AFG and its insurance subsidiaries lease the majority of their office and storage facilities in numerous cities throughout the United States and internationally, including the Company’s headquarters in Cincinnati, Ohio. Subsidiaries of AFG own several other buildings in downtown Cincinnati. AFG and its affiliates occupy approximately half of the aggregate 670,000 square feet of commercial and office space in these buildings. A property and casualty insurance subsidiary occupies approximately 87% of the 164,000 square feet of rentable office space on 17.5 acres of land that it owns in Richfield, Ohio. See Item 1 - Business - “Other Operations” for a discussion of AFG’s other commercial real estate operations.
lower earnings in the annuity segment, resulting from the fair value accounting for fixed-indexed annuities,
the fourth quarter 2017 tax expense related to the change in the U.S. corporate tax rate and
the fourth quarter 2016 tax benefits from the National Interstate merger and Neon restructuring.
the fourth quarter 2017 tax expense related to the change in the U.S. corporate tax rate,
the fourth quarter 2016 tax benefits related to the National Interstate merger and Neon restructuring.
The ratio of debt to total capital is a non-GAAP measure that management believes is useful for investors, analysts and independent ratings agencies to evaluate AFG’s financial strength and liquidity and to provide insight into how AFG finances its operations. In addition, maintaining a ratio of debt, excluding subordinated debt and debt secured by real estate (if any), to total capital of 35% or lower is a financial covenant in AFG’s bank credit facility. The ratio is calculated by dividing the principal amount of AFG’s long-term debt by its total capital, which includes long-term debt, noncontrolling interests and shareholders’ equity (excluding unrealized gains (losses) on fixed maturity investments).
Net Cash Provided by Operating Activities AFG’s property and casualty insurance operations typically produce positive net operating cash flows as premiums collected and investment income exceed policy acquisition costs, claims payments and operating expenses. AFG’s net cash provided by operating activities is impacted by the level and timing of property and casualty premiums, claim and expense payments and recoveries from reinsurers. AFG’s annuity operations typically produce positive net operating cash flows as investment income exceeds acquisition costs and operating expenses. Interest credited on annuity policyholder funds is a non-cash increase in AFG’s annuity benefits accumulated liability and annuity premiums, benefits and withdrawals are considered financing activities due to the deposit-type nature of annuities. Cash flows provided by operating activities also include the activity of AFG’s managed investment entities (collateralized loan obligations) other than those activities included in investing or financing activities. The changes in the assets and liabilities of the managed investment entities included in operating activities increased cash flows from operating activities by $60 million in 2017 and reduced cash flows from operating activities by $279 million in 2016 and $190 million in 2015, accounting for a $339 million increase in cash flows from operating activities in 2017 compared to 2016 and an $89 million decrease in cash flows from operating activities in 2016 compared to 2015. As discussed in Note A - “Accounting Policies - Managed Investment Entities” to the financial statements, AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities and such assets and liabilities are shown separately in AFG’s Balance Sheet. Excluding the impact of the managed investment entities, net cash provided by operating activities was $1.74 billion, $1.43 billion and $1.54 billion in 2017, 2016 and 2015, respectively.
Net cash used in investing activities was $2.98 billion in 2016 compared to $4.57 billion in 2015, a decrease of $1.59 billion. The $151 million decrease in net cash flows from annuity policyholders in 2016 as compared to 2015 decreased the amount of cash available for investment in 2016 compared to 2015. In addition, AFG’s cash on hand increased by $887 million during 2016, primarily in the property and casualty and annuity segments reflecting the timing of investing available cash in those segments. Net investment activity in the managed investment entities was a $364 million use of cash in 2016 compared to a $675 million use of cash in 2015, accounting for a $311 million decrease in net cash used in investing activities in 2016 compared to 2015.
Net Cash Provided by Financing Activities AFG’s financing activities consist primarily of transactions with annuity policyholders, issuances and retirements of long-term debt, repurchases of common stock and dividend payments. Net cash provided by financing activities was $1.72 billion in 2017 compared to $2.72 billion in 2016, a decrease of $999 million. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $1.99 billion in 2017 compared to $2.35 billion in 2016, resulting in a $362 million decrease in net cash provided by financing activities in 2017 compared to 2016. In 2017, AFG issued $590 million of 4.50% Senior Notes due in 2047 and $125 million of 3.50% Senior Notes due in 2026, the net proceeds of which contributed $712 million to net cash provided by financing activities in 2017 compared to net proceeds from additional long-term borrowings of $302 million in 2016, which accounted for a $410 million increase in cash provided by financing activities in 2017 compared to 2016. Redemptions of long-term debt were a $745 million use of cash in 2017 and an $18 million use of cash in 2016, which accounted for a $727 million decrease in net cash provided by financing activities in 2017 compared to 2016. There were no shares of AFG Common Stock repurchased in 2017 compared to $133 million repurchased in 2016. In addition to its regular quarterly cash dividends, AFG paid special cash dividends of $3.50 per share and $1.00 per share of American Financial Group Common Stock in 2017 and 2016, respectively, which resulted in total cash dividends of $417 million in 2017 compared to $185 million in 2016. Additionally, in 2016, $315 million was used to fund the acquisition of the noncontrolling interest in National Interstate Corporation. Financing activities also include issuances and retirements of managed investment entity liabilities, which are nonrecourse to AFG and presented separately in AFG’s Balance Sheet. Issuances of managed investment entity liabilities exceeded retirements by $146 million in 2017 compared to $693 million in 2016, accounting for a $547 million decrease in net cash provided by financing activities in 2017 compared to 2016. See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements.
Net cash provided by financing activities was $2.72 billion in 2016 compared to $3.10 billion in 2015, a decrease of $379 million. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $2.35 billion in 2016 compared to $2.50 billion in 2015, resulting in a $151 million decrease in net cash provided by financing activities in 2016 compared to 2015. AFG issued $300 million of 3.50% Senior Notes in 2016 and $150 million of 6% Subordinated Debentures in 2015, the net proceeds of which contributed $296 million in 2016 and $145 million in 2015 to net cash provided by financing activities. Redemptions of long-term debt was an $18 million use of cash in 2016 and a $192 million use of cash in 2015. During 2016, AFG repurchased $133 million of its Common Stock compared to $126 million repurchased in 2015, which accounted for a $7 million decrease in net cash provided by financing activities in 2016 compared to 2015. Additionally, during the fourth quarter of 2016, $315 million was used to fund the acquisition of the noncontrolling interest in National Interstate Corporation. Issuances of managed investment entity liabilities exceeded retirements by $693 million in 2016 compared to $890 million in 2015, accounting for a $197 million decrease in net cash provided by financing activities in 2016 compared to 2015.
AFG can borrow up to $500 million under its revolving credit facility which expires in June 2021. Amounts borrowed under this agreement bear interest at rates ranging from 1.00% to 1.875% (currently 1.375%) over LIBOR based on AFG’s credit rating. There were no borrowings under this agreement, or under any other parent company short-term borrowing arrangements, during 2017.
In June 2017, AFG issued $350 million of 4.50% Senior Notes due in June 2047. Net proceeds from the offering were used to redeem AFG’s $230 million outstanding principal amount of 6-3/8% Senior Notes due in June 2042, at par value in June 2017 and AFG’s $125 million outstanding principal amount of 5-3/4% Senior Notes due in August 2042 at par value in August 2017.
All debentures and notes issued by AFG are rated investment grade by two nationally recognized rating agencies. Under a currently effective shelf registration statement, AFG can offer additional equity or debt securities. The shelf registration provides AFG with flexibility to access the capital markets from time to time as market and other conditions permit.
Subsidiary Liquidity Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions, which provides the annuity operations with an additional source of liquidity. At December 31, 2017, GALIC had $871 million in outstanding advances from the FHLB (included in annuity benefits accumulated), bearing interest at rates ranging from 0.03% to 0.35% over LIBOR (average rate of 1.75% at December 31, 2017). While these advances must be repaid between 2018 and 2020 ($285 million in 2018 and $586 million in 2020), GALIC has the option to prepay all or a portion of the advances. GALIC has invested the proceeds from the advances in fixed maturity securities with similar expected lives as the advances for the purpose of earning a spread over the interest payments due to the FHLB. At December 31, 2017, GALIC estimated that it had additional borrowing capacity of approximately $300 million from the FHLB.
In the annuity business, where profitability is largely dependent on earning a spread between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG’s annuity products. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to contractually guaranteed minimum interest rates (“GMIRs”). AFG began selling policies with GMIRs below 2% in 2003; almost all new business since late 2010 has been issued with a 1% GMIR. At December 31, 2017, AFG could reduce the average crediting rate on approximately $25 billion of traditional fixed and fixed-indexed annuities without guaranteed withdrawal benefits by approximately 92 basis points (on a weighted average basis). Annuity policies are subject to GMIRs at policy issuance. The table below shows the breakdown of annuity reserves by GMIR. The current interest crediting rates on substantially all of AFG’s annuities with a GMIR of 3% or higher are at their minimum.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses. In addition, these subsidiaries have sufficient capital to meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies. Nonetheless, changes in statutory accounting rules, significant declines in the fair value of the insurance subsidiaries’ investment portfolios or significant ratings downgrades on these investments, could create a need for additional capital.
Parent Net Cash Used in Investing Activities Parent holding company investing activities consist of capital contributions to and returns of capital from subsidiaries and, to a much lesser extent, parent company investment activity. Parent holding company net cash used in investing activities was $63 million in 2017 compared to $560 million in 2016 and $33 million in 2015. The $63 million in net cash used in investing activities in 2017 and $33 million in 2015 are significantly lower than the $560 million in net cash used in investing activities in 2016 due primarily to capital contributions to a subsidiary to fund the acquisition of the noncontrolling interest in National Interstate Corporation.
Parent Net Cash Provided by (Used in) Financing Activities Parent company financing activities consist primarily of repurchases of AFG Common Stock, dividends to shareholders, the issuance and retirement of long-term debt and, to a lesser extent, proceeds from employee stock option exercises. Significant long-term debt and common stock transactions are discussed above under “Parent Holding Company Liquidity.” Parent holding company net cash used in financing activities was $413 million in 2017 compared to net cash provided by financing activities of $13 million in 2016 and net cash used in financing activities of $232 million in 2015. The $426 million increase in cash used in financing activities in 2017 as compared to 2016 reflects higher net redemptions of long-term debt in 2017 and increased dividends (due primarily to special dividends of $3.50 per share in 2017 compared to $1.00 per share in 2016), partially offset by the absence of American Financial Group, Inc. Common Stock repurchases in 2017. The $245 million increase in net cash provided by financing activities in 2016 as compared to 2015 primarily reflects proceeds from additional long-term borrowings.
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 $2.96 billion as follows: Within 1 year - $800 million; 2-3 years - $800 million; 4-5 years - $300 million; and thereafter - $1.06 billion. Actual payments and their timing could differ significantly from these estimates.
AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2017.
AFG’s investment portfolio at December 31, 2017, contained $38.38 billion in fixed maturity securities and $1.60 billion in equity securities classified as available for sale and carried at fair value with unrealized gains and losses included in a separate component of shareholders’ equity on an after-tax basis. In addition, $348 million in fixed maturities and $62 million in equity securities were classified as trading with changes in unrealized holding gains or losses included in net investment income.
As detailed in Note E - “Investments - Net Unrealized Gain on Marketable Securities” 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 DPAC and certain liabilities related to annuity, long-term care and life businesses, noncontrolling interests and deferred income taxes. DPAC and certain other balance sheet amounts applicable to annuity, long-term care and life businesses are adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with
The pricing services use a variety of observable inputs to estimate fair value of fixed maturities that do not trade on a daily basis. Based upon information provided by the pricing services, these inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data, and measures of volatility. Included in the pricing of MBS are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Due to the lack of transparency in the process that brokers use to develop prices, valuations that are based on brokers’ prices are classified as Level 3 in the GAAP hierarchy unless the price can be corroborated, for example, by comparison to similar securities priced using observable inputs.
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 and accumulated other comprehensive income that an immediate increase of 100 basis points in the interest rate yield curve would have at December 31, 2017 (dollars in millions). Effects of increases or decreases from the 100 basis points illustrated would be approximately proportional.
Approximately 90% of the fixed maturities held by AFG at December 31, 2017, 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 non-investment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return.
Municipal bonds represented approximately 18% of AFG’s fixed maturity portfolio at December 31, 2017. AFG’s municipal bond portfolio is high quality, with 99% of the securities rated investment grade at that date. The portfolio is well diversified across the states of issuance and individual issuers. At December 31, 2017, approximately 77% of the municipal bond portfolio was held in revenue bonds, with the remaining 23% held in general obligation bonds. AFG does not own general obligation bonds issued by Puerto Rico.
As discussed in Note A - “Accounting Policies - Investments” to the financial statements, effective January 1, 2018, all equity securities currently classified as “available for sale” will be required to be carried at fair value through net earnings instead of accumulated other comprehensive income and will therefore no longer be evaluated for other-than-temporary impairment.
The following table shows (in millions) the breakdown of AFG’s property and casualty insurance reserves between case reserves, IBNR reserves and LAE reserves (estimated amounts required to adjust, record and settle claims, other than the claim payments themselves) at December 31, 2017 and gross written premiums for the year ended December 31, 2017.
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 (dollars in millions) what the impact on AFG’s net earnings would be on the more significant lines of business if the December 31, 2017, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
Approximately 25% and 24% of AFG’s workers’ compensation reserves at December 31, 2017 relate to policies written in Florida and California, respectively. The Castellanos v. Next Door Company decision in Florida and the implementation of Senate Bill 863 in California are two examples of recent changes that impacted the workers’ compensation operating environment and added difficulty and uncertainty to the estimation of related liabilities.
Health care costs and utilization of medical services by injured parties
AFG recorded adverse prior year reserve development of $2 million in 2017, $28 million in 2016 and $20 million in 2015 for this line of business. Claim severity trends had been significantly higher than expected beginning with accident years 2010, but have more recently stabilized.
liability classes. As a result of Neon’s claims review of its exited lines of business, AFG recorded a charge of approximately $65 million, including $57 million to increase loss reserves (adverse development) primarily related to Neon’s medical malpractice and general liability lines.
As a result of the reinsurance to close transaction, Neon recorded favorable reserve development of approximately $42 million, including $24 million related to its ongoing lines of business and $18 million that relates to the exited lines of business discussed above. In addition to the prior year reserve development related to the reinsurance to close transaction and 2016 Neon exited lines charge, Neon recorded favorable prior year reserve development of $29 million in 2017 compared to adverse prior year reserve development of $21 million in 2016 and $44 million in 2015. The favorable reserve development in 2017 outside of the reinsurance to close transaction related to the retained loss reserves across all of Neon’s ongoing lines of business, particularly property lines. The adverse reserve development in 2016 outside of the exited lines charge was attributable to reserve strengthening in several lines of business, including political risk and personal accident. The adverse reserve development in 2015 was attributable to reserve strengthening in several lines of business, primarily Dutch hospital medical malpractice, Australian and other general liability and personal accident insurance.
Asbestos claims against manufacturers, distributors or installers of asbestos products were presented under the products liability section of their policies, which typically had aggregate limits that capped an insurer’s liability. In recent years, a number of asbestos claims are being presented as “non-products” claims, such as those by installers of asbestos products and by property owners or operators who allegedly had asbestos on their property, under the premises or operations section of their policies. Unlike products exposures, these non-products exposures typically had no aggregate limits, creating potentially greater exposure for insurers. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify previously settled products claims as non-products claims to restore a portion of previously exhausted products aggregate limits. AFG, along with other insurers, is and will be subject to such non-products claims. It is difficult to predict whether insureds will be successful in asserting claims under non-products coverage or whether AFG and other insurers will be successful in asserting additional defenses. Therefore, the future impact of such efforts is uncertain.
While management believes that AFG’s reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims, the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, how claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims. A 1% variation in loss cost trends, caused by any of the factors previously described, would change net earnings by approximately $35 million.
The survival ratio is a measure often used by industry analysts to compare A&E reserves strength among companies. This ratio is typically calculated by dividing reserves for A&E exposures by the three-year average of paid losses, and therefore measures the number of years that it would take to pay off current reserves based on recent average payments. Because this ratio can be significantly impacted by a number of factors such as loss payout variability, caution should be exercised in attempting to determine reserve adequacy based simply on the survival ratio. At December 31, 2017, the property and casualty insurance segment’s three-year survival ratios compare favorably with industry survival ratios published by A.M. Best (as of December 31, 2016) as detailed in the following table:
As a result of the comprehensive external study completed in the third quarter of 2017, AFG’s property and casualty insurance segment recorded an $89 million pretax special charge to increase its asbestos reserves by $53 million (net of reinsurance) and
The increase in property and casualty environmental reserves was primarily associated with updated estimates of site investigation costs with respect to existing sites and newly identified sites. AFG is seeing increased legal defense costs in environmental claims generally, as well as a number of claims and sites where the estimated investigation and remediation costs have increased. Certain individual claims are taking a longer time to settle than originally estimated, causing AFG to increase its reserves to reflect related increased costs. As in past years, there were no new or emerging broad industry trends that were identified in this study.
An in-depth internal review of AFG’s A&E reserves was completed in the third quarter of 2016 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’s property and casualty insurance segment recorded a $36 million pretax special charge to increase its asbestos reserves by $5 million (net of reinsurance) and its environmental reserves by $31 million (net of reinsurance). The increase in property and casualty asbestos reserves was due primarily to increased estimates for indemnity and defense costs. The increase in property and casualty environmental reserves was attributed primarily to increased defense costs and a number of claims and sites where the estimated investigation and remediation costs have increased.
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 Great American Financial Resources, Inc. Charges resulting from the A&E study and reviews were $24 million in 2017, $5 million in 2016 and $12 million in 2015. For a discussion of the charges recorded for those operations, see “Results of Operations - Holding Company, Other and Unallocated.” Liabilities for claims and contingencies arising from these former railroad and manufacturing operations totaled $90 million at December 31, 2017. For a discussion of the uncertainties in determining the ultimate liability, see Note M - “Contingencies” to the financial statements.
Run-off Long-term Care Insurance In December 2015, AFG completed the sale of United Teacher Associates Insurance Company and Continental General Insurance Company, the legal entities containing substantially all of its run-off long-term care insurance business, to HC2 Holdings, Inc. (“HC2”) for approximately $13 million in net proceeds. AFG may also receive up to $13 million of additional proceeds from HC2 in the future contingent upon the release of certain statutory-basis liabilities of the legal entities sold by AFG. In connection with obtaining regulatory approval for the transaction, AFG agreed to provide up to an aggregate of $35 million of capital support for the insurance companies, on an as-needed basis to maintain specified surplus levels, subject to immediate reimbursement by HC2 through a five-year capital maintenance agreement. With the completion of this sale, AFG divested substantially all of its long-term care business (96% as measured by net statutory reserves as of November 30, 2015) and retained only a small block of long-term care insurance (1,600 policies) with approximately $39 million of reserves at December 31, 2017. AFG will continue to accept renewal premiums on its remaining outstanding policies, which are guaranteed renewable.
Elimination of the fair value of AFG’s investment in CLOs and related accrued interest.
Includes income of $7 million and $8 million in the fourth quarter of 2017 and 2016, respectively, representing the change in fair value of AFG’s CLO investments plus $4 million and $5 million in the fourth quarter of 2017 and 2016, respectively, in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $6 million and $8 million in the fourth quarter of 2017 and 2016, respectively, in distributions recorded as interest expense by the CLOs.
Includes income of $23 million and $37 million in 2017 and 2016, respectively, representing the change in fair value of AFG’s CLO investments plus $18 million and $17 million in 2017 and 2016, respectively, in CLO management fees earned.
Net earnings attributable to shareholders decreased $219 million in the fourth quarter of 2017 compared to the same period in 2016 due primarily to the fourth quarter 2017 tax expense related to the change in the U.S. corporate tax rate, the fourth quarter 2016 tax benefits related to the National Interstate merger and Neon restructuring, lower net realized gains on securities in the 2017 period compared to the 2016 period and a loss on the retirement of debt in the 2017 period, partially offset by the fourth quarter 2017 favorable development in the Neon exited lines in connection with a reinsurance to close transaction and tax benefit from restructuring at Neon and higher core net operating earnings. Core net operating earnings increased $21 million in the fourth quarter of 2017 compared to the same period in 2016 reflecting higher operating earnings in the property and casualty insurance segment, partially offset by lower earnings in the annuity segment reflecting the impact of fair value accounting for fixed-indexed annuities.
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 tables for the three months ended December 31, 2017 and 2016 identify such items by segment and reconcile 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):
Gross written premiums (“GWP”) for AFG’s property and casualty insurance segment were $1.57 billion for the fourth quarter of 2017 compared to $1.44 billion for the fourth quarter of 2016, an increase of $130 million (9%). Detail of AFG’s property and casualty gross written premiums is shown below (dollars in millions):
Reinsurance premiums ceded (“Ceded”) for AFG’s property and casualty insurance segment were 26% of gross written premiums for the fourth quarter of 2017 compared to 25% for the fourth quarter of 2016, an increase of 1 percentage point. Detail of AFG’s property and casualty reinsurance premiums ceded is shown below (dollars in millions):
Net earned premiums (“NEP”) for AFG’s property and casualty insurance segment were $1.23 billion for the fourth quarter of 2017 compared to $1.14 billion for the fourth quarter of 2016, an increase of $81 million (7%). Detail of AFG’s property and casualty net earned premiums is shown below (dollars in millions):
Property and transportation Gross written premiums increased $49 million (8%) in the fourth quarter of 2017 compared to the fourth quarter of 2016. This increase was due primarily to higher year-over-year gross written premiums in the crop business, as well as higher gross written premiums in the property and inland marine and Singapore operations. This growth was partially offset by lower gross written premiums resulting from an exit from the customs bond business, which was part of the ocean marine operations. Average renewal rates increased approximately 3% for this group in the fourth quarter of 2017. Reinsurance premiums ceded as a percentage of gross written premiums are comparable between periods.
Specialty financial Gross written premiums increased $28 million (16%) in the fourth quarter of 2017 compared to the fourth quarter of 2016, due primarily to higher premiums in the lending and leasing businesses. Average renewal rates for this group were flat in the fourth quarter of 2017. Reinsurance premiums ceded as a percentage of gross written premiums increased 11 percentage points for the fourth quarter of 2017 compared to the fourth quarter of 2016 reflecting higher cessions in the lending and leasing businesses.
Specialty casualty Underwriting profit for this group was $58 million for the fourth quarter of 2017 compared to $13 million in the fourth quarter of 2016, an increase of $45 million (346%). This increase is due primarily to favorable reserve
Specialty financial Underwriting profit for this group was $19 million for the fourth quarter of 2017 compared to $20 million in the fourth quarter of 2016, a decrease of $1 million (5%) reflecting underwriting profit in all businesses in this group. Catastrophe losses had a favorable impact of $5 million (3.7 points on the combined ratio) for the fourth quarter of 2017 compared to a loss of $2 million (1.7 points) for the fourth quarter of 2016. Catastrophe losses for the fourth quarter of 2017 include the impact of the favorable reserve development on third quarter catastrophes discussed above.
AFG’s overall loss and LAE ratio was 58.5% for the fourth quarter of 2017 compared to 63.7% for fourth quarter of 2016, a decrease of 5.2 percentage points. The components of AFG’s property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
Property and transportation The 4.1 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, equine, trucking, and property and inland marine businesses and the Singapore branch in the fourth quarter of 2017 compared to the fourth quarter of 2016.
Specialty financial The loss and LAE ratio for the current year, excluding catastrophe losses increased 0.8 percentage points in the fourth quarter of 2017 compared to the fourth quarter of 2016.
Property and transportation Net favorable reserve development of $4 million in the fourth quarter of 2017 reflects lower than expected losses in the crop business and lower than expected claim severity in the property and inland marine and trucking businesses, partially offset by higher than expected claim severity and frequency in the ocean marine business. Net adverse reserve development of $13 million in the fourth quarter of 2016 reflects reserve strengthening at National Interstate and higher than expected claim severity in the ocean marine business.
Specialty casualty Net favorable reserve development of $52 million in the fourth quarter of 2017 reflects favorable reserve development on ongoing lines of business within Neon recorded in connection with the reinsurance to close agreement entered into in December 2017 for the 2015 and prior years of account, lower than anticipated claim severity in the workers’ compensation businesses and lower than expected losses in the executive liability business, partially offset by higher than anticipated claim severity in the targeted markets businesses and higher than anticipated severity in New York contractor claims. Net adverse reserve development of $3 million in the fourth quarter of 2016 reflects higher than anticipated severity in New York contractor claims, adverse reserve development at Neon and higher than anticipated claim severity in the targeted programs business, partially offset by lower than anticipated claim frequency and severity in the workers’ compensation businesses.
Specialty financial Net adverse reserve development of $1 million in the fourth quarter of 2017 reflects higher than expected claim severity in the financial institutions business, partially offset by lower than anticipated claim frequency and severity in the surety business. Net favorable reserve development of $6 million in the fourth quarter of 2016 reflects lower than expected claim frequency in the financial institutions business and lower than anticipated claim severity in the fidelity business.
Other specialty In addition to the reserve development discussed above, total Specialty prior year reserve development includes net adverse reserve development of $6 million in the fourth quarter of 2017 reflecting an $8 million charge to adjust the deferred gain on the retroactive reinsurance transaction entered into in connection with the sale of businesses in 1998, partially offset by the amortization of deferred gains on retroactive insurance.
Neon exited lines charge During the second quarter of 2016, AFG’s specialist Lloyd’s market insurer completed a strategic review of its business under a new leadership team and re-launched as Neon Underwriting Ltd. As part of its strategic review, Neon sold and/or exited certain historical lines of business including its UK and international medical malpractice and general liability classes. As a result of Neon’s claims review of its exited lines of business, AFG recorded a charge of approximately $65 million including $57 million to increase loss reserves primarily related to its medical malpractice and general liability lines. Consistent with the treatment of other items that are not indicative of AFG’s ongoing operations (both favorable and unfavorable), the 2016 charge was treated as non-core because it resulted from a special strategic review of lines of business that Neon no longer writes. Similarly, the $18 million in favorable development related to the Neon exited lines recorded in connection with the December 2017 reinsurance to close transaction (discussed above under Specialty casualty) was treated as non-core.
AFG generally seeks to reduce its exposure to catastrophes through individual risk selection, including minimizing coastal and known fault-line exposures, and the purchase of reinsurance. Based on data available at December 31, 2017, AFG’s exposure to a catastrophic earthquake or windstorm that industry models indicate should statistically occur once in every 100, 250 or 500 years as a percentage of AFG’s Shareholders’ Equity is shown below:
AFG maintains comprehensive catastrophe reinsurance coverage, including a $15 million per occurrence net retention for its U.S.-based property and casualty insurance operations for losses up to $100 million and a separate $15 million per occurrence retention for Neon for losses up to $200 million ($225 million for U.S. catastrophe events). AFG’s property and casualty insurance operations further maintain supplemental fully collateralized reinsurance coverage up to 95% of $200 million for catastrophe losses in excess of $100 million of traditional catastrophe reinsurance through a catastrophe bond.
AFG’s property and casualty commissions and other underwriting expenses (“U/W Exp”) were $336 million in the fourth quarter of 2017 compared to $305 million for the fourth quarter of 2016, an increase of $31 million (10%). AFG’s underwriting expense ratio, calculated as commissions and other underwriting expenses divided by net premiums earned, was 27.5% for the fourth quarter of 2017 compared to 26.7% for the fourth quarter of 2016, an increase of 0.8 percentage points. Detail of AFG’s property and casualty commissions and other underwriting expenses and underwriting expense ratios is shown below (dollars in millions):
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums increased 1.7 percentage points in the fourth quarter of 2017 compared to the fourth quarter of 2016 reflecting growth at Neon, which has a higher expense ratio than AFG’s overall Specialty casualty group.
Other income and expenses, net for AFG’s property and casualty insurance operations was a net expense of $8 million for the fourth quarter of 2017 compared to $13 million for the fourth quarter of 2016, a decrease of $5 million (38%). The table below details the items included in other income and expenses, net for AFG’s property and casualty insurance operations (in millions):
AFG and its consolidated subsidiaries incurred $5 million in transaction expenses in the fourth quarter of 2016 related to GAI’s acquisition of the NATL common stock that it did not already own. These expenses consisted primarily of financial advisory and legal services. See Note B - “Acquisitions and Sale of Businesses” to the financial statements.
The following table details AFG’s earnings before income taxes from its annuity operations for the three months ended December 31, 2017 and 2016 (dollars in millions):
AFG’s net interest spread decreased 0.08 percentage points to 2.62% from 2.70% in the fourth quarter of 2017 compared to the same period in 2016 due primarily to the impact of lower fixed maturity investment yields, partially offset by the impact of lower crediting rates. Features included in current annuity product offerings allow AFG to achieve its desired profitability at a lower net interest spread than historical product offerings. As a result, AFG expects its net interest spread to narrow in the future.
The $10 million decrease in other annuity benefits, net of guaranteed withdrawal benefit fees in the fourth quarter of 2017 compared to the fourth quarter of 2016 reflects the impact of the increase in the fair value of the FIA embedded derivative reserve resulting from lower than anticipated interest rates on the guaranteed withdrawal benefits.
Excluding the impact of unlocking charges, the net change in fair value of derivatives related to fixed-indexed annuities increased annuity benefits by $22 million in the fourth quarter of 2017 and decreased annuity benefits by $54 million in the fourth quarter of 2016. The $22 million increase in annuity benefits in the fourth quarter of 2017 reflects the negative impact of lower than anticipated interest rates on the fair value of these derivatives, partially offset by the positive impact of strong stock market performance. The $54 million decrease in annuity benefits in the fourth quarter of 2016 reflects the positive impact of significantly higher than anticipated interest rates and strong stock market performance on the fair value of these derivatives. As a percentage of average fixed annuity benefits accumulated, this net expense decreased 1.00 percentage points to 0.27% in the fourth quarter of 2017 from a net expense reduction of 0.73% in the fourth quarter of 2016.
Fluctuations in interest rates and the stock market, among other factors, can cause volatility in the periodic measurement of fair value of the embedded derivative that management believes can be inconsistent with the long-term economics of these products. The table below illustrates the impact of fair value accounting for derivatives related to fixed-indexed annuities on the annuity segment’s earnings before income taxes (dollars in millions):
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, excess benefits expected to be paid on future deaths and annuitizations (“EDAR”) and guaranteed withdrawal benefits. Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati. The following table is a progression of AFG’s annuity benefits accumulated liability for the three months ended December 31, 2017 and 2016 (in millions):
AFG continues to implement product and process changes needed to comply with the Department of Labor (“DOL”) Fiduciary Rule. Although the DOL Fiduciary Rule became effective on June 9, 2017, the DOL delayed certain requirements until
January 1, 2018. As a result, insurance-only agents were able to continue selling fixed-indexed annuities through the end of 2017, provided the agent acted in the customer’s best interest, made no misleading statements and received only reasonable compensation. The DOL recently released a proposal to delay full implementation until July 1, 2019. There is uncertainty as to whether the rule will take effect in its current form on that date.
AFG believes the biggest impact of the rule will be on insurance-only licensed agents whose qualified sales represented approximately 10% of its fourth quarter 2017 annuity premiums. AFG’s management continues to believe that full implementation is likely to cause some short-term disruption in annuity premiums. Nonetheless, management does not believe the new rule will have a material impact on AFG’s results of operations.
In the fourth quarters of 2017 and 2016, AFG conducted a detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded a net charge related to its annuity business of $3 million in 2017 and a net expense reduction of $1 million in 2016, which impacted AFG’s financial statements as follows (in millions):
The 2016 net expense reduction reflects the favorable impact of an increase in projected net interest spreads on in-force business, substantially offset by the unfavorable impact of (i) changes in projected policyholder annuitization and lapse behavior, (ii) an increase in the risk premium for the uncertainty in the cash flows component of the discount rates used to value the FIA-related embedded derivative and (iii) a slight decrease in projected stock market growth over the next three years. For the 2016 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 4.24% in 2017, grading up ratably to an ultimate net reinvestment rate of 5.55% in 2022 and beyond.
The following table reconciles the net spread earned on AFG’s fixed annuities to overall annuity pretax earnings for the three months ended December 31, 2017 and 2016 (in millions):
Net investment income (as a % of investments) of 4.62% and 4.72% for the three months ended December 31, 2017 and 2016, respectively, multiplied by the difference between average fixed annuity investments (at amortized cost) and average fixed annuity benefits accumulated in each period.
Other income in the table above includes $4 million and $5 million in the fourth quarter of 2017 and 2016, respectively, in management fees paid to AFG by the AFG-managed CLOs (AFG’s consolidated managed investment entities). The management fees are eliminated in consolidation - see the other income line in the Consolidate MIEs column under “Results of Operations - Segmented Statement of Earnings.” Excluding amounts eliminated in consolidation, AFG recorded a $2 million loss in other income outside of its insurance operations in the fourth quarter of 2017 due primarily to the disposal of equipment compared to income of $3 million outside of the insurance operations in the fourth quarter of 2016.
Issued $350 million of 4.50% Senior Notes on June 2, 2017
Redeemed $125 million of 5-3/4% Senior Notes on August 25, 2017
Consolidated Realized Gains (Losses) on Securities AFG’s consolidated realized gains (losses) on securities, which are not allocated to segments, were gains of $6 million in the fourth quarter of 2017 compared to $51 million in the fourth quarter of 2016, a decrease of $45 million (88%). Realized gains (losses) on securities consisted of the following (in millions):
AFG’s impairment charges on securities for the fourth quarter of 2017 consist of $14 million on equity securities, $5 million on fixed maturities and $4 million on other investments compared to $10 million on equity securities and $1 million on fixed maturities in the fourth quarter of 2016. Approximately $11 million in impairment charges in the fourth quarter of 2017 are
related to financial institutions and $4 million relate to investments in pharmaceutical companies. Approximately $7 million in impairment charges in the fourth quarter of 2016 are related to an equity investment in a pharmaceutical company.
Consolidated Income Taxes AFG’s consolidated provision (credit) for income taxes was an expense of $101 million for the fourth quarter of 2017 compared to a benefit of $71 million in the fourth quarter of 2016, a decrease of $172 million (242%). The following is a reconciliation of income taxes at the statutory rate of 35% to the provision (credit) for income taxes as shown in the segmented statement of earnings (dollars in millions):
The impact of “foreign operations” for the fourth quarter of 2017 in the table above relates to a reduction in the “foreign underwriting losses” deferred tax asset as a result of the sale of the noncontrolling interest in Neon. Since AFG maintains a full valuation allowance against the deferred tax assets related to Neon, this reduction in deferred tax assets was offset by a corresponding reduction in the valuation allowance and had no overall impact on AFG’s income tax expense or results of operations.
The changes in valuation allowance in the table above are primarily related to the cumulative losses in the Neon Lloyd’s insurance business. Due to the uncertainty concerning the realization of the deferred tax benefits associated with these losses, AFG maintains a full valuation allowance against these deferred tax assets. The $61 million decrease in the valuation allowance related to the change in the U.S. corporate tax rate is included in “Change in U.S. corporate tax rate” in the table above.
In connection with the reorganization of AFG’s Neon Lloyd’s business, in December 2016, AFG undertook a restructuring that included the liquidation for tax purposes of the foreign subsidiary that is the parent of the Neon Lloyd’s operations, resulting in a taxable loss on the liquidation on which AFG reported a $111 million tax benefit in the fourth quarter of 2016. An additional loss associated with the 2016 restructuring was deferred under U.S. tax laws, resulting in an unrecognized potential tax benefit of $48 million at December 31, 2016. On December 29, 2017, AFG entered into agreements under which certain Neon executives acquired an indirect noncontrolling interest in Neon. The sale of the noncontrolling interest in Neon resulted in the recognition for U.S. tax purposes of the loss deferred from the 2016 restructuring. AFG recorded a tax benefit of $56 million in the fourth quarter of 2017 related to the sale of the noncontrolling interest in Neon and the recognition of the previously deferred loss. See Note L - “Income Taxes” to the financial statements.
The Tax Cuts and Jobs Act of 2017 (“TCJA”), which lowers the U.S. corporate tax rate to 21% and makes other widespread changes to the U.S. tax code beginning in 2018, was enacted on December 22, 2017. Because the TCJA was enacted in December 2017, AFG recorded the $83 million decrease in its net deferred tax asset resulting from the changes in the tax code (primarily the lower corporate tax rate applicable to 2018 and future years) in the fourth quarter of 2017. See Note L - “Income Taxes” to the financial statements. Although accounting for the TCJA reduced AFG’s net deferred tax asset, management expects a net favorable future economic impact from the lower corporate income tax rate, including an expected effective tax rate in 2018 of approximately 20%.
As discussed in Note B - “Acquisitions and Sale of Businesses” to the financial statements, AFG acquired the noncontrolling interest in National Interstate Corporation in November 2016. This transaction allowed National Interstate and its subsidiaries
to become members of the AFG consolidated tax group, which resulted in a tax benefit of $66 million to AFG during the fourth quarter of 2016.
close transaction, partially offset by the impact of a $32 million pretax non-core gain on the sale of an apartment property in the second quarter of 2016 and special A&E charges of $89 million in 2017 compared to $36 million in 2016.
Gross written premiums (“GWP”) for AFG’s property and casualty insurance segment were $6.50 billion in 2017 compared to $5.98 billion in 2016, an increase of $521 million (9%). GWP increased $149 million (3%) in 2016 compared to 2015. Detail of AFG’s property and casualty gross written premiums is shown below (dollars in millions):
Reinsurance premiums ceded (“Ceded”) for AFG’s property and casualty insurance segment were 27%, 27% and 26% of gross written premiums for the years ended December 31, 2017, 2016 and 2015, respectively. Detail of AFG’s property and casualty reinsurance premiums ceded is shown below (dollars in millions):
The $149 million (3%) increase in gross written premiums in 2016 compared to 2015 reflects growth in the Property and transportation, Specialty casualty and Specialty financial sub-segments. Overall average renewal rates were flat in 2016.
Specialty casualty Gross written premiums increased $295 million (11%) in 2017 compared to 2016. New accounts written in the targeted markets businesses and higher gross written premiums at Neon, resulting from the growth of its portfolio in targeted classes of business were the primary drivers of the increase. Additionally, higher gross written premiums in the workers’ compensation businesses, primarily the result of rate increases in the state of Florida, coupled with growth in the executive liability and excess and surplus businesses contributed to the growth in gross written premiums in 2017. Average renewal rates were flat for this group in 2017. Reinsurance premiums ceded as a percentage of gross written premiums decreased 1 percentage point in 2017 compared to 2016, reflecting a change in the mix of business.
Gross written premiums increased $48 million (8%) in 2016 compared to 2015 due primarily to growth in the financial institutions and surety businesses. Average renewal rates for this group decreased approximately 1% in 2016. Reinsurance premiums ceded as a percentage of gross written premiums increased 1 percentage point in 2016 compared to 2015, reflecting higher cessions in the financial institutions business, partially offset by a decline in auto dealer business, which is heavily reinsured.
The table below (dollars in millions) details the components of the combined ratio for AFG’s property and casualty insurance segment for 2017, 2016 and 2015:
The Specialty property and casualty insurance operations generated an underwriting profit of $317 million in 2017 compared to $337 million in 2016, a decrease of $20 million (6%). The lower underwriting profit in 2017 as compared to 2016 reflects lower underwriting profit in the Property and transportation and Specialty financial insurance sub-segments, partially offset by higher underwriting profit in the Specialty casualty insurance sub-segment. Results for each of the Specialty property and casualty insurance sub-segments reflect higher catastrophe losses in 2017 compared to 2016. Overall catastrophe losses were $140 million (3.0 points on the combined ratio) for 2017 compared to $55 million (1.3 points) for 2016. In connection with catastrophe losses incurred in 2017, AFG reduced profit-based commissions payable to agents by $8 million in the Specialty financial sub-segment and paid $10 million in net reinstatement premiums, resulting in a total pretax loss from catastrophes of $142 million in 2017.
Underwriting profit for this group was $166 million in 2016 compared to $48 million in 2015, an increase of $118 million (246%). This improvement reflects higher underwriting profit in the crop insurance business, primarily the result of favorable growing conditions and relatively stable commodity pricing and higher underwriting profits in the transportation and property and inland marine businesses. These improved results were partially offset by an increase of $10 million in catastrophe losses in 2016 compared to 2015.
Underwriting profit for this group was $78 million in 2016 compared to $146 million in 2015, a decrease of $68 million (47%). Higher underwriting profitability in the workers’ compensation businesses, due primarily to higher favorable prior year reserve development, and improved results in the general liability business were more than offset by adverse prior year reserve development in the excess and surplus and targeted markets businesses, current accident year trade credit losses in Neon’s political risk and trade credit business and higher catastrophe losses.
Underwriting profit for this group was $9 million in 2016 compared to $14 million in 2015, a decrease of $5 million (36%). The decrease is due primarily to lower favorable prior year loss development in the business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments.
Aggregate Aggregate underwriting results for AFG’s property and casualty insurance segment include the asbestos and environmental reserve charges and the Neon exited lines charge and favorable development in the Neon exited lines discussed below under “Net prior year reserve development.”
AFG’s overall loss and LAE ratio was 64.5% in 2017 and 63.8% in 2016 and 2015. The components of AFG’s property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
Specialty financial The 3.8 percentage points increase in the loss and LAE ratio for the current year, excluding catastrophe losses in 2017 compared to 2016 reflects an increase in the loss and LAE ratio of the financial institutions business.
Property and transportation Net favorable reserve development of $40 million in 2017 reflects lower than expected losses in the crop and equine businesses and lower than expected claim severity in the property and inland marine and transportation businesses, partially offset by higher than expected claim frequency and severity in the ocean marine business.
Net favorable reserve development of $21 million in 2016 reflects lower than expected losses in the crop operations and lower than expected claim severity in the property and inland marine and trucking businesses, partially offset by reserve strengthening at National Interstate and higher than expected claim frequency in the ocean marine business.
Specialty casualty Net favorable reserve development of $86 million in 2017 includes favorable reserve development on ongoing lines of business within Neon recorded in connection with the reinsurance to close agreement entered into in December 2017 for the 2015 and prior years of account, lower than anticipated claim severity in the workers’ compensation businesses and lower than expected losses in the executive liability business, partially offset by higher than anticipated claim severity in the targeted markets and general liability businesses and higher than anticipated severity in New York contractor claims.
Net favorable reserve development of $30 million in 2015 reflects lower than anticipated claim frequency and severity in the surety business and products for financial institutions and lower than expected claim severity in the fidelity business and run-off collateral value insurance.
Asbestos and environmental reserve charges As previously discussed under “Uncertainties” - “Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG has established property and casualty reserves for claims related to environmental exposures and asbestos claims. Total charges recorded to increase reserves (net of reinsurance recoverable) for A&E exposures of AFG’s property and casualty group (included in loss and loss adjustment expenses) were $89 million in 2017, $36 million in 2016 and $67 million in 2015.
Aggregate Aggregate net prior accident years reserve development for AFG’s property and casualty insurance segment includes the A&E charges, the Neon exited lines charge and the favorable development on the Neon exited lines mentioned above and adverse reserve development of $4 million in 2017 and $3 million in 2015 related to business outside the Specialty group that AFG no longer writes.
AFG’s property and casualty commissions and other underwriting expenses (“U/W Exp”) were $1.38 billion in 2017 compared to $1.33 billion in 2016, an increase of $52 million (4%). AFG’s underwriting expense ratio was 30.2% in 2017 compared to 30.7% in 2016, a decrease of 0.5 percentage points.
AFG’s property and casualty U/W Exp were $1.33 billion in 2016 compared to $1.30 billion in 2015, an increase of $26 million (2%). AFG’s underwriting expense ratio was 30.7% in 2016 compared to 30.9% in 2015, a decrease of 0.2 percentage points.
AFG’s overall expense ratio decreased 0.5% in 2017 as compared to 2016 and decreased 0.2% in 2016 compared to 2015.
Commissions and other underwriting expenses as a percentage of net earned premiums decreased 1.5 percentage points in 2016 compared to 2015 reflecting an increase in ceding commissions received from reinsurers in the crop business.
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.4 percentage points in 2017 compared to 2016 reflecting the impact of reinstatement premiums on the ratio.
The increase in average invested assets and net investment income in the property and casualty insurance segment in 2017 compared to 2016 is due primarily to growth in the property and casualty insurance segment. The property and casualty insurance segment’s overall yield on investments was 3.64% in 2017 compared to 3.66% in 2016, a decrease of 0.02 percentage points reflecting the impact of lower yields available in the financial markets and lower income from certain investments that are required to be carried at fair value through earnings, partially offset by higher income from equity in the earnings of limited partnerships and similar investments.
The increase in average invested assets in the property and casualty insurance segment in 2016 as compared to 2015 is due primarily to growth in the segment. The $31 million increase in the property and casualty insurance segment’s net investment income reflects a $13 million increase in income from certain investments that are required to be carried at fair value through earnings, an $11 million increase in equity in the earnings of limited partnerships and similar investments and the increase in average invested assets, partially offset by slightly higher investment expenses and lower yields available in the financial markets. The property and casualty segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 3.66% in 2016 compared to 3.56% in 2015, reflecting the higher income from investments carried at fair value and partnership earnings discussed above, partially offset by the impact of the lower current market yields discussed above.
Other income for AFG’s property and casualty insurance operations includes $3 million in 2017 and $4 million in 2016 in death benefits from life insurance policies.
Interest expense for AFG’s property and casualty insurance operations includes interest charges on long-term debt within the property and casualty operations.
AFG’s annuity operations contributed $380 million in pretax earnings in 2017 compared to $368 million in 2016, an increase of $12 million (3%). AFG’s annuity segment results in 2017 compared to 2016 reflect an 11% increase in average annuity investments (at amortized cost), partially offset by lower investment yields due to the run-off of higher yielding investments and higher general and administrative expenses. Included in these results is the change in fair value of derivatives related to FIAs, which had a negative impact of $33 million in 2017 compared to $27 million in 2016. Both periods reflect the negative impact of lower than anticipated interest rates, partially offset by the positive impact of a higher stock market on the fair value accounting for FIAs. AFG’s periodic detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations resulted in a net annuity charge of $3 million in 2017 compared to a net annuity expense reduction of $1 million in 2016.
AFG’s annuity operations contributed $368 million in pretax earnings in 2016 compared to $331 million in 2015, an increase of $37 million (11%). The increase in AFG’s annuity segment results in 2016 compared to 2015 reflects higher investment income from certain investments that are required to be carried at fair value through earnings and a 12% increase in average annuity investments (at amortized cost), partially offset by lower investment yields due to the run-off of higher yielding investments and higher general and administrative expenses. The change in fair value of derivatives related to FIAs had a negative impact of $27 million in 2016 compared to $23 million in 2015. For 2016, the negative impact of a significant drop in interest rates on fair value accounting for FIAs was partially offset by the positive impact of an increase in the stock market. For 2015, fair value accounting for FIAs was negatively impacted by a significant decrease in the stock market and a slightly lower than expected increase in interest rates. Operating earnings also included a net unlocking expense reduction of $1 million in 2016 compared to $10 million in 2015.
The table below illustrates the impact of fair value accounting for derivatives related to fixed-indexed annuities on the annuity segment’s net spread earned on fixed annuities:
Interest credited - fixed in 2016 was $574 million compared to $532 million in 2015, an increase of $42 million (8%). The impact of growth in the annuity business was partially offset by lower interest crediting rates on new premiums as compared to the crediting rates on policyholder funds surrendered or withdrawn. The average interest rate credited to policyholders decreased 0.10 percentage points to 2.04% in 2016 from 2.14% in 2015.
AFG’s net interest spread decreased 0.11 percentage points to 2.62% from 2.73% in 2017 compared to 2016 due primarily to lower fixed maturity investment yields, partially offset by the impact of lower crediting rates. Features included in current annuity offerings allow AFG to achieve its desired profitability at a lower net interest spread than historical product offerings. As a result, AFG expects its net interest spread to narrow in the future.
AFG’s net interest spread increased 0.04 percentage points to 2.73% in 2016 from 2.69% in 2015 as the impact of lower in-force investment yields was more than offset by lower crediting rates and higher income from certain investments that are required to be carried at fair value through earnings.
Annuity policy charges and other miscellaneous income, which consist primarily of surrender charges, amortization of deferred upfront policy charges (unearned revenue) and income from sales of real estate, were $43 million in 2017 compared to $50 million in 2016, a decrease of $7 million (14%). Excluding the impact of unlocking charges of $3 million in 2017 and $1 million in 2016 related to unearned revenue, annuity policy charges and other miscellaneous income were $46 million in 2017 compared to $51 million in 2016, a decrease of $5 million (10%). Other miscellaneous income includes $1 million from the sale of real estate in 2017 compared to $5 million in 2016. Excluding the impact of unlocking charges related to unearned revenue, annuity policy charges and other miscellaneous income as a percentage of average fixed annuity benefits accumulated decreased 0.04 percentage points to 0.11% in 2017 from 0.15% in 2016.
See “Annuity Unlocking” below for a discussion of the impact that the periodic review of actuarial assumptions had on annuity policy charges and other miscellaneous income.
As discussed under “Annuity Benefits Accumulated” in Note A - “Accounting Policies” to the financial statements, guaranteed withdrawal benefit reserves are accrued for and modified using assumptions similar to those used in establishing and amortizing deferred policy acquisition costs. The guaranteed withdrawal benefit reserve related to FIAs is inversely impacted by the calculated FIA embedded derivative reserve as the value to policyholders of the guaranteed withdrawal benefits decreases when the benefit of stock market participation increases.
Excluding the impact of unlocking charges (expense reductions) discussed under “Annuity Unlocking” below, AFG’s amortization of DPAC and commission expenses as a percentage of average fixed annuity benefits accumulated was 0.62% in 2017 compared to 0.70% in 2016 and 0.74% in 2015 and has generally ranged between 0.75% and 0.85%. Variances from the general range relate primarily to the impact of (i) material changes in interest rates or the stock market on AFG’s fixed-indexed annuity business, and (ii) differences in actual experience from actuarially projected estimates and assumptions. For example, the negative impact of significantly lower than anticipated interest rates during 2017 and 2016, and the significant stock market decrease in 2015 on the fair value of derivatives related to fixed-indexed annuities (discussed below) resulted in a partially offsetting deceleration in the amortization of DPAC.
Excluding the impact of unlocking charges, the net change in fair value of derivatives related to fixed-indexed annuities increased annuity benefits by $70 million in 2017, $53 million in 2016 and $45 million in 2015. The increase in 2017 and 2016 reflects the negative impact of significantly lower than anticipated interest rates on the fair value of these derivatives, partially offset by the positive impact of strong stock market performance in both periods. The increase in 2015 reflects the negative impact of the decline in the stock market and lower than anticipated interest rates on these derivatives. As a percentage of average fixed annuity benefits accumulated, this net expense increased 0.03 percentage points to 0.22% in 2017 from 0.19% in 2016, and increased 0.01 percentage points to 0.19% in 2016 from 0.18% in 2015.
AFG’s net spread earned on fixed annuities decreased 0.06 percentage points to 1.23% in 2017 from 1.29% in 2016 due primarily to the 0.11 percentage points decrease in AFG’s net interest spread, partially offset by other small net positive items.
Management believes the 2% decrease in annuity premiums in 2017 compared to 2016 is the result of AFG’s adherence to pricing discipline in a relatively low and decreasing interest rate environment during the year, as well as from aggressive pricing in certain of AFG’s competitors.
second half of 2016 as a result of AFG’s reduction in crediting rates on its annuities in 2016 due to the decline in market interest rates; these crediting rate reductions were made to maintain appropriate returns on new business.
In 2017, 2016 and 2015, AFG conducted its detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded a net charge related to its annuity business of $3 million in 2017 and a net expense reduction of $1 million in 2016 and $10 million in 2015, which impacted AFG’s financial statements as follows (in millions):
The following table reconciles the net spread earned on AFG’s fixed annuities to overall annuity pretax earnings for 2017, 2016 and 2015 (in millions):
Run-off Long-Term Care and Life Segment - Results of Operations AFG’s run-off long-term care and life segment contributed GAAP pretax earnings of $6 million and $4 million in 2017 and 2016, respectively, compared to a loss of $152 million in 2015. Results for 2015 include a $166 million pretax non-core realized loss on the sale of the subsidiaries containing substantially all of AFG’s run-off long-term care insurance business. See Note B - “Acquisitions and Sale of Businesses” to the financial statements. The following table details AFG’s GAAP and core earnings (loss) before income taxes from its run-off long-term care and life operations in 2017, 2016 and 2015 (dollars in millions):
Substantially all of the core earnings before income taxes in AFG’s run-off long-term care and life segment in 2015 represent earnings from AFG’s long-term care business.
AFG’s net GAAP pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $181 million in 2016 compared to $176 million in 2015, an increase of $5 million (3%). AFG’s net core pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $176 million in 2016 compared to $160 million in 2015, an increase of $16 million (10%).
The following table details AFG’s GAAP and core loss before income taxes from operations outside of its insurance operations in 2017, 2016 and 2015 (dollars in millions):
AFG’s holding companies and other operations outside of its insurance operations recorded interest expense of $85 million in 2017 compared to $77 million in 2016, an increase of $8 million (10%). This increase reflects higher average indebtedness during 2017 compared to 2016, partially offset by a lower weighted average interest rate on outstanding debt.
As a result of the comprehensive external studies and internal review of A&E exposures discussed under “Uncertainties - Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG’s holding companies and other operations outside of its insurance operations recorded non-core special charges of $24 million in 2017, $5 million in 2016 and $12 million in 2015 to increase liabilities related to the A&E exposures of AFG’s former railroad and manufacturing operations. The charges in 2017 and 2016 are due to relatively small movements across several sites that primarily reflect changes in the scope and costs of investigation. In addition, AFG has seen a small increase in claims arising from exposure to deleterious substances other than asbestos, which has caused it to increase its estimated future liability. The charge in 2015 related to slightly higher estimated costs at sites where remediation is underway, coupled with higher estimated cleanup costs at a limited number of sites. Total charges recorded to increase liabilities for A&E exposures of AFG’s former railroad and manufacturing operations (included in other expenses) were $31 million in 2017, $20 million in 2016 and $22 million in 2015.
Excluding the non-core special A&E charges and the non-core losses on retirement of debt discussed above, AFG’s holding companies and other operations outside of its insurance operations recorded other expenses of $134 million in 2017 compared to $128 million in 2016, an increase of $6 million (5%). This increase reflects higher holding company expenses related to employee benefit plans that are tied to stock market performance, partially offset by the impact of a $5 million donation to the University of Cincinnati College of Business in 2016. AFG’s holding companies and other operations outside of its insurance operations recorded other expenses of $128 million in 2016 compared to $115 million in 2015, an increase of $13 million (11%). This increase reflects higher holding company expenses related to employee benefit plans that are tied to stock market
performance, a $5 million donation to the University of Cincinnati College of Business in 2016 and higher expenses related to AFG’s former railroad and manufacturing operations.
Consolidated Income Taxes AFG’s consolidated provision for income taxes was $247 million in 2017 compared to $119 million in 2016, an increase of $128 million (108%). AFG’s consolidated provision for income taxes was $119 million in 2016 compared to $195 million in 2015, a decrease of $76 million (39%). See Note L - “Income Taxes” to the financial statements for an analysis of items affecting AFG’s effective tax rate.
See Note A - “Accounting Policies - Debt Issuance Costs” to the financial statements for a discussion of accounting guidance adopted on January 1, 2016, which impacted the presentation of debt issuance costs.
See Note O - “Insurance - Property and Casualty Insurance Reserves” to the financial statements for a discussion of accounting guidance adopted for annual reporting beginning in 2016, which requires additional disclosures about the liability for unpaid losses and loss adjustment expenses (including accident year information).
In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities which, among other things, requires equity investments that are not accounted for under the equity method of accounting to be measured at fair value with changes in fair value recognized in net earnings, clarifies that the need for a valuation allowance on a deferred tax asset related to available for sale securities should be evaluated with other deferred tax assets and modifies disclosure requirements for financial instruments. AFG will be required to adopt the updated guidance effective January 1, 2018 (early adoption is not permitted). Although recording changes in the fair value of investments in equity securities in net earnings will result in more volatility in AFG’s Statement of Earnings, it is not expected to have a material effect on the carrying value of AFG’s investments or on overall shareholders’ equity as AFG’s investments in equity securities are currently carried at fair value through accumulated other comprehensive income. At the date of adoption, the net unrealized gain on equity securities included in AOCI will be reclassified to retained earnings in the Balance Sheet as the cumulative effect of an accounting change.
In February 2016, the FASB issued ASU 2016-02, Leases, which requires entities that lease assets for terms longer than one year to recognize the assets and liabilities for the rights and obligations created by those leases on the balance sheet based on the present value of cash flows. Qualitative and quantitative disclosures of the amount, timing and uncertainty of cash flows arising from leases will also be required. Although the guidance allows for early adoption, AFG expects to adopt the updated guidance effective January 1, 2019 (when it is required). The guidance will require the earliest comparative period presented to
include the measurement and recognition of existing leases with an adjustment to shareholders’ equity as if the updated guidance had always been applied. Although the guidance will result in higher assets and higher liabilities from the recognition of assets and liabilities related to operating leases, it does not change the manner in which lease expense is recognized in the statement of earnings. Although management is currently evaluating the impact of this guidance, AFG does not expect it to have a material effect on its results of operations or financial position.
Consolidated Statement of Earnings for the years ended December 31, 2017, 2016 and 2015
Consolidated Statement of Comprehensive Income for the years ended December 31, 2017, 2016 and 2015
Consolidated Statement of Changes in Equity for the years ended December 31, 2017, 2016 and 2015
Consolidated Statement of Cash Flows for the years ended December 31, 2017, 2016 and 2015
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 23, 2018 expressed an unqualified opinion thereon.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
In January 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, which, among other things, will require all equity securities currently classified as “available for sale” to be reported at fair value, with holding gains and losses recognized in net earnings, instead of AOCI. AFG will be required to adopt this guidance effective January 1, 2018. At the date of adoption, the $221 million net unrealized gain on equity securities included in AOCI as of December 31, 2017 will be reclassified to retained earnings as the cumulative effect of an accounting change.
Premiums and discounts on fixed maturity securities are amortized using the effective interest method. Mortgage-backed securities (“MBS”) are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are shown in the statement of earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is recorded to reduce the amortized cost of that security to fair value.
To qualify for hedge accounting, at the inception of a derivative contract, AFG formally documents the relationship between the terms of the hedge and the hedged items and its risk management objective. This documentation includes defining how hedge effectiveness and ineffectiveness will be measured on a retrospective and prospective basis.
For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses and unamortized acquisition costs exceed the
The fair values of a CLO’s assets may differ from the separately measured fair values of its liabilities even though the CLO liabilities only have recourse to the CLO assets. AFG has set the carrying value of the CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at a separately measured fair value. CLO earnings attributable to AFG’s shareholders are measured by the change in the fair value of AFG’s investments in the CLOs and management fees earned.
Income Taxes Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. A valuation allowance is established to reduce total deferred tax assets to an amount that will more likely than not be realized.
Effective October 1, 2016, AFG early adopted (on a retrospective basis) ASU 2016-15, which addresses the diversity in practice in how certain cash receipts and cash payments are presented in the statement of cash flows. Among other things, this guidance requires proceeds received from the settlement of corporate-owned life insurance policies to be classified as cash inflows from investing activities and allows premiums paid for policies to be reported as cash outflows either from investing activities or operating activities. AFG has elected to show all corporate-owned life insurance activity in investing activities. Prior to adoption of this guidance, AFG accounted for these transactions as operating activities. In addition, ASU 2016-15 clarifies when distributions received from investees accounted under the equity method should be accounted for as a cash inflow from operating activities or as a cash inflow from investing activities. AFG had previously accounted for all distributions from investments accounted for under the equity method as investing activities. The new guidance solely related to the presentation of certain transactions in the statement of cash flows. Accordingly, adoption of this guidance did not impact AFG’s results of operations or financial position.
Sales of property and casualty insurance outside of the United States represented 5% of AFG’s revenues in 2017 and 4% of AFG’s revenues in 2016 and 2015.
Level 1 - Quoted prices for identical assets or liabilities in active markets (markets in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis). AFG’s Level 1 financial instruments consist primarily of publicly traded equity securities and highly liquid government bonds for which quoted market prices in active markets are available and short-term investments of managed investment entities.
Level 3 - Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable or when the market for a security exhibits significantly less liquidity relative to markets supporting Level 2 fair value measurements. The unobservable inputs may include management’s own assumptions about the assumptions market participants would use based on the best information available at the valuation date. AFG’s Level 3 is comprised of financial instruments whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, observable market information.
AFG’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. AFG’s internal investment professionals are a group of approximately 25 analysts whose primary responsibility is to manage AFG’s investment portfolio. These professionals monitor individual investments as well as overall industries and are active in the financial markets on a daily basis. The group is led by AFG’s chief investment officer, who reports directly to one of AFG’s Co-CEOs. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG’s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. In addition, the Company communicates directly with the pricing services regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities.
The range of adjustments for insurance subsidiary’s credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AFG’s individual fixed-indexed annuity products with an expected range of 6% to 10% in the majority of future calendar years (3% to 23% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flow assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.
Changes in balances of Level 3 financial assets and liabilities carried at fair value during 2017, 2016 and 2015 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.
As previously discussed, these tables exclude the portion of MIE liabilities allocated to Level 3, which are derived from the fair value of the MIE assets.
Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $17 million in 2016.
The impact of implementing new guidance adopted in 2015, as discussed in Note A - “Accounting Policies - Managed Investment Entities.”
Excludes $206 million and $204 million of life contingent annuities in the payout phase at December 31, 2017 and 2016, respectively.
The non-credit related portion of other-than-temporary impairment charges is included in other comprehensive income. Cumulative non-credit charges taken for securities still owned at December 31, 2017 and December 31, 2016, respectively, were $158 million and $189 million. Gross unrealized gains on such securities at December 31, 2017 and December 31, 2016 were $137 million and $130 million, respectively. Gross unrealized losses on such securities at December 31, 2017 and December 31, 2016 were $4 million and $3 million, respectively. These amounts represent the non-credit other-than-temporary impairment charges recorded in AOCI adjusted for subsequent changes in fair values and relate primarily to residential MBS.
The following tables show gross unrealized losses (dollars in millions) on available for sale fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2017 and 2016.
AFG analyzes its MBS securities 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. During 2017, AFG recorded $1 million in other-than-temporary impairment charges related to its residential MBS.
In 2017, AFG recorded approximately $19 million and $4 million in other-than-temporary impairment charges related to other fixed maturities (other than residential MBS securities) and other investments, respectively.
AFG recorded $9 million in other-than-temporary impairment charges on preferred stock in 2017. At December 31, 2017, the gross unrealized losses on preferred stocks of $1 million relate to 7 securities. Three preferred stocks have been in an unrealized loss position for 12 months or more and all are investment grade rated.
The table below sets forth the scheduled maturities of available for sale fixed maturities as of December 31, 2017 (dollars in millions). 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.
There were no investments in individual issuers that exceeded 10% of shareholders’ equity at December 31, 2017 or 2016.
Real Estate and Other Investments Real estate and other investments on AFG’s Balance Sheet includes the following at December 31 (in millions):
Gross realized gains and losses (excluding impairment write-downs and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions consisted of the following (in millions):
The following table summarizes the gain (loss) included in AFG’s Statement of Earnings for changes in the fair value of derivatives that do not qualify for hedge accounting for 2017, 2016 and 2015 (in millions):
Derivatives Designated and Qualifying as Cash Flow Hedges As of December 31, 2017, AFG has entered into ten interest rate swaps that are designated and qualify as highly effective cash flow hedges to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities. The purpose of each of these swaps is to effectively convert a portion of AFG’s floating-rate fixed maturity securities to fixed rates by offsetting the variability in cash flows attributable to changes in short-term LIBOR.
The present value of future profits (“PVFP”) amounts in the table above are net of $141 million and $134 million of accumulated amortization at December 31, 2017 and 2016, respectively. During each of the next five years, the PVFP is expected to decrease at a rate of approximately one-eighth of the balance at the beginning of each respective year.
In 2017, AFG formed two new CLOs, which issued an aggregate of $865 million face amount of liabilities (including $48 million face amount purchased by subsidiaries of AFG). During 2017, AFG subsidiaries also purchased $71 million face amount of senior debt and subordinate tranches of existing CLOs for $71 million. During 2017, AFG subsidiaries received $103 million in sale and redemption proceeds from its CLO investments. In 2016, AFG formed two new CLOs, which issued an aggregate of $866 million face amount of liabilities (including $64 million face amount purchased by subsidiaries of AFG). During 2016, AFG subsidiaries also purchased $24 million face amount of senior debt and subordinate tranches of existing CLOs for $17 million. During 2016, AFG subsidiaries also received $115 million in sale and redemption proceeds from its CLO investments. In 2015, AFG formed two new CLOs, which issued an aggregate of $869 million face amount of liabilities (including $81 million face amount purchased by subsidiaries of AFG). In 2017, two AFG CLOs were substantially liquidated, as permitted by the CLO indentures.
Included in earnings before income taxes in AFG’s Statement of Earnings.
In September 2015, AFG used cash on hand to redeem the $132 million in outstanding AFG 7% Senior Notes due September 2050 at par value. In November 2015, AFG issued $150 million in 6% Subordinated Debentures due in 2055. During 2015, subsidiaries of AFG repaid all of the outstanding notes secured by real estate.
To achieve a desired balance between fixed and variable rate debt, AFG entered into an interest rate swap in June 2015, which effectively converted its 9-7/8% Senior Notes to a floating rate of three-month LIBOR plus 8.099%. In December 2017, AFG settled the interest rate swap contemporaneously with the redemption of the 9-7/8% Senior Notes. At December 31, 2016, the fair value of the interest rate swap (asset of $1 million at that date) and the offsetting adjustment to the carrying value of the notes were both included in the carrying value of the 9-7/8% Senior Notes in the table above.
AFG can borrow up to $500 million under its revolving credit facility, which expires in June 2021. Amounts borrowed under this agreement bear interest at rates ranging from 1.00% to 1.875% (currently 1.375%) over LIBOR based on AFG’s credit rating. No amounts were borrowed under this facility at December 31, 2017 or December 31, 2016.
Cash interest payments on long-term debt were $85 million in 2017, $75 million in 2016 and 2015. In 2017, 2016 and 2015, AFG received $2 million, $3 million and $2 million, respectively, in interest under the interest rate swap discussed above.
Stock Incentive Plans Under AFG’s stock incentive plans, employees of AFG and its subsidiaries are eligible to receive equity awards in the form of stock options, stock appreciation rights, restricted stock awards, restricted stock units and stock awards. At December 31, 2017, there were 8.0 million shares of AFG Common Stock reserved for issuance under AFG’s stock incentive plans.
AFG did not grant any stock options in 2017 or 2016. Options granted in years prior to 2016 have an exercise price equal to the market price of AFG Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant and expire ten years after the date of grant.
The total intrinsic value of options exercised during 2017, 2016 and 2015 was $65 million, $38 million and $52 million, respectively. During 2017, 2016 and 2015, AFG received $33 million, $32 million and $47 million, respectively, in cash from the exercise of stock options. The total tax benefit related to the exercises was $18 million, $11 million and $16 million (including $12 million credited directly to capital surplus in 2015) during those years, respectively.
Includes net unrealized gains of $68 million at December 31, 2017 compared to net unrealized gains of $52 million and $51 million at December 31, 2016 and 2015, related to securities for which only the credit portion of an other-than-temporary impairment has been recorded in earnings.
Other includes the December 2017 reclassification of $145 million stranded in AOCI from accounting for the Tax Cuts and Jobs Act of 2017 to retained earnings (see Note A - “Accounting Policies - Income Taxes”), and the impact on AOCI of the December 2017 sale of redeemable noncontrolling interests in Neon and the November 2016 acquisition of the noncontrolling interest in NATL (see Note B - “Acquisitions and Sale of Businesses”).
The favorable impact of stock-based compensation on AFG’s effective tax rate in the year ended December 31, 2017 reflects the high volume of employee stock option exercises during that period and the increase in the market price of AFG Common Stock.
in the recognition of an additional tax benefit of $56 million in the fourth quarter of 2017, including the recognition of the deferred loss from the 2016 restructuring. Approximately $20 million of the $56 million tax benefit recorded in 2017 reduced current taxes payable for 2017, while the majority of the remaining tax benefit will be received in 2018 from the carry-back of the tax basis capital loss to offset capital gains in prior years.
The Tax Cuts and Jobs Act of 2017 (“TCJA”), which lowers the U.S corporate tax rate to 21% and makes other widespread changes to the U.S. tax code beginning in 2018, was enacted on December 22, 2017. Because the TCJA was enacted in December 2017, AFG recorded the $83 million decrease in its net deferred tax asset resulting from the changes in the tax code (primarily the lower corporate tax rate applicable to 2018 and future years) in the fourth quarter of 2017.
The TCJA is subject to further clarification and interpretation by the U.S. Treasury Department and the Internal Revenue Service. For example, the TCJA changes the way that companies calculate their insurance claims and reserves for tax purposes, including revaluing those tax basis liabilities as of January 1, 2018, based on a methodology and discount factors that have not been published. The resulting transitional deferred tax liability (taxes payable over eight years under the TCJA) and offsetting increase in AFG’s insurance claims and reserves deferred tax assets, were recorded at December 31, 2017 using reasonable estimates based on available information and should be considered provisional in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 118 (“SAB 118”). Because the established transition liability was completely offset by an increase in related deferred tax assets, any adjustment to the provisional amount will not impact AFG’s effective tax rate. In accordance with SAB 118, the insurance claims and reserves transitional deferred tax liability (and offsetting adjustment to the related deferred tax assets) and any other changes in deferred taxes resulting from clarification and interpretation of the TCJA provided during 2018 will be recorded in the period in which the guidance is published.
AFG’s 2012 - 2017 tax years remain subject to examination by the IRS.
Total earnings before income taxes include losses subject to tax in foreign jurisdictions of $58 million in 2017, $160 million in 2016 and $66 million in 2015, primarily related to the Neon Lloyd’s operations.
AFG’s net deferred tax asset at December 31, 2017 and 2016 is included in other assets in AFG’s Balance Sheet. The decrease in AFG’s net deferred tax asset at December 31, 2017 compared to December 31, 2016 reflects the impact of the change in the U.S. corporate tax rate, partially offset by higher pretax unrealized gains on securities.
AFG increased its liability for uncertain tax positions by $1 million in 2015 due to uncertainty in state taxation of its surplus lines insurance subsidiaries. In 2017, this uncertainty was resolved, resulting in total tax payments of less than $1 million.
The property and casualty group’s liability for A&E reserves was $528 million at December 31, 2017; related recoverables from reinsurers (net of allowances for doubtful accounts) at that date were $125 million.
At December 31, 2017, American Premier and its subsidiaries had liabilities for environmental and personal injury claims and other contingencies aggregating $81 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 and other contingencies 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 and other labor disputes.
At December 31, 2017, GAFRI had a liability of $8 million for environmental costs and certain other matters associated with the sales of its former manufacturing operations.
Pretax realized gains on subsidiaries and securities (including other-than-temporary impairments), favorable (adverse) prior year development of AFG’s liability for losses and loss adjustment expenses (“LAE”) and the impact of derivatives related to FIAs were as follows (in millions):
Adverse prior year development for the third quarters of 2017 and 2016 include pretax special charges of $89 million and $36 million, respectively, to strengthen property and casualty insurance A&E reserves. As a result of the Neon reinsurance to close agreement discussed in Note O - “Insurance,” Neon recorded $42 million in favorable development in the fourth quarter of 2017, of which $24 million related to its ongoing lines of business and $18 million related to its exited lines of business. During the second quarter of 2016, AFG recorded a pretax charge of $65 million related to Neon’s claims review of its exited lines of business, including $57 million to increase loss reserves primarily related to its medical malpractice and general liability classes.
Results for the third quarter of 2017 and 2016 include pretax special charges of $24 million and $5 million, respectively, to strengthen reserves for A&E exposures related to AFG’s former railroad and manufacturing operations.
Cash and securities owned by U.S.-based insurance subsidiaries, having a carrying value of approximately $1.08 billion at December 31, 2017, were on deposit as required by regulatory authorities. In addition, $205 million was on deposit in support of AFG’s underwriting activities at Lloyd’s. At December 31, 2017, AFG and its subsidiaries had $447 million in undrawn letters of credit (none of which was collateralized) supporting the underwriting capacity of its U.K.-based Lloyd’s insurer, Neon.
The level of detail in which data is analyzed varies among the different lines of business. Data is generally analyzed by major product or by coverage within product, using countrywide data; however, in some situations, data may be reviewed by state or region. Appropriate segmentation of the data is determined based on data credibility, homogeneity of development patterns, mix of business, and other actuarial considerations.
The net increase in the provision for claims of prior years in 2015 reflects (i) the $67 million special charge to increase asbestos and environmental reserves, (ii) higher than expected claim severity at National Interstate and higher than anticipated claim frequency in the ocean marine business (all within the Property and transportation sub-segment) and (iii) adverse reserve development at Neon (within the Specialty casualty sub-segment). This adverse development was partially offset by (i) lower than expected claim severity in the property and inland marine business, agricultural operations and a run-off book of homebuilders business (all within the Property and transportation sub-segment), (ii) lower than anticipated claim severity in workers’ compensation business, lower than anticipated claim severity and frequency in excess liability insurance and lower than expected claim severity in directors and officers liability insurance (all within the Specialty casualty sub-segment), and (iii) lower than anticipated claim frequency and severity in the surety business and products for financial institutions and lower than expected claim severity in the fidelity business and run-off collateral value insurance (all within the Specialty financial sub-segment).
In May 2015, the FASB issued ASU 2015-09, Financial Services-Insurance: Disclosures about Short-Duration Contracts. The ASU requires insurance entities to disclose incurred and paid claims development information by accident year, net of reinsurance. All of AFG’s material short-duration insurance contracts are written in its property and casualty insurance segment. The development tables and the associated disclosures are aggregated in the following Specialty sub-segments: Property and transportation, Specialty casualty, Specialty financial and Other specialty. See Note C - “Segments of Operations” to the financial statements for a discussion of these sub-segments.
Closed Block of Long-Term Care Insurance Following the completion of the sale of substantially all of its run-off long-term care insurance business in December 2015, AFG’s remaining long-term care insurance reserves were $39 million at December 31, 2017 and $37 million at December 31, 2016, net of reinsurance recoverables and excluding the impact of unrealized gains on securities. AFG’s remaining outstanding long-term care policies have level premiums and are guaranteed renewable. Premium rates can potentially be increased in reaction to adverse experience; however, any rate increases would require regulatory approval.
FHLB Funding Agreements Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions. Members are required to purchase stock in the FHLB in addition to maintaining collateral deposits that back any funds advanced. GALIC’s $44 million investment in FHLB capital stock at December 31, 2017, is included in other investments at cost. Membership in the FHLB provides the annuity operations with an additional source of liquidity. These advances further the FHLB’s mission of improving access to housing by increasing liquidity in the residential mortgage-backed securities market. In the fourth quarter of 2017, GALIC refinanced the terms on advances totaling $831 million, which lowered the spread over LIBOR. In the fourth quarter of 2017, GALIC also repaid $64 million to the FHLB, decreasing the total amount advanced to $871 million (included in annuity benefits accumulated) at December 31, 2017. Interest rates under the various funding agreements on the advances range from 0.03% to 0.35% over LIBOR (average rate of 1.75% at December 31, 2017). While these advances must be repaid between 2018 and 2020 ($285 million in 2018 and $586 million in 2020), GALIC has the option to prepay all or a portion of the advances. GALIC has invested the proceeds from the advances in fixed maturity securities with similar expected lives as the advances for the purpose of earning a spread over the interest payments due to the FHLB. The advances on these agreements are collateralized by fixed maturity investments, which have a total fair value of $1.04 billion (included in available for sale fixed maturity securities) at December 31, 2017. Interest credited on the funding agreements, which is included in annuity benefits, was $14 million in 2017, $8 million in 2016 and $3 million in 2015.
The National Association of Insurance Commissioners’ (“NAIC”) model law for risk based capital (“RBC”) applies to both life and property and casualty insurance 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. Companies below specific trigger points or ratios are subject to regulatory action. At December 31, 2017 and 2016, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements. AFG’s insurance companies did not use any prescribed or permitted statutory accounting practices that differed from the NAIC statutory accounting practices at December 31, 2017 or 2016.
Payments of dividends by AFG’s insurance companies are subject to various state laws that limit the amount of dividends that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 2018 from its insurance subsidiaries without seeking regulatory approval is $826 million. Additional amounts of dividends require regulatory approval.
AFG paid common stock dividends to shareholders totaling $421 million, $187 million and $178 million in 2017, 2016 and 2015, respectively. Currently, there are no regulatory restrictions on AFG’s retained earnings or net earnings that materially impact its ability to pay dividends. Based on shareholders’ equity at December 31, 2017, AFG could pay dividends in excess of $1 billion without violating its most restrictive debt covenant. However, the payment of future dividends will be at the discretion of AFG’s Board of Directors and will be dependent on many factors including AFG’s financial condition and results of operations, the capital requirements of its insurance subsidiaries, and rating agency commitments.
Reinsurance In the normal course of business, AFG’s insurance subsidiaries cede reinsurance to other companies to diversify risk and limit maximum loss arising from large claims. However, AFG remains liable to its insureds regardless of whether a reinsurer is able to meet its obligations. The following table shows (in millions) (i) amounts deducted from property and casualty written and earned premiums in connection with reinsurance ceded, (ii) written and earned premiums included in income for reinsurance assumed and (iii) reinsurance recoveries, which represent ceded losses and loss adjustment expenses.
In June 2017, AFG’s property and casualty insurance subsidiaries entered into a reinsurance agreement to obtain supplemental catastrophe protection through a catastrophe bond structure with Riverfront Re Ltd. (“Riverfront”). The reinsurance agreement provides supplemental reinsurance coverage up to 95% of $200 million (fully collateralized) for catastrophe losses in excess of $100 million (per occurrence and annual aggregate) occurring between June 1, 2017 and December 31, 2020. In connection with the reinsurance agreement, Riverfront issued notes to unrelated investors for the full amount of coverage provided under the reinsurance agreement. Through December 31, 2017, AFG’s incurred catastrophe losses have not reached the level of attachment for the catastrophe bond structure. Riverfront is a variable interest entity in which AFG does not have a variable interest because the variability in Riverfront’s results will be absorbed entirely by the investors in Riverfront. Accordingly, Riverfront is not consolidated in AFG’s financial statements and the reinsurance agreement is accounted for as ceded reinsurance. AFG’s cost for this coverage is approximately $11 million per year.
AFG has reinsured approximately $8.32 billion of its $12.05 billion in face amount of life insurance at December 31, 2017 compared to $10.22 billion of its $13.49 billion in face amount of life insurance at December 31, 2016. Life written premiums ceded were $28 million, $31 million and $40 million for 2017, 2016 and 2015, respectively. Reinsurance recoveries on ceded life policies were $35 million, $41 million and $50 million for 2017, 2016 and 2015, respectively.
Variable Annuities At December 31, 2017, the aggregate guaranteed minimum death benefit value (assuming every variable annuity policyholder died on that date) on AFG’s variable annuity policies exceeded the fair value of the underlying variable annuities by $15 million, compared to $20 million at December 31, 2016. Death benefits paid in excess of the variable annuity account balances were less than $1 million in each of the last three years.
Allowance for Uncollectible Reinsurance AFG’s aggregate allowance for uncollectible reinsurance recoverables was $20 million at December 31, 2017 and $22 million at December 31, 2016. AFG reviews the allowance quarterly and adjusts it as necessary to reflect changes in estimates of uncollectible balances. AFG recorded net expense reductions against the allowance of less than $1 million in both 2017 and 2016 and $3 million in 2015. In 2017, the allowance was reduced by reinsurance recoverable write-offs of $2 million.
Financial Instruments - Unfunded Commitments On occasion, AFG and its subsidiaries have entered into financial instrument transactions that may present off-balance-sheet risks of both a credit and market risk nature. These transactions include commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. At December 31, 2017, AFG and its subsidiaries had commitments to fund credit facilities and contribute capital to limited partnerships and limited liability corporations of approximately $484 million.
Benefit Plans AFG expensed approximately $45 million in 2017, $43 million in 2016 and $34 million in 2015 for its retirement and employee savings plans.
The information required by the following Items will be included in AFG’s definitive Proxy Statement for the 2018 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after the end of the Registrant’s fiscal year and is incorporated herein by reference.
Senior Executive Long Term Incentive Compensation Plan, filed as Appendix A to AFG’s Proxy Statement filed on April 1, 2016.
Credit Agreement dated June 2, 2016, among American Financial Group, Inc., Bank of America, N.A., as Administrative Agent, and several lenders, filed as Exhibit 10.1 to AFG’s Form 8-K filed on June 2, 2016.