“The American Financial Group is proof that I care less about whether a stock is ‘value’ or ‘growth’ than it is about the quality of the business and the sustainability of its earnings power AFG was the front runner during this quarter The company successfully added value to its life business this quarter through an announced sale of this business to Mass Mutual. Investors generally disliked AFG’s life business due to its interest rate sensitivity and the leverage of its investment portfolio the market attributed less than a book value multiple to AFG’s life insurance business despite several publicly announced transactions by competitors that valued similar books at 1.2 times book value (which is ultimately the multiple that Mass Mutual paid) Investor Concerns About Life Expectancy hedge segment presented an opportunity for us to buy AFG at a discount to fair value, with the ability to compound the principal for many years at an annualized rate of 10-15% for many years to come. While I wasn’t expecting a full sale of the life insurance business, I applaud management for monetizing this asset and realizing its value for shareholders. AFG stock outperformed following the announcement of the sale as the value of that deal was higher than the market estimated. A more detailed description of the AFG can be found below.
American Financial Group (“AFG”): Family heritage with excellent capital responsibility
1) Leading Specialty P&C Underwriting Franchise with a consistent history of superior underwriting results.
2) Disciplined management team with a track record of making solid capital allocation decisions.
3) Family business with a high proportion of insiders (18% of the company)
AFG is a diversified insurance company that generates 60% of its earnings from the P&C (Specialty Property & Casualty) segment and 40% of its earnings from the Life Insurance segment. AFG was founded in 1959 by Carl Lindner Jr. and is now run by his two sons, who act as co-CEOs. In addition to their co-CEO roles, each brother is actively involved in day-to-day business operations: Carl Lindner III is President of the P&C segment and Craig Lindner is President of the Life segment. The Lindner family together own 18% of AFG (valued at $ 1.7 billion) and another 6% of the company is owned by executive and company pension funds.
Superior underwriting culture
Most P&C companies touted their superior drawing skills as a competitive advantage, but in reality there is little difference between these companies. As a result, most P&C firms are subject to pricing cycles in their specific business areas that ultimately determine underwriting results. For investors, this is a black box that makes predicting outcomes nearly impossible. AFG is one of the rare insurance companies that has clear evidence that the company can consistently achieve industry-leading underwriting results. AFG’s actuarial superiority is based on a number of attributes that enable the company to increase book value consistently faster than industry-wide, regardless of the underlying price cycles:
1) Aligned Incentives: Subscribers are paid based on subscription results over a period of several years, and subscription targets are based on thresholds for return on equity (ROE). Bonuses are subject to clawbacks if the underwriting results develop unfavorably.
2) Diversity of Insurance Lines: 35 separate P&C insurance lines allow management to allocate capital to the best return opportunities. In combination with the incentive remuneration described above, the capital only flows into segments in which the ROE targets can be achieved. This diversity of insurance lines serves to reduce the risk of price cycles.
3) Ownership mentality: Significant inside ownership, along with long-term compensation for stock incentives, drive insurers, managers, and executives to capitalize on the highest return opportunity.
Due to the above factors, AFG’s P&C drawing results have consistently outperformed the entire industry. Note that the combined ratio is a measure of the underwriting profitability of the company’s P&C segment (a combined ratio of 90% can be viewed as a technical profit margin of 10%).
Not only are these underwriting results cheap compared to the industry as a whole, but they stack up better than their top quality counterparts.
Disciplined capital allocators
Management’s capital allocation decisions go beyond organic growth opportunities and serve as an additional tool to maintain a consistently high ROE. While underwriting results in AFG’s P&C segment have been strong due to the careful mapping to each of these underwriting lines, results are also backed by management’s willingness to distribute excess capital to shareholders when the organic growth opportunities meet the ROE thresholds of the company does not meet. The management has always tried to compensate for these myriad opportunities for capital investment. The chart below shows how management has used a combination of regular dividends, special dividends, and share buybacks as capital investment tools.
AFG generally operates with significant excess capital that has served the company well as it enables the company to opportunistically deal with accumulated mergers and acquisitions (Summit 2014, National Interstate 2016) or share buybacks (2020). AFG had excess capital of $ 1.1 billion at year-end 20 ($ 4.3 billion after the life insurance sale was completed), which resulted in a charge to ROE of nearly 4% for 2020 (between 2% and 4% in the last 5 years). .
Management’s capital allocation discipline was fully visible in the first quarter when AFG monetized the life insurance portfolio through the sale to Mass Mutual. I was surprised that AFG sold the entire business as 1) Craig Lindner’s responsibilities were largely confined to this segment and 2) the amount of proceeds from a full sale is likely to be difficult to convert quickly. There is some risk in how AFG uses these sales proceeds, but as described above, I trust this management team to act in the best interests of shareholders. After all, the Lindner are the biggest owners of this business. “