiums that is?

That would probably be in the 5%-ish range of our premium.

Overall?

Yes. For the trucking.

How about if we include national interstate?

Okay. Great. That's it. Thanks. Great quarter.

We'll take our next question from Charles Gates of Credit Suisse.

The 5% number, what was the comment with regard to national interstate? That does not include national interstate: Is that correct?

It does include national interstate. We've got a trucking business that's embedded in Great American as well as a portion of National Interstate, but National Interstate's primary commercial auto business is in bus and public transportation. I did not include that as I was responding.

So it's about 5% of the total book, excluding National Interstate?

No, including the trucking component of National Interstate. I interpreted the question to be a trucking question, not a commercial auto question.

OK. But National Interstate is included as a commercial auto risk?

Yes, it is.

Okay. There was my first question.

My second question, during '05, you had this thing called -- I'm going to mess it up -- SEDA, S-E-D-A? That's gone away? Or --

It's not gone away, we still have it sitting on a shelf, but we have issued no shares under it for the last two years.

So, would you think that it would be likely that you probably wouldn't use that on a near term basis?

We don't see that in the near term. I think in the near term we have sufficient capital for the things that we're targeting.

Thank you.

And I'm showing no questions at this time. I'll turn the call back over to the presentors for closing remarks.

Thank you very much. We appreciate your joining us for second quarter results, and we look forward to speaking with you and reporting our progress as the year goes on. Thank you, and have a good day.