- -------------------------------------------------------------------------------
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
March 31, 2002 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 May 1, 2002, there were 10,593,000 shares of the Registrant's Common
Stock outstanding, all of which were owned by American Financial Group, Inc.
Page 1 of 22
- ------------------------------------------------------------------------------
AMERICAN FINANCIAL CORPORATION 10-Q
PART I
FINANCIAL INFORMATION
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars In Thousands)
March 31, December 31,
2002 2001
----------- -----------
ASSETS:
Cash and short-term investments $ 271,532 $ 543,644
Investments:
Fixed maturities - at market
(amortized cost - $11,050,249 and $10,593,205) 11,077,749 10,748,605
Other stocks - at market
(cost - $180,233 and $187,810) 319,733 313,710
Policy loans 208,430 211,288
Real estate and other investments 259,722 262,801
----------- -----------
Total investments 11,865,634 11,536,404
Recoverables from reinsurers and prepaid
reinsurance premiums 2,341,013 2,286,509
Agents' balances and premiums receivable 704,928 666,171
Deferred acquisition costs 852,030 818,323
Other receivables 280,797 254,137
Variable annuity assets (separate accounts) 560,821 529,590
Prepaid expenses, deferred charges and other assets 453,547 451,362
Goodwill 312,594 312,134
----------- -----------
$17,642,896 $17,398,274
=========== ===========
LIABILITIES AND CAPITAL:
Unpaid losses and loss adjustment expenses $ 4,835,895 $ 4,777,580
Unearned premiums 1,720,065 1,640,955
Annuity benefits accumulated 5,931,565 5,832,120
Life, accident and health reserves 653,458 638,522
Payable to American Financial Group, Inc. 348,100 356,689
Long-term debt:
Holding companies 249,518 228,252
Subsidiaries 270,412 270,752
Variable annuity liabilities (separate accounts) 560,821 529,590
Accounts payable, accrued expenses and other
liabilities 1,153,187 1,185,146
----------- -----------
Total liabilities 15,723,021 15,459,606
Minority interest 455,021 460,737
Shareholders' Equity:
Preferred Stock - at liquidation value 72,154 72,154
Common Stock, no par value
- 20,000,000 shares authorized
- 10,593,000 shares outstanding 9,625 9,625
Capital surplus 985,868 984,125
Retained earnings 301,207 255,127
Unrealized gain on marketable securities, net 96,000 156,900
----------- -----------
Total shareholders' equity 1,464,854 1,477,931
----------- -----------
$17,642,896 $17,398,274
=========== ===========
2
AMERICAN FINANCIAL CORPORATION 10-Q
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF EARNINGS
(In Thousands)
Three months ended
March 31,
-------------------
2002 2001
---- ----
INCOME:
Property and casualty insurance premiums $603,908 $644,723
Life, accident and health premiums 70,935 69,158
Investment income 220,959 209,790
Realized losses on:
Securities (17,800) (6,881)
Subsidiaries - (1,586)
Other income 47,612 58,292
-------- --------
925,614 973,496
COSTS AND EXPENSES:
Property and casualty insurance:
Losses and loss adjustment expenses 442,913 496,216
Commissions and other underwriting expenses 170,266 184,974
Annuity benefits 75,525 69,264
Life, accident and health benefits 55,920 54,083
Interest charges on borrowed money 11,094 18,873
Other operating and general expenses 113,311 107,871
-------- --------
869,029 931,281
-------- --------
Operating earnings before income taxes 56,585 42,215
Provision for income taxes 2,703 14,952
-------- --------
Net operating earnings 53,882 27,263
Minority interest expense, net of tax (5,068) (6,919)
Equity in net losses of investees, net of tax (2,734) (3,334)
-------- --------
NET EARNINGS $ 46,080 $ 17,010
======== ========
3
AMERICAN FINANCIAL CORPORATION 10-Q
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(Dollars in Thousands)
Common Stock Unrealized
Preferred and Capital Retained Gain on
Stock Surplus Earnings Securities Total
--------- ------------ -------- ---------- ----------
BALANCE AT JANUARY 1, 2002 $72,154 $993,750 $255,127 $156,900 $1,477,931
Net earnings - - 46,080 - 46,080
Change in unrealized - - - (60,900) (60,900)
----------
Comprehensive income (loss) (14,820)
Capital contribution from parent - 1,533 - - 1,533
Other - 210 - - 210
------- -------- -------- -------- ----------
BALANCE AT MARCH 31, 2002 $72,154 $995,493 $301,207 $ 96,000 $1,464,854
======= ======== ======== ======== ==========
BALANCE AT JANUARY 1, 2001 $72,154 $984,391 $258,371 $139,200 $1,454,116
Net earnings - - 17,010 - 17,010
Change in unrealized - - - 34,400 34,400
----------
Comprehensive income 51,410
Capital contribution from parent - 3,067 - - 3,067
Other - (174) - - (174)
------- -------- -------- -------- ----------
BALANCE AT MARCH 31, 2001 $72,154 $987,284 $275,381 $173,600 $1,508,419
======= ======== ======== ======== ==========
4
AMERICAN FINANCIAL CORPORATION 10-Q
AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Thousands)
Three months ended
March 31,
------------------------
2002 2001
---- ----
OPERATING ACTIVITIES:
Net earnings $ 46,080 $ 17,010
Adjustments:
Equity in net losses of investees 2,734 3,334
Depreciation and amortization 44,295 36,485
Annuity benefits 75,525 69,264
Realized (gains) losses on investing activities 17,605 (6,840)
Deferred annuity and life policy acquisition costs (38,600) (35,551)
Decrease (increase) in reinsurance and other
receivables (119,921) 4,727
Increase in other assets (7,997) (19,369)
Increase in insurance claims and reserves 152,361 74,616
Increase (decrease) in other liabilities (4,307) 38,419
Increase in minority interest 3,284 4,095
Other, net 321 (434)
---------- --------
171,380 185,756
---------- --------
INVESTING ACTIVITIES:
Purchases of and additional investments in:
Fixed maturity investments (1,499,179) (544,186)
Equity securities - (2,571)
Real estate, property and equipment (4,518) (13,278)
Maturities and redemptions of fixed maturity
investments 408,962 131,547
Sales of:
Fixed maturity investments 597,159 194,182
Equity securities 5,164 4,679
Subsidiaries - 22,000
Real estate, property and equipment 1,669 24,562
Cash and short-term investments of former
subsidiaries - (132,858)
Decrease (increase) in other investments 3,368 (673)
---------- --------
(487,375) (316,596)
---------- --------
FINANCING ACTIVITIES:
Fixed annuity receipts 169,872 126,223
Annuity surrenders, benefits and withdrawals (135,912) (186,921)
Net transfers from (to) variable annuity assets (5,570) 2,929
Additional long-term borrowings 41,000 26,842
Reductions of long-term debt (20,240) (47,601)
Borrowings from AFG 4,400 1,000
Payments to AFG (12,000) (23,000)
Capital contribution 2,333 4,667
---------- --------
43,883 (95,861)
---------- --------
NET DECREASE IN CASH AND SHORT-TERM INVESTMENTS (272,112) (226,701)
Cash and short-term investments at beginning
of period 543,644 437,263
---------- --------
Cash and short-term investments at end of period $ 271,532 $210,562
========== ========
5
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. All acquisitions have been treated as
purchases. 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.
INVESTMENTS All fixed maturity securities are considered "available for
sale" and reported at fair value with unrealized gains and losses reported
as a separate component of shareholders' equity. Short-term investments
are carried at cost; loans receivable are carried primarily at the
aggregate unpaid balance. Premiums and discounts on mortgage-backed
securities are amortized over a period based on estimated future principal
prepayments and adjusted to reflect actual prepayments.
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, a provision for impairment is
charged to earnings and the cost basis of that investment is reduced.
Emerging Issues Task Force Issue No. 99-20 established a new standard for
recognizing interest income and impairment on certain asset-backed
investments. Interest income on these investments is recorded at a yield
based on projected cash flows. The yield is adjusted prospectively to
reflect actual cash flows and changes in projected amounts. Impairment
losses on these investments must be recognized when (i) the fair value of
the security is less than its cost basis and (ii) there has been an
adverse change in the expected cash flows. The new standard became
effective on April 1, 2001. Impairment losses on initial application of
this rule were recognized as the cumulative effect of an accounting
change. Subsequent impairments are recognized as a component of net
realized gains and losses.
GOODWILL Goodwill represents the excess of cost of subsidiaries over AFC's
equity in their underlying net assets. Through December 31, 2001, goodwill
was being amortized over periods of 20 to 40 years. Effective January 1,
2002, AFC implemented Statement of Financial Accounting Standards ("SFAS")
No. 142, under which goodwill is no longer amortized but is subject to an
impairment test at least annually. As required under SFAS No. 142, AFC
will complete the transitional test for goodwill impairment (as of January
1, 2002) by the end of 2002. Any resulting write-down will be reported by
restating first quarter 2002 results for the cumulative effect of a change
in accounting principle.
6
AMERICAN FINANCIAL CORPORATION 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
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 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 reinsured
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 companies.
DEFERRED 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. 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.
DPAC related to annuities and universal life insurance products is
amortized, with interest, in relation to the present value of expected
gross profits on the policies. 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.
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 (losses) on marketable securities.
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.
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 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. These 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.
In spite of 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.
7
AMERICAN FINANCIAL CORPORATION 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
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 anticipated
investment yield, mortality, morbidity and surrenders and include
provisions for unfavorable deviations. Reserves 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 deposits invested in underlying investment
funds on which Great American Financial Resources, Inc. ("GAFRI"), an
83%-owned subsidiary, earns a fee. Investment funds are selected and may
be changed only by the policyholder, who retains all investment risk.
Accordingly, GAFRI's liability for these accounts equals the value of the
account assets.
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. Estimates are accrued during the
period in which premiums are 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.
MINORITY INTEREST For balance sheet purposes, minority interest represents
(i) the interests of noncontrolling shareholders in AFC subsidiaries,
including preferred securities issued by trust subsidiaries of GAFRI and
(ii) American Financial Group, Inc.'s ("AFG") direct ownership interest in
American Premier Underwriters, Inc. ("American Premier" or "APU") and
American Financial Enterprises, Inc. 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.
INCOME TAXES AFC files consolidated federal income tax returns which
include all 80%-owned U.S. subsidiaries, except for certain life insurance
subsidiaries and their subsidiaries. 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.
8
AMERICAN FINANCIAL CORPORATION 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
BENEFIT PLANS AFC provides retirement benefits to qualified employees of
participating companies through contributory and noncontributory defined
contribution plans contained in AFG's Retirement and Savings Plan. The
Company makes all contributions to the retirement fund and matches a
portion of employee contributions to the savings fund. Employees have been
permitted to direct the investment of their contributions to independently
managed investment funds, while Company contributions have been invested
primarily in securities of AFG and affiliates. Employees are being
afforded the flexibility to direct the investment of a portion of their
vested retirement fund account balances (increasing from 12.5% in July
2002 to 100% in April 2004) from securities of AFG and its affiliates to
independently managed investment funds. The Plan owns 12% of AFG's
outstanding common stock. Company contributions are charged against
earnings in the year for which they are declared.
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 employees earn such
benefits.
DERIVATIVES Derivatives included in AFC's Balance Sheet consist primarily
of investments in common stock warrants (included in other stocks), the
equity-based component of certain annuity products (included in annuity
benefits accumulated) and call options (included in other investments)
used to mitigate the risk embedded in the equity-indexed annuity products.
Changes in the fair value of derivatives are included in current earnings.
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. ACQUISITIONS AND SALES OF SUBSIDIARIES
MANHATTAN NATIONAL LIFE INSURANCE In March 2002, GAFRI reached an
agreement to acquire Manhattan National Life Insurance Company ("MNL")
from Conseco, Inc. for $48.5 million in cash. GAFRI expects to close on
this transaction in the second quarter of 2002 and to fund this
acquisition with cash on hand and through reinsurance of up to 90% of the
business in force. While MNL is not currently writing new policies, the
company reported over $43 million of statutory renewal premiums in 2001.
At December 31, 2001, MNL had approximately 90,000 policies in force
(primarily term life) representing over $12 billion in face amount of
insurance, statutory assets of $297.8 million and statutory capital and
surplus of $23.1 million.
JAPANESE DIVISION In December 2000, AFC agreed to sell its Japanese
property and casualty division to Mitsui Marine & Fire Insurance Company
of America for $22 million in cash and recorded an estimated $10.7 million
pretax loss. Upon completion of the sale in March 2001, AFC realized an
additional pretax loss of $1.6 million and deferred a gain of
approximately $21 million on ceded insurance; the deferred gain is being
recognized over the estimated settlement period (weighted average of 4
years) of the ceded claims.
9
AMERICAN FINANCIAL CORPORATION 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
C. SEGMENTS OF OPERATIONS AFC's property and casualty group is engaged
primarily in specialty and private passenger automobile insurance
businesses. The Specialty group includes a highly diversified group of
specialty business units. Some of the more significant areas are inland
and ocean marine, California workers' compensation, agricultural-related
coverages, executive and professional liability, fidelity and surety
bonds, collateral protection, and umbrella and excess coverages. The
Personal group writes nonstandard and preferred/standard private passenger
auto and other personal insurance coverage. AFC's annuity, life and health
business markets primarily retirement products as well as life and
supplemental health insurance.
The following table (in thousands) shows AFC's revenues and operating
profit (loss) by significant business segment. Operating profit (loss)
represents total revenues less operating expenses.
Three months ended
March 31,
----------------------
2002 2001
---- ----
REVENUES (a)
Property and casualty insurance:
Premiums earned:
Specialty $356,415 $316,307
Personal 247,203 327,632
Other lines (b) 290 784
-------- --------
603,908 644,723
Investment and other income 100,259 107,335
-------- --------
704,167 752,058
Annuities, life and health (c) 217,422 217,030
Other 4,025 4,408
-------- --------
$925,614 $973,496
======== ========
OPERATING PROFIT (LOSS)
Property and casualty insurance:
Underwriting:
Specialty $ 5,294 ($ 2,230)
Personal (5,239) (27,782)
Other lines (b) (9,326) (6,455)
-------- --------
(9,271) (36,467)
Investment and other income 63,251 75,202
-------- --------
53,980 38,735
Annuities, life and health 21,981 30,123
Other (d) (19,376) (26,643)
-------- --------
$ 56,585 $ 42,215
======== ========
(a) Revenues include sales of products and services as well as
other income earned by the respective segments.
(b) Represents lines in "run-off"; AFC has ceased underwriting
new business in these operations.
(c) Represents primarily investment income.
(d) Includes holding company expenses.
D. GOODWILL Effective January 1, 2002, goodwill is no longer amortized. If
the $3.5 million of goodwill amortization had not been deducted in the
first quarter of 2001, net earnings for that period would have been $20.5
million.
E. PAYABLE TO AMERICAN FINANCIAL GROUP AFC has a reciprocal Master Credit
Agreement with various AFG holding companies under which these companies
make funds available to each other for general corporate purposes.
10
AMERICAN FINANCIAL CORPORATION 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
F. LONG-TERM DEBT The carrying value of long-term debt consisted of the
following (in thousands):
March 31, December 31,
2002 2001
-------- -----------
HOLDING COMPANIES:
AFC notes payable under bank line $225,000 $203,000
APU 10-7/8% Subordinated Notes due May 2011 11,542 11,557
Other 12,976 13,695
-------- --------
$249,518 $228,252
======== ========
SUBSIDIARIES:
GAFRI 6-7/8% Senior Notes due June 2008 $100,000 $100,000
GAFRI notes payable under bank line 121,100 121,100
Notes payable secured by real estate 36,081 36,253
Other 13,231 13,399
-------- --------
$270,412 $270,752
======== ========
At March 31, 2002, sinking fund and other scheduled principal payments on
debt for the balance of 2002 and the subsequent five years were as follows
(in millions):
Holding
Companies Subsidiaries Total
--------- ------------ ------
2002 $234.9 $ .9 $235.8
2003 - 1.2 1.2
2004 - 122.4 122.4
2005 - 10.4 10.4
2006 - 19.1 19.1
2007 .1 .6 .7
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.
AFC and GAFRI each have an unsecured credit agreement with a group of
banks under which they can borrow up to $300 million and $155 million,
respectively. Borrowings bear interest at floating rates based on prime or
Eurodollar rates. Loans mature in December 2002 under the AFC credit
agreement and in December 2004 under the GAFRI credit agreement.
G. MINORITY INTEREST Minority interest in AFC's balance sheet is comprised
of the following (in thousands):
March 31, December 31,
2002 2001
-------- -----------
Interest of AFG (parent) and noncontrolling
shareholders in subsidiaries' common stock $312,108 $317,824
Preferred securities issued by
subsidiary trusts 142,913 142,913
-------- --------
$455,021 $460,737
======== ========
11
AMERICAN FINANCIAL CORPORATION 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
TRUST ISSUED PREFERRED SECURITIES Wholly-owned subsidiary trusts of GAFRI
have issued preferred securities and, in turn, purchased a like amount of
subordinated debt which provides interest and principal payments to fund
the respective trusts' obligations. The preferred securities must be
redeemed upon maturity or redemption of the subordinated debt. GAFRI
effectively provides unconditional guarantees of its trusts' obligations.
The preferred securities consisted of the following (in thousands):
Date of March 31, December 31, Optional
Issuance Issue (Maturity Date) 2002 2001 Redemption Dates
------------- ------------------------ -------- ----------- --------------------
November 1996 GAFRI 9-1/4% TOPrS (2026) $72,913 $72,913 Currently redeemable
March 1997 GAFRI 8-7/8% Pfd (2027) 70,000 70,000 On or after 3/1/2007
MINORITY INTEREST EXPENSE Minority interest expense is comprised of (in
thousands):
Three months ended
March 31,
-------------------
2002 2001
---- ----
Interest of AFG (parent) and noncontrolling
shareholders in earnings of subsidiaries $5,479 $4,005
Effect of basis difference in realized gains
(losses) of subsidiaries (2,517) -
Accrued distributions by subsidiaries
on trust issued preferred securities, net of tax 2,106 2,914
------ ------
$5,068 $6,919
====== ======
H. SHAREHOLDERS' EQUITY At March 31, 2002, and December 31, 2001, American
Financial Group beneficially owned all of the outstanding shares of AFC's
Common Stock.
PREFERRED STOCK Under provisions of both the Nonvoting (4.0 million shares
authorized) and Voting (4.0 million shares authorized) Cumulative
Preferred Stock, the Board of Directors may divide the authorized stock
into series and set specific terms and conditions of each series. At March
31, 2002, and December 31, 2001, the outstanding voting shares of AFC's
Preferred Stock consisted of the following:
SERIES J, no par value; $25.00 liquidating value per share; annual
dividends per share $2.00; redeemable at AFC's option at $25.75
per share beginning December 2005 declining to $25.00 at December
2007 and thereafter; 2,886,161 shares (stated value $72.2 million)
outstanding at March 31, 2002, and December 31, 2001.
The change in unrealized gain on marketable securities for the three
months ended March 31 included the following (in millions):
Minority
Pretax Taxes Interest Net
------ ----- -------- -----
2002
---------------------------------------
Unrealized holding losses on securities
arising during the period ($125.1) $43.6 $12.9 ($68.6)
Realized losses included in net income 17.8 (6.2) (3.9) 7.7
------ ----- ----- -----
Change in unrealized gain on marketable
securities, net ($107.3) $37.4 $ 9.0 ($60.9)
====== ===== ===== =====
2001
---------------------------------------
Unrealized holding gains on securities
arising during the period $ 59.0 ($20.6) ($8.2) $30.2
Realized losses included in net income 6.9 (2.4) (.3) 4.2
------ ----- ---- -----
Change in unrealized gain on marketable
securities, net $ 65.9 ($23.0) ($8.5) $34.4
====== ===== ==== =====
12
AMERICAN FINANCIAL CORPORATION 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
I. EQUITY IN LOSSES OF INVESTEES Since 1998, AFC subsidiaries have made loans
to two start-up manufacturing businesses which were previously owned by
unrelated third-parties. During 2000, the former owners chose to forfeit
their equity interests to AFC rather than invest additional capital.
During the fourth quarter of 2000, AFC sold the equity interests to a
group of employees for nominal cash consideration plus warrants to
repurchase a significant ownership interest. Due to the absence of
significant financial investment by the buyers relative to the amount of
loans ($61.5 million at December 31, 2000) owed to AFC subsidiaries, the
sale was not recognized as a divestiture for accounting purposes. Assets
of the businesses transferred ($56.1 million at March 31, 2002 and $57.1
million at December 31, 2001) are included in other assets; liabilities of
the businesses transferred ($11.7 million at March 31, 2002 and $11.8
million at December 31, 2001, after consolidation and elimination of loans
from AFC subsidiaries) are included in other liabilities. Investee losses
in the Statement of Earnings represents AFC's equity in the losses of
these two companies. One of the businesses is involved in litigation
impacting its operations; see "Investee Corporations" in Management's
Discussion and Analysis.
J. COMMITMENTS AND CONTINGENCIES There have been no significant changes to
the matters discussed and referred to in Note M "Commitments and
Contingencies" of AFC's Annual Report on Form 10-K for 2001.
13
AMERICAN FINANCIAL CORPORATION 10-Q
ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
AFC and American Premier are organized as holding companies with almost
all of their operations being conducted by subsidiaries. These parent
corporations, however, have 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, 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.
IT INITIATIVE In 1999, AFC initiated an enterprise-wide project to study
its information technology ("IT") resources, needs and opportunities. The
initiative, involving improvements in physical infrastructure and business
support systems, entails extensive effort and costs over a period of
several years. While the costs precede the expected savings, management
believes the benefits will exceed the costs incurred, all of which have
been and will be funded through available working capital.
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 forward-looking
words such as "believes", "expects", "may", "will", "should", "seeks",
"intends", "plans", "estimates", "anticipates" or the negative version of
those words or other comparable terminology. Examples of 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; expected losses
and the adequacy of reserves for asbestos, environmental pollution and
mass tort claims; rate increases, improved loss experience and expected
expense savings resulting from recent initiatives.
Actual results could differ materially from those contained in or implied
by such forward-looking statements for a variety of factors including:
o changes in economic conditions, including interest rates, performance
of securities markets, and the availability of capital;
o regulatory actions;
o changes in legal environment;
o tax law changes;
o levels of catastrophes and other major losses;
o the ultimate amount of liabilities associated with certain asbestos
and environmental-related insurance claims;
o adequacy of loss reserves;
o availability of reinsurance and ability of reinsurers to pay their
obligations; and
o competitive pressures, including the ability to obtain rate
increases.
The forward-looking statements herein are made only as of the date of this
report. AFC assumes no obligation to publicly update any forward-looking
statements.
14
AMERICAN FINANCIAL CORPORATION 10-Q
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED
LIQUIDITY AND CAPITAL RESOURCES
RATIOS AFC's debt to total capital ratio at the parent holding company
level (excluding amounts due AFG) was approximately 15% at March 31, 2002,
and 13% at December 31, 2001. Including amounts due AFG, the ratio was 29%
at March 31, 2002, and 28% at December 31, 2001.
AFC's ratio of earnings to fixed charges, excluding and including
preferred dividends, on a total enterprise basis was 3.86 and 3.57 for the
first three months of 2002 and 1.56 and 1.45 for the entire year of 2001.
SOURCES OF FUNDS Management believes the parent holding companies have
sufficient resources to meet their liquidity requirements, primarily
through funds generated by their subsidiaries' operations. If funds
provided by subsidiaries through dividends and tax payments are
insufficient to meet fixed charges in any period, the holding companies
would be required to generate cash through borrowings, sales of securities
or other assets, or similar transactions.
AFC has a revolving credit agreement with several banks under which it can
borrow up to $300 million until December 31, 2002. At March 31, 2002,
three-fourths of the credit line had been used. While management expects
to negotiate a replacement bank agreement later this year, market
conditions indicate the maximum amount may be smaller and interest costs
will likely be greater.
INVESTMENTS AFC's investment portfolio at March 31, 2002, contained $11.1
billion in "Fixed maturities" and $320 million in "Other stocks", all
carried at market value with unrealized gains and losses reported as a
separate component of shareholders' equity on an after-tax basis. At March
31, 2002, AFC had pretax net unrealized gains of $27.5 million on fixed
maturities and $139.5 million on other stocks.
Approximately 93% of the fixed maturities held by AFC at March 31, 2002,
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 a high quality investment
portfolio is more likely to generate a stable and predictable investment
return.
Individual portfolio securities are sold creating gains or losses as
market opportunities exist. Since all of these securities are carried at
market value in the balance sheet, there is virtually no effect on
liquidity or financial condition upon the sale and ultimate realization of
unrealized gains and losses.
15
AMERICAN FINANCIAL CORPORATION 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
AFC's balance sheet at March 31, 2002, follows (dollars in millions):
Securities with
-------------------
Gains Losses
------ ------
Fixed Maturities
----------------
Market value $6,100 $4,600
Gross unrealized $ 228 $ 201
Number of security positions 1,200 600
Number individually exceeding
$2 million gain or loss 4 11
Concentration of gains or losses by
type or industry (exceeding 5% of
unrealized):
Mortgage-backed securities $ 75.2 $ 36.5
U.S. Treasuries 14.2 11.0
Telephone communications 3.2 33.3
Banks 24.0 1.9
Electric services 7.7 12.3
Air transportation 1.5 11.3
Percentage rated investment grade 96% 90%
Other Stocks
------------
Market value $ 264 $ 19
Gross unrealized $ 151 $ 12
Number individually exceeding
$2 million gain or loss 3 2
AFC's investment in equity securities of Provident Financial Group, a
Cincinnati-based commercial banking and financial services company,
represents $137 million of the $151 million in unrealized gains on other
stocks at March 31, 2002.
The table below sets forth the scheduled maturities of fixed maturity
securities (by separate gain/loss segments and in total) at March 31,
2002, based on their market values.
Unrealized
---------------
Maturity Gains Losses Total
-------- ----- ------ -----
One year or less 9% 1% 6%
After one year through five years 27 15 22
After five years through ten years 18 40 27
After ten years 16 14 15
--- --- ---
70 70 70
Mortgage-backed securities 30 30 30
--- --- ---
100% 100% 100%
=== === ===
AFC realized aggregate losses of $5.9 million during the first three
months of 2002 on $71.1 million in sales of fixed maturity securities (16
issues) that had unrealized losses at December 31, 2001. Market values of
ten of the issues improved from year-end to date of sale while the other
six deteriorated; overall, there was a slight net improvement. Of the
three with unrealized losses greater than $500,000 at year-end, actual
losses on sale were $1.1 million less than the unrealized loss at
year-end. Although AFC had the ability to continue holding these
investments, its intent to hold them changed due to a variety of reasons
including actual or expected deterioration in the issuer's credit and
decisions to lessen exposure to a particular credit or industry.
16
AMERICAN FINANCIAL CORPORATION 10-Q
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED
The length of time securities with unrealized losses at March 31, 2002,
have been in an unrealized loss position varies by individual security. Of
the 96 individual securities at that date with unrealized losses exceeding
$500,000, 78 have been in that position for less than one year, including
68 that have been in that position for less than six months. Of the 111
individual securities at that date with unrealized gains exceeding
$500,000, 48 have been in that position for less than one year, including
9 that have been in that position for less than six months.
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. The determination of whether unrealized losses are "other than
temporary" requires judgment based on subjective as well as objective
factors. A listing of factors considered and resources used is contained
in the discussion of "Investments" under Management's Discussion and
Analysis in AFC's 2001 Form 10-K.
Based on its analysis, management believes (i) AFC will recover its cost
basis in the securities with unrealized losses and (ii) that AFC has
the ability and intent to hold the securities until they mature or recover
in value. Should either of these beliefs 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 a future period. Management
believes it is not likely that future impairment charges will have a
significant effect on AFC's liquidity.
UNCERTAINTIES Aside from risks common to most insurance operations,
management believes that the areas posing the greatest risk of material
loss are Great American's exposure to asbestos, environmental and other
mass tort claims and American Premier's exposure to asbestos,
environmental and other contingencies arising out of its former
operations.
PROPERTY AND CASUALTY INSURANCE RESERVES Future costs of claims
are projected based on historical trends adjusted for changes in
underwriting standards, policy provisions, product mix and other factors.
Estimating the liability for unpaid losses and LAE is inherently
judgmental and is influenced by factors which are subject to significant
variation. Through the use of analytical reserve development techniques,
management monitors items such as the effect of inflation on medical,
hospitalization, material, repair and replacement costs, general economic
trends and the legal environment.
ASBESTOS AND ENVIRONMENTAL-RELATED ("A&E") RESERVES Establishing
reserves for A&E claims is subject to uncertainties that are significantly
greater than those presented by other types of claims. Estimating ultimate
liability for asbestos claims presents unique and difficult challenges to
the insurance industry 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. The casualty insurance industry is engaged, as is AFC,
in extensive litigation over these coverage and liability issues as the
volume and severity of claims against asbestos defendants continue to
increase.
17
AMERICAN FINANCIAL CORPORATION 10-Q
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED
While management believes that AFC's reserves for A&E claims are a
reasonable estimate of ultimate liability for such claims, actual results
may vary materially from the amount currently recorded due to outstanding
issues and uncertainties such as whether coverage exists, whether claims
are to be allocated among triggered policies and implicated years, whether
claimants who exhibit no signs of illness will be successful in pursuing
their claims, predicting the number of future claims, and the impact of
recent bankruptcy filings.
Further, certain policyholders assert that each bodily injury claim should
be treated as a separate occurrence under the policy, and that their
claims are not subject to aggregate limits on coverage because either
their policies did not contain aggregate limits with respect to products
liability coverage or, faced with exhaustion of products coverage limits,
their asbestos claims fall within non-products liability coverage which is
not subject to any aggregate limit. These claims are now being contested
in insurance coverage litigation in various jurisdictions. In rejecting
the claims that are the basis of this litigation, AFC believes its
coverage defenses are substantial and intends to continue to vigorously
defend its position. Nonetheless, the outcome of this litigation is
uncertain and such claims may have a material adverse effect upon AFC's
future results of operations and financial condition.
For further discussion of uncertainties and litigation involving AFC, see
Note M "Commitments and Contingencies" to the financial statements and
"Legal Proceedings" in AFC's Annual Report on Form 10-K for 2001.
RESULTS OF OPERATIONS
GENERAL Pretax operating earnings for the first quarter of 2002 were $56.6
million compared to $42.2 million for the first quarter of 2001. First
quarter results reflect significantly improved property and casualty
underwriting results, partially offset by a decrease in income from the
sale of real estate and higher realized losses.
PROPERTY AND CASUALTY INSURANCE - UNDERWRITING AFC's property and
casualty group consists of two major business groups: Specialty and
Personal.
The Specialty group includes a highly diversified group of business lines.
Some of the more significant areas are inland and ocean marine, California
workers' compensation, agricultural-related coverages, executive and
professional liability, fidelity and surety bonds, collateral protection,
and umbrella and excess coverages.
The Personal group sells nonstandard and preferred/standard private
passenger auto insurance and, to a lesser extent, homeowners' insurance.
Nonstandard automobile insurance covers risk not typically accepted for
standard automobile coverage because of an applicant's driving record,
type of vehicle, age or other criteria.
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.
18
AMERICAN FINANCIAL CORPORATION 10-Q
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED
Net written premiums and combined ratios for AFC's property and casualty
insurance subsidiaries were as follows (dollars in millions):
Three months ended
March 31,
--------------------
2002 2001
---- ----
Net Written Premiums (GAAP)
---------------------------
Specialty $386.7 $356.6 (a)
Personal 256.4 (b) 370.5
Other lines .3 -
------ ------
$643.4 $727.1
====== ======
Combined Ratios (GAAP)
----------------------
Specialty 98.5% 100.6%
Personal 102.1 108.5
Aggregate (including discontinued lines) 101.4 105.6
(a) Before a reduction of $29.7 million for unearned premium
transfer related to the sale of the Japanese division.
(b) Reflects the ceding of $88.7 million in premiums under a
reinsurance agreement (effective April 1, 2001).
SPECIALTY The Specialty group's increase in net written premiums reflects
the impact of rate increases and the realization of growth opportunities
in certain commercial markets, partially offset by the decision to
discontinue certain lines of business (during 2001) that were not
achieving adequate returns and by additional reinsurance agreements.
Specialty rate increases averaged over 25% during the first quarter of
2002 and are expected to average approximately 20% for the year. The
Specialty group reported a solid underwriting profit for the 2002 quarter
with a combined ratio of 98.5%. The 2.1 point improvement in the combined
ratio compared to 2001 reflects strategic changes in the mix of specialty
businesses and the impact of rate increases.
PERSONAL The Personal group's decline in net written premiums reflects a
reinsurance agreement, effective April 1, 2001, under which AFC cedes 90%
of the automobile physical damage business written by certain of its
insurance subsidiaries. This agreement is enabling AFC to reallocate some
of its capital to the more profitable specialty operations. Excluding the
effect of this agreement, the Personal group's net written premiums
declined about 7%, reflecting lower business volume partially offset by
the impact of rate increases. Rate increases implemented in the first
quarter of 2002 were about 4% and are expected to range between 8% and 10%
for the year. As a result of rate increases implemented over the last
year, the combined ratio improved by 6.4 points over the first quarter of
2001. Management expects the Personal group to achieve underwriting
profitability by the fourth quarter of 2002.
19
AMERICAN FINANCIAL CORPORATION 10-Q
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED
REAL ESTATE OPERATIONS AFC's subsidiaries are engaged in a variety of
real estate operations including hotels, apartments, office buildings and
recreational facilities; they also own several parcels of land. Revenues
and expenses of these operations, including gains and losses on disposal,
are included in AFC's statement of earnings as shown below (in millions).
Three months ended
March 31,
------------------
2002 2001
---- ----
Other income $15.3 $32.0
Other operating and general expenses 14.5 15.0
Interest charges on borrowed money .6 .7
Minority interest expense, net - 1.9
Other income includes net pretax gains on the sale of real estate assets
of $171,000 in the first quarter of 2002 and $15.3 million in the first
quarter of 2001.
OTHER INCOME Excluding gains on sales of real estate assets (discussed
above), other income increased $4.4 million (10%) due primarily to fees
earned by certain new specialty insurance operations.
REALIZED GAINS Realized capital gains have been an important part of the
return on investments. Individual assets are sold creating gains and
losses as market opportunities exist.
LOSSES ON SECURITIES Realized losses on securities include provisions for
other than temporary impairment of securities still held of $18.3 million
in the first quarter of 2002 and $8 million in the first quarter of 2001.
Increased impairment charges in recent years reflect a rise in corporate
defaults in the marketplace resulting from the weakened economy.
Warrants to purchase common stock of publicly traded companies are
generally considered derivatives and marked to market through current
earnings as realized gains and losses. Realized losses on securities
include losses of $3 million in the first quarter of 2002 and $.8 million
in the first quarter of 2001 to adjust the carrying value of AFC's
investment in warrants to market value ($26.4 million at March 31, 2002).
LOSS ON SUBSIDIARIES AFC recognized a $1.6 million pretax loss in
connection with the sale of the Japanese division in 2001.
ANNUITY BENEFITS Annuity benefits reflect amounts accrued on annuity
policyholders' funds accumulated. The majority of GAFRI's fixed rate
annuity products permit GAFRI 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.
INTEREST EXPENSE Interest expense for the first quarter of 2002 decreased
compared to 2001 as lower average interest rates on AFC's variable rate
debt (including AFC's payable to AFG) more than offset higher average
indebtedness.
20
AMERICAN FINANCIAL CORPORATION 10-Q
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - CONTINUED
OTHER OPERATING AND GENERAL EXPENSES Other operating and general expenses
for the first quarter of 2001 include goodwill amortization of $3.5
million. Under SFAS No. 142, which was implemented January 1, 2002,
goodwill is no longer amortized. Excluding 2001 goodwill amortization,
other operating and general expenses increased $8.9 million (9%) due
primarily to expenses related to certain new specialty insurance
operations and increased amortization of annuity and life deferred
acquisition costs.
INCOME TAXES The 2002 provision for income taxes includes a $16 million
tax benefit for the reversal of previously accrued amounts due to the
resolution of certain tax matters.
INVESTEE CORPORATIONS Equity in losses of investee corporations represents
losses of two start-up manufacturing businesses (see Note I). In November
2001, an injunction was issued against one of the companies which would
prohibit the company from using equipment subject to litigation alleging
the misappropriation of a trade secret and effectively close the plant.
The injunction was subsequently modified, pending appeal, to permit
operations to continue and require certain escrow payments. If the
investee is unsuccessful in its attempt to have the injunction lifted or
further modified, or if operating results fail to improve, a substantial
portion of AFC's investment ($32.4 million as of March 31, 2002), may be
written off.
--------------------------------------
ITEM 3
QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
------------------------------------------------------
As of March 31, 2002, there were no material changes to the information
provided in AFC's Form 10-K for 2001 under the caption "Exposure to Market
Risk" in Management's Discussion and Analysis of Financial Condition and
Results of Operations.
21
AMERICAN FINANCIAL CORPORATION 10-Q
PART II
OTHER INFORMATION
ITEM 6
EXHIBITS AND REPORTS ON FORM 8-K
--------------------------------
(a) Exhibit 10 - 2002 Annual Bonus Plan
(b) Reports on Form 8-K: none
--------------------------------------------------------------------
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
May 13, 2002 BY: Fred J. Runk
-----------------------------------
Fred J. Runk
Senior Vice President and Treasurer
22