Subsidiaries of AFG own several buildings in downtown Cincinnati. AFG and its affiliates occupy about half of the aggregate 680,000 square feet of commercial and office space in these buildings.
The ratio of earnings to fixed charges excluding annuity benefits was 9.09, 11.06, 4.75, 8.49 and 9.15 for 2010, 2009, 2008, 2007 and 2006, respectively. Although the ratio of earnings to fixed charges excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, some investors and lenders may not consider interest credited to annuity policyholders’ accounts a borrowing cost for an insurance company, and accordingly, believe this ratio is meaningful.
At December 31, 2010, AFG (parent) held approximately $410 million in cash and securities and had $500 million available under a bank line of credit expiring in August 2013.
The property and casualty business is cyclical in nature with periods of high competition resulting in low premium rates, sometimes referred to as a “soft market” or “downcycle” followed by periods of reduced competition and higher premium rates, referred to as a “hard market” or “upcycle.” For the past several years, AFG’s Specialty insurance operations have experienced soft market conditions. Overall renewal pricing was flat in 2010 and 2009, after being down about 4% in both 2008 and 2007.
See “Liquidity and Capital Resources - Uncertainties” for a discussion of insurance reserves, recoverables from reinsurers, and contingencies related to American Premier’s former operations and “Liquidity and Capital Resources - Investments” for a discussion of impairments on investments. Deferred policy acquisition costs (“DPAC”) and certain liabilities related to annuities and universal life insurance products are amortized in relation to the present value of expected gross profits on the policies. Assumptions considered in determining expected gross profits involve significant judgment and include management’s estimates of assumed interest rates and investment spreads, surrenders, annuitizations, renewal premiums and mortality. Should actual experience require management to change its assumptions (commonly referred to as “unlocking”), a charge or credit would be recorded to adjust DPAC or annuity liabilities to the levels they would have been if the new assumptions had been used from the inception date of each policy.
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, 2010, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements.
During 2010, AFG repurchased 10.3 million shares of its Common Stock for $292 million. Through February 18, 2011, an additional 614,000 shares were repurchased for $21 million, using cash on hand at the parent company.
During 2009, AFG retired $136 million of 7-1/8% Senior Debentures at maturity, issued $350 million of 9-7/8% Senior Notes due 2019 and repurchased 3.3 million shares of its Common Stock for $81 million.
In 2008, GAFRI used cash on hand to redeem its $28 million in 6-7/8% notes at maturity. In 2008, NATL redeemed its $15 million in outstanding variable rate debentures at par.
For statutory accounting purposes, equity securities of non-affiliates are generally carried at fair value. At December 31, 2010, AFG’s insurance companies owned publicly traded equity securities with a fair value of $659 million. In addition, GAI’s investment in NATL common stock had a fair value of $218 million and a statutory carrying value of $173 million at December 31, 2010. Decreases in market prices could adversely affect the insurance group’s capital, potentially impacting the amount of dividends available or necessitating a capital contribution. Conversely, increases in market prices could have a favorable impact on the group’s dividend-paying capability.
Dollar amounts and time periods are estimates based on historical net payment patterns applied to the gross reserves and do not represent actual contractual obligations. Based on the same assumptions, AFG projects reinsurance recoveries related to these reserves totaling $2.2 billion as follows: Within 1 year - $600 million; 2-3 years - $700 million; 4-5 years - $400 million; and thereafter - $549 million. Actual payments and their timing could differ significantly from these estimates.
Off-Balance Sheet Arrangements See Note P - “Additional Information - Financial Instruments with Off-Balance Sheet Risk” to the financial statements.
AFG’s investment portfolio at December 31, 2010, contained $19.3 billion in “Fixed maturities” classified as available for sale and $690 million in “Equity securities”, all carried at fair value with unrealized gains and losses included in a separate component of shareholders’ equity on an after-tax basis. In addition, $393 million in fixed maturities were classified as trading with changes in unrealized holding gains or losses included in investment income.
As detailed under “Net Unrealized Gain on Marketable Securities” in Note E to the financial statements, unrealized gains and losses on AFG’s fixed maturity and equity securities are included in Shareholders’ Equity after adjustments for related changes in deferred policy acquisition costs and certain liabilities related to annuities, noncontrolling interests and deferred income taxes. DPAC applicable to annuity products is adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding increases or decreases (net of tax) included in accumulated other comprehensive income in AFG’s Balance Sheet.
Fair values for AFG’s portfolio are determined by AFG’s internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on closing prices obtained from the pricing services. For mortgage-backed securities (“MBS”), which comprise approximately one-third of AFG’s fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the other two-thirds of AFG’s fixed maturity portfolio, approximately 94% are priced using pricing services and the balance is priced internally or by using non-binding broker quotes. When prices obtained for the same security vary, AFG’s internal investment professionals select the price they believe is most indicative of an exit price.
In general, the fair value of AFG’s fixed maturity investments is inversely correlated to changes in interest rates. The following table demonstrates the sensitivity of such fair values to reasonably likely changes in interest rates by illustrating the estimated effect on AFG’s fixed maturity portfolio that an immediate increase of 100 basis points in the interest rate yield curve would have at December 31, 2010 (dollars in millions). Increases or decreases from the 100 basis points illustrated would be approximately proportional.
Approximately 91% of the fixed maturities held by AFG at December 31, 2010, were rated “investment grade” (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and noninvestment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return.
Summarized information for AFG’s MBS (including those classified as trading) at December 31, 2010, is shown (in millions) in the table below. Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The majority of the Alt-A securities and substantially all of the subprime securities are backed by fixed rate mortgages. The average life of the residential and commercial MBS is approximately 4 and 5 years, respectively.
The National Association of Insurance Commissioners (“NAIC”) assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC has retained third-party investment management firms to assist in the determination of appropriate NAIC designations for mortgage-backed securities based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At December 31, 2010, 98% (based on statutory carrying value of $5.7 billion) of AFG’s MBS securities had an NAIC designation of 1 or 2.
The table below sets forth the scheduled maturities of AFG’s available for sale fixed maturity securities at December 31, 2010, based on their fair values. Asset- backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Based on its analysis of the factors listed above, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability to hold the securities until they recover in value and, at December 31, 2010, had no intent to sell them. Although AFG has the ability to continue holding its investments with unrealized losses, its intent may change due to deterioration in the issuers’ creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG’s ability or intent change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG’s investment portfolio could have a significant adverse effect on AFG’s liquidity. For information on AFG’s realized gains (losses) on securities, including charges for “other-than-temporary” impairment, see Management’s Discussion and Analysis - “Results of Operations - Realized Gains (Losses) on Securities.”
The estimates of liabilities for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon: (a) the accumulation of case estimates for losses reported prior to the close of the accounting periods on direct business written (“case reserves”); (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of claims incurred but not reported or “IBNR” (including possible development on known claims); (d) estimates (based on experience) of expense for investigating and adjusting claims; and (e) the current state of law and coverage litigation.
In determining management’s best estimate of the ultimate liability, management (including Company actuaries) considers items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, the nature and maturity of lines of insurance, general economic trends and the legal environment. In addition, historical trends adjusted for changes in underwriting standards, policy provisions, product mix and other factors are analyzed using actuarial reserve development techniques. Weighing all of the factors, the management team determines a single or “point” estimate that it records as its best estimate of the ultimate liabilities. Ranges of loss reserves are not developed by Company actuaries. This reserve analysis and review is completed each quarter and for every line of business.
The period of time from the occurrence of a loss through the settlement of the liability is referred to as the “tail”. Generally, the same actuarial methods are considered for both short-tail and long-tail lines of business because most of them work properly for both. The methods are designed to incorporate the effects of the differing length of time to settle particular claims. For short-tail lines, management tends to give more weight to the Case Incurred and Paid Development methods, although the various methods tend to produce similar results. For long-tail lines, more judgment is involved, and more weight may be given to the Bornhuetter-Ferguson method and the Projected Claim Count times Projected Claim Severity method. Liability claims for long-tail lines are more susceptible to litigation and can be significantly affected by changing contract interpretation and the legal environment. Therefore, the estimation of loss reserves for these classes is more complex and subject to a higher degree of variability.
The estimated cumulative impact that a 1% change in cost trends would have on net earnings is shown below (in millions).
The judgments and uncertainties surrounding management’s reserve estimation process and the potential for reasonably possible variability in management’s most recent reserve estimates may also be viewed by looking at how recent historical estimates of reserves have developed. The following table shows (in millions) what the impact on AFG’s net earnings would be on the more significant lines of business if the December 31, 2010, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
AFG recorded favorable development of $108 million in 2010, $55 million in 2009 and $72 million in 2008 related to its other liability-occurrence coverage where both the frequency and severity of claims were lower than previously projected.
Uncertainty has emerged regarding AFG’s potential exposure for claims arising from the use of Chinese drywall. The potential exposure arises from insured policyholders who may have been associated with the installation of Chinese drywall in residential construction. While potential liability is uncertain and is subject to judicial decisions including interpretation of coverage provisions, management believes that AFG’s reserves for claims arising from the use of Chinese drywall are adequate.
The general state of the economy and the variability of the stock price of the insured can affect the frequency and severity of shareholder class action suits that trigger coverage under directors’ and officers’ liability policies.
This line of business is a mix of coverage protecting the insured against legal liability for property damage or personal injury to others arising from the operation of commercial motor vehicles. The property damage liability exposure is usually short-tail with relatively quick reporting and settlement of claims. The bodily injury and medical payments exposures are longer-tailed; although the claim reporting is relatively quick, the final settlement can take longer to achieve.
Some of the important variables affecting estimation of loss reserves for commercial auto/truck liability/medical are similar to other liability - occurrence and include:
Trends in claim costs, including medical cost inflation and, in Italy, escalating tables used to establish damages for personal injury
Marketform recorded adverse prior year reserve development of $55 million in 2010 and $56 million in 2009 related primarily to its Italian public hospital medical malpractice business, which it ceased writing in 2008. The development resulted from significant issues related to third party administration of claims and a challenging legal environment in Italy. Management believes that current reserves, which represent its best estimate of future liabilities, are adequate. Nonetheless, it concluded that sufficient uncertainty exists with respect to Italian public hospital medical malpractice reserves to leave open the 2007 year of account, in accordance with Lloyd’s provisions until a larger percentage of claims have been paid and the ultimate liabilities can be estimated with greater certainty.
Contingencies related to Subsidiaries’ Former Operations The A&E studies and reviews discussed above encompassed reserves 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 and certain manufacturing operations disposed of by American Premier and its subsidiaries and by GAFRI. Charges resulting from the A&E studies and review were less than $10 million in 2010, 2009 and 2008. Liabilities for claims and contingencies arising from these former operations totaled $97 million at December 31, 2010. For a discussion of the uncertainties in determining the ultimate liability, see Note M - “Contingencies” to the financial statements.
Includes $17 million in realized gains representing the change in fair value of AFG’s CLO investments plus $15 million in CLO management fees earned.
General AFG’s net earnings attributable to shareholders, determined in accordance with GAAP, include certain items that may not be indicative of its ongoing core operations. The following table identifies such items and reconciles net earnings attributable to shareholders to core net operating earnings, a non-GAAP financial measure that AFG believes is a useful tool for investors and analysts in analyzing ongoing operating trends (in millions, except per share amounts):
Property and Casualty Insurance - Underwriting AFG reports its Specialty insurance business in the following sub-segments: (i) Property and transportation, (ii) Specialty casualty and (iii) Specialty financial.
To understand the overall profitability of particular lines, the timing of claims payments and the related impact of investment income must be considered. Certain “short-tail” lines of business (primarily property coverages) generally have quick loss payouts, which reduce the time funds are held, thereby limiting investment income earned thereon. On the other hand, “long-tail” lines of business (primarily liability coverages and workers’ compensation) generally have payouts that are either structured over many years or take many years to settle, thereby significantly increasing investment income earned on related premiums received.
The Specialty insurance operations generated an underwriting profit of $308 million in 2010, $116 million lower than in 2009. In addition to soft market conditions, the reduced profit in 2010 compared to 2009 reflects a $35 million decrease in favorable prior year reserve development and a $31 million increase in catastrophe losses. Results for 2010 include $170 million (6.7 points on the combined ratio) of favorable reserve development compared to $205 million (8.5 points) in 2009. Catastrophe losses totaled $49 million (1.9 points) in 2010 compared to $18 million (.7 points) in 2009.
In June 2010, the United States Department of Agriculture’s Risk Management Agency released the 2011 Standard Reinsurance Agreement (“SRA”), which governs the FCIC’s reinsurance agreements with insurers such as AFG. The revised SRA reduces flexibility in managing underwriting risks, limits potential underwriting gains, and lowers administrative and operating expense reimbursements to crop insurers. Assuming similar premium levels to 2010, management believes that the impact of the SRA will reduce AFG’s annual pretax operating income by approximately $20 million beginning in 2011.
Gross written premiums decreased in 2009 compared to 2008, primarily due to the impact of lower automobile sales on automotive-related lines of business. The decrease in net written premiums also reflects the decision to exit certain automotive-related lines of business. Premium growth in the financial institutions and fidelity and crime businesses partially offset these declines. This group reported an underwriting profit of $134 million in 2009, compared to an underwriting loss of $46 million in the comparable 2008 period. The run-off RVI operations reported an underwriting profit of $94 million in 2009 compared to an underwriting loss of $106 million in 2008, due to significant improvement in used car sale prices during the year. This group reported a combined ratio of 74.1%, a 35.1 point improvement over the 2008 period. Excluding the effect of RVI, the group’s 2009 combined ratio was 91.8%, 5.0 points higher than in 2008 due primarily to losses in certain automotive-related lines.
Favorable reserve development in the Specialty casualty group in 2010 is due to lower than expected severity on claims in general liability, directors and officers liability and the run-off legal professional liability partially offset by adverse development on run-off Italian public hospital medical malpractice liability products in Marketform. Favorable reserve development in the Specialty casualty group in 2009 reflects lower severity on claims in general liability and directors and officers liability as well as lower than expected frequency in the program (leisure camps, fairs and festivals, and sports and leisure) business; partially offset by adverse development on Marketform’s run-off Italian medical malpractice reserves. The favorable reserve development in Specialty casualty in 2008 reflects lower severity on claims in the nursing home liability product, general liability, homebuilders and executive liability for large accounts, lower than expected frequency in homebuilders, executive liability for small accounts and the program (leisure camps, fairs and festivals, and sports and leisure) business and lower than expected claim severity and frequency on claims in the California workers’ compensation business as a result of reform legislation passed in 2003 and 2004.
Annuity and Supplemental Insurance Operations Operating earnings before income taxes (excluding realized gains (losses)) of the annuity and supplemental insurance segment increased $34 million (21%) in 2010 compared to 2009. Expense savings and higher earnings in the fixed annuity and supplemental insurance operations were partially offset by lower earnings in the variable annuity operations. The 2009 results were 3% higher than 2008 as improved profitability in the annuity operations more than offset lower earnings in the supplemental insurance operations.
The decrease in annuity premiums in 2009 compared to 2008 is attributable to (i) the impact of the economy and new regulations on 403(b) business, (ii) the impact of lower interest rates and (iii) AFG’s pricing discipline across its annuity business.
The increase in life, accident and health benefits in 2009 compared to 2008 reflects higher claim reserves and liabilities in the long-term care business, as well as growth in the overall supplemental insurance business. In January 2010, AFG ceased new sales of long-term care insurance. Renewal premiums will be accepted unless those policies lapse.
Since January 1, 2009, the amortized cost of AFG’s portfolio of non-agency residential MBS decreased $750 million due primarily to paydowns. As these securities paid down, proceeds were reinvested principally in high quality corporate bonds, highly rated commercial mortgage-backed securities, municipal bonds and dividend-paying stocks, placing downward pressure on AFG’s investment portfolio yield. Management estimates that 2011 investment income in AFG’s property and casualty segment will be approximately 10% lower than in 2010. Given the growth expected in 2011 in the annuity and supplemental insurance business, this segment’s investment income is expected to exceed that of 2010.
Realized Gains (Losses) on Securities Realized gains (losses) on securities consisted of the following (in millions):
Realized gains on disposals for 2010 include a third quarter gain of approximately $26 million on the sale of 1 million shares of Verisk Analytics, Inc. Realized gains on disposals for 2009 include a fourth quarter gain of approximately $76 million on the sale of 3.6 million shares of Verisk. Realized losses on disposals for 2008 includes third quarter losses of $80 million on the sales of securities issued by Fannie Mae, Freddie Mac, Washington Mutual, Lehman Brothers and AIG.
The change in fair value of derivatives includes gains of $50 million in 2010, $157 million in 2009 and $81 million in 2008 from the mark-to-market of MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. See Note F - “Derivatives.”
Approximately $79 million, $221 million and $246 million of the impairment charges in 2010, 2009 and 2008, respectively, related to fixed maturity investments, primarily corporate bonds and MBS. See Note A - “Accounting Policies - Investments” for new accounting guidance adopted in 2009. In 2008, $199 million of the impairment charges were attributable to equity investments, primarily in financial institutions, including $47 million for National City Corporation.
Realized Losses on Subsidiaries In the third quarter of 2010, AFG recorded an impairment charge of $22 million resulting from management’s decision to de-emphasize the sale of supplemental health insurance products through career agents, including the sale of a marketing subsidiary. Partially offsetting this loss was National Interstate’s $7 million gain on the acquisition of Vanliner in 2010. See Note I - “Goodwill and Other Intangibles” and Note B - “Acquisitions.” In the third quarter of 2009, AFG recorded an estimated pretax loss of $2 million related to the October 2009 sale of a subsidiary that represented less than 1% of AFG’s 2009 assets and revenues. Realized losses on subsidiaries for 2009 also includes a $2 million impairment charge to write off the goodwill associated with an annuity and supplemental insurance agency subsidiary.
Annuity Benefits Annuity benefits reflect amounts accrued on annuity policyholders’ funds accumulated. On deferred annuities (annuities in the accumulation phase), interest is generally credited to policyholders’ accounts at their current stated interest rates. Furthermore, for “two-tier” deferred annuities (annuities under which a higher interest amount can be earned if a policy is annuitized rather than surrendered), additional reserves are accrued for (i) persistency and premium bonuses and (ii) excess benefits expected to be paid for future deaths and annuitizations. Changes in investment yields, crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect these additional reserves and could result in charges (or credits) to earnings in the period the projections are modified.
In the fourth quarters of 2010, 2009 and 2008, AFG conducted its detailed review of actual results and future assumptions underlying its annuity operations. As a result of the reviews, AFG recorded a $3 million expense reduction in 2010 and charges of $5 million in 2009 and $19 million in 2008 to annuity benefits related to changes in these assumptions. Excluding these items, annuity benefits increased $17 million in 2010 compared to 2009 reflecting growth in the annuity business partially offset by lower crediting rates and the impact of changes in interest rates and stock market performance on the fair value of derivatives related to the indexed annuity business. The $31 million increase in annuity benefits for 2009 compared to 2008 (excluding the charges discussed above) reflects growth in the annuity business as well as the impact of changes in interest rates on the fair value of the embedded derivatives related to the indexed annuity business.
Interest Charges on Borrowed Money Interest expense increased $11 million (16%) in 2010 compared to 2009 reflecting AFG’s issuance of $132 million of 7% Senior Notes in September 2010 and $350 million of 9-7/8% Senior Notes in June 2009. Interest expense decreased $3 million (4%) for 2009 compared to 2008 as the impact of the June 2009 issuance of $350 million in 9-7/8% Senior Notes was more than offset by the effect of lower average indebtedness and lower interest rates on floating rate borrowings.
Noncontrolling Interests The following table details net earnings (loss) in consolidated subsidiaries attributable to holders other than AFG (in millions):
National Interstate’s net earnings attributable to noncontrolling shareholders in 2008 reflects net realized losses from investments and large loss severity related to its charter passenger transportation business. Marketform’s losses in 2010 and 2009 reflect adverse reserve development in its run-off Italian public hospital medical malpractice business. As discussed in Notes A and H to the financial statements, the $64 million loss of Managed Investment Entities in 2010 represents CLO losses that ultimately inure to holders of CLO debt other than AFG.
AFG’s management, with participation of its Co-Chief Executive Officers and its principal 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 principal financial officer concluded that these controls and procedures are effective. There have been no changes in AFG’s internal control over financial reporting during the fourth fiscal quarter of 2010 that materially affected, or are reasonably likely to materially affect, AFG’s internal control over financial reporting. There have been no significant changes in AFG’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
In conducting AFG’s evaluation of the effectiveness of its internal control over financial reporting, AFG has not included Vanliner Group, Inc. which was acquired in 2010. This acquisition constituted less than 2% of total assets as of December 31, 2010 and less than 2% of total revenues and net earnings for the year then ended. Refer to Note B to the consolidated financial statements for further discussion of this acquisition.
As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of the Vanliner Group, Inc., which is included in the 2010 consolidated financial statements of American Financial Group, Inc. and constituted less that 2% of total assets as of December 31, 2010, and less than 2% of total revenues and net earnings for the year then ended. Management did not assess the effectiveness of internal control over financial reporting at this entity because the Company acquired this entity during 2010. Our audit of internal control over financial reporting of American Financial Group, Inc. and subsidiaries also did not include an evaluation of the internal control over financial reporting of this acquired entity.
In our opinion, American Financial Group, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Financial Group, Inc. and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of earnings, changes in equity and cash flows for each of the three years in the period ended December 31, 2010, and our report dated February 28, 2011, expressed an unqualified opinion thereon.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Financial Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2011, expressed an unqualified opinion thereon.
New accounting guidance adopted by AFG on January 1, 2010, requires additional disclosures about transfers between levels in the hierarchy of fair value measurements. The guidance also clarifies existing disclosure requirements related to the level of disaggregation presented and inputs used in determining fair values. Additional detail relating to the roll-forward of Level 3 fair values will be required beginning in 2011.
Reinsurance Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG’s property and casualty insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers as well as ceded premiums retained by AFG’s property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG’s insurance subsidiaries also assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues.
DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of accumulated other comprehensive income (loss) in AFG’s Balance Sheet.
At December 31, 2009, AFG’s investments in the CLOs were included in fixed maturity securities and had a cost of less than $1 million and a fair value of $6 million. Beginning January 1, 2010, these investments are eliminated in consolidation.
Unpaid Losses and Loss Adjustment Expenses The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims; and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
Vanliner Group, Inc. (“Vanliner”) In July 2010, National Interstate (“NATL”), a 52%-owned subsidiary of AFG, completed the acquisition of Vanliner, a market leader in providing insurance for the moving and storage industry. Vanliner’s moving and storage insurance premiums associated with policies in force as of December 31, 2010, totaled approximately $90 million, representing approximately 78% of its total business. The $128 million initial purchase price (funded primarily with cash on hand) was based on Vanliner’s estimated tangible book value at the date of closing and is subject to certain adjustments, including a four and one-half-year balance sheet guarantee whereby both favorable and unfavorable developments related to the closing balance sheet inure to the seller, UniGroup, Inc. Adjustments subsequent to closing reduced the initial purchase price to $114 million. In accordance with accounting standards, all assets acquired and liabilities assumed were recognized at their fair values as of the acquisition date. The purchase price allocation based on these fair values resulted in a gain on purchase of $7 million (included in realized gains on subsidiaries). Pro forma results of operations for AFG assuming the acquisition of Vanliner had taken place at the beginning of 2010 would not differ significantly from actual reported results.
Includes holding company expenses and, in 2010, $32 million in earnings from managed investment entities attributable to AFG shareholders and $64 million in losses of managed investment entities attributable to noncontrolling interests.
Assets and liabilities measured at fair value at December 31 are summarized below (in millions):
During 2010, there were no significant transfers between Level 1 and Level 2. Approximately 4% of the total assets measured at fair value on December 31, 2010, were Level 3 assets. Approximately 38% of these assets were MBS whose fair values were determined primarily using non-binding broker quotes; the balance was primarily private placement debt securities whose fair values were determined internally using significant unobservable inputs, including the evaluation of underlying collateral and issuer creditworthiness, as well as certain Level 2 inputs such as comparable yields and multiples on similar publicly traded issues. The fair values of the liabilities of managed investment entities were determined using non-binding broker quotes, which were reviewed by AFG’s internal investment professionals.
Available for sale fixed maturities and equity securities at December 31 consisted of the following (in millions):
Gross Unrealized Losses on MBS At December 31, 2010, gross unrealized losses on AFG’s residential MBS represented 59% of the total gross unrealized loss on fixed maturity securities. Of the residential MBS that have been in an unrealized loss position (“impaired”) for 12 months or more (258 securities), approximately 40% of the unrealized losses and 47% of the fair value relate to investment grade rated securities. AFG analyzes its MBS for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. For 2010, AFG recorded in earnings $51 million and $2 million in other-than-temporary impairment charges related to its residential and commercial MBS, respectively.
Gross Unrealized Losses on All Other Corporates AFG recognized in earnings approximately $24 million in other-than-temporary impairment charges on “all other corporate” securities during 2010. Management concluded that no additional charges for other-than-temporary impairment were required based on many factors, including AFG’s ability and intent to hold the investments for a period of time sufficient to allow for anticipated recovery of its amortized cost, the length of time and the extent to which fair value has been below cost, analysis of historical and projected company-specific financial data, the outlook for industry sectors, and credit ratings.
There were no investments in individual issuers that exceeded 10% of Shareholders’ Equity at December 31, 2010 or 2009.
Net Unrealized Gain on Marketable Securities In addition to adjusting equity securities and fixed maturity securities classified as “available for sale” to fair value, GAAP requires that deferred policy acquisition costs related to annuities and certain other balance sheet amounts be adjusted to the extent that unrealized gains and losses from securities would result in adjustments to those balances had the unrealized gains or losses actually been realized. The following table shows the components of the net unrealized gain on securities that is included in accumulated other comprehensive income in AFG’s Balance Sheet.
Realized gains include net gains of $50 million in 2010, $157 million in 2009 and $81 million in 2008 from the mark-to-market of certain MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. Gross realized gains and losses (excluding impairment writedowns and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
The following table summarizes the gain (loss) included in the Statement of Earnings for changes in the fair value of these derivatives for 2010 and 2009 (in millions):
The PVFP amounts in the table above are net of $174 million and $148 million of accumulated amortization at December 31, 2010 and 2009, respectively. Amortization of the PVFP was $26 million in 2010, $29 million in 2009 and $30 million in 2008. During each of the next five years, the PVFP is expected to decrease at a rate of approximately one-sixth of the balance at the beginning of each respective year.
AFG’s maximum ultimate exposure to economic loss on its CLOs is limited to its investment in the CLOs, which had an aggregate fair value of $17 million at December 31, 2010.
The net loss from changes in the fair value of assets and liabilities of managed investment entities included in the Statement of Earnings for 2010 includes gains of $150 million from changes in the fair value of CLO assets and losses of $220 million from changes in the fair value of CLO liabilities. The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $69 million at December 31, 2010. The aggregate unpaid principal balance of the CLOs’ debt exceeded its fair value by $301 million at that date. The CLO assets include $6 million in loans (aggregate unpaid principal balance of $12 million) for which the CLOs are not accruing interest because the loans are in default.
In the third quarter of 2010, management decided to de-emphasize the sale of supplemental health insurance products through career agents, including the sale of a marketing subsidiary. As a result of this decision, AFG performed an interim impairment test of the goodwill associated with the reporting unit using an income valuation method based on discounted cash flows. Based on the results of this test, AFG recorded a goodwill impairment charge of $22 million (included in realized gains (losses) on subsidiaries) to write off all of the goodwill related to this reporting unit.
AFG recorded a goodwill impairment charge of $2 million (included in realized gains (losses) on subsidiaries) in the third quarter of 2009 to write off the goodwill associated with an annuity and supplemental insurance agency subsidiary. A review for impairment was prompted by a decrease in estimated future earnings from this agency. Fair value of the agency was estimated using the present value of expected future cash flows.
The total intrinsic value of options exercised during 2010, 2009 and 2008 was $19 million, $11 million and $14 million, respectively. During 2010, 2009 and 2008, AFG received $27 million, $10 million and $17 million, respectively, in cash from the exercise of stock options. The total tax benefit related to the exercises was $6 million, $4 million and $5 million, respectively.
The restricted Common Stock that AFG has granted generally vests over a three or four year period. The $6 million of unamortized expense related to these grants will be expensed over the weighted average of 3.2 years. Data relating to grants of restricted stock is presented below:
Total compensation expense related to stock incentive plans of AFG and its subsidiaries for 2010, 2009 and 2008 was $20 million, $13 million and $15 million (including $2 million in non-deductible stock awards), respectively. Related tax benefits totaled $6 million in 2010 and $3 million in both 2009 and 2008. As of December 31, 2010, there was a total of $20 million of total unrecognized compensation expense related to nonvested stock options granted under AFG’s plans. That cost is expected to be recognized over the weighted average of 2.9 years.
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2010 (in millions):
AFG’s net deferred tax liability at December 31, 2010, is included in other liabilities in AFG’s Balance Sheet; its net deferred tax asset at December 31, 2009, is included in other assets.
“Foreign underwriting losses” in the table above includes the net operating loss carryforward and other deferred tax assets related to the Marketform Lloyd’s insurance business, which resulted from underwriting losses in its run-off Italian public hospital medical malpractice business. These deferred tax assets can be carried forward indefinitely to offset future taxable income in the United Kingdom. At December 31, 2010, AFG determined that it was more likely than not that it will be able to utilize these losses based upon the historical and projected profitability of Marketform’s ongoing operations and the fact that the losses resulted from a business that has not been written since 2008.
The likelihood of realizing deferred tax assets is reviewed periodically; any adjustments required to the valuation allowance are made in the period during which developments requiring an adjustment become known.
In 2010, AFG increased its liability for uncertain tax positions by $16 million, exclusive of interest, to reflect uncertainty as to the timing of tax return inclusion of income related to certain securities. Because the ultimate recognition of income with respect to these securities is highly certain, the recording of this liability resulted in an offsetting reduction in AFG’s deferred tax liability. Accordingly, the ultimate resolution of this item will not impact AFG’s annual effective tax rate but could accelerate the payment of taxes.
The total unrecognized tax benefits and related interest that, if recognized, would impact the effective tax rate is $48 million at December 31, 2010. This amount does not include tax and interest totaling $17 million paid to the IRS in 2005 and 2006 for which a suit for refund has been filed (discussed below). AFG’s provision for income taxes included $2 million in both 2010 and 2009 and $3 million in 2008 of interest (net of federal benefit). AFG’s liability for interest related to unrecognized tax benefits was $12 million at December 31, 2010 and $10 million at December 31, 2009 (net of federal benefit); no penalties were accrued at those dates.
The insurance group’s liability for asbestos and environmental reserves was $416 million at December 31, 2010; related recoverables from reinsurers (net of allowances for doubtful accounts) at that date were $74 million.
At December 31, 2010, American Premier and its subsidiaries had liabilities for environmental and personal injury claims aggregating $90 million. The environmental claims consist of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs related to certain sites formerly owned or operated by the railroad and manufacturing operations. Remediation costs are difficult to estimate for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. The personal injury claims include pending and expected claims, primarily by former employees of PCTC, for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the workplace.
At December 31, 2010, GAFRI had a liability of approximately $7 million for environmental costs and certain other matters associated with the sales of its former manufacturing operations.
Realized gains (losses) on securities in 2009 include pretax charges of $76 million for other-than-temporary impairments on securities in the first quarter and a pretax gain of $76 million from the sale of shares of Verisk in the fourth quarter. Prior year development in 2009 includes favorable development of $39 million, $31 million and $21 million in the second, third and fourth quarters, respectively, related to the run-off residual value insurance operations and $48 million of unfavorable development in the fourth quarter related to Marketform’s run-off Italian public hospital medical malpractice business.
The following table provides an analysis of changes in the liability for losses and loss adjustment expenses, net of reinsurance (and grossed up), over the past three years (in millions). Favorable development in 2010 was primarily in the Specialty casualty and Specialty financial sub-segments. Favorable development in 2009 was in the Specialty financial, Specialty casualty and Property and transportation sub-segments. In 2008, AFG had significant favorable reserve development in the Specialty casualty and Property and transportation sub-segments.
Statutory Information AFG’s U.S.-based insurance subsidiaries are required to file financial statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Net earnings (loss) and policyholders’ surplus on a statutory basis for the insurance subsidiaries were as follows (in millions):
AFG has reinsured approximately $18 billion in face amount of life insurance at December 31, 2010 and $19 billion at December 31, 2009. Life premiums ceded were $49 million, $54 million and $57 million for 2010, 2009 and 2008, respectively.
Losses and loss adjustment expenses included charges for possible losses on reinsurance recoverables of less than $1 million in 2010, 2009 and 2008. The aggregate allowance for losses on reinsurance recoverables amounted to approximately $28 million at December 31, 2010 and 2009.
Operating Leases Total rental expense for various leases of office space and equipment was $42 million in each of 2010, 2009 and 2008. AFG has committed to lease approximately 530,000 square feet of office space under a 15-year lease beginning in 2011. Rentals, which escalate over the lease term, average approximately $17 million per year. Future minimum rentals, related principally to office space, required under operating leases having initial or remaining noncancelable lease terms in excess of one year at December 31, 2010, were as follows: 2011 - $46 million; 2012 - $46 million; 2013 - $42 million; 2014 - $37 million; 2015 - $32 million; and $205 million thereafter.
Restrictions on Transfer of Funds and Assets of Subsidiaries Payments of dividends, loans and advances by AFG’s subsidiaries are subject to various state laws, federal regulations and debt covenants that limit the amount of dividends, loans and advances that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 2011 from its insurance subsidiaries without seeking regulatory clearance is $801 million. Additional amounts of dividends, loans and advances require regulatory approval.
Benefit Plans AFG expensed approximately $30 million in 2010, $34 million in 2009 and $19 million in 2008 for its retirement and employee savings plans.
AFG has guaranteed all of the outstanding public debt of GAFRI and GAFRI’s wholly-owned subsidiary, AAG Holding Company, Inc. In addition, GAFRI guarantees AAG Holding’s public debt. The AFG and GAFRI guarantees are full and unconditional and joint and several. Condensed consolidating financial statements for AFG are as follows:
Grossed up for reinsurance recoverables of $2,249 and $2,513 at December 31, 2010 and 2009, respectively.
2010 Annual Senior Executive Bonus Plan, filed as Exhibit 10(d) to AFG’s Form 10-K for 2009.