AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.40 for the year ended December 31, 2007. Excluding annuity benefits, this ratio was 8.49 for 2007. Although the ratio excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
To better facilitate flows of capital between AFG (parent company) and its annuity and supplemental insurance operations, Great American Insurance paid a dividend to AFG in December 2007 in the form of its majority ownership in GAFRI, giving AFG 100% direct ownership of GAFRI.
related to these reserves totaling $2.3 billion as follows: Within 1 year -
"Insurance - Reinsurance" and the gross loss development table under Item 1 - "Business" - "Property and Casualty Operations - Loss and Loss Adjustment Expense Reserves."
In 2005, AFG completed a similar comprehensive study of its A&E exposures relating primarily to the run-off operations of its property and casualty group. As a result of this study, AFG recorded a 2005 third quarter pretax charge of $169 million, net of $32 million in reinsurance recoverables. This charge resulted in an increase in asbestos reserves of $124 million and environmental reserves of $45 million.
A primary driver of the increase in AFG's asbestos reserves in 2005 was the use by independent actuaries of evolving methodologies, including developing parameters for estimating loss adjustment expenses and reducing reliance on extrapolation techniques. In addition, the independent actuaries indicated that their views evolved regarding estimation of the potential exposure for both products and non-products claims. In the actuaries' views, this refined approach increased estimates of the Company's indicated ultimate losses. The estimates of industry ultimate losses and AFG's historic premium market share had not changed since a 2001 study. In addition, there had been no significant change in AFG's payment patterns. In the 2005 study, the actuaries also gave additional weight to claims associated with peripheral defendants bringing direct insurance claims. The increase in the number of direct insurance claims from peripheral defendants increased the projections of future defense cost and loss exposure.
As a result of the 2007 annual review of actual results and future assumptions discussed above under "Annuity Benefits," AFG recorded a $9.4 million write-off of DPAC due to increased mortality in the run-off life operations. In 2006, no significant "unlockings" were deemed necessary. In 2005, AFG recorded net charges of $4.2 million to annuity and supplemental insurance acquisition expenses primarily related to spread narrowing partially offset by the expected improved future persistency related to AFG's annuities, due to the impact of the current interest rate environment. Also in 2005, AFG recorded a $13.6 million write-off of DPAC due to an unexpected increase in mortality in the run-off life operations.
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of earnings, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
As discussed in Note A to the consolidated financial statements, in connection with implementing new accounting standards, the Company changed its methods of accounting for unrecognized tax benefits in 2007 and stock-based compensation in 2006.
The preparation of the financial statements in conformity with U.S. generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
On September 30, 2005, AFG acquired the multi-peril crop insurance and the crop hail insurance business written through Farmers Crop Insurance Alliance, Inc. for $17.5 million in cash. AFG will pay additional amounts of up to 10% of annual premiums through September 2008 based on certain customer retention criteria. Approximately $16.5 million of the initial Farmers Crop purchase price was recorded as intangible renewal rights and is being amortized over an estimated retention period of four years on a straight-line basis. Additional payments totaling $19.4 million and $848,000 were made in 2007 and 2006, respectively; any future payments (not expected to exceed $1 million) based on customer retention will also be recorded as intangible renewal rights. This business generated gross written premiums of approximately $200 million in 2007 and 2006.
To achieve a desired balance between fixed and variable rate debt, AAG Holding has entered into interest rate swaps that effectively convert its 6-7/8% fixed rate Senior Notes to a floating rate of 3-month LIBOR plus 2.9%. In connection with the 2006 debt repurchases discussed above, AAG Holding paid an additional $2 million to effectively terminate the portion of the interest rate swaps that covered the repurchased debt.
Establishing property and casualty insurance reserves for claims related to environmental exposures, asbestos and other mass tort claims is subject to uncertainties that are significantly greater than those presented by other types of claims. In addition, accruals (included in other liabilities) have been recorded for various environmental and occupational injury and disease claims and other contingencies arising out of the railroad operations disposed of by American Premier's predecessor, Penn Central Transportation Company ("PCTC"), prior to its bankruptcy reorganization in 1978 and certain manufacturing operations disposed of by American Premier and GAFRI. During 2007, AFG completed a comprehensive study of these exposures with the assistance of outside actuarial and engineering firms and specialty outside counsel. As a result of the study, the following pretax charges were recorded in the second quarter of 2007 (in millions):