“American Financial Group is proof that I’m less concerned with whether a stock is a “value” or “growth” stock, but more concerned with the quality of the business and the durability of its earnings power. AFG was the top performer during the quarter as it successfully realized value for its life insurance segment through an announced sale of this business to Mass Mutual. Investors generally disliked AFG’s life insurance business due to its interest rate sensitivity and investment portfolio leverage. As a result, the market was ascribing less than a book value multiple for AFG’s life insurance business despite multiple publicly announced transactions of competitors that valued similar books of business at 1.2x book value (which is ultimately the multiple that Mass Mutual paid). Investor concerns with the life insurance segment presented an opportunity for us to purchase AFG at a discount to fair value with an opportunity to compound capital at a 10-15% annualized rate for many years to come. While I didn’t expect an outright sale of the life insurance business, I applaud management for monetizing this asset and realizing value for shareholders. AFG’s stock outperformed once the sale was announced as the value of this business was higher than the market appreciated. See below for a more detailed discussion of AFG.
American Financial Group (“AFG”): Family Legacy of Excellent Capital Stewardship
1) Leading specialty P&C underwriting franchise with a consistent history of superior underwriting results.
2) Disciplined management team with a track record of sound capital allocation decisions.
3) Family business with high insider ownership (18% of company)
AFG is a diversified insurance company that generates 60% of its earnings from its specialty Property & Casualty (“P&C”) segment and 40% of its earnings from its Life Insurance segment. AFG was founded in 1959 by Carl Lindner Jr and is now led by his two sons who serve as co-CEO’s. In addition to their co-CEO roles, each brother is actively involved in the ongoing operations of the business: Carl Lindner III is President of the P&C segment and Craig Lindner is President of the Life Insurance segment. The Lindner family collectively owns 18% of AFG ($1.7B value) and an additional 6% of the company is owned by executives and the company retirement plan.
Superior Underwriting Culture
Most P&C businesses tout their superior underwriting capabilities as a competitive advantage, but in reality, there is little differentiation between each of these companies. As a result, most P&C companies are subject to pricing cycles in their specific lines of business that ultimately determine underwriting results. For investors, this is a black box that makes predicting results nearly impossible. AFG is one of the rare insurance companies where there is clear evidence that the company can consistently generate industry leading underwriting results. AFG’s underwriting superiority is driven by a collection of attributes that allow the company to consistently grow book value at rates faster than the industry, regardless of underlying pricing cycles:
1) Aligned incentives: underwriters are compensated based on underwriting results over multiple years and underwriting targets are based on return on equity (“ROE”) thresholds. Bonuses are subject to clawbacks if underwriting results develop unfavorably.
2) Diversity of Insurance Lines: 35 separate P&C insurance lines allows management to distribute capital to the highest return opportunities. When combined with the incentive compensation outlined above, capital only flows to segments where ROE targets can be met. This diversity of insurance lines serves to mitigate the risk from pricing cycles.
3) Ownership mentality: Significant insider ownership along with long-term equity incentive compensation drives underwriters, managers and executives to allocate capital to the highest return opportunity.
As a result of the above factors, AFG’s P&C underwriting results have consistently outpaced the overall industry. Note that the combined ratio is a measure of the underwriting profitability for the company’s P&C segment (a 90% combined ratio can be thought of as a 10% underwriting profit margin).
Not only do these underwriting results compare favorably to the overall industry, they also stack up better than their highest quality peers.
Disciplined Capital Allocators
Management’s capital allocation decisions extend beyond organic growth opportunities and serve as another tool to maintain a consistently high ROE. While underwriting results have been strong in AFG’s P&C segment due to thoughtful allocation to each of these underwriting lines, the results are also bolstered by management’s willingness to distribute excess capital to shareholders if organic growth opportunities do not meet the company’s ROE thresholds. Management has always been thoughtful about balancing these myriad capital deployment opportunities. The chart below shows how management has used a combination of regular dividends, special dividends and share repurchases as capital deployment tools.
AFG generally operates with substantial excess capital, which has served the company well as it allows the company to be opportunistic with accretive M&A (Summit in 2014, National Interstate in 2016) or share repurchases (2020). AFG had $1.1B of excess capital at YE ’20 ($4.3B once the Life Insurance sale is complete), resulting in a drag on ROE of nearly 4% for 2020 (has ranged from 2%-4% over the last 5 years).
Management’s capital allocation discipline was on full display in Q1 when AFG monetized the life insurance portfolio through the sale to Mass Mutual. I was surprised AFG sold the entire business given that 1) Craig Lindner’s duties were largely confined to this segment and 2) the amount of proceeds from an outright sale will likely be difficult to deploy quickly. There is some risk as to how AFG will use these sale proceeds, but as described above, I trust this management team to act in the best interests of shareholders. After all, the Lindner’s are the largest owners of this business.”