Includes special cash dividends of $1.00 per share paid in December 2014 and 2013 and $0.25 per share paid in December 2012.
Adjusted shareholders’ equity and adjusted book value per share exclude appropriated retained earnings and net unrealized gains related to fixed maturity securities. Management believes that investors find a measurement of shareholders’ equity excluding these items to be meaningful as (i) the unrealized gain on fixed maturities fluctuates with changes in interest rates in a way that is primarily only meaningful to AFG if it sells those investments and (ii) appropriated retained earnings represents amounts that will ultimately inure to the debt holders of the collateralized loan obligations managed by AFG.
lower earnings in the annuity segment resulting from the impact of changes in interest rates and the stock market on the fair value accounting for fixed-indexed annuities, and
Full year 2014 net earnings attributable to AFG’s shareholders were $452 million ($4.97 per share, diluted) compared to $471 million ($5.16 per share) in 2013, reflecting:
Significant accounting policies are summarized in Note A - “Accounting Policies” to the financial statements. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions change and, thus, impact amounts reported in the future. The areas where management believes the degree of judgment required to determine amounts recorded in the financial statements make accounting policies critical are as follows:
AFG’s ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.90 for the year ended December 31, 2014. Excluding annuity benefits, this ratio was 7.95. Although the ratio excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
Net Cash Used in Investing Activities AFG’s investing activities consist primarily of the investment of funds provided by its property and casualty and annuity products. Net cash used in investing activities was $3.62 billion in 2014 compared to $2.92 billion in 2013, an increase of $704 million. In addition to the investment of funds provided by the insurance operations, investing activities also include the purchase and disposal of managed investment entity investments (collateralized loan obligations) which are presented separately in AFG’s Balance Sheet. Net investment activity in the managed investment entities was a $275 million use of cash in 2014 compared to a $478 million source of cash in 2013, accounting for a $753 million increase in net cash used in investing activities in 2014 compared to 2013. See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements.
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 $2.10 billion in 2014 compared to $2.09 billion in 2013, an increase of $12 million. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $1.97 billion in 2014 compared to $2.68 billion in 2013, resulting in a $711 million decrease in net cash provided by financing activities. During 2014, AFG repurchased 3.3 million shares of its Common Stock for $191 million compared to 1.4 million shares repurchased in 2013 for $70 million, which accounted for a $121 million decrease in net cash provided by financing activities in 2014 compared to 2013. In September 2014, AFG issued $150 million of 6-1/4% Subordinated Debentures due 2054, the net proceeds of which contributed $145 million to net cash provided by financing activities in 2014. Financing activities also include the issuance and retirement of managed investment entity liabilities, which are nonrecourse to AFG and presented separately in AFG’s Balance Sheet. The issuance of managed investment entity liabilities exceeded retirements by $306 million in 2014 while the retirement of managed investment entity liabilities exceeded issuances by $368 million in 2013, accounting for a $674 million increase in net cash provided by financing activities in 2014 compared to 2013. See Managed Investment Entities in Note A - “Accounting Policies” and Note H - “Managed Investment Entities” to the financial statements.
Net cash provided by financing activities was $2.09 billion in 2013 compared to $989 million in 2012, an increase of $1.10 billion. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $2.68 billion in 2013 compared to $1.53 billion in 2012, resulting in a $1.15 billion increase in net cash provided by financing activities. During 2013, AFG repurchased 1.4 million shares of its Common Stock for $70 million compared to 10.9 million shares repurchased in 2012 for $415 million, which accounted for $345 million of the increase in net cash provided by financing activities in 2013 compared to 2012. The retirement of managed investment entity liabilities exceed issuances by $368 million in 2013 compared to $49 million in 2012, accounting for a $319 million reduction in net cash provided by financing activities in 2013 compared to 2012.
Parent Holding Company Liquidity Management believes AFG has sufficient resources to meet its liquidity requirements. If funds generated from operations, including dividends, tax payments and borrowings from subsidiaries, are insufficient to meet fixed charges in any period, AFG would be required to utilize parent company cash and marketable securities or to generate cash through borrowings, sales of other assets, or similar transactions.
During 2014, AFG repurchased 3.3 million shares of its Common Stock for $191 million. In December 2014, AFG paid a special cash dividend of $1.00 per share of AFG Common Stock totaling approximately $88 million. In January 2015, AFG repurchased 506,276 additional shares of its Common Stock for $30 million.
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 a substantial 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. At December 31, 2014, GALIC had $440 million in outstanding advances from the FHLB (included in annuity benefits accumulated), bearing interest at rates ranging from 0.02% to 0.23% over LIBOR (average rate of 0.32% at December 31, 2014). While these advances must be repaid between 2016 and 2018, 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 for the purpose of earning a spread over the interest payments due to 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, 2014, AFG could reduce the average crediting rate on approximately $18 billion of traditional fixed and fixed-indexed deferred annuities without guaranteed withdrawal benefits by approximately 58 basis points (on a weighted average basis).
Parent Net Cash Provided by Operating Activities Parent holding company cash flows from operating activities consist primarily of dividends and tax payments received from AFG’s insurance subsidiaries, reduced by tax payments to the IRS and holding company interest and other expenses. Parent holding company net cash provided by operating activities was $372 million in 2014 compared to $428 million in 2013 and $380 million in 2012. Higher dividends from subsidiaries received in 2013 as compared to 2014 and 2012 were the primary driver of the $56 million decrease in net cash provided by operating activities in 2014 compared to 2013 and the $48 million increase in net cash provided by operating activities in 2013 compared to 2012.
Reserve projections include anticipated cash benefit payments only. Projections do not include any impact for future earnings or additional premiums. Based on the same assumptions, AFG projects reinsurance recoveries related to life, accident and health reserves totaling $895 million as follows: Within 1 year - $119 million; 2-3 years - $139 million; 4-5 years - $119 million; and thereafter - $518 million. Actual payments and their timing could differ significantly from these estimates.
Fixed income investment funds are generally invested in securities with intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions. At December 31, 2014, the average life of AFG’s fixed maturities was about 6-1/2 years.
Fair values for AFG’s portfolio are determined by AFG’s internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on published closing prices. For mortgage-backed securities (“MBS”), which comprise approximately 22% of AFG’s fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the remainder of AFG’s fixed maturity portfolio, approximately 82% are priced using pricing services and the balance is priced primarily by using non-binding broker quotes. When prices obtained for the same security vary, AFG’s internal investment professionals select the price they believe is most indicative of an exit price.
In general, the fair value of AFG’s fixed maturity investments is inversely correlated to changes in interest rates. The following table demonstrates the sensitivity of such fair values to reasonably likely changes in interest rates by illustrating the estimated effect on AFG’s fixed maturity portfolio that an immediate increase of 100 basis points in the interest rate yield curve would have at December 31, 2014 (dollars in millions). Effects of increases or decreases from the 100 basis points illustrated would be approximately proportional.
Approximately 87% of the fixed maturities held by AFG at December 31, 2014, 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.
MBS are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates. Although interest rates have been low in recent years, tighter lending standards have resulted in fewer buyers being able to refinance the mortgages underlying much of AFG’s non-agency residential MBS portfolio.
The National Association of Insurance Commissioners (“NAIC”) assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC retains third-party investment management firms to assist in the determination of appropriate NAIC designations for mortgage-backed securities based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value.
At December 31, 2014, 98% (based on statutory carrying value of $6.27 billion) of AFG’s MBS securities had a NAIC designation of 1 or 2.
Municipal bonds represented approximately 22% of AFG’s fixed maturity portfolio at December 31, 2014. AFG’s municipal bond portfolio is high quality, with 98% 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, 2014, approximately 72% of the municipal bond portfolio was held in revenue bonds, with the remaining 28% held in general obligation bonds. General obligation securities of California, Illinois, Michigan, New Jersey, New York and Puerto Rico collectively represented approximately 1% of this portfolio.
The following table summarizes (dollars in millions) the unrealized loss for all securities with unrealized losses by issuer quality and the length of time those securities have been in an unrealized loss position:
Management believes that each method has particular strengths and weaknesses and that no single estimation method is most accurate in all situations. When applied to a particular group of claims, the relative strengths and weaknesses of each method can change over time based on the facts and circumstances. Ultimately, the estimation methods chosen are those which management believes produce the most reliable indication for the particular liabilities under review.
While current factors and reasonably likely changes in variable factors are considered in estimating the liability for unpaid losses, there is no method or system that can eliminate the risk of actual ultimate results differing from such estimates. As shown in the reserve development table (loss triangle) on page 7, the original estimates of AFG’s liability for losses and loss adjustment expenses, net of reinsurance and including the effect of special charges for asbestos and environmental exposures, over the past 10 years have developed through December 31, 2014, to be deficient (for two years) by as much as 7.7% and redundant (for seven years) by as much as 14.9%. This development illustrates the historical impact caused by variability in factors considered in estimating insurance reserves.
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, 2014, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
AFG recorded favorable prior year reserve development of $7 million in both 2014 and 2013, as favorable reserve development in the business written in California was partially offset by adverse reserve development in other states. AFG recorded adverse prior year reserve development of $11 million in 2012, due primarily to higher than expected claim severity, particularly in the 2011 accident year.
During 2012, AFG recorded $28 million of favorable prior year reserve development on claims related to the use of Chinese drywall in residential construction in prior years. Much of the uncertainty in estimating the potential exposure and possible liabilities for such claims was clarified during 2012 by favorable judicial decisions and the announcements of settlements of class action lawsuits making the potential liabilities better defined and more effectively anticipated.
While management applies the actuarial methods mentioned above, more judgment may be needed to determine appropriate reserves due to the complexity of claims, litigation and the length of time necessary to determine exposure.
Reserves of foreign operations relate primarily to the operations of Marketform Group, Limited, AFG’s wholly-owned United Kingdom-based Lloyd’s insurer. Historically, the largest line of business written by Marketform has been non-U.S. medical malpractice, which provides coverage for injuries and damages caused by medical care providers, including but not limited to, hospitals and their physicians. Although Marketform offers this product in approximately 30 countries, the majority of the business has been written in the United Kingdom, Australia and Italy. Significant variables in estimating the loss reserves for the medical malpractice business include:
Outside of its property and casualty operations, AFG also has reinsurance recoverables totaling $946 million, including$378 million related to the run-off life business, $280 million related to the run-off long-term care business, $237 million related to the August 2012 sale of the Medicare supplement and critical illness businesses and $51 million in the annuity
Approximately 39% of AFG’s net asbestos reserves relate to policies written directly by AFG subsidiaries. Claims from these policies generally are product oriented claims with only a limited amount of non-products exposures, and are dominated by small to mid-sized commercial entities that are mostly regional policyholders with few national target defendants. The remainder is assumed reinsurance business that includes exposures for the periods 1954 to 1983. The asbestos and environmental assumed claims are ceded by various insurance companies under reinsurance treaties. A majority of the individual assumed claims have exposures of less than $100,000 to AFG. Asbestos losses assumed include some of the industry known manufacturers, distributors and installers. Pollution losses include industry known insured names and sites.
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, 2014, the property and casualty insurance segment’s three year survival ratios, excluding amounts associated with the settlements of A.P. Green Industries and another large claim, were 14.2 times paid losses for the asbestos reserves, 5.8 times paid losses for environmental reserves and 9.6 times paid losses for total A&E reserves. Overall, these ratios compare favorably with data published by A.M. Best in December 2014, which indicate that industry survival ratios were 10.1 for asbestos, 6.3 for environmental, and 9.1 for total A&E reserves at December 31, 2013.
AFG’s property and casualty insurance segment recorded a $24 million pretax special charge to increase its asbestos reserves by $4 million (net of reinsurance) and its environmental reserves by $20 million (net of reinsurance). As the overall industry exposure to asbestos has matured, the focus of litigation has shifted to smaller companies and companies with ancillary exposures. AFG’s insureds with these exposures have been the driver of the property and casualty segment’s asbestos reserve increases in recent years. The increase in property and casualty environmental reserves was attributed primarily to AFG’s increased defense costs and a number of claims where the estimated costs of remediation have increased. There were no newly identified or emerging broad industry trends that management believes would significantly impact the overall adequacy of AFG’s A&E reserves.
At December 31, 2012, loss recognition testing assumptions for claim costs, expenses and persistency were updated based on the results of AFG’s periodic internal analysis of claim experience, including the impact of supplemental data from an external actuarial study that used a large, uniform database of industry experience. Ultimate voluntary lapse rates for most in-force business range from 0.5% to 2.5%, varying by policy form, marital status, and the presence of inflation protection. Projected reinvestment rates are based on assumptions about future treasury rates, investment spreads and the types and duration of future investments. In aggregate, net reinvestment rates (net of expense and default assumptions) in the 2012 loss recognition testing were estimated at 4.54% for 2013, and projected to increase gradually to 6.00% in 2023. After 2023, reinvestment rates were projected to be relatively flat. As a result of the updated assumptions discussed above, AFG recorded a $153 million pretax loss recognition charge in the fourth quarter of 2012 to write off all of the remaining deferred policy acquisition costs and strengthen reserves in this business. As part of the loss recognition charge, policy benefit assumptions were reset to the 2012 assumptions and will not be changed again unless a future loss recognition event occurs.
At December 31, 2013, the most significant loss recognition testing assumption update was to projected reinvestment rates. Due to higher than anticipated increases in interest rates, net reinvestment rates (net of expense and default assumptions) were estimated at 5.01% for 2014 and projected to increase gradually to 6.25% in 2022. After 2022, reinvestment rates were projected to be relatively flat. As a result of the updated assumptions, the existing contract liabilities plus the present value of future premiums (including reasonably expected rate increases) exceeded the present value of future claims payments and related settlement and maintenance costs by approximately $64 million (a loss recognition margin). As a result, no additional loss recognition charges were recorded in 2013.
Although management believes that its loss recognition assumptions at December 31, 2014, are reasonable, actual results will depend on how well future experience conforms to these assumptions, including the level and type of claim activity, persistency, expected rate increase approvals, and reinvestment rates. The relationship among these assumptions is complex, with deviations in one assumption often influencing the outcome of others. External factors, including, but not limited to changes in the regulatory and judicial environment, along with medical advancements and innovation in long-term care delivery systems, could have a material impact on the ultimate performance of this closed block of business. The loss recognition charge recorded in 2012 did not include any margin for adverse deviation in the reserve assumptions (in accordance with accounting guidance).
Includes net investment income of ($2 million) in the fourth quarter of 2014 and $8 million in the fourth quarter of 2013 representing the change in fair value of AFG’s CLO investments plus $7 million and $4 million in the fourth quarter of 2014 and 2013, respectively, in CLO management fees earned.
Includes $31 million in net investment income representing the change in fair value of AFG’s CLO investments plus $18 million in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $18 million in distributions recorded as interest expense by the CLOs.
Net earnings attributable to shareholders decreased $31 million in the fourth quarter of 2014 compared to the same period of 2013 reflecting significantly lower realized gains on securities, partially offset by higher core net operating earnings. Core net operating earnings increased $5 million in the fourth quarter of 2014 compared to the fourth quarter of 2013 due to higher underwriting profits in the property and casualty insurance segment and higher property and casualty net investment income due primarily to the investment of cash acquired in the Summit acquisition in April 2014, partially offset by lower earnings in the annuity segment.
Net earnings attributable to shareholders decreased $19 million for the full-year of 2014 compared to the same period of 2013 reflecting significantly lower realized gains on securities, partially offset by higher core net operating earnings and lower special A&E charges. Core net operating earnings increased $54 million in 2014 compared to 2013 due primarily to higher underwriting profits and higher net investment income in the property and casualty insurance segment and lower holding company expenses.
For the full-year of 2013 compared to 2012, net earnings attributable to shareholders decreased as higher core net operating earnings were more than offset by the net impact of the following items recorded in 2012: (i) a $114 million after tax gain on the sale of AFG’s Medicare supplement and critical illness businesses, (ii) tax benefits of $67 million related to the favorable resolution of certain tax litigation and settlement of open tax years, and (iii) an after tax charge of $99 million to write off deferred acquisition costs and strengthen reserves in the closed block of long-term care insurance. Net earnings attributable to shareholders were also impacted by special A&E charges, which were higher in 2013 compared to 2012. Core net operating earnings increased $71 million in 2013 compared to 2012 reflecting significantly higher profits in both the annuity segment and Specialty property and casualty insurance operations, partially offset by the absence of earnings from the Medicare supplement and critical illness businesses, which were sold in August 2012.
RESULTS OF OPERATIONS - QUARTERS ENDED DECEMBER 31, 2014 AND 2013
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 quarters ended December 31, 2014 and 2013 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):
While AFG desires and seeks to earn an underwriting profit on all of its business, it is not always possible to do so. As a result, AFG attempts to expand in the most profitable businesses and control growth or even reduce its involvement in the least profitable businesses.
Net written premiums (“NWP”) for AFG’s property and casualty insurance segment were $1.03 billion for the fourth quarter of 2014 compared to $821 million for the fourth quarter of 2013, an increase of $204 million (25%). Detail of AFG’s property and casualty net written premiums is shown below (dollars in millions):
Property and transportation Gross written premiums increased $35 million (8%) in the fourth quarter of 2014 compared to the fourth quarter of 2013 reflecting growth in most businesses in this group. Average renewal rates for this group were up approximately 4% in the fourth quarter of 2014. Reinsurance premiums ceded as a percentage of gross written premiums increased 1 percentage point in the fourth quarter of 2014 compared to the fourth quarter of 2013 reflecting a change in the mix of business.
Specialty financial Gross written premiums decreased $4 million (2%) for the fourth quarter of 2014 compared to the fourth quarter of 2013, due primarily to the impact of the October 2013 sale of a service contract business, which ceded all of its premiums under reinsurance contracts. Average renewal rates for this group were flat in the fourth quarter of 2014. Reinsurance premiums ceded as a percentage of gross written premiums declined 2 percentage points due to the sale of the service contract business, partially offset by higher cessions of certain business in the financial institutions business.
Property and transportation Underwriting profit for this group was $22 million for the fourth quarter of 2014 compared to$17 million in the fourth quarter of 2013, an increase of $5 million (29%). The increase is due primarily to higher underwriting profit in the property and inland marine operations, partially offset by lower underwriting profit in the transportation operations.
Specialty casualty Underwriting profit for this group was $36 million for the fourth quarter of 2014 compared to $32 million in the fourth quarter of 2013, an increase of $4 million (13%). This increase was due primarily to higher profitability in the workers’ compensation businesses, including the impact of the Summit business acquired in April 2014, partially offset by $14 million of adverse prior year reserve development, primarily attributable to the international operations.
Other specialty Underwriting profit for this group was $3 million for the fourth quarter of 2014 compared to $9 million in the fourth quarter of 2013, a decrease of $6 million (67%). The decrease reflects lower profitability in the business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments.
Specialty casualty The 3.6 percentage point increase in the loss and LAE ratio for the current year, excluding catastrophe losses reflects the inclusion of Summit following its acquisition in April 2014, which has a higher loss and LAE ratio than AFG’s overall Specialty casualty group and higher losses in the general liability and foreign operations, partially offset by higher profitability in the California workers’ compensation business.
Specialty casualty Net adverse reserve development of $14 million in the fourth quarter of 2014 reflects adverse reserve development at Marketform and higher than expected claim severity in contractor claims and in a run-off book of casualty business, partially offset by lower than anticipated claim severity in specialty workers’ compensation business. Net adverse reserve development of $2 million in the fourth quarter of 2013 reflects higher than expected claim severity in products liability claims and contractor claims as well as adverse reserve development at Marketform, substantially offset by lower frequency of severe claims in the directors and officers and workers’ compensation businesses.
Specialty financial Net favorable reserve development of $4 million in the fourth quarter of 2014 reflects lower than expected claim severity in the surety and fidelity businesses. Net favorable reserve development of $4 million in the fourth quarter of 2013 reflects lower than expected frequency of significant claims in the foreign credit business where economic conditions did not affect this line as adversely as previously anticipated.
Other specialty In addition to the development discussed above, total Specialty prior year reserve development includes net favorable reserve development of $3 million in the fourth quarter of 2014 and $6 million in the fourth quarter of 2013, reflecting amortization of the deferred gain on the retroactive insurance transaction entered into in connection with the sale of a business in 1998 and reserve development associated with AFG’s internal reinsurance program.
AFG’s property and casualty commissions and other underwriting expenses (“U/W Exp”) were $303 million in the fourth quarter of 2014 compared to $247 million for the fourth quarter of 2013, an increase of $56 million (23%). AFG’s underwriting expense ratio, calculated as commissions and other underwriting expenses divided by net premiums earned, was 28.6% for the fourth quarter of 2014 compared to 28.9% for the fourth quarter of 2013, a decrease of 0.3 percentage points. Detail of AFG’s property and casualty commissions and other underwriting expenses and underwriting expense ratios is shown below (dollars in millions):
The $56 million increase in commissions and other underwriting expenses for the fourth quarter of 2014 as compared to the fourth quarter of 2013 reflects the acquisition of Summit in April 2014. The overall decrease of 0.3% in AFG’s expense ratio for the fourth quarter of 2014 as compared to the fourth quarter of 2013 reflects the inclusion of Summit following its acquisition in April 2014, which has a lower expense ratio than AFG’s overall property and casualty operations and the impact of higher premiums on the ratio.
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums decreased 2.9 percentage points for the fourth quarter of 2014 compared to the fourth quarter of 2013, due primarily to the inclusion of Summit following its acquisition in April 2014, which has a lower expense ratio than AFG’s overall Specialty casualty group and the impact of higher premiums on the ratio.
Net investment income in AFG’s property and casualty operations was $75 million for the fourth quarter of 2014 compared to $67 million in the fourth quarter of 2013, an increase of $8 million (12%). In recent years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG’s investment portfolio yield. The average invested assets and overall yield earned on investments held by AFG’s property and casualty operations are provided below (dollars in millions):
Other income and expenses, net for AFG’s property and casualty operations was a net expense of $11 million for the fourth quarter of 2014 compared to $6 million for the fourth quarter of 2013, an increase of $5 million (83%). The table below details the items included in other income and expenses, net for AFG’s property and casualty operations (in millions):
AFG’s annuity operations contributed $85 million in pretax earnings in the fourth quarter of 2014 compared to $92 million in the fourth quarter of 2013, a decrease of $7 million (8%). While AFG’s average annuity investments (at amortized cost) were 14% higher for the fourth quarter of 2014 as compared to the fourth quarter of 2013, the benefit of this growth was more than offset by the run-off of higher yielding investments and the impact that fluctuations in interest rates in the fourth quarter of 2014 and 2013 had on the fair value accounting for fixed-indexed annuities (“FIAs”). AFG’s periodic detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations resulted in a net annuity expense reduction of $1 million in the fourth quarter of 2014 compared to a $2 million charge in the fourth quarter of 2013.
accumulated, decreased 0.14 percentage points in the fourth quarter of 2014 compared to the fourth quarter of 2013. During the fourth quarter of 2014, interest rates credited on new premiums generally ranged from 1.00% to 2.00%.
Annuity policy charges and other miscellaneous income, which consist primarily of surrender charges, were $12 million in the fourth quarter of 2014 compared to $14 million in the fourth quarter of 2013, a decrease of $2 million (14%). This decrease reflects the impact of $4 million in income from the sale of real estate recorded in the fourth quarter of 2013, partially offset by growth in the annuity business.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) for the fourth quarter of 2014 was $13 million compared to $16 million for the fourth quarter of 2013, a decrease of $3 million (19%). In addition to interest credited to policyholders’ accounts and the change in fair value of derivatives related to fixed-indexed annuities, annuity benefits expense also includes the following expenses (in millions, net of guaranteed withdrawal benefit fees):
Excluding the impact of unlocking charges, AFG’s amortization of DPAC and commission expenses as a percentage of average fixed annuity benefits accumulated was 0.61% for the fourth quarter of 2014 and 0.75% for the fourth quarter of 2013 and has generally ranged between 0.70% and 0.80%. 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 lower interest rates during the fourth quarter of 2014 on the fair value of derivatives related to fixed-indexed annuities (discussed below) resulted in a partially offsetting deceleration in the amortization of DPAC; conversely, higher interest rates during the fourth quarter of 2013 had a positive impact on the fair value of the derivatives, resulting in a partially offsetting acceleration in the amortization of DPAC.
Annuity other expenses for the fourth quarter of 2014 were $17 million compared to $27 million for the fourth quarter of 2013, a decrease of $10 million (37%). The fourth quarter of 2014 includes the favorable impact of settling certain accrued expenses
at a lower cost than previously estimated while annuity other expenses for the fourth quarter of 2013 includes a $7 million charge to write off certain previously capitalized project costs. Annuity other expenses represent primarily general and administrative expenses, as well as selling and issuance expenses that are not deferred. As a percentage of average fixed annuity benefits accumulated, these expenses decreased 0.25 percentage points for the fourth quarter of 2014 as compared to the fourth quarter of 2013. In general, this percentage is expected to decrease as AFG’s annuity business grows and annuity other expenses remain relatively stable.
AFG’s fixed-indexed annuities, which represented approximately one-half of annuity benefits accumulated at December 31, 2014, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG’s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will generally be offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives that must be marked-to-market through earnings each period. The fair values of these derivatives are impacted by actual and expected stock market performance and interest rates as well as other factors. For a list of other factors impacting the fair value of the index-based component of AFG’s annuity benefits accumulated, see Note D - “Fair Value Measurements” to the financial statements. Excluding the impact of unlocking charges, the net change in fair value of derivatives related to fixed-indexed annuities increased annuity benefits by $18 million in the fourth quarter of 2014 and reduced annuity benefits by $11 million in the fourth quarter of 2013. The $18 million increase in the fourth quarter of 2014 reflects the negative impact of lower interest rates on the derivatives, partially offset by the favorable impact of strong stock market performance. Conversely, the $11 million decrease in the fourth quarter of 2013 reflects the positive impact of moderately higher interest rates and strong stock market performance on these derivatives.
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, 2014 and 2013 (in millions):
In the fourth quarters of 2014 and 2013, AFG conducted a detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded charges (expense reductions) in annuity benefits expense and annuity and supplemental insurance acquisition expenses related to its annuity business. AFG’s net annuity unlocking expense reduction of $1 million in 2014 and net annuity unlocking charge of $2 million in 2013 impacted AFG’s financial statements as follows (in millions):
Although the table above includes the impact of assumption changes in both the fixed and variable annuity businesses, the vast majority of the net charge in each period relates to the fixed (including fixed-indexed) annuity business. The 2014 net expense reduction was due primarily to the impact of changes in assumptions to reflect a decrease in future expected call option costs related to the fixed-indexed annuity business and lower lapses, partially offset by lower future investment yield assumptions. Reinvestment rates used to project future investment yields are based primarily on 7-year and 10-year corporate bond yields. For the 2014 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 3.57% in 2015, grading up ratably to an ultimate net reinvestment rate of 5.54% in 2022 and beyond.
The 2013 net charge was due primarily to the impact of changes in assumptions to reflect increased future investment yields being more than offset by an increase in future expected call option costs related to the fixed-indexed annuity business, and higher crediting rates and lapse assumptions. For the 2013 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 4.05% in 2014, grading up to an ultimate net reinvestment rate of 5.52% in 2020 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, 2014 and 2013 (in millions):
Other income in the table above includes $7 million and $4 million in the fourth quarter of 2014 and 2013, respectively, in management fees paid to AFG by the AFG-managed CLOs (AFG’s consolidated managed investment entities). These fees are eliminated in consolidation - see the other income line in the Consolidate MIEs column under “Results of Operations - Segmented Statement of Earnings.” Results for the fourth quarter of 2014 include $3 million in income related to the sale of real estate. Results for the fourth quarter of 2013 include a $2 million loss related to the sale of fixed assets.
Consolidated Noncontrolling Interests AFG’s consolidated net earnings (loss) attributable to noncontrolling interests was a loss of $2 million for the fourth quarter of 2014 compared to earnings of $7 million for the fourth quarter of 2013. The following table details net earnings (loss) in consolidated subsidiaries attributable to holders other than AFG (dollars in millions):
RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012
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 years ended December 31, 2014, 2013 and 2012 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):
Property and Casualty Insurance Segment - Results of Operations AFG’s property and casualty insurance operations contributed $456 million in GAAP pretax earnings in 2014 compared to $375 million in 2013, an increase of $81 million (22%). Property and casualty core pretax earnings were $480 million in 2014 compared to $429 million in 2013, an increase of $51 million (12%). The increase in GAAP and core pretax earnings reflects higher underwriting profit in the Specialty casualty group and Property and transportation group, and higher net investment income (due primarily to the investment of cash
acquired in the April 2014 Summit acquisition), partially offset by higher other net expenses. The increase in GAAP pretax earnings also reflects lower non-core special A&E charges in 2014 as compared to 2013.
Gross written premiums (“GWP”) for AFG’s property and casualty insurance segment were $5.48 billion in 2014 compared to $4.81 billion in 2013, an increase of $672 million (14%). GWP increased $484 million (11%) in 2013 compared to 2012. Detail of AFG’s property and casualty gross written premiums is shown below (dollars in millions):
Net earned premiums (“NEP”) for AFG’s property and casualty insurance segment were $3.88 billion in 2014 compared to $3.20 billion in 2013, an increase of $674 million (21%). NEP increased $357 million (13%) in 2013 compared to 2012. Detail of AFG’s property and casualty net earned premiums is shown below (dollars in millions):
Excluding premiums from Summit, gross written premiums increased by 5% compared to 2013. Overall average renewal rates increased approximately 3% in 2014.
Gross written premiums increased $306 million (21%) in 2013 compared to 2012 as a result of increased premiums in nearly all businesses in this group, particularly in the workers’ compensation and excess and surplus lines. New business opportunities, increased exposures from higher payroll on existing accounts, strong retentions and higher renewal pricing have contributed to increased premiums in the workers’ compensation businesses. In addition, new business opportunities and general market hardening have generated increased premiums in several of the excess and surplus lines businesses. Average renewal rates were up approximately 5% for this group in 2013. Reinsurance premiums ceded as a percentage of gross written premiums declined 1 percentage point for 2013 compared to 2012 reflecting changes in the mix of business and higher retention of gross premiums in certain operations.
Gross written premiums increased $56 million (10%) in 2013 compared to 2012. This increase was due primarily to premium growth related to real estate owned and collateral products for financial institutions and growth in the surety operations. Gross written premiums in 2013 include $22 million in risk fees from AFG’s warranty operations. Prior to 2013, fees in the warranty operations were included in other income. Average renewal rates for this group remained relatively unchanged in 2013. Reinsurance premiums ceded as a percentage of gross written premiums declined 5 percentage points in 2013 compared to 2012 reflecting the sale of the service contract business, which was 100% reinsured and lower reinsurance reinstatement premiums reflecting the impact of large reinsured losses in 2012 in the surety and foreign credit businesses.
The Specialty property and casualty insurance operations generated an underwriting profit of $206 million in 2013 compared to $131 million in 2012, an increase of $75 million (57%). The higher profit in 2013 is primarily the result of higher underwriting profits in the Specialty casualty and Specialty financial groups, partially offset by lower underwriting profits in the Property and transportation businesses. Overall catastrophe losses were $31 million (1.0 points) in 2013 compared to $46 million, including $9 million of reinstatement premiums (1.3 points) in 2012.
Underwriting profit for this group was $12 million in 2013 compared to $19 million in 2012, a decrease of $7 million (37%). This decline is due primarily to lower profitability in the transportation businesses, partially offset by improved profitability in the crop operations. Catastrophe losses were $27 million (1.8 points) for this group in 2013 compared to $35 million, including $8 million of reinstatement premiums (1.9 points) in 2012.
Specialty casualty Underwriting profit for this group was $136 million in 2014 compared to $102 million in 2013, an increase of $34 million (33%). Higher underwriting profit in the workers’ compensation businesses, including the impact of the Summit business acquired in April 2014, was partially offset by lower underwriting results in the general liability lines of business, adverse prior year reserve development in the international operations and lower favorable prior year reserve development in the executive liability business.
Underwriting profit was $102 million in 2013 compared to $53 million in 2012, an increase of $49 million (92%), reflecting improved results in the workers’ compensation business as well as increased favorable reserve development in other operations.
Other specialty Underwriting profit for this group was $16 million in 2014 compared to $25 million in 2013, a decrease of $9 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.
Underwriting profit for this group was $25 million in 2013 compared to $15 million in 2012, an increase of $10 million (67%). The increase is due primarily to higher favorable prior year loss development in the business assumed by AFG’s internal reinsurance program.
Specialty casualty The 1.9 percentage point increase in the loss and LAE ratio in 2014 compared to 2013, excluding catastrophe losses reflects the inclusion of Summit following its acquisition in April 2014, which has a higher loss and LAE ratio than AFG’s overall Specialty casualty group, partially offset by higher profitability in the California workers’ compensation business.
Property and transportation Net adverse reserve development of $16 million in 2014 reflects higher than expected severity in commercial auto liability losses written in the transportation businesses, partially offset by lower than expected claim frequency
and severity in the property and inland marine business and lower than expected claim frequency in the agricultural operations. Net favorable reserve development of $1 million in 2013 reflects lower than expected claims handling expense in the crop business and lower claim severity in the property inland marine and ocean marine businesses, substantially offset by adverse development from higher than expected claim severity in commercial auto liability business written in the transportation businesses. Net favorable reserve development of $16 million in 2012 reflects lower than expected loss frequency in crop products, partially offset by higher than expected claim severity in the property and inland marine and commercial auto liability in the transportation businesses.
Specialty financial Net favorable reserve development of $17 million in 2014 reflects lower than expected claim severity in the surety and fidelity businesses and lower than expected claim frequency and severity in the foreign credit business and products for financial institutions. Net favorable reserve development of $14 million in 2013 is due to lower than expected frequency and severity in the foreign credit and financial institution services businesses as economic conditions did not affect these lines as adversely as had been anticipated. Net favorable reserve development of $29 million in 2012 reflects lower than expected frequency and severity in the surety, fidelity, crime, foreign credit and financial institution services businesses as economic conditions did not affect these lines as adversely as had been anticipated.
Other specialty In addition to the development discussed above, total Specialty prior year reserve development includes net favorable reserve development of $11 million in 2014, $20 million in 2013 and $11 million in 2012, reflecting amortization of the deferred gain on the retroactive insurance transaction entered into in connection with the sale of a business in 1998 and reserve development associated with AFG’s internal reinsurance program.
Aggregate Aggregate net prior accident years reserve development for AFG’s property and casualty segment includes the A&E charges mentioned above.
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums decreased 3.8 percentage points in 2014 compared to 2013 due primarily to the inclusion of Summit following its acquisition in April 2014, which has a lower expense ratio than AFG’s overall Specialty casualty group, and the impact of higher premiums across the Specialty casualty group on the ratio.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.2 percentage points in 2013 compared to 2012 reflecting higher profitability-based commissions related to international business and increases in staffing costs related to business growth, partially offset by the impact of higher premiums on the ratio.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.5 percentage points in 2014 compared to 2013 due primarily to the impact of $5 million in reinsurance reinstatement premiums paid in 2014 on the ratio.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 1.7 percentage points in 2013 compared to 2012 reflecting higher profitability-based commissions and lower ceding commissions from reinsurers, partially offset by the impact of higher premiums on the ratio.
The increase in average invested assets and net investment income in the property and casualty segment in 2014 compared to 2013 is due primarily to the investment of cash acquired in the Summit acquisition in April 2014 and organic growth in the property and casualty segment. The property and casualty segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 3.75% in 2014 compared to 3.83% in 2013, a decline of 0.08 percentage points. The impact of equity in the earnings of limited partnerships and similar investments and strong investment results in the first nine months of 2014 was more than offset by the impact of lower yields available in the financial markets.
Other income and expenses, net for AFG’s property and casualty operations was a net expense of $50 million in 2014, $33 million in 2013 and $40 million in 2012, representing an increase of $17 million (52%) in 2014 compared to 2013 and a decrease of $7 million (18%) in 2013 compared to 2012. The table below details the items included in other income and expenses, net for AFG’s property and casualty operations (in millions):
Annuity policy charges and other miscellaneous income, which consist primarily of surrender charges, were $44 million in 2014 compared to $42 million in 2013, an increase of $2 million (5%) reflecting growth in the business, partially offset by the impact of $4 million in income from the sale of real estate recorded in 2013.
The $8 million increase in other annuity benefits, net of guaranteed withdrawal benefit fees in 2013 compared to 2012 reflects increased sales of products with guaranteed withdrawal benefit features.
See “Annuity Unlocking” below for a discussion of the impact that the periodic review of actuarial assumptions had on annuity benefits expense.
Excluding the non-core ELNY guaranty fund assessments charge, annuity other expenses were $82 million in 2014, $93 million in 2013 and $81 million in 2012, representing a decrease of $11 million (12%) in 2014 compared to 2013 and an increase of $12 million (15%) in 2013 compared to 2012. Annuity other expenses for 2014 includes the favorable impact of settling certain accrued expenses at a lower cost than previously estimated, while annuity other expenses for 2013 includes a $7 million charge to write off certain previously capitalized project costs. Annuity other expenses represent primarily general and administrative expenses, as well as selling and issuance expenses that are not deferred. As a percentage of average fixed annuity benefits accumulated, these expenses declined 0.12 percentage points in 2014 compared to 2013 and were flat in 2013 compared to 2012. In general this percentage is expected to decrease as AFG’s annuity business grows and annuity other expenses remain relatively stable.
AFG’s fixed-indexed annuities, which represented approximately one-half of annuity benefits accumulated at December 31, 2014, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG’s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will generally be offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives that must be marked-to-market through earnings each period. The fair values of these derivatives are impacted by actual and expected stock market performance and interest rates as well as other factors. For a list of other factors impacting the fair value of the index-based component of AFG’s annuity benefits accumulated, see Note D - “Fair Value Measurements” to the financial statements. Excluding the impact of unlocking charges, the net change in fair value of derivatives related to fixed-indexed annuities increased annuity benefits by $59 million in 2014 and $27 million in 2012, reflecting the negative impact of lower interest rates on these derivatives. Conversely, the net change in fair value of the derivatives related to fixed-indexed annuities reduced annuity benefits by $26 million in 2013 due to the positive impact of higher market interest rates and the net impact of strong market performance on these derivatives.
AFG’s annuity operations generated statutory premiums of $3.70 billion in 2014, $4.03 billion in 2013 and $2.99 billion in 2012, a decrease of $337 million (8%) in 2014 compared to 2013 and an increase of $1.04 billion (35%) in 2013 compared to 2012. The following table summarizes AFG’s annuity sales (dollars in millions):
The 8% decrease in annuity premiums in 2014 compared to 2013 was largely the result of a decline in premiums in the second half of 2014 as compared to recent quarters, which management attributes to AFG’s disciplined approach to product pricing in a declining interest rate environment and increased competition. Partially offsetting this decline, AFG experienced growth in the sales of fixed-indexed annuities in the financial institutions market during the first six months of 2014 resulting from new products, expanded distribution and improved market penetration within existing distribution channels.
In 2014, 2013 and 2012, AFG conducted its detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded charges (expense reductions) in annuity benefits expense and annuity and supplemental insurance acquisition expenses related to its annuity business. AFG’s net annuity unlocking expense reduction of $1 million in 2014 and net annuity unlocking charges of $2 million in 2013 and $14 million in 2012 impacted AFG’s financial statements as follows (in millions):
See “Results of Operations - Quarters ended December 31, 2014 and 2013 - Annuity Segment - Results of Operations - Annuity Unlocking” for a discussion of the overall net expense reduction and charge from the periodic review of actuarial assumptions in 2014 and 2013.
The following table reconciles the GAAP and core net spread earned on AFG’s fixed annuities to overall annuity pretax earnings for 2014, 2013 and 2012 (in millions):
Run-off Long-Term Care and Life Segment - Results of Operations As previously discussed under “Uncertainties - Run-off Long-term Care Insurance,” AFG recorded a $153 million loss recognition charge in the fourth quarter of 2012 to write off deferred policy acquisition costs and strengthen reserves in its closed block of long-term care insurance. The charge was due primarily to lower projected future investment rates resulting from the continued low interest rate environment, as well as changes in claims, expenses and persistency assumptions. Excluding this charge, pretax core operating losses for the run-off long-term care and life segment were $10 million in both 2014 and 2013, and $4 million in 2012.The following table details AFG’s GAAP and core losses before income taxes from its run-off long-term care and life operations in 2014, 2013 and 2012 (dollars in millions):
AFG expects revenues and expenses related to the long-term care business to generally increase over time as this closed block of business ages. Due to the age and relatively small size of its long-term care business, AFG expects claims volatility from period to period.
The following table details AFG’s GAAP and core loss before income taxes from operations outside of its insurance operations in 2014, 2013 and 2012 (dollars in millions):
Excludes pretax non-core special A&E charges of $6 million, $22 million and $2 million in 2014, 2013 and 2012, respectively. Other expenses in 2012 also exclude $23 million in other non-core charges (discussed below).
Other income in the table above includes management fees paid to AFG by the AFG-managed CLOs (AFG’s consolidated managed investment entities) of $25 million, $16 million and $18 million in 2014, 2013 and 2012, respectively. These fees are eliminated in consolidation - see the other income line in the Consolidated MIEs column under “Results of Operations - Segmented Statement of Earnings.” Excluding amounts eliminated in consolidation, AFG recorded other income outside of its insurance operations of $11 million in both 2014 and 2013, and $4 million in 2012. Results for 2012 include a loss related to the sale of fixed assets of $7 million.
Excluding the non-core charges, AFG’s holding companies and other operations outside of its insurance operations recorded other expenses of $115 million in 2014, $135 million in 2013 and $116 million in 2012. The $20 million (15%) decrease in 2014 compared to 2013 and the $19 million (16%) increase in 2013 compared to 2012 reflect the impact of higher holding company expenses in 2013, primarily related to employee benefit plans that are tied to stock market performance and certain share-based incentive plans.
Consolidated Realized Gains on Securities AFG’s consolidated realized gains on securities, which are not allocated to segments, were $52 million in 2014 compared to $221 million in 2013, a decrease of $169 million (76%). AFG’s consolidated realized gains on securities were $221 million in 2013 compared to $210 million in 2012, an increase of $11 million (5%). Realized gains (losses) on securities consisted of the following (in millions):
Consolidated Income Taxes AFG’s consolidated provision for income taxes was $220 million in 2014 compared to $236 million in 2013, a decrease of $16 million (7%). AFG’s consolidated provision for income taxes was $236 million in 2013 compared to $135 million in 2012, an increase of $101 million (75%). The provision for income taxes recorded in 2012 includes a $67 million non-core tax benefit related to the favorable resolution of certain tax litigation and settlement of open tax years. See Note L - “Income Taxes” to the financial statements for an analysis of items affecting AFG’s effective tax rate.
Consolidated Noncontrolling Interests AFG’s consolidated net loss attributable to noncontrolling interests was $46 million in 2014 compared to $18 million in 2013, an increase of $28 million (156%). AFG’s consolidated net loss attributable to noncontrolling interests was $18 million in 2013 compared to $86 million in 2012, a decrease of $68 million (79%). The following table details net earnings (loss) in consolidated subsidiaries attributable to holders other than AFG (dollars in millions):
Consolidated Statement of Earnings for the years ended December 31, 2014, 2013 and 2012
Consolidated Statement of Changes in Equity for the years ended December 31, 2014, 2013 and 2012
AFG’s management, with participation of its Co-Chief Executive Officers and its Chief Financial Officer, has evaluated AFG’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG’s Co-CEOs and CFO concluded that the controls and procedures are effective. There have been no changes in AFG’s internal control over financial reporting during the fourth fiscal quarter of 2014 that materially affected, or are reasonably likely to materially affect, AFG’s internal control over financial reporting.
As previously reported, in connection with the transition by James E. Evans effective January 1, 2014 from his role as an officer and employee of AFG to that of executive consultant, Mr. Evans agreed to a three-year consulting arrangement. On February 23, 2015, AFG and Mr. Evans extended the term of the consulting agreement by one year on the same terms.
In our opinion, American Financial Group, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the COSO criteria.
Basis of Presentation The consolidated financial statements include the accounts of American Financial Group, Inc. (“AFG”) and its subsidiaries. Certain reclassifications have been made to prior years to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to December 31, 2014, and prior to the filing of this Form 10-K, have been evaluated for potential recognition or disclosure herein.
Fair Value Measurements Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. Other than the recording of the acquisition of Summit Holding Southeast, Inc. and its related companies (see Note B - “Acquisitions and Sales of Businesses”), AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in 2014 or 2013.
Derivatives Derivatives included in AFG’s Balance Sheet are recorded at fair value. Changes in fair value of derivatives are included in earnings, unless the derivatives are designated as cash flow hedges. Derivatives that do not qualify for hedge accounting under GAAP consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related call options (included in other investments) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products.
DPAC related to annuities is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and annuity policy charges, less death, annuitization and guaranteed withdrawal benefits in excess of account balances and estimated future policy administration expenses. To the extent that realized gains and losses result in
The net gain or loss from accounting for the CLO assets and liabilities at fair value is separately presented in AFG’s Statement of Earnings. CLO earnings attributable to AFG’s shareholders represent the change in fair value of AFG’s investments in the CLOs (including distributions) and management fees earned. All other CLO earnings (losses) are not attributable to AFG’s shareholders and will ultimately inure to the CLO debt holders. As a result, such CLO earnings (losses) are included in net earnings (loss) attributable to noncontrolling interests in AFG’s Statement of Earnings and in appropriated retained earnings - managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2026), it is expected that earnings (losses) attributable to noncontrolling interests will reduce appropriated retained earnings towards zero as the fair values of the assets and liabilities converge and the CLO assets are used to pay the CLO debt.
the option to 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 fair value. Under this alternative, CLO earnings attributable to AFG’s shareholders would continue to be measured by the change in the fair value of AFG’s investments in the CLOs and management fees earned. However, as a result of setting the carrying value of the CLO liabilities equal to the fair value of the CLO assets, there would no longer be any excess carrying value of CLO assets over the carrying value of CLO liabilities to be reported as “appropriated retained earnings - managed investment entities” in AFG’s Balance Sheet or any CLO earnings to be attributed to noncontrolling interests in AFG’s Statement of Earnings. If AFG elects to continue to measure both the CLO assets and liabilities at fair value, ASU 2014-13 will require amounts currently reflected as “appropriated retained earnings - managed investment entities” to be reclassified to unappropriated retained earnings in the Balance Sheet and amounts currently attributed to noncontrolling interests in the Statement of Earnings to be included in earnings attributable to AFG shareholders. Although ASU 2014-13 is not required to be adopted until 2016, AFG intends to early adopt the guidance effective January 1, 2015 (as permitted) and to elect the alternative measurement guidance on a modified retrospective basis. As a result, the amount reported as “appropriated retained earnings - managed investment entities” in AFG’s Balance Sheet at December 31, 2014 will effectively be reclassified to “liabilities of managed investment entities” on January 1, 2015. While the ASU will have an impact on the future presentation of individual CLO-related line items in AFG’s Statement of Earnings in future periods, it will have no overall impact on AFG’s net earnings attributable to shareholders.
For long-duration contracts (such as traditional life and long-term care policies), loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums (including reasonably expected rate increases) are not expected to cover the present value of future claims payments and related settlement
and maintenance costs (excluding overhead) as well as unamortized acquisition costs. If a block of business is determined to be in loss recognition, a charge is recorded in earnings in an amount equal to the excess of the present value of expected future claims costs and unamortized acquisition costs over existing reserves plus the present value of expected future premiums (with no provision for adverse deviation). The charge is recorded first to reduce unamortized acquisition costs and then as an additional reserve (if unamortized acquisition costs have been reduced to zero).
Earnings Per Share Although basic earnings per share only considers shares of common stock outstanding during the period, the calculation of diluted earnings per share includes the following adjustments to weighted average common shares related to stock-based compensation plans: 2014 - 2.0 million, 2013 - 1.9 million and 2012 - 1.7 million.
Included with AFG’s net deferred tax liabilities, which are included in Other liabilities in AFG’s Consolidated Balance Sheet.
Acquisitions and Sale of Other Businesses On March 27, 2014, AFG completed a renewal rights agreement with Selective Insurance Company of America to acquire Selective’s pooled public entity book of business for $8 million. At the acquisition date, this book of business had approximately $38 million in in-force gross written premiums.
ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, professional liability, umbrella and excess liability, specialty coverage in targeted markets, customized programs for small to mid-sized businesses and workers’ compensation insurance, and (iii) Specialty financial, which includes risk management insurance programs for leasing and financing institutions (including collateral and lender-placed mortgage property insurance), surety and fidelity products and trade credit insurance. Premiums and underwriting profit included under Other specialty represent business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments and amortization of deferred gains on retroactive reinsurance transactions related to the sales of businesses in prior years. AFG’s annuity business markets traditional fixed and fixed-indexed annuities in the retail, financial institutions and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
Sales of property and casualty insurance outside of the United States represented 5% of AFG’s revenues in 2014, 2013 and 2012.
The transfers between Level 1 and Level 2 for the years ended December 31, 2014, 2013 and 2012 are reflected in the table below at fair value as of the end of the reporting period (dollars in millions):
The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AFG’s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $1.16 billion at December 31, 2014. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note F - “Derivatives.”
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 5% to 11% in the majority of future calendar years (4% to 16% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flows 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.
Total realized/unrealized gains (losses) included in net income for the embedded derivatives reflects gains related to the unlocking of actuarial assumptions of $58 million in 2014.
The carrying amount of cash and cash equivalents approximates fair value. Fair values for mortgage loans are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. The fair value of policy loans is estimated to approximate carrying value; policy loans have no defined maturity dates and are inseparable from insurance contracts. The fair value of annuity benefits was estimated based on expected
cash flows discounted using forward interest rates adjusted for the Company’s credit risk and includes the impact of maintenance expenses and capital costs. Fair values of long-term debt are based primarily on quoted market prices.
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, 2014 and December 31, 2013, respectively, were $220 million and $229 million. Gross unrealized gains on such securities at December 31, 2014 and December 31, 2013 were $151 million and $150 million, respectively. Gross unrealized losses on such securities at December 31, 2014 and December 31, 2013 were $8 million and $13 million, respectively. These amounts represent the non-credit other-than-temporary impairment charges recorded in AOCI adjusted for subsequent changes in fair values and nearly all relate to residential MBS.
The following tables show gross unrealized losses (dollars in millions) on 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, 2014 and 2013.
At December 31, 2014, the gross unrealized losses on fixed maturities of $79 million relate to approximately 650 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 70% of the gross unrealized loss and 85% of the fair value.
AFG recorded $26 million in other-than-temporary impairment charges on common stocks in 2014. At December 31, 2014, the gross unrealized losses on common stocks of $25 million relate to 34 securities, none of which has been in an unrealized loss position for more than 12 months.
Management believes AFG will recover its cost basis in the securities with unrealized losses and that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, 2014.
The table below sets forth the scheduled maturities of available for sale fixed maturities as of December 31, 2014 (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, 2014 or 2013.
Gross realized gains and losses (excluding impairment writedowns and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
Derivatives Designated and Qualifying as Cash Flow Hedges In the third quarter of 2014, AFG entered into a five-year $431 million notional amount interest rate swap under which AFG receives fixed rate interest payments in exchange for variable interest payments based on one-month LIBOR. The purpose of the swap is to effectively convert a portion of AFG’s floating rate MBS to fixed rate by offsetting the variability in cash flows attributable to changes in one-month LIBOR. The notional amount of the swap amortizes down over its five-year life in anticipation of an expected decline in AFG’s portfolio of MBS with interest rates based on one-month LIBOR ($401 million notional amount at December 31, 2014). The fair value of the effective portion of the interest rate swap was less than $1 million at December 31, 2014, and is included in AOCI. During 2014, $2 million was reclassified from AOCI to net investment income and there was no ineffectiveness recorded in Net Earnings.
Includes AFG’s run-off long-term care and life segment and Medicare supplement and critical illness segment (sold in August 2012).
The present value of future profits (“PVFP”) amounts in the table above are net of $209 million and $198 million of accumulated amortization at December 31, 2014 and 2013, respectively. The loss recognition charge recorded in the fourth quarter of 2012 for AFG’s closed block of long-term care insurance resulted in the write off of all remaining deferred policy acquisition costs for this business. During each of the next five years, the PVFP is expected to decrease at a rate of approximately one-sixth of the balance at the beginning of each respective year.
In 2014, AFG formed two new CLOs, which issued an aggregate of $917 million face amount of liabilities (including $94 million face amount purchased by subsidiaries of AFG). During 2014, AFG subsidiaries also purchased $13 million face amount of senior debt tranches of existing CLOs for $13 million and received $81 million in redemption proceeds from its CLO investments. In 2013, AFG formed two new CLOs, which issued an aggregate of $829 million face amount of liabilities (including $85 million face amount purchased by subsidiaries of AFG). During 2013, AFG subsidiaries also purchased $94 million face amount of senior debt tranches of existing CLOs for $89 million and received $142 million in redemption proceeds from its CLO investments. In 2012, AFG formed two new CLOs, which issued an aggregate of $860 million face amount of liabilities (including $74 million face amount purchased by subsidiaries of AFG). During 2012, AFG subsidiaries also purchased $74 million face amount of senior debt tranches of existing CLOs for $69 million and received $12 million in redemption proceeds from its CLO investments. In 2014 and 2013, four and two AFG CLOs were substantially liquidated as permitted by the CLO indentures, respectively.
Included in other assets in AFG’s Balance Sheet is $49 million at December 31, 2014 and $14 million at December 31, 2013 of amortizable intangible assets related to property and casualty insurance acquisitions. These amounts are net of accumulated amortization of $91 million and $75 million, respectively. The increase in amortizable intangible assets in 2014 reflects the acquisition of Summit in April 2014 (see Note B - “Acquisitions and Sales of Businesses”) and a renewal rights intangible asset established in connection with the acquisition of a small property and casualty book of business in the first quarter of 2014. Amortization of intangibles was $19 million in 2014 and $14 million in each of 2013 and 2012. Future amortization of intangibles (weighted average amortization period of 6 years) is estimated to be $8 million per year in each of 2015 through 2019 and $9 million thereafter.
National Interstate can borrow up to $100 million under its unsecured credit agreement, which expires in November 2017. At December 31, 2014, there was $12 million outstanding under this agreement, bearing interest at 1.20% (six-month LIBOR plus 0.875%).
AFG issued 84,036 shares of Common Stock (fair value of $57.16 per share) in the first quarter of 2014 and 88,602 shares (fair value of $47.12 per share) in the first quarter of 2013 under its Equity Bonus Plan.
Accumulated Other Comprehensive Income, Net of Tax (“AOCI”) Comprehensive income is defined as all changes in Shareholders’ Equity except those arising from transactions with shareholders. Comprehensive income includes net earnings and other comprehensive income, which consists primarily of changes in net unrealized gains or losses on available for sale securities.
The reclassification adjustment out of net unrealized gains on securities affected the following lines in AFG’s Consolidated Statement of Earnings:
Total earnings before income taxes include losses subject to tax in foreign jurisdictions of less than $1 million in 2014 compared to income of $12 million in 2013 and losses of $3 million in 2012.
Deferred income tax assets and liabilities reflect temporary differences between the carrying amounts of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. The significant components of deferred tax assets and liabilities included in the Balance Sheet at December 31 were as follows (in millions):
AFG’s net deferred tax liability at December 31, 2014 and 2013 is included in other liabilities in AFG’s Balance Sheet.
“Foreign underwriting losses” in the table above include the net operating loss carryforward and other deferred tax assets related to the Marketform Lloyd’s insurance business, which resulted primarily from underwriting losses in its run-off Italian public hospital medical malpractice business that has not been written since 2008. Due to uncertainty concerning the realization of the deferred tax benefits associated with these losses, AFG maintains a full valuation allowance of $56 million against these deferred tax assets at December 31, 2014. In addition to the valuation allowance related to the Marketform Lloyd’s insurance business, the gross deferred tax asset has also been reduced by a $50 million valuation allowance related to a portion of AFG’s net operating loss carryforwards (“NOL”) subject to the separate return limitation year (“SRLY”) tax rules. A SRLY NOL can be used only by the entity that created it and only in years that both it and the consolidated group have taxable income.
In July 2014, AFG finalized a settlement with the IRS related to tax years 2008 and 2009. As a result, AFG’s uncertain tax positions are now effectively settled, allowing AFG to reduce its liability for previously uncertain tax positions by $19 million in the third quarter of 2014. Although AFG agreed to pay $11 million to the IRS, the majority of the reduction in this liability resulted in offsetting adjustments to AFG’s deferred tax liability and did not impact AFG’s effective tax rate. The portion of the reduction in this liability that favorably impacted the effective tax rate was approximately $4 million including interest. The reduction of the liability for previously uncertain tax positions includes $17 million related to the timing of recognition of investment income on certain debt securities and $2 million related to the deductibility of certain financing expenses.
At December 31, 2014, GAFRI had a liability of approximately $10 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) and favorable (adverse) prior year development of AFG’s liability for losses and loss adjustment expenses (“LAE”) were as follows (in millions):
Adverse prior year development for the second quarter of 2014 includes $22 million of adverse reserve development in the property and transportation sub-segment, which resulted from an increase in claim severity in the commercial auto liability business, partially offset by lower than expected claim severity in the agricultural and property and inland marine businesses. Adverse prior year development for the third quarter of 2014 includes pretax special charges of $24 million to strengthen property and casualty insurance A&E reserves. Adverse prior year development in the fourth quarter of 2014 was due primarily to adverse reserve development at Marketform and higher than expected claim severity in contractor claims and in a run-off book of casualty business.
Results for the third quarter of 2014 and 2013 include pretax special charges of $6 million and $22 million, respectively, to strengthen reserves for A&E exposures related to AFG’s former railroad and manufacturing operations.
Securities owned by U.S.-based insurance subsidiaries having a carrying value of approximately $1.18 billion at December 31, 2014, were on deposit as required by regulatory authorities. At December 31, 2014, AFG and its subsidiaries had $223 million in undrawn letters of credit (none of which was collateralized) supporting the underwriting capacity of its U.K.-based Lloyd’s insurer.
Property and Casualty Insurance Reserves The liability for losses and LAE for long-term scheduled payments under certain workers’ compensation insurance has been discounted at 4.5% at both December 31, 2014 and 2013, which represents an approximation of long-term investment yields. As a result, the total liability for losses and loss adjustment expenses at December 31, 2014 and 2013, has been reduced by $19 million and $20 million.
Net adverse development in 2014 reflects higher than expected severity in commercial auto liability losses written in the transportation businesses (within the Property and transportation sub-segment), higher than expected claims severity in contractor claims and in a run-off book of casualty business and adverse reserve development at Marketform (all within the Specialty casualty sub-segment), and the $24 million special charge to increase asbestos and environmental reserves. This adverse development was offset by (i) lower than expected claim severity in directors and officers liability insurance, lower than expected claim severity and frequency in excess liability insurance and lower than anticipated claim severity in specialty workers’ compensation business (all within the Specialty casualty sub-segment), and (ii) lower than expected claim severity in the surety and fidelity businesses and lower than expected claim frequency and severity in the foreign credit business and products for financial institutions (within the Specialty financial sub-segment).
Favorable development in 2012 was due primarily to lower than expected frequency and severity in the homebuilders’ general liability business (within the Specialty casualty sub-segment) and lower than expected frequency in the crop business (within the Property and transportation sub-segment), partially offset by higher frequency and severity in a block of program business (within the Specialty casualty sub-segment) and the $31 million special charge to increase asbestos and environmental reserves.
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, 2014 and 2013, 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, 2014 or 2013.
In March 2014, AFG’s property and casualty insurance operations entered into a reinsurance agreement to obtain additional catastrophe protection through a catastrophe bond structure with Riverfront Re Ltd. (“Riverfront”). The reinsurance agreement provides supplemental reinsurance coverage up to $95 million (fully collateralized) for catastrophe losses in excess of $100 million occurring during the period from April 1, 2014 through December 31, 2016. In connection with the reinsurance agreement, Riverfront issued notes to unrelated investors for the full $95 million of coverage provided under the reinsurance agreement. At the time of the agreement, AFG concluded that Riverfront is a variable interest entity, but that it does not have a variable interest in the entity because the variability in Riverfront’s results is expected to 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 $5 million per year.
Variable Annuities At December 31, 2014, 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 $23 million, compared to $26 million at December 31, 2013. Death benefits paid in excess of the variable annuity account balances were less than $1 million in each of the last three years.
Operating Leases Total rental expense for various leases of office space and equipment was $65 million in 2014, $57 million in 2013 and $51 million in 2012. Future minimum rentals, related principally to office space, required under operating leases having initial or remaining noncancelable lease terms in excess of one year at December 31, 2014, were as follows: 2015 - $62 million; 2016 - $59 million; 2017 - $50 million; 2018 - $42 million; 2019 - $38 million; and $174 million thereafter.
Benefit Plans AFG expensed approximately $30 million in 2014, $32 million in 2013 and $27 million in 2012 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 2015 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.
Amended and Restated Consulting Agreement dated February 23, 2015 between AFG and James E. Evans.