The next presentation, which is American Financial Group. AFG has actually had a more colorful history than you would think. I've covered this stock really many years, since they had different names back in the past, Penn Central. I had to learn about things like the world banana market, what the value was of air rights over Grand Central Terminal. Luckily for me, the business is much more simple now, and they make money from things like insurance, which I can understand and analyze. Thank you, making my job a bit easier over the years. We're pleased to have with us today Craig Lindner, who's Co-CEO, Jeff Consolino, the company's CFO. Jeff was out late last night doing karaoke, so his voice is a little hoarse. If you know Jeff, he does a lot of karaokes.
Will there be time for rebuttal in this presentation, or how is this going to work?
You're being cut off now. Let me start with more of a structural question for Craig. You're really one of the few companies at this point that have both a sizable property casualty business and also a decent size annuity business. Most people don't see the benefits of putting those two businesses together. In fact, you bought in the rest of your annuity business several years ago. What's the rationale for keeping these businesses together?
Jay, what I would say is having a diversified model of P&C businesses and annuity businesses has worked extremely well for us over a very long period of time. Both businesses are among the better performers in their respective industries. The annuity business, obviously, is one that has a larger investment portfolio and frankly has allowed us to put a highly skilled investment team in place that has outperformed on the investment side for a long period of time. That has benefited the P&C side of the business significantly. We just like having a real diversification of businesses. We like having a number of businesses that aren't correlated to the general P&C cycle. We believe that over a long period of time, that's allowed us to produce more consistent results.
Does that diversification allow you as a company to hold a little less capital from a rating agency standpoint because of that diversification?
We get a little bit of credit. Jeff could answer that probably better than I could, but it's my understanding we get a little bit of credit for that diversification.
Yeah. Obviously, Jay, the theory is that by having diverse businesses, your earnings are more stable, the vicissitudes of any one market won't affect you as much, and as a result, your required capital is lower than the standalone business it would require separately.
Diane just put a slide up here. I think the proof that our business model works is in the performance of the stock. If you look at our performance over five years, over 10 years, we've significantly outperformed the various indices.
You're one of also the few companies that kind of openly talks about the excess capital that you believe you have. At the end of the fourth quarter, it was $950 million, soon to go a bit higher than that as you sell off some of the legacy businesses. The question that comes to us is, what are they going to do with it? I'm going to pose that to you. What's the plan with this excess capital? It's not an insignificant amount of money given the size of your company.
We see a very steady flow of acquisition candidates. We're probably tougher buyers than some others. We don't do deals just because they're accretive. Frankly, with interest rates where they are today, any deal would be accretive. We look for double-digit returns over time on acquisitions. Clearly, we look at paying special dividends. If the excess capital gets up to a level that's way beyond what we think we're going to need, we'll look at paying special dividends. I think we've done that four years running, Jeff?
Correct.
Paid $1 a share special dividend last year. We raised our dividend by 12%. Various uses of the excess capital. Carl and I view the management of our excess capital as one of our real priorities. The other thing that we've done historically is in certain periods of time when we found our stock to be exceptionally attractive, we've repurchased a significant amount of our outstanding shares. Fortunately, we went into the 2008, 2009 period in really good shape. We had a fair amount of excess capital going into that period. We were able to get through that without any ratings downgrades, and we actually repurchased about a third of our outstanding shares at what in hindsight was a very attractive level.
For those in the audience, we've got some slides up usually responding to one of the questions I'm asking, so make sure you glance up at the slides as well. They'll probably add to your understanding of the answer. With the capital, wrong way to say this, but do you feel like there's a burning hole in your pocket? This is now the biggest amount of excess capital that you've had. You've got to feel some pressure to deploy that.
Honestly, we don't feel a lot of pressure. If we get closer to year-end, and that number just continues to build, we don't see great opportunities for the excess capital, we can pay another special dividend. We're not going to let it cause us to do a deal that's priced the wrong way or doesn't have the potential to generate the right returns.
Are you seeing, given some of the stress that seems to be emerging, not across the board, but from more selective companies, are you seeing more opportunities to potentially get deal? Are you being approached more?
Jay, I think that at least in my time with the company, we've seen a pretty steady flow of what I would call opportunities. I don't want to limit that solely to acquisition opportunities. One thing that's worked really well for our company over time is starting up businesses through the Property and Casualty segment. We operate over 30 independent autonomous units that each have their own defined niche, and many of those successful units have been startups. Over the last couple of years, we've started up a Public Sector division, we started up an Aviation division, we started up a Professional Liability division, and we would hope those companies and those opportunities would marry talented underwriters with our capital strength and our high ratings and would build the franchise value of our overall organization.
Acquisitions are one flow of opportunities we see, we do see through other sources we have, teams of people, that we evaluate as to whether they would be a good fit with our company and that help grow our business overall.
Given that the company is bigger now, when you look at deals, are you looking at bigger deals? Do you need to do something a little larger just to move the needle?
Jay, if you look at our history on the property casualty side, we have very successfully acquired smaller to middle-sized companies over the years. We love our mix of businesses. We don't feel the need to do a giant deal to really change the mix of business. As a matter of fact, we don't want to do that. I think on the property casualty side, you'll see us do smaller to medium-sized deals. On the annuity side, frankly, our organic growth is strong enough that we really don't see the need to look at acquisitions on the annuity side. We also like to design our own products so that we know the risk of the features and the products.
When you make an acquisition of an annuity company, it's very difficult to get your arms around the design of every product that's been sold over a long period of time. I think you'll see acquisitions on the property casualty side, and we're happy with the organic growth on the annuity side and really not looking to make acquisitions there.
If I could just chime in, it seems to me that needle moving is a poor motivation to undertake any kind of transaction. A company that performs well is really built well from within and making acquisitions to try to make a bigger impact as opposed to focusing on returns on capital or things like fit, that could be a really bad mistake.
I guess ideally with excess capital, you would just be growing organically. Tough in this environment, obviously. If I said to you, what are the two or three best opportunities to grow your business? I assume annuity is one of them. I'll let you talk about that. Anything else?
Yeah, why don't I start? We've published guidance for the 2016 year. Roundly speaking, we expect our P&C business to grow net written premium by 2%-6%. Annuity, we're expecting to grow annuity premiums by 4%-8%, so at a higher rate than P&C net written premium. For annuity, that would translate into 10%-12% growth in annuity account value. That certainly will provide us with the opportunity to grow in line with what the market opportunities are. As we are targeting the right level of return, we can't really push that farther than what the market will bear, and given our guidance is established at $5.35-$5.75 per share, that would be at the midpoint, an approximate 11.5% ROE. We'll probably generate more capital through profitability than we'd be able to redeploy organically.
That way, just down the waterfall that Craig was talking about of things like dividend increases, share repurchases, and/or special dividends, if nothing else arises.
Got it. On the annuity side, one topic that has already come up several times today in earlier presentations is the Department of Labor proposals. You guys have said it's not a big issue for the company. Not everyone is an expert on this topic. It might be helpful if you could go over some of the reasons why that's the case. That might set the stage a little better.
Oh, sure. First of all, our annuity business is different than a number of other annuity companies out there, because we are in the fixed and fixed indexed annuity business. We're not in the variable business. At least in the proposal that was made public, fixed annuities and fixed indexed annuities are exempt from the most onerous provisions of the Department of Labor proposal. It's a big difference between us and companies that are big in the variable business. We also think that we're going to be less impacted than many of our competitors because of our very high ratings. We have a consumer-centric model, what we call a consumer-centric model, where generally we pay much lower commissions than many of our competitors. It allows us to offer more value, allows us to offer a higher credited rate to our annuitants, our policyholders.
Much of our sales is in very compliant business. If you look at the distribution of the product, there's a very small percent of it that is in the retail portion. Diane's got to put a chart up here. About 48% of our business is impacted. It is IRA-related business. If you look at the breakdown on that, you can see the biggest part is sold through banks. That is very compliant. Then the next largest segment is sold through registered reps, which is very compliant. The piece that we're at risk on is the retail piece. That's sold by agents who sell insurance products only. They don't sell registered products and so forth. I believe we are at risk for that segment, but we compete against companies whose entire distribution is in that segment.
We think we're much better positioned for a lot of reasons than most of the industry, and long term, potentially could even be a beneficiary because of our current consumer-centric model, because of our very high ratings, and for a number of reasons.
Sticking with the annuity business, I guess really the more obvious challenge for the company is probably the interest rate environment. Let's assume we've got a lower for longer, which after five years feels like it's going to be forever. If we have that environment, what does that mean for your annuity business?
One lever that we have to pull that many of our competitors don't have, because we are a consumer-centric company and we're much slower than many of our competitors to reduce credited rates. We actually have the ability, if we went down to minimums, we have the ability to reduce credited rates on around $20 billion of reserves by an average of 72 basis points. We'd rather not do that. As I said, I think we get a lot of credit for offering great value to our customers. In the event that we'd stay at a very low interest rate period for a long period of time, we do have the ability to reduce the credited rate by a significant amount on a very large amount of our reserves. We have about $7 billion of reserves that have a guaranteed minimum interest rate of 3%-4%.
That piece, what you'd see spreads get squeezed on that piece. On the balance of the business, we have the ability to adjust credited rates to maintain spreads.
Still some flexibility.
Absolutely
if you look at the book entirely. On the P&C side, obviously in the U.S., we've had rates that have stopped going up and probably begin to come down in many lines of business. What are the ways in which AFG will defend the underwriting margins, looking at 2016 and 2017?
Jay, we're coming off a very successful underwriting year in 2015. Our GAAP combined ratio for the P&C segment was a little bit higher than 93. I think it was 93.1. Our guidance for 2016 contemplates a consolidated combined ratio in the range of 92%-94%, so largely consistent year-over-year. Within that, again, we've got a tremendous diversity of businesses. We're pleased with that business mix. When you look at our sub-segments, we've got our property and transportation segment. We expect that our commercial auto business resident there, especially National Interstate, will continue to take rate and continue to improve upon their combined ratio. Within our specialty casualty sub-segment, which contains our liability businesses and our workers' compensation business, as well as our Lloyd's business Marketform, we're coming off terrific years for a lot of those businesses. Rate is challenged in those areas.
We're trying to address that through things like predictive analytics and continually improving the character of the book. Even as we're dealing with that, we would look for improvement in Marketform in the specialty casualty segment coming off a pretty bad comparison in 2015. Just a reduction in the losses into 2016 would have a positive impact on the combined ratio. Finally, for specialty financial, our combined ratios there have been very strong in the mid to low 80s. We don't expect that performance to continue, but still, that has been very profitable for us, and if they come in within the range of our guidance, we'd be very pleased with that.
The other, I guess one important line of business you didn't mention, workers' compensation.
Both organically and through acquisition, you've grown it. What's the outlook for that line of business?
We're very pleased with the underwriting profitability. We did add to that business when we made the acquisition of Summit, which is a Florida-based workers' compensation company back in 2014. 2014 benefited from nine months of Summit's earnings. 2015 for a full year. The performance of that business relative to our expectations when we acquired it has been favorable. We feel like we priced that acquisition for a double-digit return on our capital. So far we're outperforming our targets. We have two other specialty workers' comp carriers within our group of companies. One that operates in California, Republic Indemnity. Republic is one of the few companies that's succeeded and stayed solvent over the period since open rating. I know you know what happened to many of those companies, Jay. Then we have a specialized Strategic Comp unit that does high deductible business.
Each of these businesses have different markets, each of them have different competitive advantages. Summit, which is concentrated in Florida, they're an administered pricing state. There are mandated rate decreases. With our mix of business, we think that our overall rate decrease will be less than the, call it 5%, that's called for. Then we're working to ameliorate that with predictive analytics and improving the character of the book. Republic, again in California with many decades of success, they're good at risk selection and where to operate and where to stay out of. We're constructive on their ability to navigate through any rate decreases that come through. Strategic Comp is also performing very well for us, and we are looking forward to more good performance.
Overall, Jay, I would say that the combined ratios and the returns on capital have been very satisfactory for us in comp. We'd like to defend that profitability as rates starts to slacken or even go in reverse.
Got it. Let's shift to the investment portfolio. The company actually has, I think, a pretty good history of being opportunistic. When prices have come down in various asset classes, you tend to be a buyer, whether it was real estate or mortgage bonds. We're in a fairly disruptive environment now. Are you seeing more opportunities to deploy, especially when you have the excess capital, you have flexibility to do that?
Clearly there's been some spread widening. I think on high-grade bonds, spreads have widened about 30 basis points since year-end, which has partially mitigated a fall in treasury rates. On the non-investment grade side, I think spreads have widened out by 110, 120 basis points ex energy. It's not enough to cause us to really change our mix. We're still buying principally high-grade corporate securities, mortgage-backed securities, and so forth. We don't see the spreads being at a level that will entice us to really reach for yield and take more risk. We're at the lowest level in our history in terms of non-investment grade bond exposure. Our non-investment grade bonds are at about 2.7% of total invested assets and cash. We clearly have some room to grow that if we see the opportunity, but we have not started there yet.
The one opportunity that the crack in the market has created is giving us the ability to buy our shares in at a more attractive price than at the end of last year. We had a 10b5-1 program in place in January. It really accelerated the repurchase of our shares.
On the investment side, obviously another hot button is the energy side. Where do you stand now as far as your exposure there, underexposed, overexposed?
Yeah. We feel reasonably good about our exposure there. We were not buyers of high-yield energy. At year-end, we had high-yield energy exposure of around $150 million at book, $130 million at market. A $20 million pre-tax unrealized loss. I should mention also that the great majority of those investments are fallen angels, which we believe are better credits than some of the issuance over the last couple of years.
Not a real big issue given the size of your balance sheet.
It is not.
Any questions from the audience at all? We've got mics floating out there, if you do have one, just raise your hand. Geographically, you're mostly a U.S. company. You do have Marketform. You did plant a flag, if you will, in Asia recently. What do you hope to get out of that? What was the rationale for that investment?
Jay, it would be the same as any of the other startup opportunities that we've had. Through the network of people we know and the executives in the company, we connected with a underwriter out in that market that had a very successful track record, primarily in the ocean marine arena. Our aspiration is to build up a business there that is a specialized business that makes underwriting profits for us, focusing in that niche, and overall add to the franchise value of our business.
How long before this is profitable? Is this going to be an expense sink for a while?
I don't know what an expense sink is. Maybe we can define that more clearly. We're always looking to make an underwriting profit. We would expect that the main focus is profit, not growth.
Okay. One line of business we didn't mention, and it's not an insignificant line of business for the company, is agriculture, crop insurance.
As you look at 2016, given the fall in corn and soybeans, what kind of revenue expectations do you have?
Well, first, I'm happy to be talking about crop coming on the heels of a normal crop year. With my three years with the company, 2015 was the first year that we really had what I would consider to be a normal crop year. I would expect that our revenue would be largely flat 2016 versus 2015. When you look at commodity prices, which are obviously subject to change, they're within single-digit % down from last year's spring discovery prices. We also picked up about half a percentage point of market share in 2015. We're continuing to kind of chip away at growing there. In large measure, I would expect our top-line opportunity, unless something changes dramatically, to be roughly the same as 2015.
You did have a change in ownership in one of the bigger competitors, biggest competitor.
in that space. Does that change things that maybe give you a chance to pick up some market share?
Possibly. These things only occur over time. This is a fairly specialized market. We're the fourth-largest writer with about $1 billion of gross premium income. The whole market is $10 billion in round numbers. I would expect that the buyer of this company, which I assume you're referring to RCIS, they went from a standalone unit of a large commercial bank to a division of a large international insurance company, but with the same management team in place. I wouldn't expect any changes in their strategy. Over time, you shift market share through good service to customers and good service to agents. That's our focus all the time, and we'll be ready to pick up opportunities from there, as well as the other transactions that have occurred in the market. I wouldn't expect any profound changes from that one acquisition.
I guess the last question from me is, Craig, it's an election year. You're running a business here in the U.S. mostly. Does the election result matter to you? Are you spending much time thinking about this, planning for eventualities, or is it just entertainment like it is for the rest of us?
You know, it is good entertainment. I never would've dreamed that we'd be where we are, I'll say at this point. I'll say that. I don't know that it matters to us a lot, unless somebody would be elected who wants to put a lot more regulation in place for our industries. I don't know that it matters a lot to us.
Okay. It's not something you guys are paying much attention to other than personal reasons or whatever.
We are not.
Okay. Any other questions? Raquel.
Hi. Maybe you can just update us on your debt capital management plans. You have been a repeat issuer in the junior subordinated debt market. Is that something we should expect to continue?
Our next major maturity is in 2019, Jeff. That's a $350 million issue. We'll be happy to get rid of that because that was issued in a much higher interest rate environment. I think there's a nine and seven-eighths coupon on that. Certainly sometime between now and the maturity of that debt issue, we will be back in the market to issue some debt. Frankly, if we would find the right acquisition opportunity or the right opportunity, we have a lot of capacity to take on debt, and still be at or under the targets that we've set and the debt-to-cap levels that we've committed to the ratings agencies. There's a lot of capacity there.
Any other questions? Great. Well, join me in thanking Craig and Jeff. Good stuff. Thank you.