American Financial Group Inc (AFG) 2007 Q2 法說會逐字稿

Welcome to the second quarter 2007 American Financial Group earnings conference call. My name is Melanie, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session at the end of the conference. (OPERATOR INSTRUCTIONS) As a reminder, this call is being recorded for replay purposes.

I would now like to turn the call over to Keith Jensen, Senior Vice President. Please proceed sir.

Thank you. Thank you for joining us this morning. I am here with Carl Lindner III, the Co-CEO of American Financial Group, and Chuck Shepherd, the Chief Operating Officer of Great American Financial Resources this morning. We are pleased to welcome you to American Financial Group's 2007 second quarter earnings conference call. If you are viewing the webcast from our website, you can follow along with the slide presentation if you would 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, by their nature are subject to risk and uncertainty.

Factors which could cause results to differ materially 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 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 not considered to be part of ongoing operations, such as net realized gains or losses on investments, the effects of accounting changes, discontinued operations, special asbestos and environmental charges, and certain non-recurring items. AFG believes it to be a useful tool for analysts and investors in analyzing the 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 earnings is included in our earnings release.

Now I am pleased to turn the call over to Carl Lindner III, Co-Chief Executive Officer of American Financial Group.

Good morning, and thank you for joining us. Please turn to slide 3 of our webcast. We released the 2007 second quarter results for American Financial Group, as well as for our 81% owned sub, Great American Financial Resources yesterday afternoon, as well as the outcome of our asbestos and environmental reserve study. Our insurance results for the quarter and through the first half of the year continued at an excellent pace exceeding our expectations. We again achieved record core net operating earnings in the second quarter. 22% higher than the same period a year earlier.

Through the first half of 2007, those core earnings were 26% above the 2006 period. This significant increase was driven by improved underwriting profits in the Specialty Property and Casualty operations, and higher investment income. Our financial condition and liquidity remain real strong. Our book value per share of $26.03 was up 15% compared to the end of the 2006 second quarter. We had about $370 million of excess capital at the end of the quarter.

AFG's $18 billion investment portfolio is the highest quality in our history. At June 30th, 2007 investments and non-investment grade securities represent 5% of our investment portfolio. Mortgage backed and related securities represented about 27% of the portfolio, and 99% of those securities are rated AAA. Excluding commercial mortgage backed securities, which generate can't be prepaid, the percentage declines to 23%. Investments with subprime asset-backed collateral securities are limited to the highest quality. AAA rated shorter-maturity traunches, none of which have been subject to the downgrades or watch listing by rating agencies.

This is due in part to the fact that all of our investments are in mortgages with fixed rates, and a majority of the issues in the subprime markets have been with variable rate paper. None of our collateralized debt obligations hold asset-backed securities. Our investment in private partnerships and hedge funds is less than $35 million. The exposure of these partnerships and funds to asset backed securities is diminimus. Net earnings for the 2007 second quarter were impacted by $0.46 per share of charges for strengthening our asbestos and environmental reserves. Also the 2006 results included a $0.21 per share gain from the sale of Chatham Bars Inn.

Turning to slide 4, the record underwriting profit of the Specialty Property and Casualty operations in the 2007 second quarter of nearly $115 million, was 49% higher than in the same period a year ago. The combined ratio improved 5.7 points to 81.8, excluding the 7 point impact of the A&E reserve strength on the insurance runoff operations. I would point out that development during the quarter, including the A&E charge was at breakeven.

The 2007 results continue to benefit from premium rate adequacy, premium growth, and favorable reserve development. Our premium rate adequacy is evidenced by our strong underwriting profits. While they are at differing levels, nearly all of various businesses are producing profitable underwriting margins. I continue to be encouraged by the stability of our overall rate levels. Excluding the effect of California Worker's Comp, the average rates in the other specialty operations to the 2007 second quarter were down about 2% from the same prior year period.

Gross written premiums in the 2007 second quarter and six month period were slightly below the same period a year earlier, resulting from premium declines in California Worker's Comp, as well as the decision to exit the residual value insurance and earthquake exposed excess property businesses. Excluding the impact of these three businesses, gross written premiums are up 4% in the 2007 periods, compared to the 2006 periods. Even though overall net written premium growth of 3% for the first half of the year is below our stated expectations of 4 to 6% in this softer commercial market, premiums of our continuing operations, excluding RVI and earthquake exposed excess property, were 5% higher than the same 2006 period.

We are experiencing healthy growth in certain targeted areas, such as several businesses in our Property and Transportation group, and most of our specialty financial businesses. With our strong capital position, we are retaining more premium in many of our business lines also. The results of the first half of 2007 included $55 million, or 4.3 points including the A&E charge, of favorable reserve development, compared to $23.5 million, or 2 points in the same period the year earlier.

Turning to pages 5 and 6. All of our Specialty business groups reported excellent results for the 2007 second quarter, and the first six months. Talking about our specific groups, the Property and Transportation group continued its strong growth and profitability through the first half of the year.

For the 2007 second quarter and six month period, this group's combined ratios of 89 and 86, are up around 3 points over 2006 periods. Less favorable development in the crop insurance operations, and lower underwriting results in the trucking insurance operations, more than offset a significant improvement in inland and the ocean marine operations.

During the same periods, net written premiums increased 4 and 5%, driven by new insurance programs at National Interstate, and a higher business volume at Great American's Property and Inland Marine operations. The gross written premium growth rates were impacted by our decision to exit the earthquake exposed excess property business in the early part of 2006. Excluding this change, gross written premiums grew approximately 10% and 9%. Average rate levels for this group through the first half of the year remained about the same as the year earlier.

On our Specialty and Casualty group, we again reported outstanding profitability in the 2007 second quarter, and modest net written premium growth. Second quarter underwriting profit of $67 million, increased $39 million over the 2006 second quarter. Through the first half of the year, the combined ratios improved 18.7 points over the same period a year earlier.

These results continue to be driven by favorable development in the excess and surplus lines and our mid-continent subsidiaries general liability operations. Moderate net written premium growth is due primarily to lower premiums ceded under the reinsurance agreements within our specialized program business, partly offset by volume reductions in our excess and surplus lines, and general liability operations, reflecting stronger competition in those particular commercial casualty markets. For the first six months of 2007, this group's average overall rate was about 3% lower than the 2006 period.

On our Specialty Financial Group, it has produced solid underwriting profitability through the first half of '07, and very strong premium growth. The '07 second quarter combined ratio of 90.6 improved nearly 9 points compared to the 2006 second quarter. For the first half of the year, the combined ratio improved 5.5 points. Financial institutions, Fidelity and Crime, and lease and loan operations were the main drivers of this improvement, as well as better results in the runoff RVI business. Excluding the RVI business, the group's combined ratio is about 89%.

Net written premiums for the 2007, three and six-month periods were up 15 and 19% respectively over the same periods last year. These increases were driven by volume growth in our financial institutions, lender services, and surety businesses, as well as greater premium retention in the lease and loan operations. Rates in this group were down about 2% for the first half of this year.

Our California Worker's Comp business continued to generate excellent profitability through the 2007 second quarter. Net written premiums are still impacted by a lower rate environment. The 2007 second quarter combined ratio was 1.7 points higher than in the '06 quarter. However for the first six months of 2007, it improved 1.81 points, compared to the 2006 period.

The business continued to benefit from favorable prior year reserve development, reflecting the improving claims environment over the last several years. The 2007 six-month period included $10 million, or 8.2 points of favorable development compared to a negligible amount in the 2006 period. Due to the long-tail nature of this business, we will continue to be conservative in our reserving, until a higher percentage of claims have been paid, and the full impact of the California Reform Legislation can be determined. Rate decreases in California averaged about 24% during the first half of '07. Lower rate environment resulting from reform legislation has significantly reduced Worker's Compensation costs for employers. Even at these lower rate levels, we still expect to achieve healthy returns on this business.

Now lets review our annuity and supplemental insurance group managed by Great American Financial Resources as shown on slide 7. Statutory premiums for the 2007 second quarter and six-month period were up 47% and 54% over the 2006 periods. These increases were due primarily to higher indexed annuity sales and an increase supplemental insurance premiums resulting from the Ceres acquisition in August 2006, partly offset by lower sales of traditional fixed annuities.

Forward net operating earnings from continuing operations for the 2007 second quarter and six-month period as reported in Great American Financial Resources earnings release, were 6% above the comparable prior year periods. The increases reflect improvement in the supplemental insurance and fixed annuity segments, as well as slightly higher earnings in the variable annuity business.

These increases were partly offset by higher mortality in runoff life operations. While the supplemental lines results were improved over the comparable 2006 periods, increased lapses, and lower premiums in the Medicare supplement segment, primarily as a result of competition from Medicare Advantage have negatively impacted '07 results, and could adversely impact future results. Year-to-date 2006 results included $3.2 million of after-tax earnings related to a payment received from a Florida county in exchange for certain limitations on the future development of a marina owned by the company.

We recently completed the previously announced comprehensive studies of AFG's asbestos and environmental exposures, relating to the runoff operations of our Property and Casualty group, and exposures related to the former railroad and former manufacturing operations and sites. Studies were done with the aid of a respected outside actuarial and engineering firms, and Specialty outside counsel.

The most recent study of our Property & Casualty A&E reserves was completed in 2005. As you can see on slide 8, Property and Casualty groups asbestos reserves were increased by $31 million, and it's environmental reserves were increased by $13 million, relatively modest amounts. At June 30th, 2007, Property & Casualty groups A&E reserves were $456 million, net of reinsurance recoverables.

The primary reasons for the increase in our asbestos reserves were an increases in settlement amounts attributed to mesothelomia claims. The impact of a large case settlement of an installer of material containing asbestos, and continuing uncertainties related to non-product liability exposures.

The primary driver of the increase in environmental reserves was a reassessment of the potential amount of loss related to an environmental site owned by a single insured. Our survivor ratio for asbestos reserves is 17.4 times paid losses, and for A&E reserves it is 11.4 times paid losses. As you can see, these ratios compare favorably with A.M. Best's most recent report on A&E survivor ratios of 9 times for asbestos reserves, and 8 times for A&E reserves at the end of 2005.

In addition, our A&E study encompass reserves for asbestos and environmental exposures of our former railroad and manufacturing operations. As you can see on slide 9, these reserves were increased by $43 million. The increase of $19 million in asbestos reserves was the result of increasing estimates of the cost of mesothelomia claims, partially offset by lower estimated overall claims counts.

The $24 million increase in environmental reserves, including $2 million associated with GAFRI's former manufacturing operations, was due in large part to increased clean-up estimates at certain existing sites, and the recent notice received of environmental exposures at other former rail sites. We do plan to perform an internal ground up review next year, and another external review in 2009.

Now I would like to summarize some key aspects of our strategic focus on slide 10. Our operations will remain focused on specialty niche markets within the Property and Casualty, annuity and supplemental health insurance industries, where we have significant expertise, and continue to build franchise value.

A significant objective is the appropriate use of excess capital. We will pursue several potential courses of action. As previously announced, we continue to work on the proposed merger transaction if completed, would increase AFG's ownership of GAFRI to 100%. We will continue to seek acquisition start-up opportunities that follow our strategy of being a Specialty Insurance player. We will also pursue internal growth opportunities for existing Specialty Insurance businesses, with emphasis on our Transportation and Inland Marine operations, as well as the annuity operations.

We are going to continue share repurchases. During the first half of 2007, we repurchased 845,000 shares at an average price of about $33.86. We will remain committed to strong culture and pricing discipline, and continually monitor the adequacy of our rates in all markets. We will reduce business volume in lines as needed to achieve appropriate returns. We will continue to focus on maintaining investment returns that outperform the market.

Now I would like to reiterate our expectations for 2007 on slide 11. We expect growth and net written premiums of 3 to 5% in our Specialty Property and Casualty operations, with a stable to slightly better combined ratio. Excluding the California Worker's Comp business, our expectation is that rates in our overall Specialty operations will decline slightly, as some of our markets continue to be increasingly competitive.

Our Property and Transportation businesses are expected to generate double-digit net written premium growth through the year, resulting from higher crop premiums, geographic penetration in our Property and Inland Marine unit, and new programs in Great American's trucking operations, as well as in our subsidiary National Interstate. This group should also maintain excellent underwriting margins.

Specialty Casualty groups underwriting profit for the year should be higher than 2006, with a modest decrease in net written premiums. We expect the underwriting margins of the Specialty Financial group to improve significantly over 2006, and it's premiums to grow in the low-double digits. We expect an overall rate decrease in excess of 20% in our California Worker's Comp business in '07. As a result, we now anticipate that this group's 2000 premiums will decline around 20%. Combined ratio is expected to increase somewhat, but should be in the low 80s or below, still producing excellent returns.

In our Annuity and Supplemental insurance group, we expect premium growth and continued strong operating results. We continue to work on several product and distribution initiatives to help further our premium growth. Based on our outstanding results so far this year, we are increasing AFG's 2007 core net operating earnings to be between $3.45 and $3.65 per share, up from $3.23 to $3.43 per share. These expected earnings exclude the potential for significant catastrophe or crop losses, the just announced adjustments to A&E reserves and large real estate gains.

Now we would be pleased to open the line for any questions. Thank you.

Ladies and gentlemen, (OPERATOR INSTRUCTIONS) Our first question comes from the line of Jay Cohen with Merrill Lynch. Go ahead.

Couple of questions, first is can you talk a little bit more about the California Comp business? It just seems every year we hear price decreases in the 15 to 20%, now north of 20%. So the cumulative price decline has to be 50%, I would think or maybe even more. At some point that is going to catch up to the favorable environment. How close are we to that, do you think?

Well Jay, you know, so far we've been comfortable with the rate declines, you know, you have seen the industry severity trends, that have moderated significantly, as well as the frequency trends having declined. Our trends had been, you know, have shown strong improvements really in both areas. So we have been comfortable that you know, with the rate decreases we have been taking.

And our ability to continue to you know, improve our, you know, continue to have real solid underwriting profitability. This is a line of business that even in the low 90s, you are still getting returns of 20% plus. Returns of 40 and 50% just aren't going to last forever.

And with that said, we have said also that we are taking an continued conservative approach, and are reserving until we see how, you know, the whole legislation plays out. I think from this point on, you know, we are going to be very careful about taking much more in the way of decreases, you know, per your concerns.

Yes. Thank you, that is helpful. On the subprime, just to cross it off my list, can you actually give us the dollar amount of subprime exposure you have, and if you can also break it down into the vintages, that would be helpful?

Sure, I can do that. The total is about $520 million as of the end of the quarter. The vintages break roughly 20% in '05, 20% in '06, a little bit more than 20% in '07. '04 and '03 would be the remaining 40%. The one thing we would pointed out is in the '06 vintage, which is about 20% of the total, about half of that has been credit wrapped with monoline carriers.

Okay, and I assume the bulk of this is AAA?

Actually 100%, there is no exception. It is entirely AAA, and 100% using fixed rate collateral.

And the 520, not that it matters much, but it is both in the Property Casualty, and in the Life company?

It splits about 200 is in the Life company, and about 320 in the Property Casualty. And the percentages in the various vintages would be similar to what I gave you in the total.

That is great, thanks for that detail.

All right.

(OPERATOR INSTRUCTIONS) Our next question comes from the line of John Gwynn with Morgan Keegan. Go ahead.

Thanks. Keith or Carl, the agricultural legislation, the Bill that just passed the House appeared to contain some onerous changes for the insurance industry, could you comment on how you would handicap that in the Senate? And if this thing does pass, when would those changes take place?

This is Keith, in terms of handicapping in the Senate, we think fairly low probability that a Bill of the nature that passed in the House will succeed. Clearly if a Bill goes through the Senate, there will be a Conference Committee process. We think there is relatively low support for something as draconian, as just passed. Until we see a final legislation, we really haven't gone through an analysis of exactly what the impact would be for us.

Whatever is resolved in the Committee, when would it take place?

I am no legislative expert, but as I have talked to guys in the crop group, they are not looking for something final for at least a month or two.

What calendar year?

Our expectation is it would not be retroactive, so we would be looking at the '08 calendar year.

Keith, the GAO, there is some testimony they published back in June on crop underwriting margins, and cost reimbursements to the private industry, did you happen to see that?

I am not familiar specifically with the GAO report, no.

Okay, they pointed out that underwriting margins actually have been pretty healthy for the private carriers, running around 20% of retained premium, what they call retained premium, which I think is after government reinsurance, but before private reinsurance, is that, does that sound like a reasonable conclusion?

That would probably be reasonable in recent years. I think the thing I would point out John, is that agriculture is a business that if you take a 10 year period, in that 10 year period you are going to have a couple years that are pretty tough years and very low margins, and you will have a couple years that are very healthy margins.

There is a lot of variability because of the very nature of the business. 80% of the exposures are around water, either having too much water in the form of floods or too little in the form of droughts, and the last couple years, as you know, have been pretty good years.

Right. Is your reinsurance arrangement with Munich a quota share deal?

It is, it a 50% quota share of the residual after we have ceded to the Federal government programs.

Okay, you wouldn't happen to know the ceding commission off hand would you?

Not off the top of my head.

The reason I asked the original question, I just found this article. It is a Best wire, A.M. Best daily thing. The headline is that the house passed a Bill cutting $2 billion crop insurance, and then the text says it is administrative and operating expense reimbursements. The $2 billion is more than the entire industry gets in reimbursements. Have you had people ask you about that?

We have had folks ask particularly about what might happen to the administration and operating portion of that, and there is speculation that that might go down a couple of points. It has reduced, over the last five, six years, I think it has reduced probably 3 or 4 points so there is certainly pressure on that. But we don't think that it will be so onerous, that it has a material adverse impact on the business.

The other side of that, John, is the lower it goes, the more advantage you know, the larger companies have you know, on the expense side, and the harder it is to enter.

Right, right. Keith, this might be up your alley. On the A&E charges, you provide a split roughly 50/50 P&C, and former railroad manufacturing operations.

That is right.

What exactly is the legal entity that the former railroad and manufacturing operations fall under?

The vast majority would be under American Premiere Underwriters.

The old [Penn] Central.

Yes.

Is that a sub of Great American?

It is. No, I am sorry, it is a sub of AFG, not a sub of Great American.

Okay. Is it Chuck or Charles?

Chuck.

On GAFRI, the Medicare Advantage products made a lot of headlines over the past six weeks, in terms of marketing abuses, and so on, and so forth, is that working to your benefit in terms of your Med Supp lapse experience?

Well the Medicare Advantage caused our Med Supp lapses to accelerate and increase. And Congress earlier this year extended the selling season, typically it was November to March, they extended it, and then subsequently have rescinded that. Now our lapse experience is improving as a result of Medicare Advantage being closed.

There is also some more discussion in Congress about eliminating the subsidy currently, anywhere between a 12 and 19% subsidy to the industry for Medicare Advantage, and any of those actions would be beneficial to our supplemental, traditional Medicare supplement business.

Despite the increased lapses on the Med Supp business, you didn't take a DAC charge during the quarter, is that a possibility going forward?

We write off the DAC as the policies lapse off automatically, so in a sense we have been taking DAC charges along the way relative to that, to the business that is lapsing.

Okay. And Chuck, in the proxy merger, proxy material that you all distributed, in connection with AFG purchasing the minority interest, there was some relatively crude forecast numbers, and I noted that 2008 is a pretty significant earnings improvement year for GAFRI, could you just give me a couple reasons why you are looking for that? And by the way, I am in the earnings forecast business, I know how fragile that whole process is.

Well, we have been looking for, well we have been experiencing growth, in fact our premiums are up 50%, a little over 50% the first half of the year, and while it doesn't have an immediate impact on earnings, the continued growth of our annuity business should improve our results as we are aiming our cost at building the businesses going forward. Various acquisition also should have a positive impact, in terms of creating a more critical mass, and achieving some additional cost efficiencies and savings with consolidating some of those operations.

Thanks, that is all I have.

Gentlemen, I am showing no further questions at this time. I would like to turn the call back to management for closing remarks. Please proceed.

Thank you very much. We appreciate your taking the time to join us, and we look forward to reporting to you at the conclusion of our third quarter. Have a good day.

Ladies and gentlemen, thank you for your participation in today's conference. That does conclude the presentation. You may disconnect. Have a wonderful day.