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 Commission File September 30, 1997 No. 1-7361 AMERICAN FINANCIAL CORPORATION Incorporated under IRS Employer I.D. the Laws of Ohio No. 31-0624874 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 X No ___ As of November 1, 1997, there were 45,000,000 shares of the Registrant's Common Stock outstanding, all of which were owned by American Financial Group, Inc. Page 1 of 18 AMERICAN FINANCIAL CORPORATION 10-Q PART I FINANCIAL INFORMATION AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars In Thousands) September 30, December 31, 1997 1996 Assets Cash and short-term investments $ 352,261 $ 404,831 Investments: Bonds and redeemable preferred stocks: Held to maturity - at amortized cost (market - $3,318,500 and $3,528,100) 3,250,282 3,491,126 Available for sale - at market (amortized cost - $7,051,321 and $6,362,597) 7,307,421 6,494,597 Other stocks - principally at market (cost - $110,812 and $142,364) 401,112 327,664 Investment in investee corporations 219,044 199,651 Loans receivable 541,694 568,055 Real estate and other investments 213,769 205,021 Total investments 11,933,322 11,286,114 Recoverables from reinsurers and prepaid reinsurance premiums 1,001,615 942,450 Agents' balances and premiums receivable 709,882 609,403 Deferred acquisition costs 481,859 452,041 Other receivables 259,976 272,766 Deferred tax asset 12,384 137,284 Assets held in separate accounts 280,461 247,579 Prepaid expenses, deferred charges and other assets 368,488 368,114 Cost in excess of net assets acquired 269,850 278,581 $15,670,098 $14,999,163 Liabilities and Capital Unpaid losses and loss adjustment expenses $ 4,199,056 $ 4,123,701 Unearned premiums 1,336,031 1,247,806 Annuity benefits accumulated 5,505,794 5,365,612 Life, accident and health reserves 600,105 575,380 Payable to American Financial Group, Inc. 334,388 422,015 Other long-term debt: Holding companies 243,719 339,504 Subsidiaries 147,134 178,415 Liabilities related to separate accounts 280,461 247,579 Accounts payable, accrued expenses and other liabilities 973,563 915,398 Total liabilities 13,620,251 13,415,410 Minority interest 494,744 306,858 Shareholders' Equity: Preferred Stock (liquidation value $258,638) 162,760 162,760 Common Stock without par value (45,000,000 shares outstanding) 9,625 9,625 Capital surplus 931,892 919,746 Retained earnings 139,226 1,364 Net unrealized gain on marketable securities, net of deferred income taxes 311,600 183,400 Total shareholders' equity 1,555,103 1,276,895 $15,670,098 $14,999,163 2 AMERICAN FINANCIAL CORPORATION 10-Q AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS (In Thousands) Three months ended Nine months ended September 30, September 30, 1997 1996 1997 1996 Income: Property and casualty insurance premiums $ 739,858 $ 718,826 $2,102,001 $2,162,634 Life, accident and health premiums 32,149 24,809 84,845 80,323 Investment income 218,626 212,571 645,961 627,128 Realized gains on sales of securities 29,682 3,161 35,693 24,604 Equity in net earnings (losses) of investee corporations (13,914) (3,361) 18,094 22,505 Gain on sale of investee corporation - 169,376 - 169,376 Gains on sales of subsidiaries - - 731 36,837 Other income 28,335 38,072 80,582 103,007 1,034,736 1,163,454 2,967,907 3,226,414 Costs and Expenses: Property and casualty insurance: Losses and loss adjustment expenses 545,915 616,294 1,510,426 1,655,634 Commissions and other underwriting expenses 208,975 187,486 586,580 596,505 Annuity benefits 72,868 69,514 212,305 206,319 Life, accident and health benefits 28,250 21,742 78,238 70,212 Interest charges on borrowed money 21,167 20,180 67,293 68,528 Minority interest expense 10,530 18,670 30,887 39,348 Other operating and general expenses 89,775 81,587 233,214 240,628 977,480 1,015,473 2,718,943 2,877,174 Earnings before income taxes and extraordinary items 57,256 147,981 248,964 349,240 Provision for income taxes 22,339 28,799 91,343 92,967 Earnings before extraordinary items 34,917 119,182 157,621 256,273 Extraordinary items - loss on prepayment of debt (6,908) (8,286) (6,986) (25,644) Net Earnings $ 28,009 $ 110,896 $ 150,635 $ 230,629 3 AMERICAN FINANCIAL CORPORATION 10-Q AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands) Nine months ended September 30, 1997 1996 Operating Activities: Net earnings $ 150,635 $ 230,629 Adjustments: Extraordinary items 6,986 25,644 Depreciation and amortization 51,173 50,724 Annuity benefits 212,144 206,319 Equity in net earnings of investee corporations (18,094) (22,505) Changes in reserves on assets (102) 11,866 Realized gains on investing activities (36,102) (230,142) Increase (decrease) in reinsurance and other receivables (216,226) 48,171 Decrease in other assets 66,962 29,799 Increase in insurance claims and reserves 188,305 62,453 Decrease in other liabilities (104,382) (133,124) Increase in minority interest 24,944 34,857 Dividends from investees 3,600 3,600 Other, net (19,044) (7,169) 310,799 311,122 Investing Activities: Purchases of and additional investments in: Fixed maturity investments (1,816,550) (1,522,126) Equity securities (22,783) (9,270) Investees and subsidiaries (4,900) - Real estate, property and equipment (35,396) (25,629) Maturities and redemptions of fixed maturity investments 535,178 444,986 Sales of: Fixed maturity investments 935,942 587,677 Equity securities 85,677 32,687 Investees and subsidiaries 2,500 286,648 Real estate, property and equipment 2,792 7,438 Cash and short-term investments of former subsidiaries (70) (4,589) Increase in other investments (4,448) (9,183) (322,058) (211,361) Financing Activities: Annuity receipts 369,731 410,203 Annuity payments (439,818) (372,005) Additional long-term borrowings 63,090 278,275 Reductions of long-term debt (110,494) (515,253) Borrowings from AFG 44,100 106,972 Payments to AFG (118,500) (55,000) Capital contribution 14,000 14,000 Issuances of trust preferred securities 149,353 - Cash dividends paid (12,773) (12,753) (41,311) (145,561) Net Decrease in Cash and Short-term Investments (52,570) (45,800) Cash and short-term investments at beginning of period 404,831 448,201 Cash and short-term investments at end of period $ 352,261 $ 402,401 4 AMERICAN FINANCIAL CORPORATION 10-Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. Accounting Policies Basis of Presentation The accompanying consolidated financial statements for American Financial Corporation ("AFC") 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 generally accepted accounting principles. Certain reclassifications have been made to prior years 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. 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. At the close of business on December 31, 1996, American Financial Group ("AFG") contributed to AFC 81% of the common stock of American Premier. Since AFC and American Premier are under the common control of AFG, the acquisition of American Premier has been recorded by AFC at AFG's historical cost in a manner similar to a pooling of interests. Accordingly, the historical consolidated financial statements of AFC for periods subsequent to April 3, 1995 (date of common control) have been restated to include the accounts of American Premier. AFC's ownership of subsidiaries and significant affiliates with publicly traded common shares was as follows: September 30, December 31, 1997 1996 1995 American Annuity Group, Inc. ("AAG") 81% 81% 81% American Financial Enterprises, Inc. ("AFEI") 81% 83% 83% Chiquita Brands International, Inc. 40% 43% 44% Citicasters Inc. (a) (a) 38% (a) Sold in September 1996. Investments Debt securities are classified as "held to maturity" and reported at amortized cost if AFC has the positive intent and ability to hold them to maturity. Debt and equity securities are classified as "available for sale" and reported at fair value with unrealized gains and losses reported as a separate component of shareholders' equity if the securities are not classified as held to maturity or bought and held principally for selling in the near term. Only in certain limited circumstances, such as significant issuer credit deterioration or if required by insurance or other regulators, may a company change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. 5 AMERICAN FINANCIAL CORPORATION 10-Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Premiums and discounts on mortgage-backed securities are amortized over their expected average lives using the interest method. Gains or losses on sales of securities are recognized at the time of disposition with the amount of gain or loss determined on the specific identification basis. 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 and the carrying value of that investment is reduced. Short-term investments are carried at cost; loans receivable are stated primarily at the aggregate unpaid balance. Investment in Investee Corporations Investments in securities of 20%- to 50%-owned companies are carried at cost, adjusted for AFC's proportionate share of their undistributed earnings or losses. Investments in less than 20%-owned companies are accounted for by the equity method when, in the opinion of management, AFC can exercise significant influence over operating and financial policies of the investee. Cost in Excess of Net Assets Acquired The excess of cost of subsidiaries and investees over AFC's equity in the underlying net assets ("goodwill") is being amortized over 40 years. The excess of AFC's equity in the net assets of other subsidiaries and investees over its cost of acquiring these companies ("negative goodwill") is allocated to AFC's basis in these companies' fixed assets, goodwill and other long-term assets and is amortized on a 10- to 40-year basis. Insurance As discussed under "Reinsurance" below, unpaid losses and loss adjustment expenses and unearned premiums have not been reduced for reinsurance recoverable. Reinsurance In the normal course of business, AFC's insurance subsidiaries cede reinsurance to other companies to diversify risk and limit maximum loss arising from large claims. To the extent that any reinsuring companies are unable to meet obligations under the agreements covering reinsurance ceded, AFC's insurance subsidiaries would remain liable. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsurance policies. AFC's insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on 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. AFC's insurance subsidiaries also assume reinsurance from other companies. Income on reinsurance assumed is recognized based on reports received from ceding reinsurers. Deferred Acquisition Costs Policy acquisition costs (principally commissions, premium taxes and other underwriting expenses) related to the production of new business are deferred ("DPAC"). For the property and casualty companies, the deferral of acquisition costs is limited based upon their recoverability without any consideration for anticipated investment income. DPAC is charged against income ratably over the terms of the related policies. For the annuity companies, DPAC is amortized, with interest, in relation to the present value of expected gross profits on the policies. 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 the direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses based on past 6 AMERICAN FINANCIAL CORPORATION 10-Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED experience; (d) estimates based on experience of expenses for investigating and adjusting claims and (e) the current state of the law and coverage litigation. These liabilities are subject to the impact of changes in claim amounts and frequency and other factors. In spite of the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate. 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. 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. Life, Accident and Health Reserves Liabilities for future policy benefits under traditional ordinary life, accident and health policies are computed using a net level premium method. Computations are based on anticipated investment yields, mortality, morbidity and surrenders and include provisions for unfavorable deviations. Reserves are modified as necessary to reflect actual experience and developing trends. Assets Held In and Liabilities Related to Separate Accounts Investment annuity deposits and related liabilities represent primarily deposits maintained by several banks under a previously offered tax-deferred annuity program. AAG receives an annual fee from each bank for sponsoring the program; if depositors elect to purchase an annuity from AAG, funds are transferred to AAG. Premium Recognition Property and casualty premiums are earned 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 reports 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. Policyholder Dividends Dividends payable to policyholders are included in "Accounts payable, accrued expenses and other liabilities" and represent estimates of amounts payable on participating policies which share in favorable underwriting results. The estimate is accrued during the period in which the related premium is earned. Changes in estimates are included in income in the period determined. Policyholder dividends do not become legal liabilities unless and until declared by the boards of directors of the insurance companies. Income Taxes AFC and American Premier have each filed consolidated federal income tax returns which include all 80%- owned U.S. subsidiaries, except for certain life insurance subsidiaries and their subsidiaries. At the close of business on December 31, 1996, AFG contributed 81% of the common stock of American Premier to AFC. Accordingly, AFC and American Premier will file a single consolidated return for 1997. Because holders of AFC Preferred Stock hold in excess of 20% of AFC's voting rights, AFG (parent) owns less than 80% of AFC, and therefore, will file a separate return. 7 AMERICAN FINANCIAL CORPORATION 10-Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 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. Benefit Plans AFC provides retirement benefits to qualified employees of participating companies through contributory and noncontributory defined contribution plans. Contributions to benefit plans are charged against earnings in the year for which they are declared. Both AFC and American Premier had contributory employee savings plans and noncontributory Employee Stock Ownership Retirement Plans ("ESORP"). Under one of the savings plans, American Premier matched a specific portion of employee contributions. Under the ESORP plans, contributions were invested in securities of AFG and affiliates for the benefit of their employees. In 1997, these ESORP plans were combined into a new plan. AFC and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFC 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 the employees qualify for such benefits. Minority Interest For balance sheet purposes, minority interest represents the interests of noncontrolling shareholders in AFC subsidiaries including preferred securities issued by trust subsidiaries of AAG and AFG's direct ownership interest in American Premier. For income statement purposes, minority interest expense represents those shareholders' interest in the earnings of AFC subsidiaries as well as accrued distributions on the trust preferred securities. 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. 8 AMERICAN FINANCIAL CORPORATION 10-Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED B. Segments of Operations AFC operates its property and casualty insurance business in three major segments: nonstandard automobile, specialty lines, and commercial and personal lines. AFC's annuity and life business primarily sells tax-deferred annuities to employees of primary and secondary educational institutions and hospitals. In addition, AFC has owned significant portions of the voting equity securities of certain companies (investee corporations - see Note C). The following table (in thousands) shows AFC's revenues by significant business segment. Nine months ended September 30, Revenues 1997 1996 Property and casualty insurance: Premiums earned: Nonstandard automobile $ 898,390 $ 900,989 Specialty lines 778,447 742,075 Commercial and personal lines 425,140 519,112 Other lines 24 458 2,102,001 2,162,634 Investment and other income 340,608 423,294 2,442,609 2,585,928 Annuities and life (*) 466,046 437,763 Other 41,158 180,218 2,949,813 3,203,909 Equity in net earnings of investee corporations 18,094 22,505 $2,967,907 $3,226,414 (*) Represents primarily investment income. C. Investment in Investee Corporations Investment in investee corporations reflects primarily AFC's 40% ownership (24 million shares; carrying value of $214.1 million at September 30, 1997) of Chiquita common stock. The market value of AFC's investment in Chiquita was $387 million and $306 million at September 30, 1997 and December 31, 1996, respectively. Chiquita is a leading international marketer, producer and distributor of bananas and other quality fresh and processed food products. Summarized financial information for Chiquita follows (in millions): Nine months ended September 30, 1997 1996 Net Sales $1,834 $1,880 Operating Income 134 149 Income before Extraordinary Item 56 60 Extraordinary Loss from Debt Refinancings - (23) Net Income 56 37 In September 1997, AFC sold its investment in Citicasters to Jacor Communications for approximately $220 million in cash plus warrants to purchase Jacor common stock. AFC realized a pretax gain of approximately $169 million, before minority interest of $6.5 million, on the sale. 9 AMERICAN FINANCIAL CORPORATION 10-Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED D. Payable to American Financial Group, Inc. At September 30, 1997, AFC had outstanding borrowings under a note with AFG (bearing interest at 11-5/8%) of $213 million, plus accrued interest of $6.2 million. American Premier has a credit agreement with AFG under which American Premier and AFG may make loans of up to $250 million available to each other. The balance outstanding under the credit line bears interest at a variable rate of one percent over LIBOR and is payable on December 31, 2010. At September 30, 1997, American Premier had outstanding borrowings under the credit agreement of $113.1 million, plus accrued interest of $2.0 million. E. Other Long-Term Debt The carrying value of other long-term debt consisted of the following (in thousands): September 30, December 31, 1997 1996 Holding Companies: 9-3/4% AFC Debentures due April 2004 $ 80,446 $164,368 9-3/4% APU Subordinated Notes due August 1999 92,299 93,604 10-5/8% APU Subordinated Notes due April 2000 44,676 54,595 10-7/8% APU Subordinated Notes due May 2011 18,158 18,496 Other 8,140 8,441 $243,719 $339,504 Subsidiaries: AAG notes payable under bank lines due September 1998 and 1999 $ 56,000 $ 44,700 9-1/2% AAG Senior Notes due August 2001 - 40,845 11-1/8% AAG Senior Subordinated Notes due February 2003 24,080 24,080 Notes payable secured by real estate 52,120 52,543 Other 14,934 16,247 $147,134 $178,415 In a September 1997 tender offer, AFC retired $82.8 million of its 9-3/4% Debentures for $90.6 million in cash. In addition, during the first nine months of 1997, American Premier repurchased $10.1 million of its Notes for $11.1 million in cash and AAG redeemed all of its outstanding 9-1/2% Senior Notes for $42.5 million in cash. At September 30, 1997, sinking fund and other scheduled principal payments on debt for the balance of 1997 and the subsequent five years were as follows (in thousands): Holding Companies Subsidiaries Total 1997 $ 5,282 $ 670 $ 5,952 1998 - 18,841 18,841 1999 90,903 42,433 133,336 2000 42,967 8,746 51,713 2001 - 1,453 1,453 2002 - 1,458 1,458 Debentures purchased in excess of scheduled payments may be applied to satisfy any sinking fund requirement. The scheduled principal payments shown above assume that debentures previously purchased are applied to the earliest scheduled retirements. 10 AMERICAN FINANCIAL CORPORATION 10-Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED F. Minority Interest Included in minority interest are the preferred securities issued by trust subsidiaries of AAG. In November 1996, a wholly-owned subsidiary trust of AAG issued three million units of 9-1/4% trust originated preferred securities ("TOPrS") for $75 million in cash. The Trust then purchased $75 million of newly issued AAG 9-1/4% Subordinated Debentures due 2026, which, along with related interest and principal payments received, are the only assets of the Trust. The TOPrS are mandatorily redeemable upon maturity or redemption of the Subordinated Debentures. The Subordinated Debentures are redeemable by AAG on or after November 7, 2001. AAG effectively provides an unconditional guarantee of the Trust's obligations under the TOPrS. Through private transactions completed in March and May 1997, wholly-owned subsidiary trusts of AAG issued $75 million of 8- 7/8% preferred securities and $75 million of 7-1/4% Remarketed Par Securities ("ROPES"), respectively, and used the proceeds to purchase the related debentures of their parent due in 2027 and 2041. G. Preferred Stock Under provisions of both the Nonvoting (21.1 million shares authorized) and Voting (17.0 million shares authorized, 13.9 million shares outstanding) Cumulative Preferred Stock, the Board of Directors may divide the authorized stock into series and set specific terms and conditions of each series. The outstanding shares of preferred stock consisted of the following (see Note L - "Subsequent Event"): Series F, $1 par value; $20.00 liquidating value per share; annual dividends per share $1.80; nonredeemable; 11,900,725 shares (stated value $145.4 million) outstanding at September 30, 1997 and December 31, 1996. Series G, $1 par value; annual dividends per share $1.05; redeemable at $10.50 per share; 1,964,158 shares (stated value $17.4 million) outstanding at September 30, 1997 and December 31, 1996. H. Common Stock At September 30, 1997, American Financial Group owned all of the outstanding shares of AFC's Common Stock. I. Extraordinary Items Extraordinary items represent AFC's proportionate share of gains and losses related to debt retirements by the following companies. Amounts shown are net of minority interest and income tax benefits (in thousands): Nine months ended September 30, 1997 1996 AFC (parent) ($5,357) ($ 9,605) Subsidiaries: APU (parent) (379) (458) AAG (1,250) (7,159) Other - 57 Investee: Chiquita - (8,479) ($6,986) ($25,644) 11 AMERICAN FINANCIAL CORPORATION 10-Q NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED J. Cash Flows - Fixed Maturity Investments "Investing activities" related to fixed maturity investments in AFC's Statement of Cash Flows consisted of the following (in thousands): Held to Available 1997 Maturity For Sale Total Purchases $ 3,759 $1,812,791 $1,816,550 Maturities and redemptions 268,432 266,746 535,178 Sales - 935,942 935,942 1996 Purchases $175,629 $1,346,497 $1,522,126 Maturities and redemptions 220,417 224,569 444,986 Sales 9,310 578,367 587,677 Securities classified as "held to maturity" having an amortized cost of $9.5 million were sold in 1996 due to significant deterioration in the issuers' creditworthiness. K. Commitments and Contingencies There have been no significant changes to the matters discussed and referred to in Note N "Commitments and Contingencies" in AFC's Annual Report on Form 10-K for 1996. L. Subsequent Events Sale of Millennium Dynamics On October 22, 1997, AFG announced that it has agreed to sell the assets of its software solutions and consulting services subsidiary, Millennium Dynamics, Inc., to a subsidiary of Peritus Software Services, Inc. AFC is to receive $30 million in cash and 2,175,000 shares of Peritus common stock on the sale which is expected to close in the fourth quarter of 1997. AFG estimates that its basis in the subsidiary plus fees and expenses related to the sale will be approximately $15 million to $20 million. Merger Transactions Involving AFC and AFEI In July 1997, AFG announced that it has entered into agreements with AFC and AFEI to reduce its corporate expenses and improve its corporate capital structure. AFG has proposed a merger transaction, as amended in October 1997, whereby holders of AFC's Series F Preferred would receive consideration of the greater of $23.75 per share or a fixed spread price which will be measured at the time of closing. Also, accrued dividends on Series F Preferred Stock will be paid from November 1, 1997 to the closing date. Holders of AFC's Series G Preferred would receive consideration of $10.50 per share plus accrued dividends. Consideration would be payable, at the holder's election, in shares of a new issue of AFC Preferred Stock, in cash, or a combination of the two. It is a condition to the merger that there be approximately $70.4 million in liquidation value of a new Preferred Stock issued, representing at least 20% of AFC's total voting power. The new preferred would be redeemable at AFC's option after the eighth anniversary of its issuance, have a liquidation value of $25.00 per share and pay an 8% dividend of $2.00 per share per year on a semi-annual basis. AFG has also proposed that AFEI engage in a merger transaction whereby all publicly held shares of AFEI would be exchanged, at the option of AFEI shareholders, for shares of AFG common stock on a one-for-one basis, or $37.00 per share in cash. There are approximately 2.7 million shares of AFEI common stock outstanding (including yet-unexercised stock options) which are not beneficially owned by AFG. These transactions are subject to the receipt of all required shareholder, stock exchange listing and regulatory approvals. Shareholder meetings for the companies involved in these transactions are scheduled for December 2, 1997. 12 AMERICAN FINANCIAL CORPORATION 10-Q ITEM 2 Management's Discussion and Analysis of Financial Condition and Results of Operations GENERAL AFC is organized as a holding company with almost all of its operations being conducted by subsidiaries and affiliates. The parent corporation, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, dividends on AFC Preferred Stock, 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, since most of its businesses are financial in nature, AFC does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful. LIQUIDITY AND CAPITAL RESOURCES Ratios AFC's debt to total capital ratio at the parent holding company level was approximately 14% at September 30, 1997 and 20% at December 31, 1996. AFC's ratio of earnings to fixed charges on a total enterprise basis was 3.85 for the first nine months of 1997 compared to 4.99 for the entire year of 1996; ratios of earnings to fixed charges and preferred dividends were 2.90 and 3.96 for the same periods. Sources of Funds Management believes AFC has sufficient resources to meet its liquidity requirements through operations in the short-term and long-term future. If funds generated from operations, including dividends from subsidiaries, are insufficient to meet fixed charges in any period, these companies would be required to generate cash through borrowings, sales of securities or other assets, or similar transactions. In December 1996, American Premier paid a dividend to AFG in the form of a $675 million note receivable from AFC plus $18.7 million of related accrued interest. AFG then contributed $450 million of the note (without accrued interest) to the capital of AFC. At September 30, 1997, $213 million is outstanding under the note and included in payable to AFG on AFC's balance sheet. American Premier has a credit agreement with AFG under which American Premier and AFG will make loans of up to $250 million available to each other. Principal amounts payable to AFG under the credit agreement totaled $113.1 million and $175.5 million at September 30, 1997 and December 31, 1996, respectively. Bank credit lines at several subsidiary holding companies provide ample liquidity and can be used to obtain funds for the operating subsidiaries or, if necessary, for the parent company. Agreements with the banks generally run for three to seven years and are renewed before maturity. While it is highly unlikely that all such amounts would ever be borrowed at one time, a maximum of $510 million is available under these bank facilities, $56 million of which was borrowed at September 30, 1997. In the past, funds have been borrowed under certain of these bank facilities and used for working capital, capital infusions into subsidiaries, and to retire other issues of short-term or high-rate debt. Also, AFC believes it may be prudent and advisable to borrow up to $200 million of bank debt in the normal course in order to retire public or privately held fixed rate obligations over the next year or two. The cash to be utilized for the proposed merger transactions involving AFC and AFEI is expected to come from internally generated funds and existing credit lines (see Note L). 13 AMERICAN FINANCIAL CORPORATION 10-Q Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued Dividend payments from subsidiaries have been very important to the liquidity and cash flow of the individual holding companies in the past. However, the reliance on such dividend payments has been lessened by the combination of (i) strong capital at AFC's insurance subsidiaries (and the related decreased likelihood of a need for investment in those companies), (ii) the reductions of debt at the holding companies (and the related decrease in ongoing cash needs for interest and principal payments), (iii) AFC's ability to obtain financing in capital markets, as well as (iv) the sales of non-insurance investments. Investments Approximately 93% of the bonds and redeemable preferred stocks held by AFC were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies at September 30, 1997. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and non-investment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return. AFC's equity securities are concentrated in a relatively limited number of major positions. This approach allows management to more closely monitor the companies and the industries in which they operate. RESULTS OF OPERATIONS General Pretax earnings before extraordinary items for the three months ended September 30, 1997 were $57.3 million compared to $148 million for the third quarter of 1996. Results for 1996 include (i) $166 million in pretax gains (net of minority interest) primarily on the sale of Citicasters, (ii) a charge of $80 million resulting from an increase in insurance reserves relating to asbestos and other environmental matters ("A&E") and (iii) losses of about $30 million form Hurricane Fran. Excluding realized gains and the unusual 1996 items, pretax earnings before extraordinary items were approximately $30 million and $90 million for the third quarter of 1997 and 1996, respectively. This decrease is attributable to a deterioration in underwriting profit in the property and casualty operations due primarily to increasing claims severity in the California workers' compensation business, several unusually large commercial lines casualty losses, increased investee losses, and a nonrecurring charge associated with an arbitration settlement. Pretax earnings before extraordinary items were $249 million for the first nine months of 1997 compared to $349.2 million for the first nine months of 1996. Excluding realized gains (net of minority interest), the A&E charge and the effect of Hurricane Fran, pretax earnings before extraordinary items were approximately $215 million and $240 million for the first nine months of 1997 and 1996, respectively. This decrease was due primarily to third quarter results which more than offset improved earnings in the first six months of 1997. Property and Casualty Insurance - Underwriting AFC manages and operates its property and casualty business as three major sectors. The nonstandard automobile insurance companies (the "NSA Group") insure risks not typically accepted for standard automobile coverage because of the applicant's driving record, type of vehicle, age or other criteria. The specialty lines are a diversified group of over twenty-five business lines that offer a wide variety of specialty insurance products. Some of the more significant areas are California workers'compensation, executive liability, inland and ocean marine, U.S.-based operations of Japanese companies, agricultural-related coverages, excess and surplus lines, aviation coverages and fidelity and surety bonds. The commercial and personal lines provide coverages in commercial multi-peril, workers' compensation, umbrella and commercial automobile, standard private passenger automobile and homeowners insurance. 14 AMERICAN FINANCIAL CORPORATION 10-Q Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued Underwriting profitability is measured by the combined ratio which is a sum of the ratios of underwriting losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, other income or federal income taxes. For certain lines of business and products where the credibility of the range of loss projections is less certain (primarily the various specialty lines listed above), management believes that it is prudent and appropriate to use conservative assumptions until such time as the data, experience and projections have more credibility, as evidenced by data volume, consistency and maturity of the data. While this practice mitigates the risk of adverse development on this business, it does not eliminate it. Net written premiums and combined ratios for AFC's property and casualty insurance subsidiaries were as follows (dollars in millions): Three months ended Nine months ended September 30, September 30, 1997 1996 1997 1996 Net Written Premiums (GAAP) NSA Group $299.1 $277.2 $ 957.0 $ 868.8 Specialty Operations 304.8 270.5 826.8 755.6 Commercial and Personal Operations 136.4 160.7 367.0 488.9 Other Lines - - - .3 $740.3 $708.4 $2,150.8 $2,113.6 Combined Ratios (GAAP) NSA Group 97.3% 98.2% 97.2% 100.3% Specialty Operations 101.5 69.2 94.5 85.0 Commercial and Personal Operations 111.7 126.7 105.8 111.2 Aggregate (including A&E and other lines) 102.0 111.8 99.8 104.2 Operating results for the third quarter and first nine months of 1996 were adversely impacted by two unusual items: (i) approximately $30 million in losses due to Hurricane Fran and (ii) increases in A&E reserves (exposures for which AFC has been held liable under general liability policies written years ago). A standard insurance measure used in analyzing the adequacy of A&E reserves is the "survival ratio" (reserves divided by three-year average annual paid losses). Due in part to the greater uncertainties inherent in estimating A&E claims, management evaluates its survival ratio in relation to those published for the industry. Based primarily on industry survival ratios published in mid-1996, AFC increased A&E reserves of its discontinued insurance lines by $120 million by recording a third quarter, non-cash, pretax charge of $80 million and reallocating $40 million, or approximately 2%, of reserves from its Specialty Operations. Reserves for unpaid losses and loss adjustment expenses of the Specialty Lines were approximately $2.1 billion at September 30, 1997 and December 31, 1996. A&E reserves at September 30, 1997, were approximately $348 million, an amount equal to approximately 10 times the preceding three years' average claim payments. 15 AMERICAN FINANCIAL CORPORATION 10-Q Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued NSA Group Net written premiums for the NSA Group increased 8% during the third quarter and 10% during the first nine months of 1997 from the comparable 1996 periods due primarily to volume increases in California resulting from enactment of legislation which requires drivers to provide proof of insurance in order to obtain a valid permit. The improvement in the combined ratio reflects rate increases in various states over the last couple of years. Specialty Operations Net written premiums for the specialty operations increased 13% during the third quarter and 9% during the first nine months of 1997 from the comparable 1996 periods due primarily to premiums recorded by a newly acquired aviation division and the return of premiums related to the withdrawal from a voluntary pool in 1996. Underwriting results for the third quarter and first nine months of 1997 declined due primarily to (i) the reallocation of $40 million in reserves to A&E reserves (a combined ratio impact of 15.0 points and 5.4 points for the third quarter and first nine months of 1996, respectively), (ii) 1996 reductions in reserves for business written primarily prior to 1995 in response to fundamental changes in the California workers' compensation market and actuarial evaluations, and (iii) increased losses during the third quarter of 1997 relating to deteriorating underwriting margins in California workers' compensation business written in 1996 and 1997. Commercial and Personal Operations Net written premiums for the commercial and personal operations decreased 15% during the third quarter and 25% during the first nine months of 1997 from the comparable 1996 periods due primarily to a reinsurance agreement, effective January 1, 1997, under which 80% of all AFG's homeowners' business will be reinsured, and reduced writings of personal automobile coverages in certain states. Excluding the impact of the reinsurance agreement, premiums decreased 6% and 9%, respectively. Underwriting results for 1997 were impacted by several current year commercial casualty losses as well as adverse development in certain prior year claims. Underwriting results for 1996 included losses attributable to Hurricane Fran and other weather-related losses. Investment Income Investment income increased approximately 3% in the third quarter and the first nine months of 1997 compared to 1996 due primarily to an increase in the average amount of investments held. Realized Gains Realized capital gains have been an important part of the return on investments in marketable securities. Individual securities are sold creating gains and losses as market opportunities exist. Investee Corporations Equity in net earnings of investee corporations in 1997 represents AFC's proportionate share of Chiquita's earnings. Chiquita reported net earnings (losses) before extraordinary item for the third quarter and first nine months of 1997 of ($28 million) and $56.4 million, respectively, and ($7.6 million) and $59.7 million for the comparable 1996 periods. Chiquita's results for 1997 have been adversely affected by (i) a stronger dollar, mitigated in part by the company's foreign currency hedging program and (ii) increased banana production costs arising from weather-related effects on current productivity. Chiquita's results for 1996 include first quarter writedowns and costs of $12 million resulting from flood damage in Costa Rica. Included in earnings from investees in 1996 were earnings of $1.5 million attributable to AFC's investment in Citicasters which was sold in September 1996. Gain on Sale of Investee Corporation The gain on sale of investee corporation for the third quarter and first nine months of 1996 represent pretax gains, before minority interest, on the sale of Citicasters common stock. 16 AMERICAN FINANCIAL CORPORATION 10-Q Management's Discussion and Analysis of Financial Condition and Results of Operations - Continued Gains on Sales of Subsidiaries The gain on sale of subsidiaries in 1997 represents a pretax gain on the sale of a travel agency. The gains on sales of subsidiaries in 1996 include a pretax gain of $33.9 million on the sale of Buckeye Management Company and the settlement of litigation related to a subsidiary sold in 1993. Other Income Other income decreased $9.7 million (26%) during the third quarter and $22.4 million (22%) during the first nine months of 1997 due primarily to the sale of a subsidiary in the first quarter of 1997. Annuity Benefits Annuity benefits reflect interest credited to annuity policyholders' funds accumulated. The majority of AAG's fixed rate annuity products permit AAG to change the crediting rate at any time (subject to minimum interest rate guarantees of 3% or 4% per annum). As a result, management has been able to react to changes in market interest rates and maintain a desired interest rate spread without a substantial effect on persistency. Annuity benefits increased 5% in the third quarter and 3% in the first nine months of 1997 due primarily to an increase in average annuity benefits accumulated. Minority Interest Expense Minority interest expense decreased $8.1 million (44%) during the third quarter and $8.5 million (22%) during the first nine months of 1997 due primarily to lower earnings reported by American Premier in 1997 and the absence of the $6.5 million in minority interest recorded from the sale of Citicasters common stock in the third quarter of 1996. These items were partially offset by increases in the charge for distribution requirements on trust preferred securities. Other Operating and General Expenses Other operating and general expenses increased $8.2 million (10%) during the third quarter of 1997 compared to 1996. Decreases in other operating and general expenses resulting from the sale of a subsidiary in 1997 were more than offset by additional expenses recorded including a nonrecurring charge of $5.5 million relating to an arbitration settlement and a $4 million charge related to the estimated costs of relocating operations of a subsidiary to Cincinnati. Other operating and general expenses decreased $7.4 million (3%) during the first nine months of 1997. New Accounting Standards to be Implemented During 1997, the Financial Accounting Standards Board issued the following Statement of Financial Accounting Standards ("SFAS"); the implementation of these standards will not have a significant effect on AFC's financial position or results of operations. SFAS # Subject of Standard Period to be Implemented 129 Capital Structure 4th quarter of 1997 130 Comprehensive Income 1st quarter of 1998 131 Segment Information 4th quarter of 1998 __________________________________________________________ 17 AMERICAN FINANCIAL CORPORATION 10-Q PART II OTHER INFORMATION Item 6 Exhibits and Reports on Form 8-K (a) Exhibit 27 - Financial Data Schedule - Included in Report filed electronically with the Securities and Exchange Commission. (b) Reports on Form 8-K: Date of Report Item Reported July 14, 1997 Proposal to pay cash or issue new Preferred Stock in exchange for Series F and G Preferred Stock. ____________________________________________________________ Signature Pursuant to the requirements of the Securities Exchange Act of 1934, American Financial Corporation has duly caused this Report to be signed on its behalf by the undersigned duly authorized. American Financial Corporation November 13, 1997 BY:Fred J. Runk Fred J. Runk Senior Vice President and Treasurer 18