Form 10-Q
Table of Contents

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
     
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
     
For the Quarterly Period Ended June 30, 2011
 
Commission File No. 1-13653
AMERICAN FINANCIAL GROUP, INC.
     
Incorporated under the Laws of Ohio   IRS Employer I.D. No. 31-1544320
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes þ No o
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company:
             
Large Accelerated Filer þ   Accelerated Filer o  Non-Accelerated Filer o  Smaller Reporting Company o
Indicate by check mark whether the Registrant is a shell company. Yes o No þ
As of August 1, 2011, there were 100,516,338 shares of the Registrant’s Common Stock outstanding, excluding 14.9 million shares owned by subsidiaries.
 
 

 

 


 

AMERICAN FINANCIAL GROUP, INC.
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 Exhibit 12
 Exhibit 31(a)
 Exhibit 31(b)
 Exhibit 31(c)
 Exhibit 32
 EX-101 INSTANCE DOCUMENT
 EX-101 SCHEMA DOCUMENT
 EX-101 CALCULATION LINKBASE DOCUMENT
 EX-101 LABELS LINKBASE DOCUMENT
 EX-101 PRESENTATION LINKBASE DOCUMENT
 EX-101 DEFINITION LINKBASE DOCUMENT

 

 


Table of Contents

AMERICAN FINANCIAL GROUP, INC. 10-Q
PART I
ITEM I — FINANCIAL STATEMENTS
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (UNAUDITED)
(Dollars In Millions)
                 
    June 30,     December 31,  
    2011     2010  
Assets:
               
Cash and cash equivalents
  $ 1,629     $ 1,099  
Investments:
               
Fixed maturities, available for sale at fair value (amortized cost — $19,417 and $18,490)
    20,500       19,328  
Fixed maturities, trading at fair value
    395       393  
Equity securities, at fair value (cost — $549 and $458)
    779       690  
Mortgage loans
    340       468  
Policy loans
    255       264  
Real estate and other investments
    470       428  
 
           
Total cash and investments
    24,368       22,670  
 
               
Recoverables from reinsurers
    2,866       2,964  
Prepaid reinsurance premiums
    439       422  
Agents’ balances and premiums receivable
    705       535  
Deferred policy acquisition costs
    1,198       1,244  
Assets of managed investment entities
    2,591       2,537  
Other receivables
    438       674  
Variable annuity assets (separate accounts)
    624       616  
Other assets
    638       606  
Goodwill
    186       186  
 
           
 
               
Total assets
  $ 34,053     $ 32,454  
 
           
 
               
Liabilities and Equity:
               
Unpaid losses and loss adjustment expenses
  $ 6,345     $ 6,413  
Unearned premiums
    1,555       1,534  
Annuity benefits accumulated
    14,123       12,905  
Life, accident and health reserves
    1,685       1,650  
Payable to reinsurers
    302       320  
Liabilities of managed investment entities
    2,430       2,323  
Long-term debt
    940       952  
Variable annuity liabilities (separate accounts)
    624       616  
Other liabilities
    1,424       1,121  
 
           
Total liabilities
    29,428       27,834  
 
               
Shareholders’ equity:
               
Common Stock, no par value
               
- 200,000,000 shares authorized
               
- 101,020,235 and 105,168,366 shares outstanding
    101       105  
Capital surplus
    1,138       1,166  
Retained earnings:
               
Appropriated — managed investment entities
    142       197  
Unappropriated
    2,512       2,523  
Accumulated other comprehensive income, net of tax
    579       479  
 
           
Total shareholders’ equity
    4,472       4,470  
 
               
Noncontrolling interests
    153       150  
 
           
Total equity
    4,625       4,620  
 
           
 
               
Total liabilities and equity
  $ 34,053     $ 32,454  
 
           

 

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Table of Contents

AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF EARNINGS (UNAUDITED)
(In Millions, Except Per Share Data)
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Revenues:
                               
Property and casualty insurance premiums
  $ 609     $ 572     $ 1,208     $ 1,151  
Life, accident and health premiums
    107       113       217       228  
Investment income
    306       294       606       589  
Realized gains (losses) on:
                               
Securities (*)
    19       11       19       15  
Subsidiaries
                (3 )      
Income (loss) of managed investment entities:
                               
Investment income
    26       23       51       45  
Loss on change in fair value of assets/liabilities
    (22 )     (15 )     (55 )     (40 )
Other income
    48       54       89       98  
 
                       
Total revenues
    1,093       1,052       2,132       2,086  
 
                               
Costs and Expenses:
                               
Property and casualty insurance:
                               
Losses and loss adjustment expenses
    413       302       754       606  
Commissions and other underwriting expenses
    207       207       419       411  
Annuity benefits
    125       118       241       226  
Life, accident and health benefits
    89       93       185       189  
Annuity and supplemental insurance acquisition expenses
    52       54       105       103  
Interest charges on borrowed money
    21       18       42       36  
Expenses of managed investment entities
    18       14       36       23  
Other operating and general expenses
    99       88       186       187  
 
                       
Total costs and expenses
    1,024       894       1,968       1,781  
 
                       
 
                               
Operating earnings before income taxes
    69       158       164       305  
Provision for income taxes
    32       58       78       117  
 
                       
 
                               
Net earnings, including noncontrolling interests
    37       100       86       188  
Less: Net earnings (loss) attributable to noncontrolling interests
    (18 )     (8 )     (52 )     (26 )
 
                       
 
                               
Net Earnings Attributable to Shareholders
  $ 55     $ 108     $ 138     $ 214  
 
                       
 
                               
Earnings Attributable to Shareholders per Common Share:
                               
Basic
  $ .53     $ .98     $ 1.33     $ 1.92  
 
                       
Diluted
  $ .52     $ .97     $ 1.31     $ 1.90  
 
                       
 
                               
Average number of Common Shares:
                               
Basic
    102.7       110.2       103.7       111.1  
Diluted
    104.4       111.8       105.3       112.5  
 
                               
Cash dividends per Common Share
  $ .1625     $ .1375     $ .325     $ .275  
 
                                 
(*)    Consists of the following:
                               
 
Realized gains before impairments
  $ 40     $ 27     $ 50     $ 52  
 
                               
Losses on securities with impairment
    (10 )     (20 )     (17 )     (34 )
Non-credit portion recognized in other comprehensive income (loss)
    (11 )     4       (14 )     (3 )
 
                       
Impairment charges recognized in earnings
    (21 )     (16 )     (31 )     (37 )
 
                       
 
                               
Total realized gains (losses) on securities
  $ 19     $ 11     $ 19     $ 15  
 
                       

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED)
(Dollars in Millions)
                                                                   
              Shareholders’ Equity              
              Common Stock                     Accum.             Noncon-        
    Common       and Capital     Retained Earnings     Other Comp             trolling     Total  
    Shares       Surplus     Appro.     Unappro.     Inc. (Loss)     Total     Interests     Equity  
Balance at December 31, 2010
    105,168,366       $ 1,271     $ 197     $ 2,523     $ 479     $ 4,470     $ 150     $ 4,620  
 
                                                                 
Net earnings
                        138             138       (52 )     86  
Other comprehensive income (loss), net of tax:
                                                                 
Change in unrealized gain (loss) on securities
                              94       94       2       96  
Change in foreign currency translation
                              5       5             5  
Change in unrealized pension and other postretirement benefits
                              1       1             1  
 
                                                 
Total comprehensive income (loss)
                                              238       (50 )     188  
 
                                                                 
Allocation of losses of managed investment entities
                  (55 )                 (55 )     55        
 
                                                                 
Dividends on Common Stock
                        (34 )           (34 )           (34 )
Shares issued:
                                                                 
Exercise of stock options
    654,799         16                         16             16  
Other benefit plans
    357,042         8                         8             8  
Dividend reinvestment plan
    7,870                                              
Stock-based compensation expense
            7                         7             7  
Shares acquired and retired
    (5,167,842 )       (63 )           (115 )           (178 )           (178 )
Other
                                          (2 )     (2 )
 
                                                 
 
                                                                 
Balance at June 30, 2011
    101,020,235       $ 1,239     $ 142     $ 2,512     $ 579     $ 4,472     $ 153     $ 4,625  
 
                                                 
 
                                                                 
Balance at December 31, 2009
    113,386,343       $ 1,344     $     $ 2,274     $ 163     $ 3,781     $ 138     $ 3,919  
 
                                                                 
Cumulative effect of accounting change
                  261       4       (4 )     261             261  
Net earnings
                        214             214       (26 )     188  
Other comprehensive income (loss), net of tax:
                                                                 
Change in unrealized gain (loss) on securities
                              240       240       2       242  
Change in foreign currency translation
                              (1 )     (1 )           (1 )
 
                                                 
Total comprehensive income (loss)
                                              453       (24 )     429  
 
                                                                 
Allocation of losses of managed investment entities
                  (33 )                 (33 )     33        
 
                                                                 
Dividends on Common Stock
                        (31 )           (31 )           (31 )
Shares issued:
                                                                 
Exercise of stock options
    523,671         11                         11             11  
Other benefit plans
    371,186         5                         5             5  
Dividend reinvestment plan
    8,672                                              
Stock-based compensation expense
            6                         6             6  
Shares acquired and retired
    (5,642,355 )       (66 )           (85 )           (151 )           (151 )
Other
            (1 )                       (1 )     (1 )     (2 )
 
                                                 
 
                                                                 
Balance at June 30, 2010
    108,647,517       $ 1,299     $ 228     $ 2,376     $ 398     $ 4,301     $ 146     $ 4,447  
 
                                                 

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions)
                 
    Six months ended  
    June 30,  
    2011     2010  
Operating Activities:
               
Net earnings, including noncontrolling interests
  $ 86     $ 188  
Adjustments:
               
Depreciation and amortization
    96       97  
Annuity benefits
    241       226  
Realized gains on investing activities
    (16 )     (15 )
Net (purchases) sales of trading securities
    6       (9 )
Deferred annuity and life policy acquisition costs
    (126 )     (97 )
Change in:
               
Reinsurance and other receivables
    156       571  
Other assets
    12       10  
Insurance claims and reserves
    (12 )     (329 )
Payable to reinsurers
    (18 )     (185 )
Other liabilities
    113       (28 )
Other operating activities, net
    (4 )     32  
 
           
Net cash provided by operating activities
    534       461  
 
           
 
               
Investing Activities:
               
Purchases of:
               
Fixed maturities
    (2,302 )     (2,353 )
Equity securities
    (104 )     (24 )
Mortgage loans
    (91 )     (137 )
Real estate, property and equipment
    (57 )     (54 )
Proceeds from:
               
Maturities and redemptions of fixed maturities
    1,106       970  
Repayments of mortgage loans
    224       27  
Sales of fixed maturities
    374       932  
Sales of equity securities
    41       8  
Sales of real estate, property and equipment
    1       1  
Managed investment entities:
               
Purchases of investments
    (681 )     (394 )
Proceeds from sales and redemptions of investments
    754       441  
Other investing activities, net
    (6 )     (124 )
 
           
Net cash used in investing activities
    (741 )     (707 )
 
           
 
               
Financing Activities:
               
Annuity receipts
    1,578       945  
Annuity surrenders, benefits and withdrawals
    (636 )     (617 )
Additional long-term borrowings
    2       30  
Reductions of long-term debt
    (14 )     (6 )
Managed investment entities’ retirement of liabilities
    (8 )     (39 )
Issuances of Common Stock
    16       11  
Repurchases of Common Stock
    (178 )     (151 )
Cash dividends paid on Common Stock
    (34 )     (31 )
Other financing activities, net
    11       (5 )
 
           
Net cash provided by financing activities
    737       137  
 
           
 
               
Net Change in Cash and Cash Equivalents
    530       (109 )
 
               
Cash and cash equivalents at beginning of period
    1,099       1,120  
 
           
 
               
Cash and cash equivalents at end of period
  $ 1,629     $ 1,011  
 
           

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INDEX TO NOTES
 
A. Accounting Policies
 
   
B. Acquisition
 
   
C. Segments of Operations
 
   
D. Fair Value Measurements
 
   
E. Investments
 
   
F. Derivatives
 
   
G. Deferred Policy Acquisition Costs
 
   
H. Managed Investment Entities
 
   
I. Goodwill and Other Intangibles
 
   
J. Long-Term Debt
 
   
K. Shareholders’ Equity
 
   
L. Income Taxes
 
   
M. Contingencies
 
   
N. Condensed Consolidating Information
A.   Accounting Policies
    Basis of Presentation The accompanying consolidated financial statements for American Financial Group, Inc. (“AFG”) and subsidiaries are unaudited; however, management believes that all adjustments (consisting only of normal recurring accruals unless otherwise disclosed herein) necessary for fair presentation have been made. The results of operations for interim periods are not necessarily indicative of results to be expected for the year. The financial statements have been prepared in accordance with the instructions to Form 10-Q and therefore do not include all information and footnotes necessary to be in conformity with U.S. generally accepted accounting principles.
    Certain reclassifications have been made to prior periods to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to June 30, 2011, and prior to the filing date of this Form 10-Q, have been evaluated for potential recognition or disclosure herein.
    The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
    Fair Value Measurements Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. In the first six months of 2011, AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities.
    Investments Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income (loss) in AFG’s Balance Sheet. Fixed maturity and equity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.
    Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities (“MBS”) are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other-than-temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced. If management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then the other-than-temporary impairment is separated into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit-related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are shown in the Statement of Earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is recorded to reduce the amortized cost of that security to fair value.
    Derivatives Derivatives included in AFG’s Balance Sheet are recorded at fair value and consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related call options (included in other investments) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products. Changes in the fair value of derivatives are included in earnings.
    Goodwill Goodwill represents the excess of cost of subsidiaries over AFG’s equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually.
    Reinsurance Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG’s property and casualty insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers as well as ceded premiums retained by AFG’s property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG’s insurance subsidiaries also assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.
    Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaries retain the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies’ assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to these transactions are classified as “trading.” The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of the related trading portfolios.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    Deferred Policy Acquisition Costs (“DPAC”) Policy acquisition costs (principally commissions, premium taxes and other marketing and underwriting expenses) related to the production of new business are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses.
    For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses, unamortized acquisition costs and policy maintenance costs exceed the related unearned premiums. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.
    DPAC related to annuities is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and variable annuity policy charges, less death and annuitization benefits in excess of account balances and estimated future policy administration expenses. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains (losses).
    DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
    DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains on marketable securities, a component of accumulated other comprehensive income in AFG’s Balance Sheet.
    New accounting guidance issued in October 2010 specifies that a cost must be directly related to the successful acquisition of an insurance contract to qualify for deferral. The guidance is effective January 1, 2012, with retrospective application permitted, but not required. This guidance will result in fewer acquisition costs being capitalized by AFG. Management continues assessing the impact of adoption and expects that adoption will be reported retrospectively.
    DPAC includes the present value of future profits on business in force of annuity and supplemental insurance companies acquired (“PVFP”). PVFP represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. PVFP is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    Managed Investment Entities A company is considered the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”) based primarily on its ability to direct the activities of the VIE that most significantly impact that entity’s economic performance and the obligation to absorb losses of, or receive benefits from, the entity that could potentially be significant to the VIE.
    AFG manages, and has minor investments in, six collateralized loan obligations (“CLOs”) that are VIEs (see Note H — “Managed Investment Entities”). Both the management fees (payment of which are subordinate to other obligations of the CLOs) and the investments in the CLOs are considered variable interests. AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) it has exposure to CLO losses (through its investments in the CLO subordinated debt tranches) and the right to receive benefits (through its subordinated management fees and returns on its investments), both of which could potentially be significant to the CLOs.
    Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG’s Balance Sheet. As permitted under accounting guidance adopted on January 1, 2010, the assets and liabilities of the CLOs are included in AFG’s Balance Sheet at fair value. Prior to adoption of this guidance, the CLOs were not consolidated. Upon adoption of the guidance, the $261 million excess of fair value of the CLOs’ assets over the fair value of the liabilities was recorded in AFG’s Balance Sheet as appropriated retained earnings — managed investment entities, representing the cumulative effect of adopting the new guidance that ultimately will inure to the benefit of the CLO debt holders.
    AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The net gain or loss from accounting for the CLO assets and liabilities at fair value subsequent to January 1, 2010, is separately presented in AFG’s Statement of Earnings. CLO earnings attributable to AFG’s shareholders represent the change in fair value of AFG’s investments in the CLOs and management fees earned. All other CLO earnings (losses) are not attributable to AFG’s shareholders and will ultimately inure to the benefit of the other CLO debt holders. As a result, such CLO earnings (losses) are included in net earnings (loss) attributable to noncontrolling interests in AFG’s Statement of Earnings and in appropriated retained earnings — managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2022), it is expected that losses attributable to noncontrolling interests will reduce appropriated retained earnings towards zero as the fair values of the assets and liabilities converge and the CLO assets are used to pay the CLO debt.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    Unpaid Losses and Loss Adjustment Expenses The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims; and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
    Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
    Annuity Benefits Accumulated Annuity receipts and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for surrender charges are credited to other income.
    For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liability for EDAR is accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and variable annuity policy charges, and unearned revenues once they are recognized as income.
    Life, Accident and Health Reserves Liabilities for future policy benefits under traditional life, accident and health policies are computed using the net level premium method. Computations are based on the original projections of investment yields, mortality, morbidity and surrenders and include provisions for unfavorable deviations. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.
    Variable Annuity Assets and Liabilities Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which AFG earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.
    AFG’s variable annuity contracts contain a guaranteed minimum death benefit (“GMDB”) to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder’s account. A GMDB liability is established for future excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    Premium Recognition Property and casualty premiums are earned generally over the terms of the policies on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. On reinsurance assumed from other insurance companies or written through various underwriting organizations, unearned premiums are based on information received from such companies and organizations. For traditional life, accident and health products, premiums are recognized as revenue when legally collectible from policyholders. For interest-sensitive life and universal life products, premiums are recorded in a policyholder account, which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses.
    Noncontrolling Interests For Balance Sheet purposes, noncontrolling interests represents the interests of shareholders other than AFG in consolidated entities. In the Statement of Earnings, net earnings and losses attributable to noncontrolling interests represents such shareholders’ interest in the earnings and losses of those entities.
    Income Taxes Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized.
    AFG records a liability for the inherent uncertainty in quantifying its income tax provisions. Related interest and penalties are recognized as a component of tax expense.
    Stock-Based Compensation All share-based grants are recognized as compensation expense on a straight-line basis over their vesting periods based on their calculated “fair value” at the date of grant. AFG uses the Black-Scholes pricing model to measure the fair value of employee stock options. See Note K “Shareholders’ Equity” for further information.
    Benefit Plans AFG provides retirement benefits to qualified employees of participating companies through the AFG 401(k) Retirement and Savings Plan, a defined contribution plan. AFG makes all contributions to the retirement fund portion of the plan and matches a percentage of employee contributions to the savings fund. Company contributions are expensed in the year for which they are declared. AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.
    Earnings Per Share Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding during the period. The calculation of diluted earnings per share includes adjustments to weighted average common shares related to stock-based compensation plans: second quarter 2011 and 2010 — 1.7 million and 1.6 million; first six months of 2011 and 2010 — 1.6 million and 1.4 million, respectively.
    AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: second quarter 2011 and 2010 — 2.4 million and 3.8 million; first six months of 2011 and 2010 — 2.1 million and 4.3 million, respectively. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2011 and 2010 periods.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    Statement of Cash Flows For cash flow purposes, “investing activities” are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. “Financing activities” include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, benefits and withdrawals are also reflected as financing activities. All other activities are considered “operating.” Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.
B.   Acquisition
    Vanliner Group, Inc. (“Vanliner”) In July 2010, National Interstate (“NATL”), a 52%-owned subsidiary of AFG, completed the acquisition of Vanliner, a market leader in providing insurance for the moving and storage industry, for $114 million (including post-closing adjustments). Vanliner’s moving and storage insurance premiums associated with policies in force as of December 31, 2010, totaled approximately $90 million, representing approximately 78% of its total business.
C.   Segments of Operations
    AFG manages its business as three segments: (i) property and casualty insurance, (ii) annuity and supplemental insurance and (iii) other, which includes holding company costs and operations of the managed investment entities.
    AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, umbrella and excess liability, customized programs for small to mid-sized businesses and California workers’ compensation, and (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions (including collateral and mortgage protection insurance), surety and fidelity products and trade credit insurance. AFG’s annuity and supplemental insurance business markets traditional fixed and indexed annuities and a variety of supplemental insurance products such as Medicare supplement. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    The following tables (in millions) show AFG’s revenues and operating earnings before income taxes by significant business segment and sub-segment.
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Revenues
                               
Property and casualty insurance:
                               
Premiums earned:
                               
Specialty
                               
Property and transportation
  $ 274     $ 209     $ 529     $ 425  
Specialty casualty
    219       219       435       437  
Specialty financial
    100       127       212       255  
Other
    16       17       32       34  
 
                       
Total premiums earned
    609       572       1,208       1,151  
Investment income
    75       85       148       177  
Realized gains (losses)
    32       13       32       23  
Other income
    20       21       35       36  
 
                       
Total property and casualty insurance
    736       691       1,423       1,387  
Annuity and supplemental insurance:
                               
Investment income
    230       208       456       410  
Life, accident and health premiums
    107       113       217       228  
Realized gains (losses)
    (13 )     (2 )     (16 )     (8 )
Other income
    27       33       50       58  
 
                       
Total annuity and supplemental insurance
    351       352       707       688  
Other
    6       9       2       11  
 
                       
 
                               
Total revenues
  $ 1,093     $ 1,052     $ 2,132     $ 2,086  
 
                       
 
                               
Operating Earnings Before Income Taxes
                               
Property and casualty insurance:
                               
Underwriting income (loss):
                               
Specialty
                               
Property and transportation
  $     $ 8     $ 33     $ 40  
Specialty casualty
    21       23       23       41  
Specialty financial
    13       33       23       54  
Other
    5       4       6       10  
Other lines (a)
    (50 )     (5 )     (50 )     (11 )
 
                       
Total underwriting
    (11 )     63       35       134  
Investment and other income, net
    70       81       138       162  
Realized gains (losses)
    32       13       32       23  
 
                       
Total property and casualty insurance
    91       157       205       319  
Annuity and supplemental insurance:
                               
Operations
    56       46       108       90  
Realized gains (losses)
    (13 )     (2 )     (16 )     (8 )
 
                       
Total annuity and supplemental insurance
    43       44       92       82  
Other (b)
    (65 )     (43 )     (133 )     (96 )
 
                       
 
                               
Total operating earnings before income taxes
  $ 69     $ 158     $ 164     $ 305  
 
                       
     
(a)   Includes a second quarter 2011 special charge of $50 million to increase asbestos and environmental reserves.
 
(b)   Includes a second quarter 2011 special charge of $9 million to increase asbestos and environmental reserves and the following earnings (losses) of managed investment entities for the second quarter and first six months of 2011 and 2010 (in millions):
                                 
Attributable to:
                               
AFG shareholders, including management fees
  $ 6     $ 7     $ 15     $ 15  
Noncontrolling interests
  $ (20 )   $ (13 )   $ (55 )   $ (33 )

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
D.   Fair Value Measurements
    Accounting standards for measuring fair value are based on inputs used in estimating fair value. The three levels of the hierarchy are as follows:
    Level 1 — Quoted prices for identical assets or liabilities in active markets (markets in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis). AFG’s Level 1 financial instruments consist primarily of publicly traded equity securities and highly liquid government bonds for which quoted market prices in active markets are available and short-term investments of managed investment entities.
    Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets. AFG’s Level 2 financial instruments include separate account assets, corporate and municipal fixed maturity securities, mortgage-backed securities (“MBS”) and investments of managed investment entities priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, corroborated broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2.
    Level 3 — Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable. The unobservable inputs may include management’s own assumptions about the assumptions market participants would use based on the best information available in the circumstances. AFG’s Level 3 is comprised of financial instruments, including liabilities of managed investment entities, whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, observable market information.
    AFG’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. 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.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    Assets and liabilities measured at fair value are summarized below (in millions):
                                 
    Level 1     Level 2     Level 3     Total  
June 30, 2011
                               
Assets:
                               
Available for sale (“AFS”) fixed maturities:
                               
U.S. Government and government agencies
  $ 242     $ 163     $     $ 405  
States, municipalities and political subdivisions
          3,391       84       3,475  
Foreign government
          271             271  
Residential MBS
          3,587       255       3,842  
Commercial MBS
          2,361       10       2,371  
All other corporate
    10       9,744       382       10,136  
 
                       
Total AFS fixed maturities
    252       19,517       731       20,500  
 
                               
Trading fixed maturities
          394       1       395  
Equity securities
    629       129       21       779  
Assets of managed investment entities (“MIE”)
    125       2,413       53       2,591  
Variable annuity assets (separate accounts) (a)
          624             624  
Other investments
          113             113  
 
                       
Total assets accounted for at fair value
  $ 1,006     $ 23,190     $ 806     $ 25,002  
 
                       
 
                               
Liabilities:
                               
Liabilities of managed investment entities
  $ 108     $     $ 2,322     $ 2,430  
Derivatives in annuity benefits accumulated
                299       299  
 
                       
Total liabilities accounted for at fair value
  $ 108     $     $ 2,621     $ 2,729  
 
                       
 
                               
December 31, 2010
                               
Assets:
                               
Available for sale (“AFS”) fixed maturities:
                               
U.S. Government and government agencies
  $ 249     $ 218     $     $ 467  
States, municipalities and political subdivisions
          2,919       20       2,939  
Foreign government
          278             278  
Residential MBS
          3,563       312       3,875  
Commercial MBS
          2,117       6       2,123  
All other corporate
    9       9,201       436       9,646  
 
                       
Total AFS fixed maturities
    258       18,296       774       19,328  
 
                               
Trading fixed maturities
          390       3       393  
Equity securities
    461       208       21       690  
Assets of managed investment entities (“MIE”)
    96       2,393       48       2,537  
Variable annuity assets (separate accounts) (a)
          616             616  
Other investments
          98             98  
 
                       
Total assets accounted for at fair value
  $ 815     $ 22,001     $ 846     $ 23,662  
 
                       
 
                               
Liabilities:
                               
Liabilities of managed investment entities
  $ 65     $     $ 2,258     $ 2,323  
Derivatives in annuity benefits accumulated
                190       190  
 
                       
Total liabilities accounted for at fair value
  $ 65     $     $ 2,448     $ 2,513  
 
                       
     
(a)   Variable annuity liabilities equal the fair value of variable annuity assets.
    During the second quarter of 2011, there were no significant transfers between Level 1 and Level 2. Approximately 3% of the total assets measured at fair value on June 30, 2011, were Level 3 assets. Approximately 33% of these assets were MBS whose fair values were determined primarily using non-binding broker quotes; the balance was primarily private placement debt securities whose fair values were determined internally using significant unobservable inputs, including the evaluation of underlying collateral and issuer creditworthiness, as well as certain Level 2 inputs such as comparable yields and multiples on similar publicly traded issues. The fair values of the liabilities of managed investment entities were determined using non-binding broker quotes, which were reviewed by AFG’s investment professionals.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    Changes in balances of Level 3 financial assets and liabilities during the second quarter and first six months of 2011 and 2010 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.
                                                                 
            Total                                  
            realized/unrealized                                  
            gains (losses)                                  
            included in                                  
                    Other                                  
    Balance at             comp.     Purchases             Transfer     Transfer     Balance at  
    March 31,     Net     income     and     Sales and     into     out of     June 30,  
    2011     income     (loss)     issuances     Settlements     Level 3     Level 3     2011  
AFS fixed maturities:
                                                               
State and municipal
  $ 21     $     $     $ 53     $     $ 10     $     $ 84  
Residential MBS
    271             (2 )     17       (7 )           (24 )     255  
Commercial MBS
    9                               1             10  
All other corporate
    424       1       6       46       (26 )     2       (71 )     382  
Trading fixed maturities
    1                                           1  
Equity securities
    21                                           21  
Assets of MIE
    54                   9       (2 )     2       (10 )     53  
Liabilities of MIE (*)
    (2,316 )     (10 )                 4                   (2,322 )
Embedded derivatives
    (234 )     (10 )           (60 )     5                   (299 )
     
(*)   Total realized/unrealized loss included in net income includes losses of $10 million related to liabilities outstanding as of June 30, 2011. See Note H — “Managed Investment Entities.”
                                                         
            Total                          
            realized/unrealized                          
            gains (losses)                          
            included in                          
                    Other     Purchases,                    
    Balance at             comp.     sales,     Transfer     Transfer     Balance at  
    March 31,     Net     income     issuances and     into     out of     June 30,  
    2010     income     (loss)     settlements     Level 3     Level 3     2010  
AFS fixed maturities:
                                                       
State and municipal
  $ 6     $     $ 1       ($3 )   $ 17     $     $ 21  
Residential MBS
    372       1       10       (12 )     2       (47 )     326  
Commercial MBS
    6                                     6  
All other corporate
    356       (11 )     9       42       46       (16 )     426  
Trading fixed maturities
    4                               (3 )     1  
Equity securities
    24                                     24  
Assets of MIE
    100       1             (10 )     7       (52 )     46  
Liabilities of MIE
    (2,178 )     16             10                   (2,152 )
Embedded derivatives
    (131 )     13             (10 )                 (128 )
                                                                 
            Total                                  
            realized/unrealized                                  
            gains (losses)                                  
            included in                                  
                    Other                                  
    Balance at             comp.     Purchases             Transfer     Transfer     Balance at  
    Dec. 31,     Net     income     and     Sales and     into     out of     June 30,  
    2010     income     (loss)     issuances     Settlements     Level 3     Level 3     2011  
AFS fixed maturities:
                                                               
State and municipal
  $ 20     $     $ 1     $ 53     $     $ 10     $     $ 84  
Residential MBS
    312       1       (2 )     17       (20 )     7       (60 )     255  
Commercial MBS
    6                               4             10  
All other corporate
    436       (1 )     6       91       (37 )     24       (137 )     382  
Trading fixed maturities
    3                                     (2 )     1  
Equity securities
    21             2             (2 )                 21  
Assets of MIE
    48       (1 )           16       (6 )     8       (12 )     53  
Liabilities of MIE (*)
    (2,258 )     (72 )                 8                   (2,322 )
Embedded derivatives
    (190 )     (29 )           (90 )     10                   (299 )
     
(*)   Total realized/unrealized loss included in net income includes losses of $71 million related to liabilities outstanding as of June 30, 2011. See Note H — “Managed Investment Entities.”

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
                                                                 
                    Total                          
                    realized/unrealized                          
                    gains (losses)                          
                    included in                          
            Consolidate             Other     Purchases,                    
    Balance at     Managed             comp.     sales,     Transfer     Transfer     Balance at  
    Dec. 31,     Inv.     Net     income     issuances and     into     out of     June 30,  
    2009     Entities     income     (loss)     settlements     Level 3     Level 3     2010  
AFS fixed maturities:
                                                               
State and municipal
  $ 23     $     $     $ 1       ($3 )   $ 17       ($17 )   $ 21  
Residential MBS
    435             2       11       6       2       (130 )     326  
Commercial MBS
                            6                   6  
All other corporate
    311       (6 )     (12 )     8       87       69       (31 )     426  
Trading fixed maturities
    1                         4             (4 )     1  
Equity securities
    25                   (1 )                       24  
Assets of MIE
          90       5             (4 )     7       (52 )     46  
Liabilities of MIE
          (2,100 )     (90 )           38                   (2,152 )
Embedded derivatives
    (113 )           1             (16 )                 (128 )
    Fair Value of Financial Instruments The following table presents (in millions) the carrying value and estimated fair value of AFG’s financial instruments at June 30, 2011 and December 31, 2010.
                                 
    June 30, 2011     December 31, 2010  
    Carrying     Fair     Carrying     Fair  
    Value     Value     Value     Value  
Assets:
                               
Cash and cash equivalents
  $ 1,629     $ 1,629     $ 1,099     $ 1,099  
Fixed maturities
    20,895       20,895       19,721       19,721  
Equity securities
    779       779       690       690  
Mortgage loans
    340       349       468       469  
Policy loans
    255       255       264       264  
Other investments — derivatives
    113       113       98       98  
Assets of managed investment entities
    2,591       2,591       2,537       2,537  
Variable annuity assets (separate accounts)
    624       624       616       616  
 
                               
Liabilities:
                               
Annuity benefits accumulated(*)
  $ 13,915     $ 13,512     $ 12,696     $ 12,233  
Long-term debt
    940       1,033       952       1,023  
Liabilities of managed investment entities
    2,430       2,430       2,323       2,323  
Variable annuity liabilities (separate accounts)
    624       624       616       616  
Other liabilities — derivatives
    18       18       14       14  
     
(*)   Excludes life contingent annuities in the payout phase.
    The carrying amount of cash and cash equivalents approximates fair value. Fair values for mortgage loans are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. The fair value of policy loans is estimated to approximate carrying value; policy loans have no defined maturity dates and are inseparable from insurance contracts. The fair value of annuity benefits was estimated based on expected cash flows discounted using forward interest rates adjusted for the Company’s credit risk and includes the impact of maintenance expenses and capital costs. Fair values of long-term debt are based primarily on quoted market prices.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
E.   Investments
    Available for sale fixed maturities and equity securities at June 30, 2011, and December 31, 2010, consisted of the following (in millions):
                                                                 
    June 30, 2011     December 31, 2010  
    Amortized     Fair     Gross Unrealized     Amortized     Fair     Gross Unrealized  
    Cost     Value     Gains     Losses     Cost     Value     Gains     Losses  
 
                                                               
Fixed maturities:
                                                               
U.S. Government and government agencies
  $ 391     $ 405     $ 14     $     $ 453     $ 467     $ 15     $ (1 )
States, municipalities and political subdivisions
    3,378       3,475       112       (15 )     2,927       2,939       53       (41 )
Foreign government
    260       271       11             269       278       9        
Residential MBS
    3,735       3,842       224       (117 )     3,781       3,875       222       (128 )
Commercial MBS
    2,183       2,371       190       (2 )     1,972       2,123       153       (2 )
All other corporate
    9,470       10,136       693       (27 )     9,088       9,646       602       (44 )
 
                                               
 
                                                               
Total fixed maturities
  $ 19,417     $ 20,500     $ 1,244     $ (161 )   $ 18,490     $ 19,328     $ 1,054     $ (216 )
 
                                               
 
                                                               
Common stocks
  $ 407     $ 633     $ 231     $ (5 )   $ 312     $ 543     $ 232     $ (1 )
 
                                               
 
                                                               
Perpetual preferred stocks
  $ 142     $ 146     $ 8     $ (4 )   $ 146     $ 147     $ 6     $ (5 )
 
                                               
    The non-credit related portion of other-than-temporary impairment charges are included in other comprehensive income (loss). Such charges taken for residential MBS still owned at June 30, 2011 and December 31, 2010, respectively were $238 million and $258 million.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    The following tables show gross unrealized losses (in millions) on fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2011 and December 31, 2010.
                                                 
    Less Than Twelve Months     Twelve Months or More  
    Unrealized     Fair     Fair Value as     Unrealized     Fair     Fair Value as  
    Loss     Value     % of Cost     Loss     Value     % of Cost  
June 30, 2011
                                               
Fixed maturities:
                                               
U.S. Government and government agencies
  $     $ 38       100 %   $     $       %
States, municipalities and political subdivisions
    (12 )     665       98 %     (3 )     46       94 %
Foreign government
          1       100 %                 %
Residential MBS
    (20 )     629       97 %     (97 )     466       83 %
Commercial MBS
    (1 )     102       99 %     (1 )     11       92 %
All other corporate
    (19 )     1,066       98 %     (8 )     116       94 %
 
                                       
 
                                               
Total fixed maturities
  $ (52 )   $ 2,501       98 %   $ (109 )   $ 639       85 %
 
                                       
 
                                               
Common Stocks
  $ (5 )   $ 47       90 %   $     $       %
 
                                       
 
                                               
Perpetual Preferred Stocks
  $     $ 5       100 %   $ (4 )   $ 41       91 %
 
                                       
 
                                               
December 31, 2010
                                               
Fixed maturities:
                                               
U.S. Government and government agencies
  $ (1 )   $ 86       99 %   $     $       %
States, municipalities and political subdivisions
    (38 )     1,180       97 %     (3 )     40       93 %
Foreign government
          37       99 %                 %
Residential MBS
    (11 )     412       97 %     (117 )     551       82 %
Commercial MBS
    (2 )     83       98 %           15       97 %
All other corporate
    (24 )     1,020       98 %     (20 )     275       93 %
 
                                       
 
                                               
Total fixed maturities
  $ (76 )   $ 2,818       97 %   $ (140 )   $ 881       86 %
 
                                       
 
                                               
Common Stocks
  $     $ 21       99 %   $ (1 )   $ 4       88 %
 
                                       
 
                                               
Perpetual Preferred Stocks
  $     $ 22       98 %   $ (5 )   $ 37       88 %
 
                                       
    At June 30, 2011 the gross unrealized losses on fixed maturities of $161 million relate to approximately 900 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 49% of the gross unrealized loss and 79% of the fair value.
    Gross Unrealized Losses on MBS At June 30, 2011, gross unrealized losses on AFG’s residential MBS represented 73% of the total gross unrealized loss on fixed maturity securities (and 90% of the “twelve months or more”). Of the residential MBS that have been in an unrealized loss position (“impaired”) for 12 months or more (237 securities), approximately 35% of the unrealized losses and 51% of the fair value relate to investment grade rated securities. AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. For the first six months of 2011, AFG recorded in earnings $34 million in other-than-temporary impairment charges related to its residential MBS.
    Gross Unrealized Losses on All Other Corporates For the first six months of 2011, AFG recorded in earnings $2 million in other-than-temporary charges on “all other corporate” securities. Management concluded that no additional charges for other-than-temporary impairments were required based on many factors, including AFG’s ability and intent to hold the investments for a period of time sufficient to allow for anticipated recovery of its amortized cost, the length of time and the extent to which fair value has been below cost, analysis of historical and projected company-specific financial data, the outlook for industry sectors, and credit ratings.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    The following tables progress the credit portion of other-than-temporary impairments on fixed maturity securities for which the non-credit portion of an impairment has been recognized in other comprehensive income (loss) (in millions).
                 
    2011     2010  
Balance at March 31
  $ 151     $ 122  
Additional credit impairments on:
               
Previously impaired securities
    22       4  
Securities without prior impairments
    4       3  
Reductions — disposals
    (6 )     (8 )
 
           
 
               
Balance at June 30
  $ 171     $ 121  
 
           
 
               
Balance at January 1
  $ 143     $ 99  
Additional credit impairments on:
               
Previously impaired securities
    29       23  
Securities without prior impairments
    5       7  
Reductions — disposals
    (6 )     (8 )
 
           
 
               
Balance at June 30
  $ 171     $ 121  
 
           
    The table below sets forth the scheduled maturities of available for sale fixed maturities as of June 30, 2011 (in millions). Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. MBS had an average life of approximately 4 years at June 30, 2011.
                         
    Amortized     Fair Value  
Maturity   Cost     Amount     %  
One year or less
  $ 457     $ 471       2 %
After one year through five years
    5,154       5,475       27  
After five years through ten years
    5,904       6,287       31  
After ten years
    1,984       2,054       10  
 
                 
 
    13,499       14,287       70  
MBS
    5,918       6,213       30  
 
                 
Total
  $ 19,417     $ 20,500       100 %
 
                 
    Certain risks are inherent in connection with fixed maturity securities, including loss upon default, price volatility in reaction to changes in interest rates, and general market factors and risks associated with reinvestment of proceeds due to prepayments or redemptions in a period of declining interest rates.
    There were no investments in individual issuers that exceeded 10% of Shareholders’ Equity at June 30, 2011 or December 31, 2010.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    Net Unrealized Gain on Marketable Securities In addition to adjusting equity securities and fixed maturity securities classified as “available for sale” to fair value, GAAP requires that deferred policy acquisition costs related to annuities and certain other balance sheet amounts be adjusted to the extent that unrealized gains and losses from securities would result in adjustments to those balances had the unrealized gains or losses actually been realized. The following table shows the components of the net unrealized gain on securities that is included in Accumulated Other Comprehensive Income in AFG’s Balance Sheet.
                         
            Deferred Tax and        
            Amounts Attributable        
            to Noncontrolling        
    Pre-tax     Interests     Net  
June 30, 2011
                       
Unrealized gain on:
                       
Fixed maturity securities
  $ 1,083     $ (384 )   $ 699  
Equity securities
    230       (81 )     149  
Deferred policy acquisition costs
    (434 )     152       (282 )
Annuity benefits and other liabilities
    6       (2 )     4  
 
                 
 
  $ 885     $ (315 )   $ 570  
 
                 
 
                       
December 31, 2010
                       
Unrealized gain on:
                       
Fixed maturity securities
  $ 838     $ (295 )   $ 543  
Equity securities
    232       (82 )     150  
Deferred policy acquisition costs
    (340 )     118       (222 )
Annuity benefits and other liabilities
    6       (2 )     4  
 
                 
 
  $ 736     $ (261 )   $ 475  
 
                 
    Realized gains (losses) and changes in unrealized appreciation (depreciation) related to fixed maturity and equity security investments are summarized as follows (in millions):
                                                         
                    Mortgage Loans                     Noncon-        
    Fixed     Equity     and Other             Tax     trolling        
    Maturities     Securities     Investments     Other(a)     Effects     Interests     Total  
Quarter ended June 30, 2011
                                                       
Realized before impairments
  $ 11     $ 34     $ (5 )   $     $ (15 )   $ (1 )   $ 24  
Realized — impairments
    (26 )           (1 )     6       8             (13 )
Change in Unrealized
    208       (15 )           (70 )     (44 )     (2 )     77  
 
                                                       
Quarter ended June 30, 2010
                                                       
Realized before impairments
  $ 35     $ 1     $ (7 )   $ (2 )   $ (10 )   $ (1 )   $ 16  
Realized — impairments
    (22 )           (1 )     7       6             (10 )
Change in Unrealized
    283       2             (110 )     (62 )           113  
 
                                                       
Six months ended June 30, 2011
                                                       
Realized before impairments
  $ 24     $ 35     $ (7 )   $ (2 )   $ (18 )   $ (1 )   $ 31  
Realized — impairments
    (37 )           (4 )     10       11             (20 )
Change in Unrealized
    245       (2 )           (94 )     (53 )     (2 )     94  
 
                                                       
Six months ended June 30, 2010
                                                       
Realized before impairments
  $ 69     $ 2     $ (14 )   $ (5 )   $ (18 )   $ (1 )   $ 33  
Realized — impairments
    (50 )           (3 )     16       13             (24 )
Change in Unrealized
    633       (3 )           (257 )     (131 )     (2 )     240  
     
(a)   Primarily adjustments to deferred policy acquisition costs related to annuities.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
Realized gains (losses) on securities includes net losses of less than $1 million in the second quarter and $3 million in the first six months of 2011 compared to net gains of $9 million and $26 million in the second quarter and first six months of 2010 from the mark-to-market of certain MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. Gross realized gains and losses (excluding impairment writedowns and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
                 
    Six months ended  
    June 30,  
    2011     2010  
Fixed maturities:
               
Gross gains
  $ 29     $ 52  
Gross losses
    (2 )     (9 )
 
               
Equity securities:
               
Gross gains
    36       2  
Gross losses
           
F.   Derivatives
    As discussed under “Derivatives” in Note A, AFG uses derivatives in certain areas of its operations. AFG’s derivatives do not qualify for hedge accounting under GAAP; changes in the fair value of derivatives are included in earnings.
    The following derivatives are included in AFG’s Balance Sheet at fair value (in millions):
                                     
        June 30, 2011     December 31, 2010  
Derivative   Balance Sheet Line   Asset     Liability     Asset     Liability  
MBS with embedded derivatives
  Fixed maturities   $ 93     $     $ 101     $  
Interest rate swaptions
  Other investments     21             21        
Indexed annuities (embedded derivative)
  Annuity benefits accumulated           299             190  
Equity index call options
  Other investments     92             77        
Reinsurance contracts (embedded derivative)
  Other liabilities           18             14  
 
                           
 
      $ 206     $ 317     $ 199     $ 204  
 
                           
    The MBS with embedded derivatives consist primarily of interest-only MBS with interest rates that float inversely with short-term rates. AFG records the entire change in the fair value of these securities in earnings. These investments are part of AFG’s overall investment strategy and represent a small component of AFG’s overall investment portfolio.
    AFG has entered into $1 billion notional amount of pay-fixed interest rate swaptions (options to enter into pay-fixed/receive floating interest rate swaps at future dates expiring between 2012 and 2015) to mitigate interest rate risk in its annuity operations. AFG paid $29 million to purchase these swaptions, which represents its maximum potential economic loss over the life of the contracts.
    AFG’s indexed annuities, which represented 30% of annuity benefits accumulated at June 30, 2011, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG’s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be generally offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    As discussed under “Reinsurance” in Note A, certain reinsurance contracts in AFG’s annuity and supplemental insurance business are considered to contain embedded derivatives.
    The following table summarizes the gain (loss) included in the Statement of Earnings for changes in the fair value of these derivatives for the second quarter and first six months of 2011 and 2010 (in millions):
                                     
        Three months ended     Six months ended  
        June 30,     June 30,  
Derivative   Statement of Earnings Line   2011     2010     2011     2010  
MBS with embedded derivatives
  Realized gains   $     $ 9     $ (3 )   $ 26  
Interest rate swaptions
  Realized gains     (5 )     (6 )     (7 )     (14 )
Indexed annuities (embedded derivative)
  Annuity benefits     (10 )     13       (29 )     1  
Equity index call options
  Annuity benefits     2       (23 )     20       (12 )
Reinsurance contracts (embedded derivative)
  Investment income     (4 )     (5 )     (4 )     (10 )
 
                           
 
      $ (17 )   $ (12 )   $ (23 )   $ (9 )
 
                           
G.   Deferred Policy Acquisition Costs
    Deferred policy acquisition costs consisted of the following (in millions):
                 
    June 30,     December 31,  
    2011     2010  
Property and casualty insurance
  $ 331     $ 324  
Annuity and supplemental insurance:
               
Policy acquisition costs
    940       892  
Policyholder sales inducements
    208       204  
Present value of future profits (“PVFP”)
    153       164  
Impact of unrealized gains and losses on securities
    (434 )     (340 )
 
           
Total annuity and supplemental
    867       920  
 
           
 
               
 
  $ 1,198     $ 1,244  
 
           
    The PVFP amounts in the table above are net of $185 million and $174 million of accumulated amortization at June 30, 2011 and December 31, 2010, respectively. Amortization of the PVFP was $5 million in the second quarter and $11 million during the first six months of 2011 and $10 million in the second quarter and $16 million in the first six months of 2010, respectively.
H.   Managed Investment Entities
    AFG is the investment manager and has investments ranging from 7.5% to 24.4% of the most subordinate debt tranche of six collateralized loan obligation entities or “CLOs,” which are considered variable interest entities. Upon formation between 2004 and 2007, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG’s investments in these entities receive residual income from the CLOs only after the CLOs pay operating expenses (including management fees to AFG), interest on and returns of capital to senior levels of debt securities. There are no contractual requirements for AFG to provide additional funding for these entities. AFG has not provided and does not intend to provide any financial support to these entities. One of the CLOs is expected to be liquidated in August 2011, resulting in a reduction in assets and liabilities of managed investment entities of approximately $498 million and $480 million, respectively, and an $18 million reduction in appropriated retained earnings. The impact on net income attributable to shareholders is not expected to be material.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
    AFG’s maximum ultimate exposure to economic loss on its CLOs is limited to its investment in the CLOs, which had an aggregate fair value of $19 million at June 30, 2011.
    The revenues and expenses of the CLOs are separately identified in AFG’s Statement of Earnings after the elimination of management fees and earnings attributable to shareholders of AFG as measured by the change in the fair value of AFG’s investments in the CLOs. Selected financial information related to the CLOs is shown below (in millions):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Gains (losses) on change in fair value of assets/liabilities (a):
                               
Assets
  $ (12 )   $ (31 )   $ 17     $ 50  
Liabilities
    (10 )     16       (72 )     (90 )
Management fees paid to AFG
    5       4       8       8  
CLO earnings (losses) attributable to:
                               
AFG shareholders (b)
    1       3       7       7  
Noncontrolling interests (b)
    (20 )     (13 )     (55 )     (33 )
     
(a)   Included in AFG’s “Revenues.”
 
(b)   Included in AFG’s “Operating earnings before income taxes.”
    The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $60 million and $69 million at June 30, 2011 and December 31, 2010. The aggregate unpaid principal balance of the CLOs’ debt exceeded its fair value by $229 million and $301 million at those dates. The CLO assets include $6 million in loans at both June 30, 2011 and December 31, 2010, (aggregate unpaid principal balance of $18 million and $12 million, respectively) for which the CLOs are not accruing interest because the loans are in default.
I.   Goodwill and Other Intangibles
    There were no changes in the goodwill balance of $186 million during the six months ended June 30, 2011. Included in other assets in AFG’s Balance Sheet is $43 million at June 30, 2011 and $49 million at December 31, 2010, in amortizable intangible assets related to property and casualty insurance acquisitions. These amounts are net of accumulated amortization of $41 million and $35 million, respectively. Amortization of these intangibles was $3 million in the second quarter and $6 million during the first six months of both 2011 and 2010.
    Other assets also include $8 million in non-amortizable intangible assets related to insurance licenses acquired in the acquisition of Vanliner in 2010.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
J.  
Long-Term Debt
   
The carrying value of long-term debt consisted of the following (in millions):
                 
    June 30,     December 31,  
    2011     2010  
Direct obligations of AFG:
               
9-7/8% Senior Notes due June 2019
  $ 350     $ 350  
7% Senior Notes due September 2050
    132       132  
7-1/8% Senior Debentures due February 2034
    115       115  
Other
    3       3  
 
           
 
    600       600  
 
           
Subsidiaries:
               
Obligations of AAG Holding (guaranteed by AFG):
               
7-1/2% Senior Debentures due November 2033
    112       112  
7-1/4% Senior Debentures due January 2034
    86       86  
Notes payable secured by real estate due 2011 through 2016
    65       65  
Secured borrowings ($17 and $18 guaranteed by AFG)
    35       41  
National Interstate bank credit facility
    22       20  
American Premier 10-7/8% Subordinated Notes
          8  
 
           
 
    320       332  
 
           
Payable to Subsidiary Trusts:
               
AAG Holding Variable Rate Subordinated Debentures due May 2033
    20       20  
 
           
 
               
 
  $ 940     $ 952  
 
           
   
Scheduled principal payments on debt for the balance of 2011 and the subsequent five years were as follows: 2011 – $6 million; 2012 – $34 million; 2013 – $20 million; 2014 – $2 million; 2015 – $14 million and 2016 – $45 million.
 
   
As shown below (in millions), the majority of AFG’s long-term debt is unsecured obligations of the holding company and its subsidiaries:
                 
    June 30,     December 31,  
    2011     2010  
Unsecured obligations
  $ 840     $ 846  
Obligations secured by real estate
    65       65  
Other secured borrowings
    35       41  
 
           
 
  $ 940     $ 952  
 
           
   
AFG can borrow up to $500 million under its revolving credit facility which expires in August 2013. Amounts borrowed under this agreement bear interest at rates ranging from 1.75% to 3.00% (currently 2%) over LIBOR based on AFG’s credit rating. No amounts were borrowed under this facility at June 30, 2011.
 
   
In May 2011, American Premier paid $8 million to redeem its outstanding 10-7/8% Subordinated Notes at maturity.
 
   
In June 2010, National Interstate borrowed $30 million under its bank credit facility in connection with the July acquisition of Vanliner. In September 2010, AFG issued $132 million of 7% Senior Notes due in 2050.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
K.  
Shareholders’ Equity
   
AFG is authorized to issue 12.5 million shares of Voting Preferred Stock and 12.5 million shares of Nonvoting Preferred Stock, each without par value.
 
   
Accumulated Other Comprehensive Income (Loss), Net of Tax Comprehensive income (loss) is defined as all changes in Shareholders’ Equity except those arising from transactions with shareholders. Comprehensive income (loss) includes net earnings and other comprehensive income (loss), which consists primarily of changes in net unrealized gains or losses on available for sale securities and foreign currency translation. The progression of the components of accumulated other comprehensive income (loss) follows (in millions):
                                                 
                    Pension and                        
    Pretax     Foreign     Other                     Accumulated  
    Net Unrealized     Currency     Postretirement             Noncon-     Other  
    Gains (Losses)     Translation     Plans     Tax     trolling     Comprehensive  
    on Securities     Adjustment     Adjustment     Effects     Interests     Income (Loss)  
Balance at December 31, 2010
  $ 736 (a)   $ 9     $ (13 )   $ (253 )   $     $ 479 (a)
Unrealized holding gains on securities arising during the period
    179                   (63 )     (3 )     113  
Realized gains included in net income
    (30 )                 10       1       (19 )
Foreign currency translation gains
          5                         5  
Other
                1                   1  
 
                                   
 
                                               
Balance at June 30, 2011
  $ 885 (a)   $ 14     $ (12 )   $ (306 )   $ (2 )   $ 579 (a)
 
                                   
 
                                               
Balance at December 31, 2009
  $ 258     $ 1     $ (13 )   $ (86 )   $ 3     $ 163  
Unrealized holding gains on securities arising during the period
    405                   (142 )     (3 )     260  
Realized gains included in net income
    (32 )                 11       1       (20 )
Foreign currency translation losses
          (1 )                       (1 )
Other
    (6 )           1       1             (4 )
 
                                   
 
                                               
Balance at June 30, 2010
  $ 625     $     $ (12 )   $ (216 )   $ 1     $ 398  
 
                                   
(a)  
Includes a net pretax unrealized gain of $1 million at June 30, 2011 compared to a net pretax unrealized loss of $17 million at December 31, 2010 ($11 million net of tax) related to securities for which only the credit portion of an other-than-temporary impairment has been recorded in earnings.
   
Stock Based Compensation Under AFG’s Stock Incentive Plan, employees of AFG and its subsidiaries are eligible to receive equity awards in the form of stock options, stock appreciation rights, restricted stock awards, restricted stock units and stock awards. In the first six months of 2011, AFG issued 131,955 shares of restricted Common Stock (fair value of $34.34 per share) and granted stock options for 1.1 million shares of Common Stock (at an average exercise price of $34.34) under the Stock Incentive Plan. In addition, AFG issued 188,302 shares of Common Stock (fair value of $33.99 per share) in the first quarter of 2011 under its Annual Co-CEO Equity Bonus Plan.
 
   
AFG uses the Black-Scholes option pricing model to calculate the “fair value” of its option grants. Expected volatility is based on historical volatility over a period equal to the expected term. The expected term was estimated based on historical exercise patterns and post vesting cancellations. The weighted average fair value of options granted during 2011 was $12.49 per share based on the following assumptions: expected dividend yield – 1.9%; expected volatility – 38%; expected term – 7.3 years; risk-free rate – 3.04%.
 
   
Total compensation expense related to stock incentive plans of AFG and its subsidiaries was $5 million in the second quarter and $10 million during the first six months of both 2011 and 2010.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
L.  
Income Taxes
   
Operating earnings before income taxes includes $20 million and $13 million in the second quarter of 2011 and 2010, respectively, and $55 million and $33 million in the first six months of 2011 and 2010, respectively, in non-deductible losses of managed investment entities attributable to noncontrolling interests, thereby increasing AFG’s effective tax rate.
 
   
There have been no material changes to AFG’s liability for uncertain tax positions, which is discussed in Note L - “Income Taxes,” to AFG’s 2010 Form 10-K.
M.  
Contingencies
   
Except as discussed in Management’s Discussion and Analysis – “Special Asbestos and Environmental Reserve Charge,” there have been no significant changes to the matters discussed and referred to in Note M – “Contingencies” of AFG’s 2010 Form 10-K covering property and casualty insurance reserves for claims related to environmental exposures, asbestos and other mass tort claims as well as environmental and occupational injury and disease claims of former subsidiary railroad and manufacturing operations.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
N. Condensed Consolidating Information
N.  
Condensed Consolidating Information AFG has guaranteed all of the outstanding debt of Great American Financial Resources, Inc. (“GAFRI”) and GAFRI’s wholly-owned subsidiary, AAG Holding Company, Inc. In addition, GAFRI guarantees AAG Holding’s public debt. The AFG and GAFRI guarantees are full and unconditional and joint and several. Condensed consolidating financial statements for AFG are as follows:
CONDENSED CONSOLIDATING BALANCE SHEET
(In millions)
                                                 
                    AAG     All Other     Consol.        
    AFG     GAFRI     Holding     Subs     Entries     Consolidated  
JUNE 30, 2011
                                               
 
                                               
Assets:
                                               
Cash and investments
  $ 358     $ 37     $     $ 23,974     $ (1 )   $ 24,368  
Recoverables from reinsurers and prepaid reinsurance premiums
                      3,305             3,305  
Agents’ balances and premiums receivable
                      705             705  
Deferred policy acquisition costs
                      1,198             1,198  
Assets of managed investment entities
                      2,591             2,591  
Other assets
    80       8       8       1,806       (16 )     1,886  
Investment in subsidiaries and affiliates
    4,838       2,021       2,116       656       (9,631 )      
 
                                   
 
                                               
Total assets
  $ 5,276     $ 2,066     $ 2,124     $ 34,235     $ (9,648 )   $ 34,053  
 
                                   
 
                                               
Liabilities and Equity:
                                               
Unpaid losses and loss adjustment expenses and unearned premiums
  $     $     $     $ 7,900     $     $ 7,900  
Annuity, life, accident and health benefits and reserves
                      15,809       (1 )     15,808  
Liabilities of managed investment entities
                      2,430             2,430  
Long-term debt
    600             219       121             940  
Other liabilities
    204       20       112       2,159       (145 )     2,350  
 
                                   
Total liabilities
    804       20       331       28,419       (146 )     29,428  
 
                                               
Total shareholders’ equity
    4,472       2,046       1,793       5,663       (9,502 )     4,472  
Noncontrolling interests
                      153             153  
 
                                   
 
                                               
Total liabilities and equity
  $ 5,276     $ 2,066     $ 2,124     $ 34,235     $ (9,648 )   $ 34,053  
 
                                   
 
                                               
DECEMBER 31, 2010
                                               
 
                                               
Assets:
                                               
Cash and investments
  $ 412     $ 33     $     $ 22,228     $ (3 )   $ 22,670  
Recoverables from reinsurers and prepaid reinsurance premiums
                      3,386             3,386  
Agents’ balances and premiums receivable
                      535             535  
Deferred policy acquisition costs
                      1,244             1,244  
Assets of managed investment entities
                      2,537             2,537  
Other assets
    36       6       5       2,050       (15 )     2,082  
Investment in subsidiaries and affiliates
    4,816       1,899       1,996       671       (9,382 )      
 
                                   
 
                                               
Total assets
  $ 5,264     $ 1,938     $ 2,001     $ 32,651     $ (9,400 )   $ 32,454  
 
                                   
 
                                               
Liabilities and Equity:
                                               
Unpaid losses and loss adjustment expenses and unearned premiums
  $     $     $     $ 7,947     $     $ 7,947  
Annuity, life, accident and health benefits and reserves
                      14,556       (1 )     14,555  
Liabilities of managed investment entities
                      2,323             2,323  
Long-term debt
    600       1       219       133       (1 )     952  
Other liabilities
    194       19       110       1,888       (154 )     2,057  
 
                                   
Total liabilities
    794       20       329       26,847       (156 )     27,834  
 
                                               
Total shareholders’ equity
    4,470       1,918       1,672       5,654       (9,244 )     4,470  
Noncontrolling interests
                      150             150  
 
                                   
 
                                               
Total liabilities and equity
  $ 5,264     $ 1,938     $ 2,001     $ 32,651     $ (9,400 )   $ 32,454  
 
                                   

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
CONDENSED CONSOLIDATING STATEMENT OF EARNINGS
(In millions)
                                                 
                    AAG     All Other     Consol.        
    AFG     GAFRI     Holding     Subs     Entries     Consolidated  
FOR THE THREE MONTHS ENDED
JUNE 30, 2011
                                               
 
                                               
Revenues:
                                               
Property and casualty insurance premiums
  $     $     $     $ 609     $     $ 609  
Life, accident and health premiums
                      107             107  
Realized gains (losses)
                      20       (1 )     19  
Income (loss) of managed investment entities
                      4             4  
Investment and other income
          2             359       (7 )     354  
Equity in earnings of subsidiaries
    118       40       48             (206 )      
 
                                   
Total revenues
    118       42       48       1,099       (214 )     1,093  
 
                                               
Costs and Expenses:
                                               
Insurance benefits and expenses
                      886             886  
Interest charges on borrowed money
    16             7       4       (6 )     21  
Expenses of managed investment entities
                      18             18  
Other operating and general expenses
    15       6       1       79       (2 )     99  
 
                                   
Total costs and expenses
    31       6       8       987       (8 )     1,024  
 
                                   
 
                                               
Operating earnings before income taxes
    87       36       40       112       (206 )     69  
Provision (credit) for income taxes
    32       12       14       46       (72 )     32  
 
                                   
 
                                               
Net earnings, including noncontrolling interests
    55       24       26       66       (134 )     37  
Less: Net earnings (loss) attributable to noncontrolling interests
                      (18 )           (18 )
 
                                   
 
                                               
Net Earnings Attributable to Shareholders
  $ 55     $ 24     $ 26     $ 84     $ (134 )   $ 55  
 
                                   
 
   
                    AAG     All Other     Consol.        
    AFG     GAFRI     Holding     Subs     Entries     Consolidated  
FOR THE THREE MONTHS ENDED
JUNE 30, 2010
                                               
 
                                               
Revenues:
                                               
Property and casualty insurance premiums
  $     $     $     $ 572     $     $ 572  
Life, accident and health premiums
                      113             113  
Realized gains (losses)
                      11             11  
Income (loss) of managed investment entities
                      8             8  
Investment and other income
    (1 )     3             352       (6 )     348  
Equity in earnings of subsidiaries
    187       41       47             (275 )      
 
                                   
Total revenues
    186       44       47       1,056       (281 )     1,052  
 
                                               
Costs and Expenses:
                                               
Insurance benefits and expenses
                      774             774  
Interest charges on borrowed money
    13             7       4       (6 )     18  
Expenses of managed investment entities
                      14             14  
Other operating and general expenses
    7       3       1       74       3       88  
 
                                   
Total costs and expenses
    20       3       8       866       (3 )     894  
 
                                   
 
                                               
Operating earnings before income taxes
    166       41       39       190       (278 )     158  
Provision (credit) for income taxes
    58       15       14       67       (96 )     58  
 
                                   
 
                                               
Net earnings, including noncontrolling interests
    108       26       25       123       (182 )     100  
Less: Net earnings (loss) attributable to noncontrolling interests
                      (8 )           (8 )
 
                                   
 
                                               
Net Earnings Attributable to Shareholders
  $ 108     $ 26     $ 25     $ 131     $ (182 )   $ 108  
 
                                   

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
CONDENSED CONSOLIDATING STATEMENT OF EARNINGS
(In millions)
                                                 
                    AAG     All Other     Consol.        
    AFG     GAFRI     Holding     Subs     Entries     Consolidated  
FOR THE SIX MONTHS ENDED
JUNE 30, 2011
                                               
 
                                               
Revenues:
                                               
Property and casualty insurance premiums
  $     $     $     $ 1,208     $     $ 1,208  
Life, accident and health premiums
                      217             217  
Realized gains (losses)
                      17       (1 )     16  
Income (loss) of managed investment entities
                      (4 )           (4 )
Investment and other income
    2       5             702       (14 )     695  
Equity in earnings of subsidiaries
    278       89       105             (472 )      
 
                                   
Total revenues
    280       94       105       2,140       (487 )     2,132  
 
                                               
Costs and Expenses:
                                               
Insurance benefits and expenses
                      1,704             1,704  
Interest charges on borrowed money
    32             13       8       (11 )     42  
Expenses of managed investment entities
                      36             36  
Other operating and general expenses
    32       9       2       146       (3 )     186  
 
                                   
Total costs and expenses
    64       9       15       1,894       (14 )     1,968  
 
                                   
 
                                               
Operating earnings before income taxes
    216       85       90       246       (473 )     164  
Provision (credit) for income taxes
    78       30       32       104       (166 )     78  
 
                                   
 
                                               
Net earnings, including noncontrolling interests
    138       55       58       142       (307 )     86  
Less: Net earnings (loss) attributable to noncontrolling interests
                      (52 )           (52 )
 
                                   
 
                                               
Net Earnings Attributable to Shareholders
  $ 138     $ 55     $ 58     $ 194     $ (307 )   $ 138  
 
                                   
 
   
                    AAG     All Other     Consol.        
    AFG     GAFRI     Holding     Subs     Entries     Consolidated  
FOR THE SIX MONTHS ENDED
JUNE 30, 2010
                                               
 
                                               
Revenues:
                                               
Property and casualty insurance premiums
  $     $     $     $ 1,151     $     $ 1,151  
Life, accident and health premiums
                      228             228  
Realized gains (losses)
                      15             15  
Income (loss) of managed investment entities
                      5             5  
Investment and other income
          5             693       (11 )     687  
Equity in earnings of subsidiaries
    379       81       96             (556 )      
 
                                   
Total revenues
    379       86       96       2,092       (567 )     2,086  
 
                                               
Costs and Expenses:
                                               
Insurance benefits and expenses
                      1,535             1,535  
Interest charges on borrowed money
    27             13       7       (11 )     36  
Expenses of managed investment entities
                      23             23  
Other operating and general expenses
    21       7       3       156             187  
 
                                   
Total costs and expenses
    48       7       16       1,721       (11 )     1,781  
 
                                   
 
                                               
Operating earnings before income taxes
    331       79       80       371       (556 )     305  
Provision (credit) for income taxes
    117       28       28       139       (195 )     117  
 
                                   
 
                                               
Net earnings, including noncontrolling interests
    214       51       52       232       (361 )     188  
Less: Net earnings (loss) attributable to noncontrolling interests
                      (26 )           (26 )
 
                                   
 
                                               
Net Earnings Attributable to Shareholders
  $ 214     $ 51     $ 52     $ 258     $ (361 )   $ 214  
 
                                   

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
(In millions)
                                                 
                    AAG     All Other     Consol.        
    AFG     GAFRI     Holding     Subs     Entries     Consolidated  
FOR THE SIX MONTHS ENDED
JUNE 30, 2011
                                               
 
                                               
Operating Activities:
                                               
Net earnings, including noncontrolling interests
  $ 138     $ 55     $ 58     $ 142     $ (307 )   $ 86  
Adjustments:
                                               
Equity in net earnings of subsidiaries
    (181 )     (58 )     (68 )           307        
Dividends from subsidiaries
    190                         (190 )      
Other operating activities, net
    (18 )     (1 )     1       466             448  
 
                                   
Net cash provided by (used in) operating activities
    129       (4 )     (9 )     608       (190 )     534  
 
                                   
 
                                               
Investing Activities:
                                               
Purchases of investments, property and equipment
    (25 )                 (2,529 )           (2,554 )
Returns of capital from (capital contributions to) subsidiaries
    29       (10 )     (1 )           (18 )      
Proceeds from maturities and redemptions of investments
    2       8             1,320             1,330  
Proceeds from sales of investments, property and equipment
    5                   411             416  
Managed investment entities:
                                               
Purchases of investments
                      (681 )           (681 )
Proceeds from sales and redemptions of investments
                      754             754  
Other investing activities, net
                      (6 )           (6 )
 
                                   
Net cash provided by (used in) investing activities
    11       (2 )     (1 )     (731 )     (18 )     (741 )
 
                                   
 
                                               
Financing Activities:
                                               
Annuity receipts
                      1,578             1,578  
Annuity surrenders, benefits and withdrawals
                      (636 )           (636 )
Additional long-term borrowings
                      2             2  
Reductions of long-term debt
                      (14 )           (14 )
Managed investment entities’ retirement of liabilities
                      (8 )           (8 )
Issuances of Common Stock
    16                               16  
Capital contributions from (returns of capital to) parent
          8       10       (36 )     18        
Repurchases of Common Stock
    (178 )                             (178 )
Cash dividends paid
    (34 )                 (190 )     190       (34 )
Other financing activities, net
                      11             11  
 
                                   
Net cash provided by (used in) financing activities
    (196 )     8       10       707       208       737  
 
                                   
 
                                               
Net change in cash and cash equivalents
    (56 )     2             584             530  
Cash and cash equivalents at beginning of period
    370       20             709             1,099  
 
                                   
 
                                               
Cash and cash equivalents at end of period
  $ 314     $ 22     $     $ 1,293     $     $ 1,629  
 
                                   

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
(In millions)
                                                 
                    AAG     All Other     Consol.        
    AFG     GAFRI     Holding     Subs     Entries     Consolidated  
FOR THE SIX MONTHS ENDED
JUNE 30, 2010
                                               
 
                                               
Operating Activities:
                                               
Net earnings, including noncontrolling interests
  $ 214     $ 51     $ 52     $ 232     $ (361 )   $ 188  
Adjustments:
                                               
Equity in net earnings of subsidiaries
    (246 )     (53 )     (63 )           362        
Dividends from subsidiaries
    204             16             (220 )      
Other operating activities, net
    (61 )     (2 )     3       334       (1 )     273  
 
                                   
Net cash provided by (used in) operating activities
    111       (4 )     8       566       (220 )     461  
 
                                   
 
                                               
Investing Activities:
                                               
Purchases of investments, property and equipment
    (3 )                 (2,565 )           (2,568 )
Returns of capital from (capital contributions to) subsidiaries
    (8 )     8                          
Proceeds from maturities and redemptions of investments
          4             993             997  
Proceeds from sales of investments, property and equipment
                      941             941  
Managed investment entities:
                                               
Purchases of investments
                      (394 )           (394 )
Proceeds from sales and redemptions of investments
                      441             441  
Other investing activities, net
                      (124 )           (124 )
 
                                   
Net cash provided by (used in) investing activities
    (11 )     12             (708 )           (707 )
 
                                   
 
                                               
Financing Activities:
                                               
Annuity receipts
                      945             945  
Annuity surrenders, benefits and withdrawals
                      (617 )           (617 )
Additional long-term borrowings
                      30             30  
Reductions of long-term debt
                      (6 )           (6 )
Managed investment entities’ retirement of liabilities
                      (39 )           (39 )
Issuances of Common Stock
    11                               11  
Capital contributions from (returns of capital to) parent
          8       (8 )                  
Repurchases of Common Stock
    (151 )                             (151 )
Cash dividends paid
    (31 )                 (220 )     220       (31 )
Other financing activities, net
    (2 )                 (3 )           (5 )
 
                                   
Net cash provided by (used in) financing activities
    (173 )     8       (8 )     90       220       137  
 
                                   
 
                                               
Net change in cash and cash equivalents
    (73 )     16             (52 )           (109 )
Cash and cash equivalents at beginning of period
    197       12             911             1,120  
 
                                   
 
                                               
Cash and cash equivalents at end of period
  $ 124     $ 28     $     $ 859     $     $ 1,011  
 
                                   

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
ITEM 2
Management’s Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
         
    Page  
Forward-Looking Statements
    33  
Overview
    34  
Critical Accounting Policies
    34  
Liquidity and Capital Resources
    35  
Ratios
    35  
Parent and Subsidiary Liquidity
    35  
Investments
    36  
Uncertainties
    41  
Managed Investment Entities
    42  
Results of Operations
    44  
General
    44  
Income Items
    44  
Expense Items
    49  
Recent Accounting Standards
    50  
   
FORWARD-LOOKING STATEMENTS
 
   
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 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;
 
   
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;
 
   
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 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.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
OVERVIEW
 
   
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 traditional fixed and indexed annuities and a variety of supplemental insurance products such as Medicare supplement.
 
   
Net earnings attributable to AFG’s shareholders for the second quarter and first six months of 2011 were $55 million ($.52 per share, diluted) and $138 million ($1.31 per share diluted), respectively, compared to $108 million ($.97 per share, diluted) and $214 million ($1.90 per share, diluted) reported in the same periods of 2010. Improved operating results in the annuity and supplemental insurance group were more than offset by a second quarter 2011 special charge to strengthen reserves for asbestos and other environmental exposures, primarily within the property and casualty run-off operations, and lower underwriting profit and investment income in the on-going property and casualty insurance operations.
 
   
CRITICAL ACCOUNTING POLICIES
 
   
Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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,
 
   
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 2010 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
   
LIQUIDITY AND CAPITAL RESOURCES
 
   
Ratios AFG’s debt to total capital ratio on a consolidated basis is shown below (dollars in millions).
                         
    June 30,     December 31,  
    2011     2010     2009  
Long-term debt
  $ 940     $ 952     $ 828  
Total capital
    5,002       5,050       4,698  
Ratio of debt to total capital:
                       
Including debt secured by real estate
    18.8 %     18.9 %     17.6 %
Excluding debt secured by real estate
    17.7 %     17.8 %     16.4 %
   
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 its operations. It 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 1.76 for the six months ended June 30, 2011 and 2.41 for the entire year of 2010. Excluding annuity benefits, this ratio was 5.42 and 9.09, 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.
 
   
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 August 2013. There were no borrowings under this agreement, or under any other parent company short-term borrowing arrangements, during 2011. In September 2010, AFG issued $132 million of 7% Senior Notes due 2050.
 
   
During the first six months of 2011, AFG repurchased 5.2 million shares of its Common Stock for $178 million. In addition, in July 2011, AFG repurchased 534,800 shares of its Common Stock for $18 million. During 2010, AFG repurchased 10.3 million shares of its Common Stock for $292 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.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
Subsidiary Liquidity Great American Life Insurance Company (“GALIC”), a wholly-owned annuity and supplemental insurance subsidiary, became a member of the Federal Home Loan Bank of Cincinnati (“FHLB”) in 2009. The FHLB makes loans and provides other banking services to member institutions. Members are required to purchase stock in the FHLB in addition to maintaining collateral deposits that back any funds borrowed. GALIC’s $17 million investment in FHLB capital stock at June 30, 2011 is included in other investments at cost. Membership in the FHLB provides the annuity and supplemental insurance operations with a substantial additional source of liquidity. No funds have been borrowed from the FHLB.
 
   
National Interstate, a 52%-owned property and casualty insurance subsidiary, can borrow up to $75 million, subject to certain conditions, under an unsecured credit agreement expiring in December 2012. Amounts borrowed bear interest at rates ranging from .45% to .9% (currently .65%) over LIBOR based on National Interstate’s credit rating. There was $22 million outstanding under this agreement at June 30, 2011.
 
   
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 without requiring a sale of investments or contributions from AFG. 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. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums. 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.
 
   
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, 2011, contained $20.5 billion in “Fixed maturities” classified as available for sale and $779 million 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, $395 million in fixed maturities were classified as trading with changes in unrealized holding gains or losses included in investment income.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
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 30% 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 93% are priced using pricing services and the balance is priced internally or 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. Prices obtained from a broker or pricing service are adjusted only in cases where they are deemed not to be representative of an appropriate exit price (fewer than 1% of the securities).
 
   
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, 2011 (dollars in millions). Increases or decreases from the 100 basis points illustrated would be approximately proportional.
         
Fair value of fixed maturity portfolio
  $ 20,895  
Pretax impact on fair value of 100 bps increase in interest rates
  $ (919 )
Pretax impact as % of total fixed maturity portfolio
    (4.4 %)
   
Approximately 91% of the fixed maturities held by AFG at June 30, 2011, 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 noninvestment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
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.
 
   
Summarized information for AFG’s MBS (including those classified as trading) at June 30, 2011, 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 4 and 5 years, respectively.
                                         
                                    % Rated  
    Amortized             Fair Value as     Unrealized     Investment  
Collateral type   Cost     Fair Value     % of Cost     Gain (Loss)     Grade  
Residential:
                                       
Agency-backed
  $ 405     $ 421       104 %   $ 16       100 %
Non-agency prime
    2,066       2,167       105       101       75  
Alt-A
    728       718       99       (10 )     52  
Subprime
    549       546       99       (3 )     32  
Commercial
    2,221       2,409       108       188       100  
Other
    24       27       113       3       48  
 
                                 
 
  $ 5,993     $ 6,288       105 %   $ 295       80 %
 
                                 
   
The National Association of Insurance Commissioners (“NAIC”) assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC retained a third-party investment management firm to assist in the determination of appropriate NAIC designations for mortgage-backed securities based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At June 30, 2011, 98% (based on statutory carrying value of $5.9 billion) of AFG’s MBS securities had an NAIC designation of 1 or 2.
 
   
Municipal bonds represented approximately 17% of AFG’s fixed maturity portfolio at June 30, 2011. AFG’s municipal bond portfolio is high quality, with 99% of the securities rated investment grade at that date. The portfolio is well diversified across the states of issuance and individual issuers. At June 30, 2011, approximately 75% of the municipal bond portfolio was held in revenue bonds, with the remaining 25% held in general obligation bonds. State general obligation securities of California, Illinois, New Jersey and New York collectively represented only 2% of this portfolio.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
Summarized information for the unrealized gains and losses recorded in AFG’s Balance Sheet at June 30, 2011, is shown in the following table (dollars in millions). Approximately $274 million of available for sale “Fixed maturities” and $34 million of “Equity securities” had no unrealized gains or losses at June 30, 2011.
                 
    Securities     Securities  
    With     With  
    Unrealized     Unrealized  
    Gains     Losses  
Available for Sale Fixed Maturities
               
Fair value of securities
  $ 17,086     $ 3,140  
Amortized cost of securities
  $ 15,842     $ 3,301  
Gross unrealized gain (loss)
  $ 1,244     $ (161 )
Fair value as % of amortized cost
    108 %     95 %
Number of security positions
    3,550       893  
Number individually exceeding $2 million gain or loss
    106       2  
Concentration of gains (losses) by type or industry (exceeding 5% of unrealized):
               
Mortgage-backed securities
  $ 414     $ (119 )
States and municipalities
    112       (15 )
Banks, savings and credit institutions
    104       (7 )
Gas and electric services
    133       (2 )
Percentage rated investment grade
    94 %     79 %
 
               
Equity Securities
               
Fair value of securities
  $ 652     $ 93  
Cost of securities
  $ 413     $ 102  
Gross unrealized gain (loss)
  $ 239 (*)   $ (9 )
Fair value as % of cost
    158 %     91 %
Number of security positions
    120       32  
Number individually exceeding $2 million gain or loss
    12        
(*)  
Includes $138 million on AFG’s investment in Verisk Analytics, Inc.
   
The table below sets forth the scheduled maturities of AFG’s available for sale fixed maturity securities at June 30, 2011, based on their fair values. Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
                 
    Securities     Securities  
    With     With  
    Unrealized     Unrealized  
    Gains     Losses  
Maturity
               
One year or less
    3 %     1 %
After one year through five years
    30       11  
After five years through ten years
    31       29  
After ten years
    8       21  
 
           
 
    72       62  
 
               
Mortgage-backed securities (average life of approximately four years)
    28       38  
 
           
 
    100 %     100 %
 
           

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
                         
                    Fair  
    Aggregate     Aggregate     Value as  
    Fair     Unrealized     % of Cost  
    Value     Gain (Loss)     Basis  
Fixed Maturities at June 30, 2011
                       
Securities with unrealized gains:
                       
Exceeding $500,000 (719 issues)
  $ 8,934     $ 903       111 %
$500,000 or less (2,831 issues)
    8,152       341       104  
 
                   
 
  $ 17,086     $ 1,244       108 %
 
                   
 
                       
Securities with unrealized losses:
                       
Exceeding $500,000 (84 issues)
  $ 451     $ (79 )     85 %
$500,000 or less (809 issues)
    2,689       (82 )     97  
 
                   
 
  $ 3,140     $ (161 )     95 %
 
                   
   
The following table summarizes (dollars in millions) the unrealized loss for all securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
                         
                    Fair  
    Aggregate     Aggregate     Value as  
Securities with Unrealized   Fair     Unrealized     % of Cost  
Losses at June 30, 2011   Value     Loss     Basis  
 
Investment grade fixed maturities with losses for:
                       
Less than one year (469 issues)
  $ 2,134     $ (41 )     98 %
One year or longer (143 issues)
    346       (38 )     90  
 
                   
 
  $ 2,480     $ (79 )     97 %
 
                   
 
                       
Non-investment grade fixed maturities with losses for:
                       
Less than one year (128 issues)
  $ 368     $ (12 )     97 %
One year or longer (153 issues)
    292       (70 )     81  
 
                   
 
  $ 660     $ (82 )     89 %
 
                   
 
                       
Common equity securities with losses for:
                       
Less than one year (17 issues)
  $ 47     $ (5 )     90 %
One year or longer (4 issues)
                 
 
                   
 
  $ 47     $ (5 )     90 %
 
                   
 
                       
Perpetual preferred equity securities with losses for:
                       
Less than one year (1 issue)
  $ 5     $       100 %
One year or longer (10 issues)
    41       (4 )     91  
 
                   
 
  $ 46     $ (4 )     92 %
 
                   

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
When a decline in the value of a specific investment is considered to be “other-than-temporary,” a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced by the amount of the charge. The determination of whether unrealized losses are “other-than-temporary” requires judgment based on subjective as well as objective factors as detailed in AFG’s 2010 Form 10-K under Management’s Discussion and Analysis – “Investments.”
 
   
Based on its analysis, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they recover in value and, at June 30, 2011, had no intent to sell them. Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers’ creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG’s ability or intent change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG’s investment portfolio could have a significant adverse effect on AFG’s liquidity.
 
   
Uncertainties Management believes that the areas posing the greatest risk of material loss are the adequacy of its insurance reserves and contingencies arising out of its former railroad and manufacturing operations. AFG has conducted comprehensive studies of its asbestos and environmental reserves with the aid of outside actuarial and engineering firms and specialty outside counsel every two years with an in-depth internal review during the intervening years. The outcome of the 2011 study with the assistance of outside firms is included in AFG’s second quarter results. See “Results of Operations” – “Special Asbestos and Environmental Reserve Charge” below and Management’s Discussion and Analysis – “Uncertainties” in AFG’s 2010 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
   
MANAGED INVESTMENT ENTITIES
 
   
Accounting standards require AFG to consolidate its investments in six collateralized loan obligation (“CLO”) entities that it manages and owns an interest in (in the form of debt). See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities.” The effect of consolidating these entities is shown in the tables below (in millions). The “Before CLO Consolidation” columns include AFG’s investment and earnings in the CLOs on an unconsolidated basis.
CONDENSED CONSOLIDATING BALANCE SHEET
                                 
            Managed              
    Before CLO     Investment     Consol.     Consolidated  
    Consolidation     Entities     Entries     As Reported  
June 30, 2011
                               
Assets:
                               
Cash and other investments
  $ 24,387     $     $ (19 )(a)   $ 24,368  
Assets of managed investment entities
          2,591             2,591  
Other assets
    7,094                   7,094  
 
                       
Total assets
  $ 31,481     $ 2,591     $ (19 )   $ 34,053  
 
                       
 
                               
Liabilities:
                               
Unpaid losses, loss adjustment expenses and unearned premiums
  $ 7,900     $     $     $ 7,900  
Annuity, life, accident and health benefits and reserves
    15,808                   15,808  
Liabilities of managed investment entities
          2,449       (19 )(a)     2,430  
Long-term debt and other liabilities
    3,290                   3,290  
 
                       
Total liabilities
    26,998       2,449       (19 )     29,428  
 
                               
Shareholders’ Equity:
                               
Common Stock and Capital surplus
    1,239                   1,239  
Retained earnings:
                               
Appropriated – managed investment entities
          142             142  
Unappropriated
    2,512                   2,512  
Accumulated other comprehensive income
    579                   579  
 
                       
Total shareholders’equity
    4,330       142             4,472  
Noncontrolling interests
    153                   153  
 
                       
Total equity
    4,483       142             4,625  
 
                       
Total liabilities and equity
  $ 31,481     $ 2,591     $ (19 )   $ 34,053  
 
                       
 
                               
December 31, 2010
                               
Assets:
                               
Cash and other investments
  $ 22,687     $     $ (17 )(a)   $ 22,670  
Assets of managed investment entities
          2,537             2,537  
Other assets
    7,247                   7,247  
 
                       
Total assets
  $ 29,934     $ 2,537     $ (17 )   $ 32,454  
 
                       
 
                               
Liabilities:
                               
Unpaid losses, loss adjustment expenses and unearned premiums
  $ 7,947     $     $     $ 7,947  
Annuity, life, accident and health benefits and reserves
    14,555                   14,555  
Liabilities of managed investment entities
          2,340       (17 )(a)     2,323  
Long-term debt and other liabilities
    3,009                   3,009  
 
                       
Total liabilities
    25,511       2,340       (17 )     27,834  
 
                               
Shareholders’ equity:
                               
Common Stock and Capital surplus
    1,271                   1,271  
Retained earnings:
                               
Appropriated – managed investment entities
          197             197  
Unappropriated
    2,523                   2,523  
Accumulated other comprehensive income
    479                   479  
 
                       
Total shareholders’ equity
    4,273       197             4,470  
Noncontrolling interests
    150                   150  
 
                       
Total equity
    4,423       197             4,620  
 
                       
Total liabilities and equity
  $ 29,934     $ 2,537     $ (17 )   $ 32,454  
 
                       
(a)  
Elimination of the fair value of AFG’s investment in CLOs.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
CONDENSED CONSOLIDATING STATEMENT OF EARNINGS
                                 
            Managed              
    Before CLO     Investment     Consol.     Consolidated  
    Consolidation(a)     Entities     Entries     As Reported  
Six months ended June 30, 2011
                               
Revenues:
                               
Insurance premiums
  $ 1,425     $     $     $ 1,425  
Investment income
    606                   606  
Realized gains (losses) on securities
    26               (7 )(b)     19  
Realized gains (losses) on subsidiaries
    (3 )                 (3 )
Income (loss) of managed investment entities:
                               
Investment income
          51             51  
Loss on change in fair value of assets/liabilities
          (57 )     2 (b)     (55 )
Other income
    97             (8 )(c)     89  
 
                       
Total revenues
    2,151       (6 )     (13 )     2,132  
 
                               
Costs and Expenses:
                               
Insurance benefits and expenses
    1,704                   1,704  
Expenses of managed investment entities
          49       (13 )(b)(c)     36  
Interest on borrowed money and other expenses
    228                   228  
 
                       
Total costs and expenses
    1,932       49       (13 )     1,968  
 
                       
 
                               
Operating earnings before income taxes
    219       (55 )           164  
Provision for income taxes
    78                   78  
 
                       
Net earnings, including noncontrolling interests
    141       (55 )           86  
Less: Net earnings (loss) attributable to noncontrolling interests
    3             (55 )(d)     (52 )
 
                       
Net Earnings Attributable to Shareholders
  $ 138     $ (55 )   $ 55     $ 138  
 
                       
 
                               
Six months ended June 30, 2010
                               
Revenues:
                               
Insurance premiums
  $ 1,379     $     $     $ 1,379  
Investment income
    589                   589  
Realized gains (losses) on securities
    22             (7 )(b)     15  
Income (loss) of managed investment entities:
                               
Investment income
          45             45  
Loss on change in fair value of assets/liabilities
          (45 )     5 (b)     (40 )
Other income
    106             (8 )(c)     98  
 
                       
Total revenues
    2,096             (10 )     2,086  
 
                               
Costs and Expenses:
                               
Insurance benefits and expenses
    1,535                   1,535  
Expenses of managed investment entities
          33       (10 )(b)(c)     23  
Interest on borrowed money and other expenses
    223                   223  
 
                       
Total costs and expenses
    1,758       33       (10 )     1,781  
 
                       
 
                               
Operating earnings before income taxes
    338       (33 )           305  
Provision for income taxes
    117                   117  
 
                       
Net earnings, including noncontrolling interests
    221       (33 )           188  
Less: Net earnings (loss) attributable to noncontrolling interests
    7             (33 )(d)     (26 )
 
                       
Net Earnings Attributable to Shareholders
  $ 214     $ (33 )   $ 33     $ 214  
 
                       
(a)  
Includes $7 million for each of the first six months of both 2011 and 2010 in realized gains representing the change in fair value of AFG’s CLO investments plus $8 million for each of the same periods in CLO management fees earned.
 
(b)  
Elimination of the change in fair value of AFG’s investments in the CLOs, including $5 million and $2 million for the first six months of 2011 and 2010, respectively, in distributions recorded as interest expense by the CLOs.
 
(c)  
Elimination of management fees earned by AFG.
 
(d)  
Allocate losses of CLOs attributable to other debt holders to noncontrolling interests.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
RESULTS OF OPERATIONS
 
   
General Results of operations as shown in the accompanying financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”).
 
   
AFG’s net earnings attributable to shareholders, determined in accordance with GAAP, include certain items that may not be indicative of its ongoing core operations. The following table identifies such items and reconciles net earnings attributable to shareholders to core net operating earnings, a non-GAAP financial measure that AFG believes is a useful tool for investors and analysts in analyzing ongoing operating trends (in millions, except per share amounts):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Core net operating earnings
  $ 81     $ 102     $ 167     $ 205  
Special asbestos and environmental (“A&E”) charge(*)
    (38 )           (38 )      
Realized gains (*)
    12       6       9       9  
 
                       
Net earnings attributable to shareholders
  $ 55     $ 108     $ 138     $ 214  
 
                       
 
                               
Diluted per share amounts:
                               
Core net operating earnings
  $ .78     $ .91     $ 1.59     $ 1.82  
Special asbestos and environmental charge
    (.37 )           (.37 )      
Realized gains
    .11       .06       .09       .08  
 
                       
Net earnings attributable to shareholders
  $ .52     $ .97     $ 1.31     $ 1.90  
 
                       
     
(*)   The tax effects of reconciling items are shown below (in millions):
                                 
Special A&E charge
  $ 21     $     $ 21     $  
Realized gains
    (7 )     (4 )     (7 )     (5 )
   
In addition, realized gains(losses) are shown net of noncontrolling interests of $1 million for both the second quarter and first six months of 2010.
   
Net earnings attributable to shareholders and core net operating earnings decreased in the second quarter and first six months of 2011 compared to the same periods in 2010 as improved results in the annuity and supplemental insurance operations were more than offset by a decline in Specialty property and casualty underwriting results and lower property and casualty investment income. Net earnings attributable to shareholders in 2011 was also impacted by the second quarter special A&E charge.
 
   
Property and Casualty Insurance – Underwriting AFG reports its Specialty insurance business in the following sub-segments: (i) Property and transportation, (ii) Specialty casualty and (iii) Specialty financial.
 
   
Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their financial statements better understand the company’s performance. See Note C – “Segments of Operations” for the detail of AFG’s operating profit by significant business segment.
 
   
Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. A combined ratio under 100% indicates an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
Premiums, combined ratios and prior year development for AFG’s property and casualty insurance operations were as follows (dollars in millions):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Gross Written Premiums
                               
Property and transportation
  $ 496     $ 364     $ 814     $ 641  
Specialty casualty
    323       316       642       663  
Specialty financial
    129       128       245       250  
Other
    1       3       1       1  
 
                       
 
  $ 949     $ 811     $ 1,702     $ 1,555  
 
                       
 
                               
Net Written Premiums
                               
Property and transportation
  $ 346     $ 246     $ 600     $ 462  
Specialty casualty
    211       211       425       449  
Specialty financial
    96       104       194       202  
Other
    16       14       34       28  
 
                       
 
  $ 669     $ 575     $ 1,253     $ 1,141  
 
                       
 
                               
Combined Ratios
                               
Property and transportation
    99.8 %     96.0 %     93.6 %     90.5 %
Specialty casualty
    90.2       89.5       94.7       90.5  
Specialty financial
    86.6       74.0       89.1       78.8  
Total Specialty
    93.6       88.1       93.0       87.5  
Aggregate (including discontinued lines)
    101.8 %     89.1 %     97.1 %     88.4 %
 
                               
Favorable (Unfavorable) Prior Year Development
                               
Property and transportation
  $ 4     $ 15     $ 26     $ 24  
Specialty casualty
    27       31       27       50  
Specialty financial
    4       13             23  
Other specialty
    2       3       5       10  
 
                       
 
    37       62       58       107  
 
                               
Other (primarily asbestos and environmental charges)
    (50 )     (5 )     (50 )     (11 )
 
                       
 
  $ (13 )   $ 57     $ 8     $ 96  
 
                       
   
The overall increases in gross and net written premiums in the second quarter and first six months of 2011 compared to the 2010 periods resulted from increased premiums in the property and transportation segment, reflecting the impact of higher spring commodity prices on the crop business and National Interstate’s third quarter 2010 acquisition of Vanliner. Overall average renewal rates for the second quarter and first six months of 2011 were flat when compared to the same 2010 periods.
 
   
The Specialty insurance operations generated an underwriting profit of $39 million in the 2011 second quarter compared to $68 million in the second quarter of 2010. The reduced profit in 2011 is primarily the result of a $25 million decrease in favorable reserve development, which was partially offset by lower catastrophe losses. Catastrophe losses were $23 million compared to $34 million in the 2010 second quarter. Underwriting profit for the Specialty insurance operations for the first six months of 2011 was $85 million compared to $145 million in the comparable 2010 period. This difference was primarily the result of lower favorable reserve development.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
Property and transportation gross and net written premiums for the second quarter and first six months of 2011 were higher than the 2010 periods as a result of additional premiums from the Vanliner acquisition as well as the impact of higher spring commodity prices on crop premiums. This group reported a small underwriting profit in the second quarter of 2011 compared to an underwriting profit of $8 million in the second quarter of 2010. This decrease is attributable to lower favorable reserve development, particularly in the inland marine and crop insurance operations, and slightly lower earnings in the agricultural businesses, which was partially offset by lower catastrophe losses. The $18 million in catastrophe losses recorded by this group in the second quarter of 2011 as a result of the April and May tornados was $12 million lower than losses in the comparable 2010 period. Underwriting profit in the first six months of 2011 decreased approximately $7 million from the comparable 2010 period. The largest businesses in this group produced solid underwriting profit margins through the first six months of 2011.
 
   
Specialty casualty gross written premiums were up slightly and net written premiums were flat for the 2011 second quarter when compared to the second quarter of 2010. Gross and net written premiums decreased for the first six months of 2011 when compared to the 2010 period. The non-renewal of two major programs that did not meet management’s return thresholds and a decision to exit the excess workers’ compensation business resulted in lower premiums in both periods. This group reported an underwriting profit of $21 million in the second quarter of 2011, slightly lower than the second quarter of 2010. Increased underwriting profit in the excess and surplus businesses and higher favorable development in the run-off legal professional liability business were more than offset by lower underwriting profits in the Marketform, executive liability and general liability operations. Underwriting profit in the first six months of 2011 decreased approximately $18 million from the comparable 2010 period. Lower underwriting profit in a block of program business and lower favorable reserve development were partially offset by improved results in the excess and surplus lines. Most businesses in this group produced strong underwriting profit margins through the first six months of 2011.
 
   
Specialty financial gross written premiums for the second quarter and first six months of 2011 were impacted by lower premiums from the run-off of automotive-related business and lower premiums in the financial institutions business, partially offset by higher premiums in the trade credit and international operations. Net written premiums decreased for the second quarter and first six months of 2011 when compared to 2010 periods as higher premiums in the trade credit operations were more than offset by lower premiums in the fidelity and crime and financial institutions businesses. This group reported underwriting profits of $13 million in the second quarter and $23 million in the first six months of 2011 compared to $33 million and $54 million in the same 2010 periods. The absence of favorable development related to the run-off automobile residual value insurance operations and higher catastrophe losses in the financial institutions business contributed to these lower results. Almost all lines of business in this group produced strong underwriting profit margins through the first six months of 2011.
 
   
Special Asbestos and Environmental Reserve Charge AFG recently completed the previously announced comprehensive study of its asbestos and environmental exposures relating to the run-off operations of its property and casualty group and its exposures related to former railroad and manufacturing operations and sites.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
As a result of the study, AFG recorded a $50 million special charge (net of reinsurance) to increase the property and casualty group’s asbestos reserves by $28 million and its environmental reserves by $22 million. At June 30, 2011, the property and casualty group’s A&E reserves were $382 million, net of reinsurance recoverables. At that date, AFG’s three year survival ratio was 18.0 times paid losses for the asbestos reserves and 12.3 times paid losses for the total A&E reserves. Excluding amounts associated with the settlements of asbestos related coverage litigation for A.P. Green Industries (see “Legal Proceedings” in AFG’s 2010 Form 10-K) and another large claim, AFG’s three year survival ratio was 11.5 and 8.8 times paid losses for the asbestos reserves and total A&E reserves, respectively. These ratios compare favorably with A.M. Best’s most recent report on A&E survival ratios (February 2011) which were 8.3 for asbestos and 7.7 for total industry A&E reserves.
 
   
The property and casualty group’s asbestos reserve increase related primarily to exposures on business assumed from other insurers resulting from an increase in anticipated aggregate exposures in several large settlements involving several insurers in which AFG has a small proportionate share. Some insurers have settled long-standing asbestos exposures with their insureds and are seeking payment from reinsurers. Asbestos reserves related to the property and casualty group’s direct asbestos exposures were increased to reflect higher frequency and severity of mesothelioma and other cancer claims as well as increased defense costs on many of these claims. These trends were partially offset by a decline in the number of claims without serious injury and fewer new claims that required payment being reported to AFG. The increase in the property and casualty group’s environmental reserves was attributed primarily to a small number of increases on specific environmental claims at several sites.
 
   
In addition to the property and casualty group, the study encompassed reserves for asbestos and environmental exposures of AFG’s former railroad and manufacturing operations. As a result of the study, AFG recorded a $9 million special charge (included in other expenses) to increase its (i) asbestos reserves by $3 million in recognition of a higher number of expected mesothelioma and lung cancer cases than had previously been estimated, partially offset by a decrease in the number of claims without serious injury and (ii) environmental reserves by $6 million due primarily to higher estimated costs with respect to several existing sites. At June 30, 2011, AFG had liabilities totaling $101 million for environmental and personal injury claims associated with its former railroad and manufacturing operations.
 
   
The study relied on a ground-up exposure analysis. With respect to asbestos, it considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development. The asbestos legal climate remains very difficult to predict. While some progress has been made in state asbestos tort reform and judicial rulings, that progress has been somewhat offset by increased claims costs, increased defense costs, the assertion of non-products theories and an expanding pool of plaintiffs and defendants.
 
   
Annuity and Supplemental Insurance Operations Operating earnings before income taxes of the annuity and supplemental insurance segment increased $10 million (22%) in the second quarter and $18 million (20%) for the first six months of 2011 compared to the 2010 periods, due primarily to higher earnings in the fixed annuity operations, especially the bank distribution channels, as well as higher earnings in the supplemental health insurance operations.

 

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Table of Contents

AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
Statutory Annuity Premiums The following table summarizes AFG’s annuity sales (in millions):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
403(b) Fixed and Indexed Annuities:
                               
First Year
  $ 5     $ 9     $ 11     $ 20  
Renewal
    46       45       88       87  
Single Sum
    18       26       35       51  
 
                       
Subtotal
    69       80       134       158  
 
                               
Non-403(b) Indexed Annuities
    454       151       711       283  
Non-403(b) Fixed Annuities
    62       157       122       259  
Bank Annuities – Direct
    115       142       215       196  
Bank Annuities – Indirect
    190       10       361       10  
Variable Annuities
    16       19       35       39  
 
                       
Total Annuity Premiums
  $ 906     $ 559     $ 1,578     $ 945  
 
                       
   
“Bank Annuities – Direct” represent premiums generated by financial institutions appointed and serviced directly by AFG. “Bank Annuities – Indirect” represent premiums generated through banks by independent agents or brokers.
 
   
The increase in annuity premiums for the second quarter and first six months of 2011 compared to the same periods in 2010 is attributable to higher sales through the bank distribution channels and increased sales of indexed annuities in the non-403(b) single premium market. Higher sales in the bank channels reflect primarily “indirect” bank sales by one agent through Regions Bank; this relationship did not exist until late in the second quarter of 2010. Increased sales of indexed annuities reflects the industry trend towards indexed annuities and away from traditional fixed annuities, as well as AFG’s introduction of new indexed products and features.
 
   
Life, Accident and Health Premiums and Benefits The following table summarizes AFG’s life, accident and health premiums and benefits as shown in the Consolidated Statement of Earnings (in millions):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Premiums
                               
Supplemental insurance operations
                               
First year
  $ 10     $ 17     $ 21     $ 38  
Renewal
    92       90       184       177  
Life operations (in run-off)
    5       6       12       13  
 
                       
 
  $ 107     $ 113     $ 217     $ 228  
 
                       
 
                               
Benefits
                               
Supplemental insurance operations
  $ 78     $ 83     $ 164     $ 169  
Life operations (in run-off)
    11       10       21       20  
 
                       
 
  $ 89     $ 93     $ 185     $ 189  
 
                       

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
Investment Income The $12 million and $17 million increases in investment income for the second quarter and first six months of 2011, respectively, compared to the same periods in 2010 reflects higher average invested assets, primarily related to growth in the annuity business, partially offset by lower yields on fixed maturity investments. Investment income includes $7 million and $15 million in the second quarter and first six months of 2011 and $18 million and $44 million in the second quarter and first six months of 2010 of interest income earned on interest-only and similar MBS, primarily non-agency interest-only securities with interest rates that float inversely with short-term rates.
 
   
Over the past couple of years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG’s investment portfolio yield.
 
   
Realized Gains (Losses) on Securities Net realized gains (losses) on securities consisted of the following (in millions):
                                 
    Three months ended     Six months ended  
    June 30,     June 30,  
    2011     2010     2011     2010  
Realized gains (losses) before impairments:
                               
Disposals
  $ 46     $ 26     $ 63     $ 45  
Change in the fair value of derivatives
    (6 )     3       (11 )     12  
Adjustments to annuity deferred policy acquisition costs and related items
          (2 )     (2 )     (5 )
 
                       
 
    40       27       50       52  
 
                       
 
                               
Impairment charges:
                               
Securities
    (27 )     (23 )     (41 )     (53 )
Adjustments to annuity deferred policy acquisition costs and related items
    6       7       10       16  
 
                       
 
    (21 )     (16 )     (31 )     (37 )
 
                       
 
                               
 
  $ 19     $ 11     $ 19     $ 15  
 
                       
   
The change in fair value of derivatives includes net losses of less than $1 million in the second quarter and $3 million in the first six months of 2011 and net gains of $9 million and $26 million in the second quarter and first six months of 2010 from the mark-to-market of MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. See Note F – “Derivatives.”
 
   
Annuity Benefits Annuity benefits reflect amounts accrued on annuity policyholders’ funds accumulated. On deferred annuities (annuities in the accumulation phase), interest is generally credited to policyholders’ accounts at their current stated interest rates. Furthermore, for “two-tier” deferred annuities (annuities under which a higher interest amount can be earned if a policy is annuitized rather than surrendered), additional reserves are accrued for (i) persistency and premium bonuses and (ii) excess benefits expected to be paid for future deaths and annuitizations. Changes in investment yields, crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect these additional reserves and could result in charges (or credits) to earnings in the period the projections are modified.
 
   
The $7 million and $15 million increases in annuity benefits in the second quarter and first six months of 2011 compared to the 2010 periods reflect growth in the annuity business, partially offset by the impact of lower average crediting rates.

 

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AMERICAN FINANCIAL GROUP, INC. 10-Q
Management’s Discussion and Analysis
of Financial Condition and Results of Operations – Continued
   
Annuity and Supplemental Insurance Acquisition Expenses Annuity and supplemental insurance acquisition expenses include amortization of annuity, supplemental insurance and life business deferred policy acquisition costs (“DPAC”) as well as a portion of commissions on sales of insurance products. Annuity and supplemental insurance acquisition expenses also include amortization of the present value of future profits of businesses acquired (“PVFP”). The $2 million decrease in annuity and supplemental insurance acquisition expenses for the second quarter of 2011 compared to the 2010 quarter reflects the unfavorable impact of poor stock market performance on variable annuities in the 2010 quarter and lower acquisition expenses in the supplemental business in the 2011 quarter, partially offset by the impact of growth in the fixed annuity business.
 
   
The vast majority of the annuity and supplemental insurance group’s DPAC asset relates to its annuity and life insurance lines of business. Unanticipated spread compression, decreases in the stock market, adverse mortality experience, and higher than expected lapse rates could lead to write-offs of DPAC or PVFP in the future. If the current interest rate environment persists through the end of the year, AFG may be required to write-off DPAC related to its fixed annuity business. Any such write-off is not expected to have a material impact on AFG’s net earnings for the year.
 
   
Interest Charges on Borrowed Money Interest expense increased $3 million (17%) for the second quarter and $6 million (17%) during the first six months of 2011 compared to the same periods of 2010 reflecting AFG’s issuance of $132 million of 7% Senior Notes in September 2010.
 
   
Other Operating and General Expenses Other operating and general expenses for 2011 include a $9 million second quarter special charge to increase liabilities related to asbestos and environmental exposures of AFG’s former railroad and manufacturing operations. For a discussion of the study that resulted in the A&E charge, see “Special Asbestos and Environmental Reserve Charge” under Results of Operations – “Property and Casualty Insurance - Underwriting.” For the six month period, the A&E charge was offset by the impact of a $10 million recovery in the first quarter of 2011 on a prior property and casualty extracontractual obligation claim.
 
   
RECENT ACCOUNTING STANDARDS
 
   
In October 2010, the FASB issued Accounting Standards Update 2010-26 to address diversity in practice regardin