American Financial Group (“AFG”) writes specialty insurance policies for businesses, insuring them against risks in areas from the mundane to the obscure. Some areas include, for example, property & casualty insurance, professional liability insurance like errors & omissions or directors & officers insurance (protecting companies and their employees from the potential liabilities associated with lawsuits from clients, stakeholders, etc.), specialty finance, and California workers' compensation.
Over the past few years, the company has entered niche insurance areas that it believes are under-served while selling off or exiting non-core business operations (which once included banking, real estate and more). It has also moved away from insurance lines in which it does not feel it has a competitive edge in terms of either superior risk management or opportunistic pricing. Some of these areas, such as professional liability, workers' compensation, or agricultural P&C insurance, are often niches that competitors steer clear of due to inherent uncertainties in evaluating risks and others are simply so narrowly tailored as to be unlikely to attract competition. For instance, the company even offers horse mortality insurance for farmers and ranchers. In pursuing this strategy, AFG has earned an underwriting profit in each of the last three years while sporting gains in all of its product lines except specialty finance, which includes many risks associated with government and company contractual obligations and liabilities.
AFG's property and casualty business is broken down into four segments while its life and annuity business operates through another subsidiary. The breakdown of the four P&C segments and life/annuity business is as follows:
At right is a chart of the company's net premium volume over the last three fiscal years, broken down by segment.
Another important metric for the company (indeed, for any insurance company), is the combined ratio, which is the ratio of total losses, loss expenses, and other operating expenses to net premiums. It is, therefore, the metric of underwriting profitability.The table below includes the combined ratio of the company's major insurance lines.
|Property and transportation||83.00%||82.30%||77.90%|
|California workers comp||70.0||74.1||78.3|
As evidenced by the table, AFG's underwriting profitability has improved since 2005, partly a result of continued refocusing, but also due to the fact that 2005 was a particularly difficult year for insurers in the wake of a particularly severe hurricane season.
A large part of AFG’s property and casualty insurance operations focus on underwriting risks associated with natural and man-made disasters. Risks related to such policies are generally very difficult to assess and model given the year-to-year variability of severe weather frequency and intensity as well as the potential for long-run shifts in patterns, in light of the effects of global warming. For instance, while many meteorologists do not immediately blame climate change for the impact and severity of hurricanes like Katrina and Rita, there is more and more evidence that severe weather and climate change are linked. AFG, for its part, lost some $60 million on the 2005 hurricanes. Similarly, tornadoes are often difficult to predict, and AFG insures Midwestern farmers and other businesses against the risks associated with them. In 2006, for instance, the company lost $22 million on an unfriendly twister season. The company attempts to mitigate such effects with third-party reinsurance, sensible underwriting, and, generally, limiting exposure to coastal risks (more likely to be hit with severe weather) to compensate for the risk, but large, unexpected events can have a significant impact on the company’s bottom line and, perhaps worse, its financial strength.
A major part of the company's business focuses on insuring agribusiness crops. Severe weather, droughts, and simple supply and demand drive the prices for these commodities, and volatility in the agricultural commodities markets has increased substantially. This unpredictability can lead to similarly unpredictable results for the agricultural risk business of AFG, for which premium prices are largely a function of the value of the underlying crop being insured.
Insuring and estimating losses associated with asbestos liabilities has been a notoriously difficult game over the last two decades. Variables including regulatory shifts and judicial rulings -- both nearly impossible to predict with high accuracy -- have played a major role in determining ultimate outcomes from asbestos risks. AFG's net loss reserves for asbestos exposure is around $3.75 per share, which may significantly over or under-estimate its actual exposure. Over time, asbestos and environmental liabilities have tended to increase rather than decrease, though, so whether AFG's reserves are ample enough to cover future increases (or shocks) is an important but difficult question to answer.
Life insurance companies generally make money on a spread between the guaranteed payout they offer annuity customers and the rate they earn on investments. This spread has been narrowing over the past few years, and the life insurance industry, with low barriers to entry, many competing companies, and stiff competition for customers, is a tough one in which to earn outsized returns. Not surprisingly then, AFG's life and annuity business, with about a 6.5% average annual return on equity, is a drag on overall performance and will likely have a tough time approaching the same attractive economics that the company's specialty and niche insurance lines offer.
Though the majority of AFG's business is from more predictable, lower-severity risks, the company also insures against some risks that are low in frequency but can be high in severity. Thus, while not the lion's share of its top line, in adverse conditions these policies can put a big dent in the bottom line. For example, companies' directors and officers are seldom sued successfully in major tort cases, but when they are, damages awarded in court can be enormous. Directors and Officers insurance protects against these unlikely events. Similarly, exceptionally severe weather causing major property losses are relatively uncommon, but when they occur can cause billions of dollars in damage. Some of AFG's property and casualty lines insure such occurrences. The strategy of insuring these types of risks has advantages and disadvantages. Because modeling the risks associated with these policies is inherently difficult (for example, due to the probability distributions of such events often having fat-tails or due to the lack of adequate data on occurrences), the company can often take on business that competitors shy away from. This leads to attractive premium prices and substantial float from policies. However, for these same reasons, it is also exposed it to great uncertainty as well as greater fluctuations in its year-to-year results. Furthermore, because such risks are often borne out at later dates than traditional “short-tail” policies, AFG may enjoy investment returns from float on a given policy for long periods even though the eventual cost of such insurance may not be known for years.
Because of AFG's diversified product base, the company competes with many types of other insurers. While the company attempts to differentiate itself by pursuing a strategy of insuring niche risks that others may not, the insurance industry at large is generally marked by low barriers to entry, significant price competition, and an alternating cycle of under- and over-capacity that can at times pressure pricing and returns. The industry is also highly fragmented: with $3.7 trillion in global life and non-life premiums written in 2006, AFG's share is a tiny 0.12%. Indeed, discussing market share as a competitive advantage in insurance can be largely misleading -- no insurer commanded any more than a 2.5% global market share.
While apples-to-apples comparisons of insurers as diversified as AFG can be difficult, the following is a table that includes comparable companies' net premiums, most recent combined ratio, and 5 year average return on equity.
|Premiums||Combined Ratio||5 yr. ROE|
|Berkshire Hathaway (BRK)||$31,783||10.6%|
|Allianz SE (AZ)||$59,362||93.60%||13.4%|
Looking more specifically at AFG's different segments, though, the company's nearly $2 billion of 2006 North American property & casualty premiums represented less than 0.4% of that market, which wrote approximately $450 billion in premiums during the 2006 FY.
Similarly, the enormous life insurance industry, which registered some $2.4 trillion in premiums last year, dwarfs any share AFG's life segment which had just $423 million in life insurance premiums in 2007.