AFG - American Financial Group: An Underwriting Stumble Has Created Opportunity

2023-11-09 02:56:01 ET

Summary

• American Financial Group investors have been disappointed by underwriting results, causing the stock to drop 22%.
• AFG's earnings and net operating income have increased, but not as much as expected.
• Despite some setbacks, AFG is still growing its premiums and investment income, making it an attractive investment opportunity.

Investors in American Financial Group ( AFG ) have been hit by disappointing underwriting results this year, pushing the stock 22% lower. Shares have been a disappointing performer since my buy recommendation last year , losing about 10%, though it has paid $8.10 in regular and special dividends this year. Results have not been that bad, just not up to AFG’s typically strong standards. Still, I think the market has gotten overly negative on the name, and I would be a buyer here.

In the company’s third quarter , it earned $2.45, missing estimates by $0.03. This was still up from $2.24 last year. AFG is growing earnings, just not as much as hoped. Core net operating income of $208 million rose from $192 million last year, though this was flattered by a lower tax rate, accounting for about $4-5 million of the $16 million increase in results. Still, given this result, management declared a $1.50 special dividend and has raised its regular dividend from $0.63 to $0.71. This comes after paying out $4 earlier this year. AFG has also reduced its share count by about 1% via buybacks.

In isolation, these results do not seem disastrous for investors. Still, for the full year, AFG expects core net operating earnings of $10.15-$11.15. This is below the $12 I anticipated because the combined ratio will be 90-92% this year above the sub-90% I expected and that AFG has typically delivered. As a reminder, a combined ratio of 100% represents breakeven on underwriting where claims and costs match premiums. So, AFG is still earning about $0.09 on every $1 of policies it writes. Relative to the industry, this is still a decent outcome, but it does represent less underwriting profits than hoped for.

In the quarter, AFG’s net written premiums were up 4% to $2.06 billion. Property and transportation net premiums were down 6% while specialty casualty was up 7%. It is still growing its premiums quite nicely, and management expects 6-8% net written premium growth from 5-8% previously. I will later speak out about how a growing insurance book also helps boost AFG’s investment income.

Now while premiums rose, underwriting profits of $143 million were down 9% from last year as the combined ratio rose by 1.1% to 92.2%. The two stand-outs were that catastrophe losses were up 50bp to 3% while prior year development was a favorable 230bp. This rise in catastrophe losses was surprising. Most insurance companies have seen an improvement in cat losses this year because last year Hurricane Ian slammed the West Coast of Florida causing significant losses while there were no storms as severe this year, though AFG had limited losses last year from this storm.

While AFG did not have any event as severe, it saw an increased frequency of smaller-scale storms, which added up to cause more losses. Additionally, it has been a below average crop year, and so its agriculture results were a bit poorer. Cat losses are inherently volatile year to year. It was disappointing to see them rise to $56 million from $51 million last year, but I do not believe that is sufficient reasons to sell the stock.

I was also glad to see prior year developments being a favorable 2.3%. Ultimately, on long-term policies, it can take time to know how profitable your unwriting was as you wait to see whether claims materialize. As such, in-year, insurance companies estimate their results based on modelled trends, which get revised as they see more data. Essentially, this adjustment means that historic policies were more profitable than originally assumed—that AFG’s published results were too conservative. This is a positive and consistent with the company’s tradition of strong underwriting. Additionally, after doing its annual review, there was no net change to its asbestos reserves

Because AFG receives premiums now, but it does not pay out claims until they arise, it has a large investment portfolio, as does any insurer. For AFG, it is $14.8 billion. 68% of its portfolio is in fixed income, and 93% of that is investment grade Excluding alternative investments, P&C net investment income rose 33%. This portfolio continues to benefit from maturities being rolled over at today’s higher rates. The portfolio has a tax equivalent yield of 4.63% from 4.21% last year. The fixed income portfolio yields 4.68% from 3.63% in calendar 2022, and that yield will continue to rise as it reinvests at today’s higher rates.

AFG also has $2.4 billion in alternative investments, and those earned just 4.2% last quarter. Alt returns are more volatile than fixed income, and while down from the 9+% returns seen last year, this is not a particularly bad outcome. This portfolio is primarily comprised of private equity and positions in multifamily apartment buildings. Slowing rent growth has reduced the returns on these properties. I have written numerous articles discussing why I am generally optimistic on multifamily real estate over time, and I view this asset portfolio position as likely to generate value for AFG shareholders over the medium term.

Because its written premiums are growing, its float of insurance reserves has risen to $12.9 billion from $12.0 billion at the start of the year. As this float grows, AFG has more resources with which to invest. Essentially, it borrows from policyholders, but because it generates an underwriting profit, it is functionally borrowing at a negative yield while it is now investing north of 5%, creating a very large spread that is supportive of its profits. Its fixed income portfolio has an amortized cost of $10.6 billion, providing plenty of high-quality liquidity to pay claims should they arise.

AFG’s parent company (which pays the dividends) has cash of $364 million, which is down $512 million this year due to the special dividend payments. This upcoming special dividend will cost $126 million. Last year, AFG had $1.1 billion in excess capital, but this is now $660 million due to these payouts alongside business growth. Because its excess capital is declining, I would expect to see smaller special dividends next year. Still, management sees additional repurchases or special dividends next year.

Assuming AFG can get back to a 90% combined ratio as cat losses normalize and that premiums continue to rise by 5-8%, AFG should be able to earn at least $12 next year, and after retaining capital for business growth, it should be able to pay out 50-67% of earnings to shareholders, or about $6-8. After its regular dividend payment, that leaves about $4 for buybacks and/or special dividends.

AFG has a 6-7% capital return yield today, and with premium growth in the mid-single digits, it should be able to grow capital returns by ~5% over time. At less than 10x earnings, this makes shares attractive, and if we see underwriting gradually improve, I think shares can recover, particularly as net investment income continues to move higher. I see shares moving toward $140, or a 5% all-in yield and 12x earnings. AFG continues to be profitable and consistently returns capital to shareholders; patience will be rewarded.

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