Good afternoon, everyone. My name is Chris Campbell. I am on the P&C insurance team. Joining me for this session are the senior management team for American Financial Group in Cincinnati. To my right is Co-CEO, Carl Lindner. To his right is his brother, Co-CEO and in charge of the annuity operation, Craig Lindner. Then CFO, Jeff Consolino. Thank you, gentlemen, for joining us. We really appreciate it, and we are happy to have you.
Nice to be here.
Okay, great. I'll just start off with some questions. Just as we begin, can we get some overall thoughts on AFG's overall business model? It's very unique that AFG still has a P&C and annuity book for a lot of U.S. companies that kind of moved away from that model. How does that work for AFG, and what are the advantages?
We love our business model. We have some 34 different specialty property casualty niches. Craig has carved out a couple of niches in the annuity business. I think it means more consistent results over time. It works for us. Our stock has really performed well. Our results have been great. We have good returns. The annuity business, along with businesses like the crop business, lender placed property, equine mortality. Between the annuity business and a lot of P&C businesses like those, some 60% of our capital is allocated to businesses that don't correlate to the general property and casualty cycle, which I love, and I think makes us an even stronger company.
I think the annuity business also, in the insurance business in general, if you can underwrite better than your peers, invest money better than your peers, and then allocate excess capital and invest that excess capital appropriately, double-digit returns long term means great things to returns and that, and we stack up well. We have a particularly talented money management group, and we've been able to invest money at greater returns than our peers over time. The annuity business gives our overall business a higher investment leverage to our capital than most property and casualty companies. In our case, if it allows us to take advantage of a core talent or skill, and that's investing money over time, which can make a meaningful difference on growth and book value and healthy earnings.
Great. You've noticed, Carl and Craig, you've noticed that one of your most important jobs as CEOs is capital management. Can you just discuss your overall capital management philosophy, the use of special dividends, what opportunities are you seeing right now to put capital to work?
Sure. Chris, capital management is a top priority of ours. Frankly, the opportunities are a little different each year. Certainly, when we have the ability to grow our businesses at appropriate rates of return, we certainly want to have the capital to support that. We have had pretty healthy growth here the last couple of years. In addition to we certainly have more capital than required to support the growth of the business. We're always looking at a steady flow of acquisitions. Frankly, we're pretty disciplined buyers. If we make an acquisition, we want to get to a double digit after-tax rate of return in a short period of time. We're always looking at acquisition opportunities, certainly looking at bolt-on startup type opportunities.
In the recent past, dividends, we felt made a lot of sense to, given the levels of excess capital, we felt that special dividends were an appropriate thing. I think last year we paid $3.50 in special dividends, and we've got $1.50 special dividend so far this year. We'll take a look as we get closer to year end and what opportunities we have on the acquisition side or other opportunities for the capital. There is the potential for another special dividend as we get closer to year end. Carl and I also have a goal of raising our regular dividend at a double-digit rate. Just announced a 14% increase in the regular dividend.
Great. Any questions from the audience? Okay. All right. During the second quarter earnings call, you announced an increase in your 2018 EPS, along with your better segment guidance. What are the underlying drivers behind this change, and what opportunities are you capitalizing on?
Chris, we did raise the guidance. The midpoint went up by $0.20 a share. It's driven mainly by stronger than expected investment performance in the first half of the year.
Stronger investment income on both sides of the business.
Anything on the underwriting side that you're seeing?
Well, I think our guidance still, we're projecting a good underwriting result this year.
Okay. Great. Craig, just building on that. On the increased guidance for the higher investment income, can you give us a little bit more beneath the hood, underlying color on where you're seeing those opportunities in the investment portfolio?
Sure. The main driver of the very strong investment performance, somewhat above what we had projected, came from investments in assets that are marked to market on a quarterly basis. Principally, limited partnership interests, some private equity, some real estate limited partnership interests. On a consolidated basis, we have about $1.2 billion invested in those types of assets, and we generated returns in the first six months of 2016, 17% overall. Very strong performance on that $1.2 billion of investments.
Mm-hmm. Any questions from the audience? Okay. Hold on. Can we get you a mic just to make it easier for-
I guess, given your investments management style, I just was wondering what's the house view on the credit cycle right now, and are there industry asset classes or areas in the triple B space that you're spending more time to try to avoid pitfalls that may come due to volatility that's currently occurring?
Yeah. We're still fairly constructive on credit. We don't see a recession around the corner. You never know what some unexpected geopolitical event could cause. Assuming we don't have an unexpected event, we're still pretty constructive on credit. Having said that, frankly, we don't think you get paid to take risks. We are finding certain areas that we find attractive, and we'll step out and take a bit more risk. When we look at the absolute level of interest rates, and we take a look at the very tight spreads, frankly, this is a time when we're being pretty conservative, even though we're not negative on credit. Over a long period of time, we've had pretty significant outperformance on the investment side relative to our peers.
We attribute that to being very opportunistic in times like this when most asset classes are pretty highly priced, and rates are low, spreads are tight. This is a time when we're going to be pretty conservative. We had tremendous opportunities in 2009, 2010 to buy residential mortgage-backed securities, commercial mortgage-backed securities, senior tranches that we were buying at $0.70, $0.75 on the dollar. Those are the type of periods when you'll see us step out and take a bit more risk. When Meredith Whitney was predicting massive defaults in municipal bonds, we took very large positions in the muni market. Those are the types of times when you'll see us really reach a bit in terms of assets that we're purchasing. Today is not one of those times. It's kind of the opposite extreme, and we're being very cautious.
Any other questions at this point? Oh, we have one. Josh?
Sticking with munis, what is your current thought process there with tax reform making that less attractive as an alternative to investing in straight corporates?
Could you repeat the question?
Tax reform reduced the muni tax advantage. What is your thought process in terms of munis as an investment?
I think first of all, tax reform was hugely important to our businesses. On the annuity side, we were seeing almost every deal that was done was done with a structure that allowed the buyer to strip income out of the U.S. company and take it to Bermuda or some tax advantage. We were paying 35% taxes, and the companies that were taking advantage of a loophole in the tax law were paying 5% or 6% taxes. It was hugely important to us, really leveled the playing field on both sides of the business. As it relates to the investment side, buying municipal bonds is now a bit more attractive on the life side than it was previously. Really doesn't change much on the investment side as it relates to the P&C investment portfolio.
More generally on your businesses, what is your outlook for the commercial lines pricing, or what areas are you seeing that are attractive or how does that compare to your position?
Well, I think the good news is in the property and casualty side, where we're earning 15, 16% after-tax returns, I'd love to grow almost all of our businesses as the market allows an opportunity. In fact, we seem to be finding our opportunities. I think we're growing out ahead of the average company out there today. I was very pleased in the second quarter that pricing overall was rough and dirty, even with loss costs and excluding workers' comp, which is a unique situation. It was probably the highest pricing levels that we've seen in probably, I think I said 15, 16 quarters or so. I like the trend that way. Again, if we can continue to find organic opportunities to grow a 15, 16% return on equity business and find opportunities to expand geographically, to buy things right.
Our sweet spot for acquisitions is kind of in the $50 million-$500 million range. The tax law change seems to be giving certainty to quite a few entities in that price range, particularly privately owned companies in that. I think if anything, we're probably seeing maybe a few more opportunities than what we've seen in the past. I'm very enthusiastic about the environment and the ability to continue to grow our business.
Great. We have one out there.
Do you see more pressure on M&A following the [audio distortion] announcement or from Markel expanding into the [audio distortion] ?
Can you define pressure for me?
Pressure based on your investors, as well as in terms of trying to compete with the similar commercial P&C peers that are out there.
Not really. Those were probably businesses that you mentioned that weren't targets for us or weren't things that we were considering in our approach to business in that. Our focus, again, is in the price range I talked about, and more on adding geographically onto our businesses, adding new niches. That's more, I think, of our focus. Our family and our employees control some 24% of the company. We're a lot more longer term focused than probably a lot of companies, some of which probably had targets on their back and that. Could be, I don't know, some of the motivation for doing transactions, and that. We don't have short-term pressure to make acquisitions, and that.
Our focus is long-term, trying to invest or either give back too much excess capital or investing excess capital in a way that's not only accretive, which is a piece of cake with interest rates where they've been. As Craig mentioned, we want to focus on things that, putting our money to work at double-digit plus returns over the long term. I think you'll find our culture is more entrepreneurial, is more opportunistic, and more patient than those companies.
Just one follow-up. Does the M&A strategy or the targets that you're looking for expand to the annuity space as well, or is it just on the commercial P&C?
We look at annuity deals from time to time. What I would tell you is that we're pretty pleased with the organic growth. We just raised our guidance to now expecting premium growth of, when we put our guidance out, we raised the expectation to up 10% to 15% this year. My guess at this moment in time is we're going to be at the upper end of that range. For five, six years, we have been able to grow the business at a very strong rate. I kind of like designing our own products and having the features and the products that really fit our consumer-centric model.
I'm not saying that we would never make an acquisition on the annuity side, but we're very pleased with our ability to grow the business with products that we design, that we're comfortable with, and be able to grow on an organic basis. We've been growing reserves and assets at a 10% to 12% or 13% rate for some number of years. We don't feel a real need to go buy something to achieve growth.
No workers' comp questions?
I'm trying to get to them. You guys have so many good audience questions. Let's see.
A quick one on the tax reform comment you made, that the private companies you guys are targeting are now a little more comfortable and maybe more likely to sell. Can you flesh that comment out a little bit? Why would that be the case?
Well, I think before, sellers and buyers had a hard time putting accurate values until they knew with certainty what the tax law result was going to be. On the buy side, you certainly didn't want to pay A seller had expectations that you should be factoring in the new tax law, and that, which, when you put a multiple on that, could be a significant amount of money. A buyer doesn't want to do that, unless he has the certainty that those tax savings are going to be a sure thing. I think that's the primary thing that I mentioned. I think, for people that own their own businesses, also, having certainty of what the tax law is going to be certainly might have given them more clarity and comfort in doing things.
Okay. We have one from Eric in the back.
Just looking forward to your earnings and your ROE, what are some, I guess, headwinds to prevent it from improving and growing further?
Well, I don't think there are too many companies out there in our space that are earning 15%-16% returns, so I'm very happy with that. If we can grow the business at those returns, I think that's where our bigger focus is. Either growing organically on the annuity and the property and casualty side, which we are. Investing in new businesses, starting up new businesses, which we've been successful at over a long period of time. We're buying businesses that are good fits. I think that's the bigger focus and challenge. Was there a different aspect to that? Did I answer your question?
I guess just looking at consensus estimates, it's kind of a flat outlook and just kind of curious to your thought, the ability to grow that.
A consensus outlook for next year, you mean?
EPS.
We're just on the beginning of our planning process. We usually don't give guidance until later in the year or early next year in that. Being an entrepreneurial or an opportunistic culture, we seem to always, in 34 different specialty niches, find the ability to, where a given business is being disrupted, to take advantage of things, and that. A couple of our large competitors have had problems in the commercial auto space and in some of the larger buffer comp, larger comp type of area. Both last year and this year, we were able to take advantage of that. There's always markets that are melting down or markets that are being disrupted in some way. We love being a disruptor when it comes to that. Again, I think we've been very successful with the acquisitions that we've done.
The buy-in of National Interstate, we spent $300 and some million. I think I promised everybody we were going to work on getting the combined ratio under 95, which would allow us to earn a double-digit return on the incremental investment. We reported a 92.4 combined ratio through six months, a number of years later. We feel pretty good about that. We acquired Summit for $400 million. That's been an off-the-charts, huge success with big returns and that. I think we're confident in our ability to find opportunities going forward and acquire things in an intelligent fashion. If we don't, there should be some share repurchase or special dividends along the way, which most investors that I talk to really like.
Any other questions right now? Okay, awesome. Carl, here is your workers' comp question, right? Just discuss what you're seeing in terms of loss costs. We've seen one big workers' comp writer in the U.S. talk about elevated frequencies.
first half of the year. Just what are you seeing in terms of frequency and severity in AFG's book, and then what's your outlook for loss cost trends going forward?
Well, first of all, we're very happy with our workers' comp business. We take a very specialized approach, and it's been a very good business for us. The amazing thing right now is when you look at the loss ratio trend on our overall workers' comp book, it's actually flat to negative a little bit. What I mean by loss ratio trend, we take a look at loss costs. We take a look at frequency, severity, and then what's going on in the economy on payrolls. Severity is going up, but the improvement in frequency is offsetting the upward change in the severity on our workers' comp book. When you add the growth in wages, the effect of the economy, we come up with, on our book right now, a loss ratio trend of flat to down a little bit. We think that's a good thing.
As far as outlook, a little early for guidance and all that, but if you were to ask me today on our whole workers' comp business I think that 2019, we're going to continue to make healthy calendar year and healthy accident year underwriting profits there overall. I think our three main businesses there are Republic, which is mainly California comp, Summit, our Southeastern comp, and Strategic Comp. California probably ends up being closer to a very small accident year underwriting profit next year or break even. If you took the state of Florida on its own, could be break even to a little bit over. When you put all of our comp business together as an entity, I think we're still going to have healthy accident year and calendar year underwriting results with good returns.
I think on the growth side right now, because of some rate decreases in various states, I think our premiums will probably be flat to down mid-single digit next year. Again, it's early, but that would be the way, how I'd look at it.
That's very helpful. Thank you, Carl. One for you, Craig. I'm just thinking about the recent DAC unlocking charge due to the higher option cost. What drove that charge, and what are the other factors that you're keeping an eye on to make sure that you don't have to record another premium deficiency?
It is unusual for us to do an unlocking in an interim period. Normally, we do a very complete review in the fourth quarter of the year and take a look at all the assumptions that the actuaries have used related to profitability of the business. We were seeing a trend for several quarters of higher hedging costs, higher option costs, driven principally by higher short-term interest rates. This is a phenomenon that wasn't unique to us. It's affecting everybody in the indexed annuity business. We took a look at it. We made the determination that it wasn't a temporary thing. We made the determination that it was kind of a permanent change and thought it was the appropriate thing to go ahead and recognize that in the second quarter, even though typically the fourth quarter is when we look at unlocking stuff.
Right. Got it. Kind of just shifting a little bit, crop. Are there any negative potential implications for agricultural subsidies in the crop book?
I don't think so. I don't think the tariff payments really are separate from the MPCI program. I think probably the biggest impact around the tariffs and that is more on commodity prices themselves than that. Just the administration's approach on tariffs overall has had some downward pressure. Most of the commodity prices are dictated by normal supply and demand, but I do think the administration's policies have impacted prices. Obviously, it wouldn't be necessary for there to be the tariff payment type of program to begin with. Crop year's shaping up nicely. I think when you look at the corn and soybeans, which are in our book of business are, I think, 65% or so or more of the total multi-peril crop premium. Two-thirds are rated good to excellent right now. Corn and soybean yields are being projected by the USDA and others to be at record levels.
That's usually a good thing. On the price discovery themselves, again, it's a 30-day average in October of November, December contracts. Until you get most of the way through October, it's hard to prognosticate. Corn's down about 8%. Soybean price discovery on those futures are down roughly 17%, 18%. Generally, when yields are strong, you can work your way through even 16%-18% declines in prices and that. What a lot of people don't know about the government Multi-Peril Crop Program is the farmers generally choose up deductibles of 15% and higher. Before there's yield changes or prices that are down on average much more than 15%, you're not exposed to losses.
Any questions from the audience real quick? Another annuity question for Craig. You referenced your consumer-centric annuity business. Given AFG typically pays lower commissions, how are you able to successfully grow it given that small space?
We do estimate that our average commissions are 0.5 or two points lower than the average of the industry. That obviously allows us to give more value to the customer. Our consumer-centric model plays really well in this environment for a number of reasons. Our products generally are much easier to understand. We typically have shorter surrender charge periods. Yet most people think that we're kind of in the beginning of an upward trend in rates today. The fact that we're selling shorter products, shorter surrender charge periods is a real selling factor. There are other reasons that distribution or customers want to do business with a given company. We have an excellent reputation on giving great service, having consistent ratings. You go back to the 2009, 2010 period, most annuity companies were being downgraded. In some cases, they were capital constrained.
Because of our philosophy of carrying excess capital and because of the great diversification we have in lines of business, we did not receive a downgrade during that period of time. We were not capital constrained. We were able to basically take on all business that we could get so long as we were earning the right rate of return. I think just the predictability of our company. We've been in the business for a long, long time. The view that we're a high-quality company that will always be there, always have the capacity to write business, and our consumer-centric model just playing very well in this environment.
Mm-hmm. Great. Probably have time for one more, really briefly. Commercial auto. I think, Carl, you had mentioned National Interstate outperforming your expectations when you bought the rest of it. What are you seeing in terms of rates and loss cost trends across that broader book?
Well, in the commercial auto overall, industry-wide and in our case, yeah, loss cost, if there's an area where loss costs are increasing at a higher rate, it's in the commercial auto area. In commercial auto liability, even though National Interstate's accident year combines under 95, we're still taking rate, particularly in the commercial auto liability part of that. We're making a small underwriting profit there, but we want to improve that further. I think we're in our sixth year of rate, Jeff, but it's focused on the commercial auto liability part of that. When you take a look at an industry that's still way above 100 and our business is generating real solid underwriting profit returns, we got at it much earlier. We've been at it for trying to improve things for five years, and happy to report that I think we've achieved that.
Now I'd love to see us take advantage of some of the disruption, where the industry's continuing to have to take rate in that. I'd love to see us be able to take advantage of growing the business more.
Mm-hmm. Yep. Excellent. All right. I think we're at time. Thank you, gentlemen, for joining us. We appreciate it.
Thank you.
All right. Thank you.