lower net realized gains on securities in the fourth quarter of 2017 compared to the fourth quarter of 2016,
The NAIC’s model law for risk based capital (“RBC”) applies to both life and property and casualty companies. RBC formulas determine the amount of capital that an insurance company needs so that it has an acceptable expectation of not becoming financially impaired. At December 31, 2017, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements.
Parent Net Cash Provided by Operating Activities Parent holding company cash flows from operating activities consist primarily of dividends and tax payments received from AFG’s insurance subsidiaries, reduced by tax payments to the IRS and holding company interest and other expenses. Parent holding company net cash provided by operating activities was $578 million in 2017 compared to $555 million in 2016 and $162 million in 2015. The $23 million increase in net cash provided by operating activities in 2017 as compared to 2016 was due to lower taxes paid, partially offset by lower dividends received from subsidiaries for those comparable periods. Higher dividends received from subsidiaries in 2016 as compared to 2015 were the primary driver of the $393 million increase in net cash provided by operating activities.
AFG recorded favorable prior year reserve development of $5 million in 2017, $24 million in 2016 and $12 million in 2015 on its D&O business as claim severity was less than expected across several prior accident years.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $32 million and $29 million in 2017 and 2016, respectively, in distributions recorded as interest expense by the CLOs.
pretax earnings also reflects favorable development in the fourth quarter of 2017 in the Neon exited lines in connection with a reinsurance to close transaction.
Catastrophe losses of $8 million in the fourth quarter of 2017 resulted primarily from wildfires in California, partially offset by favorable development related to third quarter 2017 catastrophe losses, specifically Hurricanes Harvey, Irma and Maria, and two earthquakes in Mexico. Catastrophe losses of $12 million in the fourth quarter of 2016 resulted primarily from Hurricane Matthew.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums decreased 0.5 percentage points in the fourth quarter of 2017 compared to the fourth quarter of 2016 reflecting lower profitability-based commissions paid to agents in the financial institutions business.
AFG’s fixed-indexed annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market or other financial index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG’s strategy is designed so that the change in the fair value of the call option assets will generally offset the economic change in the liabilities from the index participation. Both the index-based component of the annuities (an embedded derivative) and the related call options are considered derivatives that must be adjusted for changes in fair value through earnings each period. The fair values of these derivatives are impacted by actual and expected stock market performance and interest rates as well as other factors. For a list of other factors impacting the fair value of the index-based component (embedded derivative) of AFG’s annuity benefits accumulated, see Note D - “Fair Value Measurements” to the financial statements. In addition, the change in the fair value of the embedded derivative includes interest accreted on the FIA embedded derivative reserve of $5 million in the fourth quarter of 2017 and $2 million in the fourth quarter of 2016 (before the related impact on the amortization of deferred sales inducements and deferred policy acquisition costs).
The following table details AFG’s GAAP and core loss before income taxes from operations outside of its insurance operations for the three months ended December 31, 2017 and 2016 (dollars in millions):
Property and Casualty Insurance Segment - Results of Operations AFG’s property and casualty insurance operations contributed $591 million in GAAP pretax earnings in 2017 compared to $577 million in 2016, an increase of $14 million (2%). Property and casualty core pretax earnings were $662 million in 2017 compared to $646 million in 2016, an increase of $16 million (2%). The increase in GAAP and core pretax earnings reflects higher underwriting profit in the Specialty casualty group, higher net investment income and lower other expenses, partially offset by lower underwriting profit in the Property and transportation and Specialty financial groups. The increase in GAAP pretax earnings also reflects the impact of a pretax non-core charge of $65 million in the second quarter of 2016 related to the exit of certain lines of business within Neon and favorable development of $18 million in the fourth quarter of 2017 in the Neon exited lines in connection with a reinsurance to
Property and transportation Underwriting profit for this group was $154 million in 2017 compared to $166 million in 2016, a decrease of $12 million (7%). Lower underwriting profits in the crop and ocean marine businesses were the primary drivers of these lower results, partially offset by higher underwriting profit in the transportation businesses. The crop insurance operations reported strong underwriting profitability in 2017, albeit at lower levels than in 2016. Catastrophe losses were $36 million (2.1 points on the combined ratio) and related reinstatement premiums were $2 million in 2017 compared to catastrophe losses of $31 million (1.9 points) in 2016.
Property and transportation The 2.4 percentage points increase in the loss and LAE ratio for the current year, excluding catastrophe losses reflects an increase in the loss and LAE ratio of the crop and property and inland marine businesses and the Singapore branch in 2017 compared to 2016.
The 2.8 percentage point increase in the loss and LAE ratio for the current year, excluding catastrophe losses in 2016 compared to 2015 reflects an increase in current accident year trade credit losses in Neon’s political risk and trade credit business and an increase in the loss and LAE ratio of the targeted markets, general liability and excess and surplus businesses.
AFG’s Specialty property and casualty insurance operations recorded net favorable reserve development related to prior accident years of $139 million in 2017 compared to $61 million in 2016 and $37 million in 2015, an increase of $78 million (128%) and $24 million (65%), respectively.
Net adverse reserve development of $15 million in 2015 reflects higher than expected claim severity at National Interstate and higher than anticipated claim frequency in the ocean marine business, partially offset by lower than expected claim severity in the property and inland marine business, agricultural operations and a run-off book of homebuilders business.
Management attributes the 7% increase in annuity premiums in 2016 compared to 2015 to growth in the annuity industry, and new products, additional staffing, and increased market share within existing financial institutions. This growth slowed in the
AFG’s management, with participation of its Co-Chief Executive Officers and its Chief Financial Officer, has evaluated AFG’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG’s Co-CEOs and CFO concluded that the controls and procedures are effective. There have been no changes in AFG’s internal control over financial reporting during the fourth fiscal quarter of 2017 that materially affected, or are reasonably likely to materially affect, AFG’s internal control over financial reporting.
Based on AFG’s evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2017. The attestation report of AFG’s independent registered public accounting firm on AFG’s internal control over financial reporting as of December 31, 2017, is set forth on the next page.
At December 31, 2017, the gross unrealized losses on fixed maturities of $82 million relate to 841 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 78% of the gross unrealized loss and 90% of the fair value.
Derivative Designated and Qualifying as a Fair Value Hedge In June 2015, AFG entered into an interest rate swap to mitigate the interest rate risk associated with its fixed-rate 9-7/8% Senior Notes due June 2019 by effectively converting the interest rate on those notes to a floating rate of three-month LIBOR plus 8.099%. In connection with redemption of the 9-7/8% Senior Notes in December 2017, AFG paid the counterparty $1 million to settle the interest rate swap.
In December 2017, the Neon Lloyd’s syndicate entered into a reinsurance to close transaction for the 2015 and prior years of account with StarStone Underwriting Limited, a subsidiary of Enstar Group Limited, which will be effective as of December 31, 2017. In the Lloyd’s market, a reinsurance to close transaction transfers the responsibility for discharging all of the liabilities that attach to the transferred year of account plus the right to any income due to the closing year of account in return for a premium. This transaction provides Neon with finality on its legacy business. As a result of the reinsurance to close agreement, Neon was able to better estimate its ultimate liability for the 2015 and prior years of account resulting in favorable development of $42 million, of which $24 million related to its ongoing lines of business (included in Specialty casualty) and $18 million related to its exited lines of business (discussed below and included in Neon exited lines charge). In November 2016, the Neon Lloyd’s syndicate completed a similar reinsurance to close transaction with StarStone, which covered liabilities relating to the syndicate’s 2007 and prior years of account. That transaction also included a quota share of the Italian public hospital business written in Neon’s 2008 year of account and represented Neon’s complete exit from the Italian public hospital medical malpractice business.
2015 Stock Incentive Plan filed as Exhibit 10(g) to AFG’s Form 10-K for 2015.