Reserves for future policy benefits related to AFG’s closed block of long-term care insurance are established (and related acquisition costs are amortized) over the life of the policies based on policy benefit assumptions as of the date of issuance, including investment yields, mortality, morbidity, persistency, and expenses. Once these assumptions are established for a given policy or group of policies, they are not changed over the life of the policy unless a loss recognition event (premium deficiency) occurs. Loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums, including reasonably expected rate increases, are not expected to cover the present value of future claims payments and related settlement and maintenance costs as well as unamortized acquisition costs. AFG recorded a loss recognition charge in its long-term care business in the fourth quarter of 2012. As a result of this charge, all remaining unamortized acquisition costs in the long-term care business were written off and policy benefit assumptions were reset to 2012 assumptions, resulting in an increase to the reserve for future policy benefits. These assumptions will not be changed again unless a future loss recognition event occurs. Although no additional loss recognition occurred in 2013, adverse changes in any of the current policy benefit assumptions could result in a future loss recognition event and additional charges to earnings.
An in-depth internal review of AFG’s A&E reserves was completed in the third quarter of 2012 by AFG’s internal A&E claims specialists and actuaries in consultation with specialty outside counsel and an outside consultant. As a result of the review, AFG recorded a $31 million pretax special charge to increase the property and casualty segment’s asbestos reserves by $19 million (net of reinsurance) and its environmental reserves by $12 million (net of reinsurance). The charge relates primarily to an increase in environmental investigative costs and related loss adjustment expenses.
AFG’s combined ratio has been better than the industry average for 26 of the last 28 years. Management believes that AFG’s insurance operations have performed better than the industry as a result of its specialty niche focus, product line diversification, stringent underwriting discipline and alignment of compensation incentives.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums increased 4.3 percentage points for the fourth quarter of 2013 compared to the fourth quarter of 2012 reflecting higher profitability-based commissions paid to agents/brokers.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) for the fourth quarter of 2013 was $16 million compared to $17 million for the fourth quarter of 2012, a decrease of $1 million (6%). In addition to interest credited to policyholders’ accounts, annuity benefits expense also includes the following expenses (in millions, net of guaranteed withdrawal benefit fees):
The Specialty insurance operations generated an underwriting profit of $131 million in 2012 compared to $231 million in 2011, a decrease of $100 million (43%). The decline in 2012 was due primarily to lower profitability in the crop insurance business as a result of the Midwest drought and lower favorable reserve development in several of the Specialty casualty businesses. Overall catastrophe losses were $46 million, including $9 million of reinstatement premiums (1.3 points) in 2012 compared to $43 million (1.6 points) in 2011.
Underwriting profit was $44 million in 2012 compared to $65 million in 2011, a decrease of $21 million (32%). Lower profitability in the financial institutions, surety and foreign credit businesses contributed to these results.
AFG's Specialty property and casualty operations recorded net favorable reserve development related to prior accident years of $74 million in 2012 compared to $120 million in 2011, a decrease of $46 million (38%).
Commissions and other underwriting expenses as a percentage of net earned premiums increased 1.8 percentage points in 2012 compared to 2011 due to lower profitability-based commissions received from reinsurers partially offset by lower profitability-based commissions paid to agents/brokers, particularly in the crop operations.
Annuity policy charges and other miscellaneous income, which consist primarily of surrender charges, in 2013 was $42 million compared to $38 million in 2012, an increase of $4 million (11%). The increase reflects $4 million in income from the sale of real estate recorded in 2013.
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the Company) as of December 31, 2013 and 2012, and the related consolidated statements of earnings, comprehensive income, changes in equity and cash flows for each of the three years in the period ended December 31, 2013. 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.
Includes holding company expenses, special charges to increase A&E reserves ($22 million in 2013, $2 million in 2012 and $9 million in 2011) and losses of managed investment entities attributable to noncontrolling interests ($26 million in 2013, $98 million in 2012 and $24 million in 2011). Holding company expenses in 2012 also include an $8 million loss on retirement of debt and a $15 million charge for a labor matter related to AFG’s former railroad operations.
AFG has $400 million notional amount of pay-fixed interest rate swaptions (options to enter into pay-fixed/receive floating interest rate swaps at future dates expiring between 2014 and 2015) outstanding at December 31, 2013, which are used to mitigate interest rate risk in its annuity operations. AFG paid $11 million to purchase these swaptions, which represents its maximum potential economic loss over the life of the contracts.
The following table summarizes the gain (loss) included in the Statement of Earnings for changes in the fair value of these derivatives for 2013, 2012 and 2011 (in millions):
At December 31, 2013, scheduled principal payments on debt for the subsequent five years were as follows: 2014 - $2 million; 2015 - $14 million; 2016 - $45 million; 2017 - $12 million and 2018 - none.
AFG issued 88,602 shares of Common Stock (fair value of $47.12 per share) in the first quarter of 2013 and 111,270 shares (fair value of $38.38 per share) in the first quarter of 2012 under its Equity Bonus Plan.
The following is a reconciliation of income taxes at the statutory rate of 35% to the provision for income taxes as shown in the Statement of Earnings (in millions):
Securities owned by U.S.-based insurance subsidiaries having a carrying value of approximately $1.10 billion at December 31, 2013, were on deposit as required by regulatory authorities. At December 31, 2013, AFG and its subsidiaries had $189 million in undrawn letters of credit ($16 million of which was collateralized) supporting the underwriting capacity of its U.K.-based Lloyd’s insurer.
Losses and loss adjustment expenses included charges for possible losses on reinsurance recoverables of $1 million in 2013 and less than $1 million in 2012 and 2011. The aggregate allowance for losses on reinsurance recoverables amounted to approximately $27 million and $26 million at December 31, 2013 and 2012, respectively.
Benefit Plans AFG expensed approximately $32 million in 2013, $27 million in 2012 and $26 million in 2011 for its retirement and employee savings plans.