American Financial Group - 10-Q quarterly report FY

       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       

       Indicate by check mark whether the Registrant is an accelerated filer. Yes   X      No       

       As of August 1, 2003, there were 69,650,289 shares of the Registrant's Common Stock outstanding, excluding 18,666,614 shares owned by subsidiaries.

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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.

Interest income on non-investment grade asset-backed 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. These impairment losses are included in realized gains and losses.

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DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and 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 gain on marketable securities, net" in the shareholders' equity section of the Balance Sheet.

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.

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(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. Establishing reserves for asbestos and environmental claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.

Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. In spite of the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.

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Recently issued accounting standards will require AFG's trust-issued preferred securities to be classified as liabilities beginning in the third quarter of 2003; distributions on these securities will be shown as interest expense.

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.

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The following table illustrates the effect on net earnings (in thousands) and earnings per share had compensation cost been recognized and determined based on "fair values" at grant dates consistent with the method prescribed by SFAS No. 123. For SFAS No. 123 purposes, the "fair value" of $5.60 per option granted in 2003 and $8.52 in 2002 was calculated using the Black-Scholes option pricing model and the following assumptions: dividend yield of 2%; expected volatility of 30%; risk-free interest rate of 3.6% for 2003 and 4.9% for 2002; and expected option life of 7.4 years. There is no single reliable method to determine the actual value of options at grant date. Accordingly, actual value of the option grants may be higher or lower than the SFAS No. 123 "fair value".

AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.

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Summarized financial information for Infinity is shown below for the six months ended June 30, 2003 (in millions).

Equity in net earnings (losses) of investees for the first six months of 2002 represents AFG's share of the losses from two start-up manufacturing businesses that were formerly subsidiaries. One of these businesses was sold in the fourth quarter of 2002; equity in the net loss of the remaining business was $707,000 for the second quarter and $1.6 million for the first six months of 2003.

Substantially all of the $79.4 million decrease in goodwill during the first six months of 2003 related to the sale of subsidiaries in AFG's Personal segment.

Included in deferred acquisition costs in AFG's Balance Sheet are $66.2 million and $66.8 million at June 30, 2003, and December 31, 2002, respectively, representing the present value of future profits ("PVFP") related to acquisitions by AFG's annuity and life business. The PVFP amounts are net of $61.6 million and $57.3 million of accumulated amortization. Amortization of the PVFP was $2.1 million in the second quarter and $4.3 million in the first six months of 2003 and $1.9 million in the second quarter and $3.6 million in the first six months of 2002. During each of the next five years, the PVFP is expected to decrease at a rate of approximately 13% of the balance at the beginning of each respective year.

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At June 30, 2003, scheduled principal payments on debt for the balance of 2003 and the subsequent five years were as follows (in millions):

In June 2003, AFG issued Senior Convertible Notes due in 2033 at an issue price of 37.153% of the principal amount due at maturity. AFG received $189.9 million before issue costs of $4.5 million. Interest is payable semiannually at a rate of 4% of issue price per year through June 2008, after which, interest at 4% annually will be accrued and added to the carrying value of the Notes. In addition, contingent cash interest will be paid if the average market price of a Note for an applicable five-day trading period equals 120% or more of the accreted value. The Notes are redeemable at AFG's option at any time on or after June 2, 2008, at prices ranging from $371.53 per Note to $1,000 per Note at maturity. Holders may require AFG to purchase all or a portion of their Notes on five year anniversaries beginning in 2008, at the accreted value. Generally, holders may convert each Note into 11.5016 shares of AFG Common Stock (i) during any quarter after September 30, 2003 , if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value, (ii) if the credit rating of the Notes is significantly lowered, or (iii) if AFG calls the notes for redemption.

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AFC may borrow up to $280 million under its credit agreement. The line consists of two facilities: a 364-day revolving facility, extendable annually, for one-third of the total line and a three-year revolving facility for the remaining two-thirds. Amounts borrowed bear interest at rates ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. In addition, GAFRI has an unsecured credit agreement under which it can borrow up to $155 million at floating rates based on prime or Eurodollar rates through December 2004.

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The Senior Convertible Notes issued in June 2003 could be converted under certain conditions into 5.9 million shares of AFG Common Stock. See Note F - "Long-Term Debt."

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AFG and its subsidiaries, 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, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.

Actual results could differ materially from those contained in or implied by such forward-looking statements for a variety of factors including:

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Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. Management believes that the establishment of insurance reserves, especially asbestos and environmental-related reserves, and the determination of "other than temporary" impairment on investments are the two areas where the degree of judgment required to determine amounts recorded in the financial statements make the accounting policies critical. For further discussion of these policies, see "Liquidity and Capital Resources - Investments" and "Liquidity and Capital Resources - Uncertainties."

AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.35 for the six months ended June 30, 2003, and 1.37 for the entire year of 2002. Excluding annuity benefits, this ratio was 2.42 for both periods. Although the ratio excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.

AFC may borrow up to $280 million under a bank credit line. The line consists of two facilities: a 364-day revolving facility, extendable annually, for one-third of the total line and a three-year revolving facility for the remaining two-thirds. Amounts borrowed bear interest at rates ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. This credit agreement provides ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent companies. About half of the net proceeds from the issuance of Senior Convertible Notes in June were used to repay borrowings under AFC's bank line. At June 30, 2003, there were no borrowings under the line. Also in June, AFG filed a shelf registration statement, which upon becoming effective, will allow AFG the flexibility to issue up to $600 million in additional equity or debt securities as market and other conditions permit.

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While management believes that AFG's reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims and the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, whether claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims.

In February 2003, Great American Insurance Company entered into an agreement for the settlement of asbestos related coverage litigation under insurance polices issued during the 1970's and 1980's to Bigelow-Liptak Corporation and related companies, subsequently known as A.P. Green Industries, Inc. ("A.P. Green"). Management believes that this settlement will enhance financial certainty and provides resolution to litigation that represents AFG's largest known asbestos-related claim and the only such claim that management believes to be material.

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Six-month pretax operating earnings improved $13.7 million compared to 2002 reflecting a $53.9 million increase in realized gains and $45.0 million increase in property and casualty underwriting results (excluding the arbitration charge) which more than offset the second quarter arbitration charge, a $43.0 million decrease in investment income due primarily to the sale of Infinity and lower yields on fixed maturity securities, and the second quarter charge in the annuity operations.

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 wrote 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.

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The Specialty group reported an underwriting profit of $17.2 million for the 2003 second quarter with a combined ratio of 95.7% and $26.7 million for the first six months with a combined ratio of 96.8%, improvements of 2.3 and 1.5 points, respectively, over the comparable 2002 periods.

Realized losses on securities include gains of $701,000 in the second quarter of 2003 and net losses of $3.8 million in the first six months of 2003 compared to gains of $3.7 million (second quarter) and $660,000 (six months) in the 2002 periods to adjust the carrying value of AFG's investment in warrants to market value.

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The increase in annuity and life acquisition expenses in the second quarter and first six months of 2003 compared to 2002 reflects a $6 million write-off of GAFRI's fixed annuity DPAC balance in the second quarter of 2003 as well as amortization costs associated with GAFRI's purchase of MNL in June 2002.

The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Continued spread compression, decreases in the stock market and adverse mortality could lead to further write-offs of DPAC in the future. However, absent significant deterioration in those factors, GAFRI does not anticipate any additional material write-offs in the foreseeable future.

AFG is currently assessing the application of FIN 46 as it relates to its investments in two collateralized debt obligations ("CDOs"), for which AFG also acts as investment manager. Under the CDOs, securities were issued in various senior and subordinate classes and the proceeds were invested primarily in bank loans, and to a lesser extent, high yield bonds, all of which serve as collateral for the securities issued by the CDOs. None of the collateral was purchased from AFG. The market value of the collateral at June 30, 2003, was approximately $835 million.

AFG's investments in the two CDOs are subordinate to the senior classes (approximately 92% of the total securities) issued by the CDOs. To the extent there are defaults and unrecoverable losses on the underlying collateral resulting in reduced cash flows, AFG's class would bear losses first. Holders of the CDO debt securities have no recourse against AFG for the liabilities of the CDOs; accordingly, AFG's exposure to loss on these investments is limited to its investment. AFG's investments in the CDOs are carried at estimated market value of $10.5 million at June 30, 2003, and are included in fixed maturities in AFG's balance sheet.

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Please refer to Item 3 "Legal Proceedings" of the AFG 2002 Form 10-K. In February 2003, Great American Insurance Company entered into an agreement for the settlement of litigation brought by certain parties referred to as A.P. Green. The initial settlement agreement was submitted for approval of the Bankruptcy Court supervising the A.P. Green reorganization shortly after its execution. Certain parties objected to the settlement agreement and the Company, the objecting parties and A.P. Green agreed to revise it; there was no change in the financial terms and conditions of the settlement agreement. All parties have now agreed to settlement terms and conditions and the revised settlement agreement has been submitted, with no objections from any party, for Bankruptcy Court approval which is expected shortly. The revised settlement agreement is conditioned upon Bankruptcy Court approval and subsequent confirmation of a plan of reorganization that includes an injunction prohibiting the asser tion against Great American of any present or future asbestos personal injury claims under policies issued to A.P. Green and related companies. No assurance can be made that all conditions will be met; no payments are required until completion of the process. If the conditions are not met, the outcome of this litigation will again be subject to the complexities and uncertainties associated with a Chapter 11 proceeding and asbestos coverage litigation.

In June, 2003, AFG completed a private offering of Senior Convertible Notes due 2033, in a private placement to qualified institutional buyers in reliance on Rule 144A promulgated under the Securities Act of 1933. AFG received 37.153% per $1,000 principal amount due at maturity or aggregate proceeds of $189.9 million, before issue costs (including underwriting commissions) of approximately $4.5 million. The Notes accrue interest at an effective yield of 4% per year. The issuance of these securities to Merrill Lynch, Pierce, Fenner & Smith Incorporated, UBS Securities LLC and Credit Suisse First Boston LLC, the initial purchasers, was exempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereof. The Notes are guaranteed by AFC, are unsecured and rank pari passu to AFG's senior indebtedness. Holders of the Notes may convert each $1,000 principal amount of their Notes into 11.5016 shares of AFG Common Stock, subject to adjustment, upon the occurrence of certain events. Note holders may require AFG to purchase, for cash, all or a portion of their Notes on June 2, 2008, 2013, 2018, 2023 and 2028 at specified amounts. AFG may redeem all or a portion of the Notes, at specified prices, for cash at any time on or after June 1, 2008.

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AFG's Annual Meeting of Shareholders was held on June 6, 2003; there were two matters voted upon: (Item 1) election of nine directors, and (Item 2) shareholder proposal to expense stock options.

The votes cast for, against, withheld and the number of abstentions and broker
non-votes as to each matter voted on at the 2003 Annual Meeting is set forth below:

(a) Exhibit 12    - Computation of ratios of earnings to fixed charges.

    Exhibit 31(a) - Certification of the Chief Executive Officer pursuant to
                    section 302(a) of the Sarbanes-Oxley Act of 2002.

    Exhibit 31(b) - Certification of the Chief Financial Officer pursuant to
                    section 302(a) of the Sarbanes-Oxley Act of 2002.

    Exhibit 32    - Certification of the Chief Executive Officer and Chief
                    Financial Officer pursuant to section 906 of the Sarbanes-
                    Oxley Act of 2002.

(b) Reports on Form 8-K:

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Pursuant to the requirements of the Securities Exchange Act of 1934, American Financial Group, Inc. has duly caused this Report to be signed on its behalf by the undersigned duly authorized.

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