Good day, ladies and gentlemen, and thank you for standing by, and welcome to the American Financial Group, Inc's conference call. At this time, all participants are in a listen-only mode. Later, we'll conduct a question and answer session, and instructions will be given at that time. If anyone should require operator assistance during today's event, you may press star then zero on your touch-tone telephone. As a reminder, today's conference may be recorded. It's now my pleasure to turn the floor over to Diane Weidner. Ma'am, the floor is yours.
Thank you. Good morning, and welcome to American Financial Group's investor conference call to discuss the agreement it has reached with Liberty Mutual Insurance to acquire Summit Holding Southeast. Leading today's discussion are Carl Lindner III, Co-CEO of American Financial Group, and Jeff Consolino, AFG's Chief Financial Officer. Craig Lindner, Co-CEO, is also with us today. If you are viewing the webcast from our website, you can follow along with the slide presentation if you'd like. Certain statements made during this call are not historical facts and may be considered forward-looking statements and are based on estimates, assumptions, and projections, which management believes are reasonable, but by their nature, subject to risks and uncertainties.
The factors which could cause actual results and/or financial condition to differ materially from those suggested by such forward-looking statements include, but are not limited to, those discussed or identified from time to time in AFG's filings with the Securities and Exchange Commission, including the annual report on Form 10-K and quarterly reports on Form 10-Q. We do not promise to update such forward-looking statements to reflect actual results or changes in assumptions or other factors that could affect these statements. If you are reading a transcript of this call, please note that it may not be authorized or reviewed for accuracy. It may contain factual or transcription errors that could materially alter the intent or meaning of our statement. I'm pleased to turn the call over to Carl Lindner III.
Good morning. We announced earlier today that AFG has entered into a definitive agreement to acquire Summit Holding Southeast, or Summit, from Liberty Mutual Insurance. As you'll see on slide three of the webcast, the purpose of our call today is to provide an overview of the transaction, discuss the strategic fit with AFG, and the related financial implications. We're really excited about this morning's announcement for several reasons. First of all, we view Summit's business as a specialty workers' comp carrier, to be an excellent fit with our business model and our corporate culture. It nicely complements our existing workers' comp specialty companies. Secondly, this acquisition adds $1 billion of cash to our balance sheet, which we'll put to work in our investment portfolio. As you know, we're real proud of the historical investment returns that American Money Management has produced.
They're our in-house money manager, as they've outperformed the industry and major indices. Finally, we view this acquisition as an intelligent use of our excess capital. We expect to achieve double-digit returns on capital, in this business and have immediate earnings accretion. If you turn to slide four, you'll see that the purchase price is Summit's tangible book value plus $45 million. This represents a price that's approximately 80% of Summit's GAAP book value and 110% of Summit's tangible GAAP book value. AFG will capitalize Summit to an A+ Standard & Poor's capital level, which will also allow AFG's P&C operations to remain capitalized to an A+ Standard & Poor's standard after the purchase. The transaction is subject to customary regulatory approvals and is expected to close late in the first quarter or early in the second quarter of 2014.
AFG's total capital invested in Summit will be approximately $400 million, which is well within the $900 million in excess capital that AFG reported at September 30th, 2013. AFG has over $500 million of cash and liquid investments at the holding company level, which will be more than sufficient to complete the transaction. There will be no external financing in this transaction. The addition of Summit's business will be immediately accretive to AFG's 2014 earnings per share following closing. We've said many times that undertaking a transaction just because it's accretive to earnings per share is not our target. Rather, our primary focus is to produce healthy long-term returns in the double digits. Summit's business is expected to generate after-tax returns of 11%-12% over time. Jeff will talk a little bit more about this later.
Following the transaction, Summit will operate as a distinct business unit within our specialty property and casualty group. We're pleased to welcome Carol Sipe and her leadership team, who will continue to ensure the delivery of the quality products and services that have made Summit a market leader in all the regions it serves. Summit will retain its own brand as a member of Great American Insurance Group. Summit is the leading provider of workers' comp solutions in the southeast U.S. and is headquartered in Lakeland, Florida, with offices also in Gainesville, Georgia, and Baton Rouge, Louisiana, as you'll see on slide five. Insurance subsidiaries, Bridgefield Employers and Bridgefield Casualty, wrote approximately $538 million in direct premiums in 2012. An additional $110 million in premiums are under management for non-affiliated insurers managed by Summit. The business is focused on small and medium-sized accounts across multiple industries.
Summit has approximately 740 employees and distributes its products through more than 1,600 independent agents. With the addition of Summit, AFG has added another specialty niche insurance business with a leading market position, bringing us to a total of 29 specialty property and casualty businesses. Half of our business comes from units with top 10 market rankings. Summit's leadership in its Southeast region adds to that. With the addition of Summit's business, our specialty casualty group grows from about 34% of total gross written premiums at December 31st, 2012, to approximately 41% on a pro forma basis. You'll see this information on slide eight. Like many of AFG's insurance businesses, Summit also has a leading market position, earning a top five ranking in Florida, Mississippi, Louisiana, and Kentucky, as you'll see on slide nine.
Summit is well diversified across industry classes, with the vast majority of policies representing small and medium-sized accounts. Summit's business as a workers' comp specialist is one that we know well. Two of our existing businesses, Republic Indemnity and Strategic Comp, are also workers' comp specialists, as summarized on slide 10. Both of these businesses are growing, achieving strong rate increases, and are expected to earn double-digit returns this year. We feel that we're well-positioned in this market, and we're enthusiastic about adding another specialist workers' compensation business. We believe that specialization is a key success factor in our business. Our Republic Indemnity unit is a specialty workers' comp insurer operating in California. With 68 years of experience in the California market, our management has the depth of underwriting expertise to consistently outperform the market by 14 percentage points over the last decade.
Republic today is seeing significant rate opportunity and profitable growth. Our Strategic Comp unit has a unique business model, which helps its clients reduce losses and workers' comp costs. Strategic Comp has seen substantial profitable growth since we acquired the company in 2008. If you turn to slide 11, you'll see that Republic's business is West Coast based, with California predominating. Strategic Comp is regionally focused in selected states, Summit is focused in the Southeast, with Florida representing over half of its business. Taken altogether, no one state or region dominates. AFG has been able to skillfully manage the workers' comp cycle in our mix of business over a sustained period of time. We've discussed with many of you our willingness to walk away from business when we couldn't achieve appropriate returns, as is evidenced on slide 12.
Today, though, with pricing on the upswing and rate adequacy in our targeted markets, AFG is back to growing its workers' comp business. Turning to slide 13, you'll see that Summit also has a strong track record for producing results that outperform the industry. Through nine months of 2013, has achieved a 96 combined ratio. I'd like to turn the discussion over to Jeff Consolino, who will review some of the financial implications of the Summit acquisition.
Thank you, Carl. I'm delighted to speak to all of you this morning, delighted to speak to our new associates at Summit. We welcome you to AFG, you're joining a great company. Starting on slide 15, this talks to our capital adequacy, financial condition, and liquidity and capital management strategy. You've seen these statements on a recurring basis from American Financial Group. Our excess capital is approximately $900 million as of September 30th, 2013. The total capital committed to Summit of approximately $400 million is well within that $900 million in excess capital reported at the end of the third quarter. Our strategy continues to be opportunistic, balancing profitable organic growth, expansion of specialty niches, acquisitions, startups, stresses maintaining a minimum of $100 million-$200 million in dry powder.
As we're opportunistic with management of our excess capital, we added our 28th specialty P&C business earlier this year with the formation of our Professional Liability division and have been pursuing opportunities to organically grow our specialty casualty and annuity operations during the 2013 year. In addition to these strategic uses of our excess capital, we announced a 13% increase in AFG's ordinary quarterly dividend in October to $0.88 per share per year and a $1 per share special dividend that was paid in December. If you turn to slide 16, the acquired entities that comprise the Summit Group are illustrated on this slide within the dashed outline. The underwriting companies that are owned by Summit Holding Southeast will be capitalized as standalone entities.
On slide 17, you'll see that in 2014, we expect the earnings per share will be increased through this transaction by approximately $0.20 per share. On an annual run rate basis, we estimate earnings per share accretion in the range of $0.40 to $0.50 per share. The acquisition of Summit will have no impact on our balance sheet ratios. As such, the pro forma debt to capital ratio for AFG remains at 18%, and our excess capital remains over $500 million. To get more specific on the financial impact of adding Summit, on slide 18, we presented summary GAAP income statement data for Summit covering the 12-month period through September 30, 2013.
In using this data in your financial models, I would ask that you consider the effect of the closing date and other items on the amount of earnings that will come through to AFG in calendar 2014. Net investment income as presented here does not give effect to the additional $150 million of capital that AFG will add to Summit. However, what might look like a $55 million pre-tax run rate for net investment income after that capital contribution will be tempered by the fact that the seller is delivering cash to us in the depooling rather than securities. We believe that we'll be able to get fully invested after two quarters, but until then, our investment yields will reflect the drag of a billion-dollar cash balance. Summit's combined ratio continues to improve with the improving business environment in workers' compensation.
After the transaction, AFG will purchase a greater level of reinsurance for Summit than has previously been the case under Liberty's ownership. I would expect that the reinsurance cost will approximate two points on the combined ratio. Finally, the $45 million tangible book value premium will create amortizable intangibles. While we've not finalized our purchase accounting, an average of seven years might be reasonable with the resulting amortization being deductible for book purposes. Consider that we expect a closing late in the first quarter of 2014 or early in the second quarter. As a result, AFG will pick up only a partial year of Summit's income statement data in calendar 2014. These factors form the basis for our expectations about EPS accretion in 2014 and beyond. Turning to slide 19.
As Carl mentioned, our in-house investment management team, American Money Management, has consistently delivered investment outperformance. We're pleased that the Summit transaction will increase AFG's invested assets by about $1 billion to a total of $30.9 billion. We believe this will provide a nice opportunity to leverage American Money Management's superior investment management capabilities over time. The charts on slide 19 illustrate the September 30th, 2013, actual and pro forma combined investment portfolios. In the near term, this will increase the cash component until these funds can be fully invested. The quality of our fixed maturity portfolio remains unchanged by the transaction. With that said, now we'd like to open the lines for any questions.
Sure thing, sir. Ladies and gentlemen on the phone lines, to queue up for a phone question, you may press star then one on your touchtone phone. If your question has been answered or wish to remove yourself from the phone queue, you may press the pound key. Again, if you would like to ask a question at this time, please press star then one on your touchtone phone. One moment for phone questioners to queue. It looks like our first question in queue will come from the line of Amit Kumar with Macquarie. Please go ahead. Your line is now open.
Thanks, and good morning, and thanks for taking my questions. Just a few questions here. First of all, just on the discussion of on excess capital. Was there some internal debate on using the cash or deploying the capital to buy back more stock for 2014? How does this alter your thought process on buying back stock going forward? If I plug that number into my model, I think one gets to the same level of accretion. Just wanted to hear what you thought about that in terms of deploying capital.
Of course it is, Amit. It's our goal to continually try to seek out the highest and best use for our excess capital, going in a direction we feel with the highest returns. As you know, we've been opportunistic purchasers of our stock. We'll continue to be able to do that. The size of this transaction uses a chunk of our excess capital, $400 million of the $900 million. It gives us plenty of flexibility to continue to opportunistically do share repurchases if we consider that to be highest and best use. Of course, we continually debate day by day. In this case, we were excited with this transaction where over time we feel we can
manage this business to achieving 11%-12% returns. Compared to our stock price, at least here in the short term, it looks like a good choice.
Got it
that's how we look at it.
The second question I had was on Summit's reserves. Obviously, the status statements are a bit commingled. Can you talk about the reserves, maybe talk about the level of IBNR, and what does their analysis of reserves tell you about them? Are they adequate or more than adequate, or would it need some sort of an adjustment going forward?
Hi, Amit. This is Jeff Consolino.
Hey.
As Carl mentioned at the outset, this transaction is the result of a discussion between us and the seller, Liberty Mutual.
where we had ample opportunity to evaluate Summit, including its loss reserves. Liberty is obviously a responsible parent company with good processes and excellent reserving actuaries and financial people. As we got into the due diligence, our conclusion is that Summit's reserves are adequate, and we've had plenty of time to do our own in-house and external review there. Of the reserves we're bringing across, which are $1 billion net, about 70% of that reserve base is made up of IBNR.
The total industry at year-end in the U.S. for the workers' comp line is a touch under 50%.
If you were looking at Summit's loss reserves, you'd see a heavier IBNR component than a typical company.
Got it. Would you plan to release some more data on the reserves separately down the road so that we can actually do our own analysis? Or at the time of closing, would there be more data, or no?
Until you threw in the qualifier of closing, I was going to give you an unreserved yes. You'll see Summit's reserves in Schedule P when we file it for the 2014 year.
Until then, Summit will be included within our consolidated GAAP financial statements from the closing date of acquisition, and any movements in Summit's reserves will come through our prior period line as we report it to you.
Got it. Then final question, I will stop here. In terms of, you were talking about the market conditions, and obviously, you talked about your prudent performance with Republic. When you look forward, how does the book shape up, and how does the combined ratio shape up going forward for this book now that it'll be under your control? I guess, does it expand? Does it contract a bit? Do you expect the combined ratios to improve, I guess, when you apply your practices to them? Maybe just talk about your forward outlook on this book.
Well, to start with, we're enthusiastic about the current management team and their track record. That's positive. One thing we're excited about is their use of predictive modeling and predictive analytics and some of their approach on managing the claims in the healthcare side.
We actually think those are things that we could probably leverage and would be useful coming the other way.
In that. Of course, I think as the AFG management team also will have some insights and will have some positive things to bring to, I think, Summit's management team also. Clearly, we have a high bar and high expectations with all of our businesses to earn the proper returns, and we'll look at Summit through the same eyes.
Got it. Okay. I will stop here and requeue. Thank you so much for all the answers.
Thank you, sir. It looks like our next question in our queue will come from the line of Ryan Byrnes with Janney. Please go ahead. Your line is open.
Great. Thanks, guys. Just had a question. It looks like that Summit has some relationships managing some captive insurance companies. Just wanted to see if they own any of the capital there, and I guess how you guys view those businesses going forward.
Thank you, Ryan. This is Jeff Consolino. Summit's business does incorporate a business that manages third-party insurance companies for which they receive fee income. It's been a good contributor to Summit's pre-tax income on the order of, call it, $10 million a year over time. We like the business. Of course, we like the management, we have no expectations that that'll change. These are truly third party, non-affiliates. Summit does not own any of the capital of those entities. It's a management relationship.
Great. Thank you. I noticed you guys are obviously putting more capital into them. Also, I guess, going from A to A-plus, what's, I guess, the rationale there? I imagine obviously it would hurt some ROE targets.
I would point you back to the slide that showed the structure of Summit pre-acquisition on page 16. Summit participated in the Liberty Mutual intercompany pool, as a result, did not need to maintain a standalone capital base as all of their premiums and losses were ceded to Liberty Mutual. As we take Summit out of the Liberty pool, we need to establish a standalone capital base for it, the total capital that we'll put in is equal to an A-plus level under the applicable Standard & Poor's methodology. You also may have seen a release from AM Best come out this morning, affirming an A rating for Summit. It's not that Summit was working with one capital base and we're adding more capital to get a higher rating or gear up the growth.
This is our assessment discussions with our rating agency partners and using our own analysis as to what an appropriate standalone capital base is for a company with more than $500 million of premium and about $1 billion in net loss reserves.
Okay, great. The last one, obviously, I think you guys mentioned that Summit is kind of small and mid account focused. Have you announced, I guess, the average premium per policy on the business?
We have. Going to get you to the slide there.
Okay, sorry.
Slide nine. If you look at slide nine on the bottom left, by policy size, you can see that 60% of the business is less than $10,000. Another 23% is less than $25,000. It really is a small and mid account focus. If you looked at this data for our Republic Indemnity unit, this would look pretty similar.
Great. Thanks for the answers, guys.
Thank you, sir. It looks like our next phone question in queue will come from the line of Vincent DeAugustino with KBW. Please go ahead. Your line is open.
Thanks, good morning, and thanks for doing the call. Just the first question I'd have is it does seem like Summit's a fairly attractive unit. I'm just curious if you'd maybe be able to talk about why Liberty wanted to part with it. I'm also kind of surprised that you're getting 10% plus ROE business kind of at this valuation. I'm just kind of curious of any thoughts that you might have on the deal and kind of how you guys seem to work out such a favorable deal for yourself.
I want to first, this is Jeff Consolino, I want to say that in no way do we speak for Liberty Mutual. Their intents in pursuing a transaction are their own. I think that we, AFG, paid a fair price to Liberty for this business. Liberty did not go out and auction the business. This transaction is the result of a conversation that was initiated between our two organizations. My understanding from Liberty is that their commercial division strategy is to approach workers' comp on a packaged basis with other commercial products, all under the Liberty brand. That made Summit a strategic non-fit. Again, that is my understanding from Liberty. I believe Liberty's benefit in transacting with AFG is we're a straightforward, financially capable organization. We're an organization that prizes our people and prizes specialization.
It's my belief that Liberty, as a good parent company, can feel positively about selling Summit to an organization like ours, where the Summit people have the chance to continue with their record of success and continue to build their careers.
On the returns, this is Carl. On the return side, I think working with Summit's management team, we'll have to continue to improve the underwriting profitability and manage money, as we do that well, to get to the 10%-plus returns. It'll take a little bit of work.
Just following up on that, I was just also curious if you might have any comments on anything from Summit's business in terms of just pricing trends more recently. Second, any other initiatives that may have been midway underway, kind of when you guys had come into the picture, just so we can think about what some of those initiatives might be.
On the pricing front, I think the last couple of years, Summit has been achieving a meaningful price increase. I think they've achieved around 8% in 2012, 7% this year. Summit has, as the case with workers' comp, when you look across the country, has been in need of rate increase. The rate trend has been good. We're enthusiastic that the management team has taken many of the right steps to continue to improve the profitability. As I mentioned before, we're particularly excited about how predictive analytics, predictive modeling can be used to continue to improve things. We're hoping to use some of their insights and expertise maybe to help impact the rest of our business.
Just one last one for Jeff. You'd mentioned some of the IBNR metrics, and I was just curious. I don't think this is the case based off of the slide deck, but would there be any major differences in terms of tail or class of business that might make that comparison to the industry not really apples to apples? Is it truly just, even though we shouldn't necessarily think about it this way, but is that delta really the result of just a difference in conservatism?
Even though one number is
Yeah. I hope I cautioned appropriately when I quoted those numbers on over-reliance on one particular data point to tell a whole story. The level of IBNR is just one component of reserve adequacy, along with a case and other reserves when you look to book ultimate loss reserves. Clearly, we've seen some problems with other companies in this industry that have failed to provide for adequate IBNR. I hope that data point would show you that Summit and Liberty are not in that camp. I don't think you could use those ratios just to simplistically subtract one from another and reach any firm conclusions, because you'd need to get under the hood and look at everything else. We've been under the hood. We like what we see. Reserves are inherently uncertain, but we do believe that reserves are adequately shaded.
That's great. Thanks very much.
Thank you, sir. Our next question will come from Steve Virgili with New Vernon Wealth Management. Please go ahead. Your line is open.
Good morning. Thank you. Quick question on the business that is managed for unaffiliated entities. Is that an attorney-in-fact business? Is that what that is?
Attorney-in-fact, this is Jeff, is typically for a reciprocal. The entities in question here are not reciprocal organizations. They are largely mutual organizations, some converted from self-insurance funds over the years. Regardless of the legal form, Summit provides all of the services required to help those businesses operate, and is compensated for that with a fee. That's the nature of the business.
It's the same idea, basically.
It's the same idea. Again, I'm not an expert on reciprocals and attorneys-in-fact. I understand there are certain things that an attorney-in-fact can't do for a reciprocal, but I'd have to refresh my memory on that.
Okay. Thank you. Last question. With respect to the agencies that distribute Summit's products, can you give us a sense as to where Summit's products rank on the distribution kind of spectrum? Is it a top product for their typical agents, or is it kind of second or third? Where does Summit kind of fall?
Summit is the market share leader in Florida and has a strong market share in all of the surrounding southeastern states. Summit puts a lot of energy and management attention on maintaining excellent agent relationships, they feel like they're very effective and at the top of their agents' lists. I'm not sure I could generalize any more than that, other than I think you'd see from Summit with its agencies what you'd expect from a well-performing company that's the leader in its business.
Okay. I'm sorry, one last question, going back to the fees that they generate from managing the unaffiliated entities. How much of earnings does that account for?
It's meaningful, earlier in the call, I had indicated that it's approximately $10 million pre-tax in the aggregate. You won't obviously see that flow through our financial statements in any specific line item. Frankly, we view that profit stream as part of the overall profit stream of the organization.
Okay. Thank you very much.
Thank you, sir. Just as a reminder, ladies and gentlemen, to queue up for a phone question, you may press star then one on your touch-tone phone. Our next question will be a follow-up question from Amit Kumar with Macquarie. Please go ahead. Your line is open.
Thanks. Just two, I guess, cleanup questions. Should we anticipate, I guess, any changes on the employee base from Summit, or are the retentions going to be unchanged, I guess, in terms of the employees coming over?
I don't think we expect any changes. We're excited by the management group and the group of employees we have. As you know, we run our businesses pretty entrepreneurially.
Each of the 29 businesses, the business heads are kind of like mini CEOs, they make the day-to-day decisions, so.
Got it. Are there any new employment contracts to retain the top management going forward from Summit?
Amit, this is Jeff. There are a series of incentives to retain management that will create stickiness as part of the transaction. Going forward, once Summit is ensconced as a unit of AFG, those managers will participate in our usual long-term incentive plans, which have also shown to create a lot of alignment with the company and a lot of retention for our employees.
There's nothing extra is being put in place. I guess that's what I was trying to ask.
No, I'm sorry. I said there is financial incentive for the top management related to this transaction.
Okay
That will inure to the benefit of management for staying. We wouldn't have undertaken a transaction like this if we didn't think the people were an excellent cultural fit, and we didn't feel that they would want to stay with us. The whole discussion of putting money on the table to retain people, I think, is almost beside the point.
Hmm. I think a lot of companies looking back might disagree with that. Thanks for all the answers and congratulations and look forward to your earnings conference call. Thanks.
Thanks, Amit.
Thank you, sir. Once again, ladies and gentlemen, if you would like to queue up for a phone question, you may press star then one on your touch-tone phone. Presenters, I am showing no additional phone questions in the queue. I'd like to turn the call back over to management for any additional or closing remarks.
Thank you, Hughie. Thank you for joining us this morning. We look forward to talking with you again when we release our 2013 fourth quarter results.
Thank you, presenters, and thank you, ladies and gentlemen. Again, this does conclude today's call. Thank you for your participation, and have a wonderful day. Attendees, you may now all disconnect.