American Financial Group, Inc. (AFG) Earnings Call Transcript & Summary

There are seats in the back. That would be great. We are very pleased to have the management of American Financial Group with us today. From the company are co-CEOs, Carl and Craig Lindner; along with CFO, Jeff Consolino. Carl and Craig were appointed co-CEOs 15 years ago, 16 years ago. So it's been quite a while. AIG's share price during that time is up about fivefold. I did a rough math yesterday. So it's been a fantastic run. In addition, in the last 5 years alone, the company has paid cash dividends of more than $16 a share. So they're giving money back to shareholders as well. The company continues to have excess capital. So it's always a good chance to hear what you might do with it. With those introductory remarks, it's my pleasure to turn the floor over to the team.

Thank you, Jay, and it's nice to be here with everyone. Always like to get a chance to talk about our favorite topic, American Financial Group. We say we're one of the top specialty insurance groups, clearly in the United States and maybe in the world. Our primary brand, Great American, back -- it goes back over 145 years. Listed there a number of brands that represent our group. Over 55% of our -- of the gross written premiums in our Specialty Property and Casualty businesses are produced by top 10 ranked businesses. We're also a top 10 provider of fixed annuities and are ranked #2 in sales of indexed annuities through financial institutions. We love the diversified model that we have, and it works really well for us. Both of the businesses are top performers in their respective industries. We like the fact that actually, in our Annuity business and quite a few of our Property and Casualty businesses, like crop and equine mortality and force-placed property, they're not correlated to the general Property and Casualty cycle. We think this has helped us achieve more consistent earnings over a long period of time. And I think our ability to report continued strong core net operating earnings per share last year, despite a poor crop year, really speaks to the strength of the diversity -- diversification in our business. We have 34 Specialty Property and Casualty businesses reported in 3 major groupings. I think between the Annuity business and the businesses I said were noncorrelated, this probably makes up about 60% of our GAAP equity, I would put in that category. We allow a strong business autonomy in each of our 34 businesses. I like to tell our investors that we have 34 CEOs because they really have the ability to be opportunistic. They have the ability to make their own decisions with regards to underwriting pricing claims, though we have strong actuarial and financial oversight of all of our businesses. So when a company like AFG combines superior underwriting results with superior investing talent, and you intelligently deploy capital, it results in substantial value creation in that. It's our management team's objective to grow book value by double digits over time. We're extremely proud of the culture that we've built up over many years. We think that's one of the cornerstones to our company's success. Our -- these values that you see form the foundation of our business. They shape our priorities. We believe that it's part of what makes AFG such a great company to work for. We have much lower turnover, I think, than our peers, have very little management turnover over time. We have a strong work ethic, but we also have -- had a value of strong family-work balance for probably about 20 years. The Lindner family formed AFG in 1959. Our family continues to have significant ownership. With about 25% of the AFG shares held by our family, executives and our retirement plan. There's a real strong alignment of interest between -- with our shareholders over a long period of time. Over the past 20 or so years, we've sharpened our focus on the businesses that we know best. We've done that through carefully selected acquisitions, starting businesses up and disposing of businesses we think are noncore or really can't meet our long-term return on equity objectives. Neon, our Lloyd's business, fit the category of the latter. We just failed to achieve the profit objectives that we've set for ourselves since we were in that business, and we decided it was time to reallocate capital to more promising areas. We did start a new Accident & Health division, which was our 34th Specialty Property and Casualty business and is in addition to our Specialty Casualty Group. As co-CEOs, we view x capital management as really one of our most important jobs. We take a balanced approach with a focus on deployment of capital that -- towards areas that have the highest returns long term, could be -- include things like organic growth, the acquisition start-ups. And while we have more excess capital than what we need, we've been pretty generous on -- in certain times of share repurchases or special dividends in that. In fact, last year, we returned $446 million to shareholders. We increased AFG's regular quarterly dividend in October of 2019. That was the 14th consecutive annual dividend increase. So about 12.5% increase in our regular dividend. We also paid $3.30 per share in special dividends last year. Excess capital at year-end was a little over $1 billion. And I think, as we've said before, as we go over $1 billion in the absence of alternatives for deployment on acquisitions, we evaluate further opportunities to return capital to shareholders. In terms of shareholder return, calculated here are cumulative price appreciation plus dividends, which you can see AFG has performed very well, with results over 5- and 10-year periods exceeding those of the major indexes. As co-CEOs and significant shareholders, we're obviously very pleased with the track record of success. Taking a closer look at our specialty insurance operations, beginning with our Specialty Property and Casualty Group. This chart shows a view of the gross written premium, net written premium by the major Property and Casualty Groups for 2019. Including the impact of the Neon runoff, guidance for net written premium for this year suggests that the mix will shift to Specialty Casualty being more like 46%, Property and Transportation will increase to 39%, Specialty Financial will increase to 13%. A sampling of some of the businesses in our -- that are top 10 in market rankings include crop, equine, executive liability or D&O operation, fidelity and crime, our financial institution services business, Florida workers' comp, nonprofit/social services business, passenger transportation, et cetera, et cetera. Again, as I mentioned before, we have a -- what I think is a nice, great spread and diversity across our book of business, which I think helps us have more consistent underwriting profits over time. I think another thing that's significant is we have a very broad distribution platform among agents and brokers. And when you take a look at the top 3 big brokers, they make up less than 7% of our overall business. So our deep knowledge within each of those 3, 4 different P&C businesses has allowed us to achieve superior underwriting results, outperforming the commercial lines industry combined ratios over time by about 10 points. You can see over the past 10 years, our midpoint guidance for our Specialty Property and Casualty combined ratio this year is 93%. So I think one secret to our culture and the way we approach business is the significant incentives and rewards that are heavily based on underwriting profitability for the individual business units. Individual guys running our businesses have annual bonus plans, and they -- the annual plans are paid out over 2- to 3-year periods and include a little -- a few operating objectives as well as underwriting targets. We also have long-term incentive compensation plans for each business -- each group of business leaders. They're measured over 5 years, again, primarily based off of underwriting profits. We're tough on the required returns on equity that we require. Factors vary business by business. Businesses with higher volatility, we require higher returns. And with businesses with longer tail, we might look at a little bit longer before we pay out 100%. But our expectations, depending on the businesses for each of our businesses -- depending on the business, the return -- to earn after-tax returns on equity of 12% to 23%. So as I mentioned before, when you have superior underwriting results and you add superior investing results, together with good allocation of capital and investment of capital, good things happen. And you can see this in the period ended '18, we don't have the '19 stats yet. But over a 1- and a 5- and a 10- and a 15-year period of time against our peers, AFG had the highest pretax Property and Casualty returns. This is an industry exhibit. So we're estimating net written premium to be 1% to 5% lower than the $5.3 billion reported in 2019 primarily due to the runoff in Neon. When you exclude the runoff of our Lloyd's operation, net written premiums will grow more like 3% to 7%. Very excited about this particular market as a company that has an opportunistic culture, that has 34 business heads, that all are looking at opportunities with the pricing changes going on in the market. Now I can't be more excited as we go into 2020 about our organization's opportunity to continue to outperform. We're going to see continued strong renewal pricing momentum, I think, this year. Average renewal pricing across our entire Property and Casualty Group was up 5% for the fourth quarter of 2019. But excluding our comp business, was up 7%. Nearly 1/3 of our nonworkers' comp businesses achieved double-digit rate increase during the quarter. Renewal pricing in our overall Specialty Property and Casualty Group and in Specialty Casualty was the highest that we have achieved probably in 5 years. Given the broad-based improvements in renewal pricing across many of our businesses, we're expecting our overall pricing to be up 3% to 5% overall. And when you exclude comp, that's going to look like -- more like 5% to 7%. I'm going to turn things over to Craig here for a minute.

Thanks, Carl. I'm going to take a few minutes and review our Annuity business and our investment operations. In our Annuity business, we focus on what we do best, selling fixed and indexed annuities. We enjoy a long history in the industry, have long-term agent relationships and a reputation for simple, consumer-friendly products. Disciplined product management and operations have enabled us to maintain a consistent crediting rate strategy at a low-cost structure. Our annuity products are simple, easy to understand, with lower upfront commissions and bonuses, which allows us to pay higher annual crediting rates. Our products are sold in financial institutions, retail, broker/dealer, registered investment adviser and education markets. Our product focus also allows us to optimize our core competency and investing. Our in-house investment management team, American Money Management Corp., has consistently outperformed the market. We'll discuss more about AMMC later in the presentation. AFG continues to achieve a top 10 ranking in the financial institutions channel and is a top 10 provider of traditional fixed and indexed annuities overall. In the current interest rate environment, we're focused on earning the appropriate returns on products we sell rather than growing our premiums. Outlined above our primary annuity distribution channels, our strategy includes profitable growth in fixed and indexed annuities, increasing market share, adding new distribution partners and accounts and creating opportunities in new channels. These charts show the change in premium mix in the annuity industry over the last 6-plus years. In 2012, variable annuity premiums accounted for almost 2/3 of total premiums, with fixed and indexed annuities accounting for the balance. In the first 9 months of 2019, industry variable premiums have accounted for 39% of total premiums, while fixed and indexed annuities accounted for nearly 60%. Because our business is focused on fixed and indexed annuities, we participated in the growth of these market segments. The reasons for the shift in the market include principal preservation available with fixed and indexed annuities and a growing awareness of the high fees associated with variable annuities. Our specialty knowledge and focus on the fixed market has allowed us to build a compelling business model. We've achieved an 18% compounded annual growth rate in annuity assets since the beginning of this business in 1974. We projected annuity investments and reserves will each grow by 7% to 9% in 2020. Based on this guidance, we would expect annuity assets to grow to approximately $49 billion by year-end 2020. You can see on this slide the transformation of our Annuity business as we focused on our core competency of fixed and indexed annuities and away from lines of business without critical mass for a competitive advantage. We've also reduced unit costs and significantly improved ROEs. Since the end of the recession -- since the end of the last recession, we've more than tripled earnings, premiums and assets. Results in 2019 included full year GAAP pretax annuity core operating earnings of $398 million. Annuity sales of $5 billion for the full year in 2019 were the second-highest level in our history. We believe we're well positioned to continue to profitably grow our business and capitalize on our consumer-centric model. In response to the continued drop in interest rates in 2019, we implemented numerous crediting rate decreases to maintain appropriate returns on annuity sales, which impacted premium volume. We expect full year 2020 premiums to be between $4.5 billion and $5.2 billion compared to $5 billion reported in 2019. As you saw in the previous slide, AFG's Annuity segment has more than tripled in size over the last 10 years. Over the same time frame, our Annuity segment's cumulative net earnings exceeded its cumulative core operating earnings, with net earnings at 105% of core operating earnings over this period. In addition, the Annuity segment has paid over $1 billion of dividends or nearly 50% of GAAP net earnings to AFG's -- to AFG parent. We believe these 2 statistics demonstrate the quality of the Annuity segment's earnings and the quality of business written over the last 10 years. Let's talk for a minute about protection from rising interest rates and falling interest rates. The risk of rising interest rates, they haven't been around for a while, but let's talk about the protection that we have in our in-force. 86% of the in-force annuities have some surrender protection. Other product features that should encourage persistency or discourage lapses: 16% of the business has a guaranteed minimum interest rate of 3% or higher; 33% of the reserves have a market value adjustment, or MVA, or a longevity rider; approximately 40% of new sales elect some form of trail or multi-year commission, when available. The asset duration is shorter than the liability duration by a little over a year. And the unrealized gains in the bond portfolio were $1.8 billion pretax, pre-DAC or 105% of book value. Now let's talk about protection that we have from falling interest rates. And this is something that truly does differentiate us from most companies in the Annuity business. We have the ability to lower crediting rates by 119 basis points on $31 billion of reserves. That number excludes immediate annuities and FIAs with riders. This would produce an extra $368 million of pretax income per year if we were forced to pull that lever. Low upfront costs. We have very low upfront costs to recover because we pay a lower commissions than competitors and low or no bonuses. The deferred acquisition on our -- costs on our books are actually less than 4% of reserves. Now let's take a look at the AFG investment portfolio. This gives you a view of our $55.3 billion investment portfolio. Fixed income investments make up approximately 91% of the portfolio. 91% of our fixed maturity portfolio is investment grade, and 98% with an NAIC 1 or 2 rating, the 2 highest levels. Our in-house team of investment professionals has consistently produced returns over time that outperform industry indices and provides a competitive advantage to our insurance operations by keeping investment management fees low. We achieved $2 billion of total return outperformance at our fixed income portfolio over the 11-year period ending 12/31/2018. This time period captures the beginning of the global financial crisis. The industry results shown on the slide reflect actual industry Life and Annuity and P&C returns, which are weighted by AFG's Annuity and P&C portfolio mix. These results are particularly compelling, given that most Life company peers do not have a similar mix of business because our business is focused on fixed and indexed annuities. The duration of our fixed income portfolio is shorter than that of the industry overall. Now let's take a look at the guidance for 2020 for AFG. Looking to 2020, our core operating earnings guidance for AFG is in the range of $8.75 to $9.25 per share. The midpoint of this range would result in 5% growth in operating EPS and an operating return on equity of approximately 15%. This guidance reflects the premiums and combined ratio assumptions shown on this slide. It also assumes a 20% effective tax rate as well as an assumed 10% yield on AFG's $2 billion of investments that are required to be marked-to-market through operating earnings and is similar to the return earned in 2019. Now Carl, Jeff and I'd be happy to take any questions you might have.

So I'll throw out a couple. One of the businesses that's actually under a bit of pressure is workers' compensation. And I've 2 questions on it. The first is, given the sense of what you see from both a pricing and a claims standpoint in workers' comp, but in addition, maybe as importantly, I think the uniqueness of your workers' comp business is not fully appreciated. People just think workers' comp as one policy or one line of business. But I know you guys do think somewhat differently. So what are you seeing? And then talk about the uniqueness of your business.

Sure. To start with, our workers' -- our overall workers' comp business between multiple units is about 18% of our overall gross written premium last year. Obviously, our '19 results were very good. Healthy accident year combined ratios, very healthy calendar year combined ratios. 2020 margins will be lower, but I still think we're going to make a small accident year underwriting profit in workers' comp. And we're going to make -- because of a strong reserve position, we'll continue to have a healthy calendar year underwriting profit in that. Net written premiums will be down. My guess is probably low single digits through this year. Pricing, I think, this year of -- I think will probably be down mid-single digits. I'm hoping that in some states like California, where there's been lots of rate decline over a period of time, you'll begin to see a bottoming out, but not only there, but nationally in that. Our overall reserve position is very strong. Loss ratio trends on our overall comp business are flat to down 1%, if you put our businesses together. But basically, any kind of loss cost increase is offset by changes in -- positive changes in exposure in that. So I continue to be very bullish about our workers' compensation business. And I think it will continue to be a good contributor to our earnings this year. Again, our comp business -- some is built into our Specialty Casualty premium and combined ratio range guidance. So...

And what are some of the ways that makes that business different than other companies?

I think the specialization versus others, it's not a one line among many for a lot of companies in that. We -- in California, we've been one of the longest-running specialty riders there. Our head of our claims understands, he's been there probably 30 years -- understands the claims environment, geographically, region by region, probably better than anybody. And I think we've begun to build that knowledge into the use of predictive analytics, both on the ratings pricing side as -- but we began to build it into the loss -- the claims side some also. Our Summit subsidiary was a -- is a specialty rider, probably the third largest in the southeast. Summit is clearly one of our best acquisitions that we've ever made, probably earning 20% returns on equity over the cumulative period since we've made the acquisition. Again -- they've specialized. They're in the states that they focus in, in the southeast. So I think specialization is very key. And again, yes, their claims executives understand the tricky environment of Florida, for instance, probably better than anybody. We're the largest rider of workers' comp in the Florida marketplace. We have a business we don't talk about a whole lot called strategic workers' comp that does business in 30-some states. They tackle tougher-to-write classes of business. And they work very closely with insureds from a loss prevention standpoint and the -- with a unique pricing model. That business has been a significant contributor -- become a significant part of our comp business as well as a significant contributor to the profitability. So I guess that's -- maybe it's a little color. That's helpful?

Yes, that's helpful. Carl, you also mentioned about allocating capital to businesses that have the highest returns. But in addition, it feels as if you've done a good job of managing risk. Because it's not just highest returns, but it's kind of risk-adjusted returns. How does the level of risk factor into your capital allocation decisions?

Well, I think the level of risk plays directly into our return on equity expectations. And we feel, right or wrong or otherwise on, if you're going to play in the catastrophe reinsurance, catastrophe cover, you should theoretically require a higher return over time. So with alternative capital, that certainly is always not the -- doesn't seem to be the case these days in that or on businesses like public D&O with -- that has more volatility, excess liability, where large jury awards create volatility in that line. We require higher returns in those businesses in that. So I think that directly plays into allocations of capital business by business. But the good news is when you look at the 34 businesses, probably outside of our Aviation business, which we're taking heavy rate and changing -- making heavy price changes in terms right now. And in Singapore, almost all of our businesses are really performing well. Crop had a bad year, but that nature -- crop is 1 year out of 7 or 8. There's either going to be too little rain or too much rain, and that's just part of the business. That business has been a really great -- had a great return on equity over a long period of time. So I hope that answers your question.

That's helpful. Any other question in the back there? Just wait for the mic.

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