At December 31, 2019, AFG (parent) held approximately $243 million in cash and securities and had $500 million available under a bank line of credit, which expires in June 2021.
AFG reported fourth quarter 2019 net earnings attributable to shareholders of $211 million ($2.31 per share, diluted) compared to a net loss attributable to shareholders of $29 million ($0.33 per share, diluted) in the fourth quarter of 2018, reflecting:
net realized gains on securities in 2019 compared to net realized losses on securities in 2018,
Net Cash Provided by Operating Activities AFG’s property and casualty insurance operations typically produce positive net operating cash flows as premiums collected and investment income exceed policy acquisition costs, claims payments and operating expenses. AFG’s net cash provided by operating activities is impacted by the level and timing of property and casualty premiums, claim and expense payments and recoveries from reinsurers. AFG’s annuity operations typically produce positive net operating cash flows as investment income exceeds acquisition costs and operating expenses. Interest credited on annuity policyholder funds is a non-cash increase in AFG’s annuity benefits accumulated liability and annuity premiums, benefits and withdrawals are considered financing activities due to the deposit-type nature of annuities. Cash flows provided by operating activities also include the activity of AFG’s managed investment entities (collateralized loan obligations) other than those activities included in investing or financing activities. The changes in the assets and liabilities of the managed investment entities included in operating activities increased cash flows from operating activities by $23 million in 2019, $148 million in 2018 and $60 million in 2017, accounting for a $125 million decrease in cash flows from operating activities in 2019 compared to 2018 and an $88 million increase in cash flows from operating activities in 2018 compared to 2017. As discussed in Note A - “Accounting Policies - Managed Investment Entities” to the financial statements, AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities and such assets and liabilities are shown separately in AFG’s Balance Sheet. Excluding the impact of the managed investment entities, net cash provided by operating activities was $2.43 billion, $1.94 billion and $1.74 billion in 2019, 2018 and 2017, respectively.
Net cash used in investing activities was $5.35 billion in 2018 compared to $3.29 billion in 2017, an increase of $2.06 billion. As discussed below (under net cash provided by financing activities), AFG’s annuity group had net cash flows from annuity policyholders of $2.76 billion in 2018 and $1.99 billion in 2017. In addition, AFG’s cash on hand decreased by $823 million during 2018 as AFG invested a large portion of its cash on hand at December 31, 2017. Net investment activity in the managed investment entities was a $169 million use of cash in 2018 compared to a $205 million use of cash in 2017, accounting for a $36 million decrease in net cash used in investing activities in 2018 compared to 2017.
Net Cash Provided by Financing Activities AFG’s financing activities consist primarily of transactions with annuity policyholders, issuances and retirements of long-term debt, issuances and repurchases of common stock, and dividend payments. Net cash provided by financing activities was $1.41 billion in 2019 compared to $2.44 billion in 2018, a decrease of $1.03 billion. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $1.66 billion in 2019 compared to $2.76 billion in 2018, resulting in a $1.10 billion decrease in net cash provided by financing activities in 2019 compared to 2018. In 2019, AFG issued $125 million of 5.875% Subordinated Debentures due in 2059 and $200 million of 5.125% Subordinated Debentures due in 2059, the net proceeds of which contributed $315 million to net cash provided by financing activities in 2019. The December redemption of AFG’s 6-1/4% Subordinated Debentures was a $150 million use of cash in 2019. During 2018, AFG had no additional long-term borrowings or repayments. In addition to its regular quarterly cash dividends, AFG paid special cash dividends of $3.30 per share and $3.00 per share in 2019 and 2018, respectively, which resulted in total cash dividends of $444 million in 2019 compared to $394 million in 2018. Financing activities also include issuances and retirements of managed investment entity liabilities, which are nonrecourse to AFG and presented separately in AFG’s Balance Sheet. Retirements of managed investment entity liabilities exceeded issuances by $11 million in 2019 compared to issuances of managed investment entity liabilities exceeding retirements by $48 million in 2018, accounting for a $59 million decrease in net cash provided by financing activities in 2019 compared to 2018. See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements.
In March 2019, AFG issued $125 million of 5.875% Subordinated Debentures due in March 2059. The net proceeds of the
On December 2, 2019, AFG issued $200 million of 5.125% Subordinated Debentures due in December 2059. A portion of the net proceeds of the offering were used to redeem AFG’s $150 million outstanding principal amount of 6-1/4% Subordinated Debentures due in September 2054, at par value on December 23, 2019, with the remainder used for general corporate purposes.
In 2018, AFG paid special cash dividends of $3.00 per share of AFG Common Stock ($1.50 per share in May and November) totaling approximately $267 million and repurchased 65,589 shares of its Common Stock for $6 million.
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 $306 million in 2019 compared to $215 million in 2018 and $578 million in 2017. The $91 million increase in net cash provided by operating activities in 2019 as compared to 2018 was due primarily to higher dividends received from subsidiaries in 2019 as compared to 2018. The $363 million decrease in net cash provided by operating activities in 2018 as compared to 2017 was due to lower dividends received from subsidiaries.
Amounts presented in the table represent estimated cash payments under such contracts, based on significant assumptions related to mortality, morbidity, lapse, renewal, retirement and annuitization. These assumptions also include interest and index crediting consistent with assumptions used to amortize DPAC and assess loss recognition. All estimated cash payments are undiscounted for the time value of money. As a result, total outflows for all years exceed the corresponding liabilities of $40.41 billion for annuity benefits accumulated and $612 million for life, accident and health reserves included in AFG’s Balance Sheet as of December 31, 2019. Based on the same assumptions, AFG projects reinsurance recoveries related to life, accident and health reserves totaling $597 million as follows: Within 1 year - $60 million; 2-3 years - $100 million; 4-5 years - $76 million; and thereafter - $361 million. Actual payments and their timing could differ significantly from these estimates.
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 AFG’s fixed maturity portfolio, approximately 90% was priced using pricing services at December 31, 2019 and the balance was 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.
The pricing services use a variety of observable inputs to estimate fair value of fixed maturities that do not trade on a daily basis. Based upon information provided by the pricing services, these inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data, and measures of volatility. Included in the pricing of mortgage backed securities (“MBS”) are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Due to the lack of transparency in the process that brokers use to develop prices, valuations that are based on brokers’ prices are classified as Level 3 in the GAAP hierarchy unless the price can be corroborated, for example, by comparison to similar securities priced using observable inputs.
Approximately 91% of the fixed maturities held by AFG at December 31, 2019, 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.
Summarized information for AFG’s MBS (including those classified as trading) at December 31, 2019, is shown in the table below (dollars in millions). Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The average life of the residential and commercial MBS is approximately 4-1/2 years and 3 years, respectively.
The National Association of Insurance Commissioners (“NAIC”) assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC retains third-party investment management firms to assist in the determination of appropriate NAIC designations for MBS 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, 2019, 97% (based on statutory carrying value of $3.74 billion) of AFG’s MBS had an NAIC designation of 1.
Based on its analysis of the factors listed above, management believes AFG will recover its cost basis in the fixed maturity 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, 2019. Although AFG has the ability to continue holding its fixed maturity investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers’ creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG’s ability or intent change regarding a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG’s investment portfolio could have a significant adverse effect on AFG’s liquidity. For information on AFG’s realized gains (losses) on securities, including charges for other-than-temporary impairment, see “Results of Operations - Consolidated Realized Gains (Losses) on Securities.”
The estimated cumulative impact that a 1% change in cost trends in AFG’s more significant lines of property and casualty business (exceeding 5% of total reserves) would have on net earnings is shown below (in millions).
AFG recorded favorable prior year reserve development of $4 million in 2019, $9 million in 2018 and $5 million in 2017 on its D&O business as claim severity was less than expected across several prior accident years.
Asbestos claims against manufacturers, distributors or installers of asbestos products were presented under the products liability section of their policies, which typically had aggregate limits that capped an insurer’s liability. In addition, asbestos claims are being presented as “non-products” claims, such as those by installers of asbestos products and by property
owners or operators who allegedly had asbestos on their property, under the premises or operations section of their policies. Unlike products exposures, these non-products exposures typically had no aggregate limits, creating greater exposure for insurers. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify previously settled products claims as non-products claims to restore a portion of previously exhausted products aggregate limits.
During the third quarter of 2019, AFG completed and in-depth internal review of its A&E exposures relating to the run-off operations of its property and casualty insurance segment and its exposures related to former railroad and manufacturing operations and sites. In addition to its ongoing internal monitoring of A&E exposures, AFG has periodically conducted comprehensive external studies of its A&E reserves with the aid of specialty actuarial, engineering and consulting firms and outside counsel, with an in-depth internal review during the intervening years. AFG has historically conducted an external study every two years. The most recent external study was in the third quarter of 2017 and AFG is currently evaluating the frequency of future external studies.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $6 million in both the fourth quarter of 2019 and 2018 in distributions recorded as interest expense by the CLOs.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $26 million and $21 million in 2019 and 2018, respectively, in distributions recorded as interest expense by the CLOs.
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. For example, core net operating earnings excludes realized gains (losses) on securities because such gains and losses are influenced significantly by financial markets, interest rates and the timing of sales. Similarly, significant gains and losses from the sale of real estate are excluded from core earnings as they are influenced by the timing of sales and realized gains (losses) and significant tax benefits (charges) related to subsidiaries are excluded because such gains and losses are largely the result of the changing business strategy and market opportunities. In addition, special charges related to coverage that AFG no longer writes, such as the Neon exited lines and for asbestos and environmental exposures are excluded from core earnings.
As discussed above, beginning prospectively with the second quarter of 2019, unlocking, the impact of changes in the fair value of derivatives related to FIAs, and other impacts of changes in the stock market and interest rates on the accounting for FIAs over or under the cost of the equity index options purchased to mitigate the risk in the index-based component of those FIAs are considered annuity non-core earnings (losses).
AFG reported net earnings attributable to shareholders of $211 million in the fourth quarter of 2019 compared to a net loss attributable to shareholders of $29 million in the fourth quarter of 2018. Results for the fourth quarter of 2019 were positively impacted by $8 million in net non-core items. Comparatively, the net loss in the 2018 fourth quarter includes $188 million in non-core net realized losses on securities. In addition, net earnings attributable to shareholders includes after-tax earnings of $19 million in the fourth quarter of 2019 and after-tax losses of $52 million in the fourth quarter of
2018 from unlocking (in the 2018 quarter), the impact of changes in the fair value of derivatives related to FIAs and other impacts of changes in the stock market and interest rates on the accounting for FIAs over or under the cost of the equity index options purchased to mitigate the risk in the index-based component of those FIAs. As discussed above, this impact on the accounting for FIAs is considered non-core earnings (losses) beginning prospectively with the second quarter of 2019. Excluding the $52 million after-tax negative impact of these items on results for the fourth quarter of 2018, core net operating earnings decreased $8 million in the fourth quarter of 2019 compared to the same period in 2018 reflecting lower earnings in the property and casualty insurance segment and higher holding company expenses, partially offset by higher earnings in the annuity segment. Realized gains (losses) on securities in the fourth quarters of 2019 and 2018 resulted primarily from the change in fair value of equity securities that were still held at the balance sheet date.
AFG’s net earnings attributable to shareholders, determined in accordance with GAAP, include certain items that may not be indicative of its ongoing core operations. The following tables for the three months ended December 31, 2019 and 2018 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):
As discussed under “Results of Operations - General,” beginning with the second quarter of 2019, unlocking, the impact of changes in the fair value of derivatives related to FIAs, and other impacts of changes in the stock market and interest rates on the accounting for FIAs over or under the cost of the equity index options purchased to mitigate the risk in the index-based component of those FIAs are considered annuity non-core earnings (losses).
GAAP pretax earnings also includes a pretax non-core charge of $76 million in the fourth quarter of 2019 related to costs associated with plans to exit the Lloyd’s of London insurance market in 2020. See “Neon exited lines charge” below.
The following table details AFG’s GAAP and core earnings before income taxes from its property and casualty insurance operations for the three months ended December 31, 2019 and 2018 (dollars in millions):
Excludes a pretax non-core charge of $30 million (2.2 points on the combined ratio) in the fourth quarter of 2019 associated with plans to exit the Lloyd’s of London insurance market in 2020.
Starting in 1986, AFG’s statutory combined ratio has been better than the U.S. industry average for 32 of the 34 years. Management believes that AFG’s insurance operations have performed better than the industry as a result of its specialty niche focus, product line diversification, stringent underwriting discipline and alignment of compensation incentives.
the Property and transportation sub-segment. Overall average renewal rates increased approximately 5% in the fourth quarter of 2019. Excluding rate decreases in the workers’ compensation business, renewal pricing increased approximately 7%.
Other specialty The amounts shown as reinsurance premiums ceded represent business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty property and casualty insurance sub-segments. Reinsurance premiums assumed increased $2 million (5%) in the fourth quarter of 2019 compared to the fourth quarter of 2018, reflecting an increase in premiums retained, primarily from businesses in the Specialty casualty sub-segment.
The Specialty property and casualty insurance operations generated an underwriting profit of $89 million for the fourth quarter of 2019 compared to $102 million in the fourth quarter of 2018, a decrease of $13 million (13%). Lower underwriting results in the Property and transportation sub-segment were partially offset by higher underwriting profits in the Specialty casualty and Specialty financial sub-segments. Overall catastrophe losses were $15 million, including $1 million of net reinstatement premiums, (1.0 points on the combined ratio) in the fourth quarter of 2019 compared to $38 million, including a $1 million favorable adjustment to net reinstatement premiums, (3.0 points) in the fourth quarter of 2018.
Specialty casualty Underwriting profit for this group was $69 million for the fourth quarter of 2019 compared to $22 million for the fourth quarter of 2018, an increase of $47 million (214%). This increase is largely due to a reduction in the underwriting loss at Neon (excluding the Neon exited lines charge), due primarily to lower year-over-year catastrophe losses. See “Neon exited lines charge” below for information about AFG’s plans to exit the Lloyd’s of London insurance market in 2020. Higher underwriting profit in the workers’ compensation businesses, due primarily to higher favorable prior year reserve development, also contributed to the increase in underwriting profit between periods. Catastrophe losses were $5 million (0.8 points on the combined ratio) for the fourth quarter of 2019 compared to $28 million (4.7 points) for the fourth quarter of 2018. Catastrophe losses in both periods were primarily in the Neon operations.
Other specialty This group reported an underwriting loss of $10 million for the fourth quarter of 2019 compared to $4 million in the fourth quarter of 2018, an increase of $6 million (150%), reflecting higher losses in the business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments in the fourth quarter of 2019 compared to the fourth quarter of 2018.
Neon exited lines charge In December 2019, AFG initiated actions to exit the Lloyd’s of London insurance market, which included placing its Lloyd’s subsidiaries including its Lloyd’s Managing Agency, Neon Underwriting Ltd., into run-off and recording a non-core charge of $76 million for reserve strengthening and expenses related to exit costs incurred with the run-off of this business. Neon and its predecessor, Marketform, have failed to achieve AFG’s profitability objectives since AFG’s purchase of Marketform in 2008. The non-core charge includes $46 million to increase loss reserves (including $7 million of net adverse prior year reserve development) and $30 million of underwriting expenses representing contractual employee severance benefits and other incurred exit costs. AFG will incur additional employee-related, rent and other expenses as the business is run-off.
In the fourth quarter of 2017, Neon entered into a reinsurance to close agreement for its 2015 and prior years of account, which transfers the responsibility for all of the liabilities that attach to the transferred year of account as well as any income due to the closing year of account in return for a premium. As a result of the reinsurance to close agreement, Neon recorded favorable reserve development of $42 million, of which $24 million related to its ongoing lines of business (included in Specialty casualty) and $18 million related to exited lines of business (included in Neon exited lines charge).
Property and transportation The 10.0 percentage points increase in the loss and LAE ratio for the current year, excluding catastrophe losses reflects an increase in the loss and LAE ratio of the crop operations due to a high level of prevented planting claims resulting from excess rain in 2019.
Specialty casualty The 4.9 percentage points decrease in the loss and LAE ratio for the current year, excluding catastrophe losses reflects a decrease in the loss and LAE ratio at Neon (excluding the impact of the Neon exited lines charge), partially offset by an increase in the loss and LAE ratio of the workers’ compensation businesses.
Specialty casualty Net favorable reserve development of $25 million in the fourth quarter of 2019 reflects lower than anticipated claim frequency and severity in the workers’ compensation businesses, partially offset by higher than expected claim severity in the excess and surplus lines businesses, higher than expected claim frequency in product liability contractor claims, and higher than anticipated claim severity in the public sector business. Net favorable reserve development of $52 million in the fourth quarter of 2018 reflects lower than anticipated claim severity in the workers’ compensation businesses and lower than expected emergence in assumed 2017 property catastrophe losses at Neon.
Aggregate Aggregate net prior accident years reserve development for AFG’s property and casualty insurance segment for the fourth quarter of 2019 includes $7 million of net adverse reserve development related to Neon exited lines discussed above under “Neon exited lines charge.”
As of January 1, 2020, AFG maintains comprehensive catastrophe reinsurance coverage, including a $15 million per occurrence net retention for its U.S.-based property and casualty insurance operations for losses up to $134 million. Neon’s excess of loss catastrophe reinsurance limits the maximum retained loss per event to $15 million for losses up to $145 million on direct business and $15 million for losses up to $45 million on assumed business. AFG’s property and casualty insurance operations further maintain supplemental fully collateralized reinsurance coverage up to 95% of $200 million for catastrophe losses in excess of $134 million of traditional catastrophe reinsurance through a catastrophe bond.
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums increased 4.3 percentage points in the fourth quarter of 2019 compared to the fourth quarter of 2018 reflecting lower profitability-based ceding commissions received from reinsurers in the crop business and growth in businesses that have higher underwriting expense ratios than many of the businesses in the Property and transportation sub-segment.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums increased 4.4 percentage points in the fourth quarter of 2019 compared to the fourth quarter of 2018 reflecting higher profitability-based commissions paid to agents in the financial institutions business, higher underwriting expenses in the European businesses, due to costs incurred in preparation for Brexit, and a change in the mix of business.
Aggregate Aggregate commissions and other underwriting expenses for AFG’s property and casualty insurance segment includes $30 million of underwriting expenses related to the Neon exited lines charge in the fourth quarter of 2019 representing contractual employee severance benefits and other incurred exit costs. See “Neon exited lines charge” above for information about AFG’s plans to exit the Lloyd’s of London insurance market in 2020.
The increase in net investment income in the property and casualty insurance segment for the fourth quarter of 2019 as compared to the fourth quarter of 2018 reflects growth in the property and casualty insurance segment, partially offset by lower income from partnerships and similar investments. The property and casualty insurance segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 4.09% for the fourth quarter of
As discussed under “Results of Operations - General,” beginning prospectively with the second quarter of 2019, unlocking, the impact of changes in the fair value of derivatives related to FIAs, and other impacts of changes in the stock market and interest rates on the accounting for FIAs over or under the cost of the equity index options purchased to mitigate the risk in the index-based component of those FIAs are considered non-core earnings (losses). For the fourth quarter of 2019, annuity benefits exclude the $30 million favorable impact of these items and acquisition expenses exclude the related $6 million unfavorable impact on the amortization of deferred policy acquisition costs.
The table below (dollars in millions) details the components of these spreads for AFG’s fixed annuity operations (including fixed-indexed and variable-indexed annuities):
Cost of funds for the fourth quarter of 2019 was $252 million compared to $233 million for the fourth quarter of 2018, an increase of $19 million (8%), reflecting growth in the annuity business. The average cost of policyholder funds, calculated as cost of funds divided by average fixed annuity benefits accumulated, decreased 0.04 percentage points to 2.54% in the fourth quarter of 2019 from 2.58% in the fourth quarter of 2018 reflecting lower renewal option costs.
Other annuity benefits, net of guaranteed withdrawal benefit fees excluding the impact of unlocking and the stock market and interest rates, for the fourth quarter of 2019 were $11 million compared to $10 million for the fourth quarter of 2018, an increase of $1 million (10%). As a percentage of average fixed annuity benefits accumulated, these net expenses decreased 0.01 percentage points to 0.11% from 0.12% in the fourth quarter of 2019 compared to the fourth quarter of 2018. 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):
As discussed under “Annuity Benefits Accumulated” in Note A - “Accounting Policies” to the financial statements, guaranteed withdrawal benefit reserves are accrued for and modified using assumptions similar to those used in establishing and amortizing deferred policy acquisition costs. In addition, the guaranteed withdrawal benefit reserve related to FIAs can be inversely impacted by the calculated FIA embedded derivative reserve as the value to policyholders of the guaranteed withdrawal benefits decreases when the benefit of stock market participation increases. As shown in the table above, changes in the stock market and interest rates increased AFG’s guaranteed withdrawal benefit reserve by $2 million in the fourth quarter of 2019 compared to $35 million in the fourth quarter of 2018. This $33 million (94%) decrease was the primary cause of the $32 million overall decrease in other annuity benefits, net of guaranteed withdrawal benefit fees in the fourth quarter of 2019 compared to the fourth quarter of 2018.
AFG’s net interest spread increased 0.04 percentage points to 1.98% from 1.94% in the fourth quarter of 2019 compared to the same period in 2018 due primarily to lower renewal option costs. Features included in current annuity product offerings allow AFG to achieve its desired profitability at a lower net interest spread than historical product offerings. As a result, AFG expects its net interest spread to narrow in the future.
See “Annuity Unlocking” below for a discussion of the impact that the periodic review of actuarial assumptions had on annuity policy charges and other miscellaneous income in the fourth quarter of 2018.
In addition to the impact of unlocking, the following table illustrates the acceleration/deceleration of the amortization of deferred policy acquisition costs (“DPAC”) resulting from changes in the fair value of derivatives related to FIAs and other impacts of changes in the stock market and interest rates on the accounting for FIAs over or under option costs (in millions):
Annuity acquisitions expenses before unlocking and the acceleration/deceleration of the amortization resulting from changes in the fair value of derivatives related to FIAs and other impacts of changes in the stock market and interest rates on the accounting for FIAs over or under option costs were $65 million for the fourth quarter of 2019 compared to $64 million for the fourth quarter of 2018, an increase of $1 million (2%), reflecting growth in the annuity business.
As discussed above under “Other Annuity Benefits, Net of Guaranteed Withdrawal Benefit Fees” and “Annuity Acquisition Expenses,” the periodic accounting for DPAC and guaranteed withdrawal benefits related to FIAs is also impacted by changes in the stock market and interest rates. These impacts may be temporary in nature and not necessarily indicative of the long-term performance of the FIA business. The table below highlights the impact of changes in the fair value of derivatives related to FIAs and the other impacts of the stock market and interest rates (excluding the impact of the 2018 unlocking charge) over or under the cost of the equity index options (discussed above) on earnings before income taxes for the annuity segment (dollars in millions):
The following table provides analysis of the primary factors impacting the change in the fair value of derivatives related to FIAs and the other impacts of the stock market and interest rates (excluding the impact of the 2018 unlocking charge) on the accounting for FIAs over or under the cost of the equity index options discussed above. Each factor is presented net of the estimated related impact on the amortization of DPAC (dollars in millions).
AFG’s net spread earned on fixed annuities excluding the impact of unlocking, changes in the fair value of derivatives related to FIAs and other impacts of changes in the stock market and interest rates over or under option costs increased 0.09 percentage points to 1.07% from 0.98% in the fourth quarter of 2019 compared to the same period in 2018 due primarily to the 0.04 percentage points increase in AFG’s net interest spread discussed above and the impact of growth in the business over stable fixed expenses. AFG’s overall net spread earned on fixed annuities increased 1.06 percentage points to 1.31% in the fourth quarter of 2019 from 0.25% in the fourth quarter of 2018 due to the increase in AFG’s net interest spread, the impact of changes in the fair value of derivatives and other impacts of the stock market and interest rates on the accounting for FIAs discussed above and the impact of the 2018 unlocking discussed below under “Annuity Unlocking.”
Annuity benefits accumulated includes a liability of $625 million at December 31, 2019 and $472 million at December 31, 2018 for guaranteed withdrawal benefits on annuities with features that allow the policyholder to take fixed periodic lifetime benefit payments that could exceed account value. As discussed above under “Other Annuity Benefits, Net of Guaranteed Withdrawal Benefit Fees” and “Annuity Acquisition Expenses,” the periodic accounting for DPAC and guaranteed withdrawal benefits related to FIAs is also impacted by changes in the stock market and interest rates.
AFG’s annuity operations generated statutory premiums of $1.14 billion in the fourth quarter of 2019 compared to $1.48 billion in the fourth quarter of 2018, a decrease of $343 million (23%). The following table summarizes AFG’s annuity sales (dollars in millions):
Management attributes the 23% decrease in annuity premiums in the fourth quarter of 2019 compared to the fourth quarter of 2018 to the lower market interest rate environment. In response to the continued drop in market interest rates during 2019, AFG lowered crediting rates on several products, which has slowed annuity sales compared to 2018 levels.
AFG monitors the major actuarial assumptions underlying its annuity operations throughout the year and conducts detailed reviews (“unlocking”) of its assumptions annually. Beginning with the third quarter of 2019, AFG moved its unlocking from the fourth quarter to the third quarter and expects to continue to conduct the annual review in the third quarter each year (consistent with many of its peers). If changes in the economic environment or actual experience would cause material revisions to future estimates, these assumptions are updated (unlocked) in an interim quarter.
The unlocking of the major actuarial assumptions underlying AFG’s annuity operations in the fourth quarter of 2018 resulted in a net charge related to its annuity business of $4 million, which impacted AFG’s financial statements as follows (in millions):
Net investment income (as a % of investments) of 4.63% and 4.64% for the three months ended December 31, 2019 and 2018, respectively, multiplied by the difference between average fixed annuity investments (at amortized cost) and average fixed annuity benefits accumulated in each period.
AFG’s net GAAP pretax loss outside of its property and casualty insurance and annuity segments (excluding realized gains and losses) totaled $55 million for the fourth quarter of 2019 compared to $29 million for the fourth quarter of 2018, an increase of $26 million (90%). AFG’s net core pretax loss outside of its property and casualty insurance and annuity segments (excluding realized gains and losses) totaled $50 million for the fourth quarter of 2019 compared to $29 million for the fourth quarter of 2018, an increase of $21 million (72%).
The following table details AFG’s GAAP and core loss before income taxes from operations outside of its property and casualty insurance and annuity segments for the three months ended December 31, 2019 and 2018 (dollars in millions):
Summit, a workers’ compensation insurance subsidiary, collects fees from a small group of unaffiliated insurers for providing underwriting, policy administration and claims services. In addition, certain of AFG’s property and casualty insurance businesses collect fees from customers for ancillary services such as workplace safety programs and premium financing. In the fourth quarter of 2019, AFG collected $17 million in fees for these services compared to $19 million in the fourth quarter of 2018. Management views this fee income, net of the $13 million in both the fourth quarter of 2019 and the fourth quarter of 2018, in expenses incurred to generate such fees, as a reduction in the cost of underwriting its property and casualty insurance policies. Consistent with internal management reporting, these fees and the related expenses are netted and recorded as a reduction of commissions and other underwriting expenses in AFG’s segmented results.
AFG’s holding companies and other operations outside of its property and casualty insurance and annuity segments recorded interest expense of $18 million in the fourth quarter of 2019 compared to $16 million in the fourth quarter of 2018, an increase of $2 million (13%). The following table details the principal amount of AFG’s long-term debt balances as of December 31, 2019 compared to December 31, 2018 (dollars in millions):
In December 2019, AFG redeemed its $150 million outstanding principal amount of 6-1/4% Subordinated Debentures due 2054 and wrote off unamortized debt issuance costs of $5 million.
The 2019 quarter includes a $55 million net gain on securities that were still held at December 31, 2019, and the 2018 quarter includes a $228 million net loss on securities that were still held at December 31, 2018.
RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 2019, 2018 AND 2017
As discussed under “Results of Operations - General,” beginning prospectively with the second quarter of 2019,
AFG’s property and casualty insurance operations contributed $649 million in GAAP pretax earnings in 2019 compared to $709 million in 2018, a decrease of $60 million (8%). Property and casualty core pretax earnings were $743 million in 2019 compared to $727 million in 2018, an increase of $16 million (2%). The decrease in GAAP pretax earnings reflects a pretax non-core charge of $76 million in 2019 related to costs associated with plans to exit the Lloyd’s of London insurance market in 2020, partially offset by higher core pretax earnings. The increase in core pretax earnings reflects
higher net investment income in 2019 compared to 2018 due primarily to growth in the business, partially offset by lower underwriting profit.
AFG’s property and casualty insurance operations contributed $709 million in GAAP pretax earnings in 2018 compared to $591 million in 2017, an increase of $118 million (20%). Property and casualty core pretax earnings were $727 million in 2018 compared to $662 million in 2017, an increase of $65 million (10%). The increase in GAAP and core pretax earnings reflects higher underwriting profit in 2018 compared to 2017 due primarily to higher favorable prior year reserve development and lower catastrophe losses, higher net investment income, due primarily to higher earnings from limited partnerships and similar investments and growth in the business, partially offset by the impact of income from the sale of real estate in 2017. The increase in GAAP pretax earnings also reflects lower special A&E charges in 2018 compared to 2017, partially offset by the impact of favorable reserve development of $18 million in the fourth quarter of 2017 in the Neon exited lines in connection with a reinsurance to close transaction.
The following table details AFG’s GAAP and core earnings before income taxes from its property and casualty insurance operations for the years ended December 31, 2019, 2018 and 2017 (dollars in millions):
The $459 million (7%) increase in gross written premiums in 2019 compared to 2018 reflects growth in each of the Specialty property and casualty sub-segments. Overall average renewal rates increased approximately 3% in 2019. Excluding rate decreases in the workers’ compensation business, renewal pricing increased approximately 6%.
Property and transportation Gross written premiums increased $114 million (4%) in 2019 compared to 2018, due primarily to new business opportunities in the transportation businesses and higher year-over-year premiums in the property and inland marine and ocean marine businesses. Average renewal rates increased approximately 4% for this group in 2019. Reinsurance premiums ceded as a percentage of gross written premiums decreased 2 percentage points in 2019 compared to 2018, reflecting lower cessions in the crop insurance business.
Specialty casualty Gross written premiums increased $323 million (9%) in 2019 compared to 2018 due primarily to the addition of premiums from ABA Insurance Services and growth in the excess and surplus lines, executive liability and targeted markets businesses and higher premiums reported by Neon. This growth was partially offset by lower premiums in the workers’ compensation businesses. Average renewal rates increased approximately 3% for this group in 2019. Excluding rate decreases in the workers’ compensation business, renewal rates for this group increased approximately 8% in 2019. Reinsurance premiums ceded as a percentage of gross written premiums increased 1 percentage point in 2019 compared to 2018, reflecting growth in the surplus lines, excess liability and mergers and acquisitions businesses, which have a higher ceding percentage than many of the businesses in the Specialty casualty sub-segment.
Gross written premiums increased $23 million (3%) in 2018 compared to 2017 due primarily to higher premiums in the financial institutions business. Average renewal rates for this group increased approximately 5% in 2018. Reinsurance premiums ceded as a percentage of gross written premiums increased 2 percentage points in 2018 compared to 2017, reflecting higher cessions in the financial institutions and equipment leasing businesses and the impact of reinstatement premiums in 2018 related to a reinsured loss in the fidelity business.
Other specialty The amounts shown as reinsurance premiums ceded represent business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty property and casualty insurance sub-segments. Reinsurance premiums assumed decreased $10 million (6%) in 2019 compared to 2018, reflecting lower premiums retained, primarily from businesses in the Specialty casualty sub-segment.
The table below (dollars in millions) details the components of the combined ratio for AFG’s property and casualty insurance segment for 2019, 2018 and 2017:
The Specialty property and casualty insurance operations generated an underwriting profit of $325 million in 2019 compared to $322 million in 2018, an increase of $3 million (1%). The higher underwriting profit in 2019 reflects higher underwriting profits in the Specialty casualty and Specialty financial sub-segments, partially offset by lower underwriting profit in the Property and transportation sub-segment. Overall catastrophe losses were $60 million (1.2 points on the combined ratio) for 2019 compared to $103 million (2.1 points) for 2018. In connection with catastrophe losses incurred in 2019 and 2018, AFG paid $1 million and $2 million in net reinstatement premiums, respectively, resulting in total pretax losses from catastrophes of $61 million in 2019 and $105 million in 2018.
Specialty financial Underwriting profit for this group was $92 million in 2019 compared to $66 million in 2018, an increase of $26 million (39%) due primarily to higher underwriting profitability in the financial institutions and surety businesses. Catastrophe losses were $10 million (1.6 points on the combined ratio) in 2019 compared to catastrophe losses of $28 million (4.7 points) and related net reinstatement premiums of $1 million in 2018.
Aggregate Aggregate underwriting results for AFG’s property and casualty insurance segment include the asbestos and environmental reserve charges, the Neon exited lines charge and favorable development in the Neon exited lines. See “Neon exited lines charge” under “Property and Casualty Insurance Segment - Results of Operations” for the quarters ended December 31, 2019 and 2018. AFG also recorded adverse prior year reserve development of $19 million in 2019 related to business outside of the Specialty group that AFG no longer writes.
The current accident year loss and LAE ratio, excluding catastrophe losses for AFG’s Specialty property and casualty insurance operations was 64.0% in 2019, 63.6% in 2018 and 62.9% in 2017.
The 1.6 percentage points increase in the loss and LAE ratio for the current year, excluding catastrophe losses in 2018 compared to 2017 reflects an increase in the loss and LAE ratio of the aviation business and the Singapore branch.
Specialty casualty The 1.6 percentage points decrease in the loss and LAE ratio for the current year, excluding catastrophe losses in 2019 compared to 2018 reflects a decrease in the loss and LAE ratio at Neon (excluding the impact of the Neon exited lines charge).
The loss and LAE ratio for the current year, excluding catastrophe losses is comparable in 2018 and 2017.
AFG’s Specialty property and casualty insurance operations recorded net favorable reserve development related to prior accident years of $187 million in 2019 compared to $212 million in 2018 and $139 million in 2017, a decrease of $25 million (12%) and an increase of $73 million (53%), respectively.
Property and transportation Net favorable reserve development of $67 million in 2019 reflects lower than expected claim frequency and severity at National Interstate and lower than expected losses in the crop business.
Specialty financial Net favorable reserve development of $38 million in 2019 reflects lower than expected claim frequency and severity in the surety and financial institutions businesses and lower than anticipated claim severity in the foreign credit business.
The net adverse reserve development in 2017 reflects a $14 million charge to adjust the deferred gain on the retroactive reinsurance transaction entered into in connection with the sale of businesses in 1998, partially offset by the amortization of deferred gains on retroactive reinsurance and favorable reserve development associated with AFG’s internal reinsurance program.
Asbestos and environmental reserve charges As previously discussed under “Uncertainties” - “Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG has established property and casualty reserves for claims related to environmental exposures and asbestos claims. Total charges recorded to increase reserves (net of reinsurance recoverable) for A&E exposures of AFG’s property and casualty group (included in loss and loss adjustment expenses) were $18 million in both 2019 and 2018 and $89 million in 2017.
Neon exited lines reserve charge AFG recorded net adverse prior year reserve development of $7 million in 2019 and net favorable prior year reserve development of $18 million in 2017 related to Neon’s exited lines of business (included in loss and loss adjustment expenses). See “Neon exited lines charge” under “Property and Casualty Insurance Segment - Results of Operations” for the quarters ended December 31, 2019 and 2018 for information about AFG’s plans to exit the Lloyd’s of London insurance market in 2020.
Aggregate Aggregate net prior accident years reserve development for AFG’s property and casualty insurance segment includes the special A&E charges, reserve development related to the Neon exited lines mentioned above and net adverse reserve development of $19 million, $2 million and $4 million in 2019, 2018 and 2017, respectively, related to business outside the Specialty group that AFG no longer writes.
AFG generally seeks to reduce its exposure to catastrophes through individual risk selection, including minimizing coastal and known fault-line exposures, and the purchase of reinsurance. AFG recorded net catastrophe losses of $60 million in 2019 primarily from winter storms in multiple regions of the United States in the first quarter, storms and tornadoes in multiple regions of the United States in the second quarter, Hurricane Dorian and Tropical Storm Imelda in the third quarter and Typhoons Faxai and Hagibis, storms and tornadoes in the south-central United States and the Kincade fire in California in the fourth quarter.
Catastrophe losses of $140 million in 2017 resulted primarily from storms and tornadoes in several regions of the United States in the first and second quarters, Hurricanes Harvey, Irma and Maria, and earthquakes in Mexico in the third quarter and wildfires in California in the fourth quarter.
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.6 percentage points in 2019 compared to 2018 reflecting lower profitability-based ceding commissions received from reinsurers in the crop business.
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums decreased 0.5 percentage points in 2019 compared to 2018 reflecting the impact of higher premiums on the ratio.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 2.0 percentage points in 2018 compared to 2017 reflecting growth at Neon, which has a higher expense ratio than many of the businesses in the Specialty casualty sub-segment, higher dividends paid to policyholders in the workers’ compensation businesses and lower underwriting, policy administration and claims services fees collected from unaffiliated insurers in the workers’ compensation businesses.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums increased 2.2 percentage points in 2019 compared to 2018 reflecting higher profitability-based commissions paid to agents in the financial institutions business, partially offset by lower underwriting expenses in the equipment leasing business.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 1.3 percentage points in 2018 compared to 2017 reflecting higher profitability-based commissions paid to agents in the financial institutions business compared to 2017, which included an $8 million commission expense reduction due to hurricane losses in the 2017 period, partially offset by the impact of higher premiums on the ratio in the international operations.
Net investment income in AFG’s property and casualty insurance operations was $472 million in 2019 compared to $438 million in 2018, an increase of $34 million (8%). Net investment income in AFG’s property and casualty operations was $438 million in 2018 compared to $362 million in 2017, an increase of $76 million (21%). The average invested assets and overall yield earned on investments held by AFG’s property and casualty insurance operations are provided below (dollars in millions):
Adjusts the yield on equity securities and tax-exempt bonds to the fully taxable equivalent yield.
The increase in average invested assets and net investment income in the property and casualty insurance segment in 2019 compared to 2018 reflects growth in the property and casualty insurance segment. The property and casualty insurance segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 4.16% in 2019 compared to 4.17% in 2018, a decrease of 0.01 percentage points, reflecting lower earnings from limited partnerships and similar investments. AFG’s property and casualty insurance operations recorded $74 million in earnings from partnerships and similar investments and AFG-managed CLOs in 2019 compared to $80 million in 2018, a decrease of $6 million (8%). The yield earned on these investments was 10.1% in 2019 compared to 13.9% in 2018.
Other income and expenses, net for AFG’s property and casualty insurance operations was a net expense of $35 million in 2019, $31 million in 2018, and $13 million in 2017. The table below details the items included in other income and expenses, net for AFG’s property and casualty insurance operations (in millions):
Other income for AFG’s property and casualty insurance operations includes $3 million in 2017 in death benefits from life insurance policies.
AFG’s annuity operations contributed $362 million in GAAP pretax earnings in 2019 compared to $361 million in 2018, an increase of $1 million. This slight increase in AFG’s GAAP annuity segment results for 2019 compared 2018 is due primarily to the positive impact of strong market performance in the 2019 period, the unfavorable impact of the decline in the stock market in 2018 and higher unlocking charges in the 2018 period, offset by the unfavorable impact of significantly lower than anticipated interest rates on the fair value of derivatives related to FIAs in 2019 compared to the favorable impact of higher than anticipated interest rates in 2018. AFG monitors the major actuarial assumptions underlying its annuity operations throughout the year and conducts detailed reviews (“unlocking”) of its assumptions annually. Beginning with the third quarter of 2019, AFG moved its annual unlocking from the fourth quarter to the third quarter and expects to continue to conduct the annual review in the third quarter of each year (consistent with many of its peers). If changes in the economic environment or actual experience would cause material revisions to future estimates, these assumptions are updated (unlocked) in an interim quarter. In addition to the fourth quarter detailed review, AFG unlocked its assumptions for option costs and interest rates in the second quarter of 2018 due to continued higher FIA option costs (resulting primarily from higher than expected risk-free rates). AFG’s unlocking of the actuarial assumptions underlying its annuity operations resulted in a net charge of $1 million in 2019 compared to $31 million in 2018.
AFG’s annuity operations contributed $361 million in pretax earnings in 2018 compared to $380 million in 2017, a decrease of $19 million (5%). AFG’s annuity segment results in 2018 compared to 2017 reflect a 10% increase in average annuity investments (at amortized cost) and higher earnings from limited partnerships and similar investments, more than offset by higher unlocking charges, the impact of lower investment yields due to the run-off of higher yielding investments and the impact of higher than anticipated interest rates, higher than expected option costs and lower stock market performance in the 2018 period.
Annuity core earnings before income taxes were $398 million in 2019 compared to $361 million in 2018, an increase of $37 million (10%). As discussed under “Results of Operations - General,” beginning prospectively with the second quarter of 2019, unlocking, changes in the fair value of derivatives related to FIAs, and other impacts of changes in the stock market and interest rates on the accounting for FIAs over or under the cost of the equity index options purchased to mitigate the risk in the index-based component of those FIAs are considered non-core earnings (losses). For 2019, the annuity segment’s GAAP earnings before income taxes includes $47 million in pretax losses related to these items (including $11 million in the first quarter). Since annuity core earnings for the first quarter of 2019 and prior periods were not adjusted, the annuity segment’s core earnings before income taxes for 2019 includes the $11 million unfavorable impact from these items in the first quarter of 2019 and the full-year results for 2018 and 2017 include the $48 million and $8 million, respectively, unfavorable impact from these items. Excluding the unfavorable impact of these items in the first quarter of 2019 and full-year 2018, annuity core earnings before income taxes were $409 million for both 2019 and 2018 reflecting growth in the business, offset by the impact of lower investment yields and higher renewal option costs. Excluding the $48 million and $8 million unfavorable impact of these items in 2018 and 2017, respectively, annuity core earnings before income taxes for 2018 increased $21 million (5%) compared to 2017 reflecting growth in the business, partially offset by the impact of lower investment yields. The table below highlights the impact of unlocking, changes in the fair value of derivatives and other impacts of the changes in the stock market and interest rates on annuity segment results (dollars in millions):
Because fluctuations in interest rates and the stock market, among other factors, can cause volatility in annuity benefits expense related to FIAs that can be inconsistent with the long-term economics of the FIA business, management believes that including the actual cost of the equity options purchased in the FIA business and excluding unlocking, the impact of changes in the fair value of derivatives related to FIAs, and other impacts of changes in the stock market and interest rates on the accounting for FIAs provides investors with a better view of the true cost of funds in the business and a more comparable measure to the cost of funds reported by its peers. The cost of the equity options included in AFG’s cost of funds is the net purchase price of the option contracts amortized on a straight-line basis over the life of the contracts, which is generally one year. The following table reconciles AFG’s non-GAAP cost of funds measure to total annuity benefits expense (in millions):
2019 includes the $45 million in expense from these items in the first quarter of 2019 and 2018 includes the $34 million unfavorable impact from these items. Excluding the $45 million expense in the first quarter of 2019, the $34 million unfavorable impact of these items in 2018 and the $57 million unfavorable impact of these items in 2017, core annuity benefits expense for 2019 increased $131 million compared to 2018 and increased $129 million in 2018 compared to 2017 reflecting growth in the annuity business and higher renewal option costs.
Net investment income in 2018 was $1.64 billion compared to $1.46 billion in 2017, an increase of $180 million (12%). This increase reflects growth in AFG’s annuity business and higher earnings from limited partnerships and similar investments, partially offset by the impact of lower investment yields. The overall yield earned on investments in AFG’s annuity operations increased by 0.10 percentage points to 4.73% from 4.63% in 2018 compared to 2017. This increase in net investment yield reflects higher earnings from limited partnerships and similar investments, partially offset by (i) the investment of new premium dollars at lower yields as compared to the existing investment portfolio and (ii) the impact of
the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets. AFG’s annuity operations recorded $114 million in earnings from partnerships and similar investments and AFG-managed CLOs in 2018 compared to $53 million in 2017, an increase of $61 million (115%). The yield earned on these investments was 12.4% in 2018 compared to 8.2% in 2017.
Cost of funds for 2018 was $863 million compared to $739 million for 2017, an increase of $124 million (17%). This increase reflects growth in the annuity business and higher renewal option costs. The average cost of policyholder funds increased 0.15 percentage points to 2.49% from 2.34% in 2018 compared to 2017 reflecting higher renewal option costs.
As discussed under “Annuity Benefits Accumulated” in Note A - “Accounting Policies” to the financial statements, guaranteed withdrawal benefit reserves are accrued for and modified using assumptions similar to those used in establishing and amortizing deferred policy acquisition costs. In addition, the guaranteed withdrawal benefit reserve related to FIAs can be inversely impacted by the calculated FIA embedded derivative reserve as the value to policyholders of the guaranteed withdrawal benefits decreases when the benefit of stock market participation increases. As shown in the table above, changes in the stock market and interest rates increased AFG’s guaranteed withdrawal benefit reserve by $14 million in 2019 compared to $83 million in 2018. This $69 million (83%) decrease was the primary cause of the $58 million overall decrease in other annuity benefits, net of guaranteed withdrawal fees in 2019 compared to 2018.
The change in the stock market and interest rates increased AFG’s guaranteed withdrawal benefit reserve by $83 million in 2018 compared to $58 million 2017. This $25 million (43%) increase was the primary cause of the $25 million overall increase in other annuity benefits, net of guaranteed withdrawal benefit fees in 2018 compared to 2017.
AFG’s net interest spread decreased 0.13 percentage points to 2.01% from 2.14% in 2019 compared to 2018 due primarily to higher renewal option costs and lower investment yields. Features included in current annuity product offerings allow AFG to achieve its desired profitability at a lower net interest spread than historical product offerings. As a result, AFG expects its net interest spread to narrow in the future.
AFG’s net interest spread decreased 0.05 percentage points to 2.14% in 2018 from 2.19% in 2017 due primarily to higher renewal option costs and lower investment yields, partially offset by higher earnings from limited partnerships and similar investments.
impacts of changes in the stock market and interest rates on the accounting for FIAs over or under option costs (in millions):
Annuity acquisitions expenses before unlocking and the acceleration/deceleration of the amortization resulting from changes in the fair value of derivatives related to FIAs and other impacts of changes in the stock market and interest rates on the accounting for FIAs over or under option costs were $256 million for 2019 compared to $242 million for 2018, an increase of $14 million (6%), reflecting growth in the annuity business.
Annuity acquisitions expenses before unlocking and the acceleration/deceleration of the amortization resulting from changes in the fair value of derivatives related to FIAs and other impacts of changes in the stock market and interest rates
As discussed above under “Other Annuity Benefits, Net of Guaranteed Withdrawal Benefit Fees” and “Annuity Acquisition Expenses,” the periodic accounting for DPAC and guaranteed withdrawal benefits related to FIAs is also impacted by changes in the stock market and interest rates. These impacts may be temporary in nature and not necessarily indicative of the long-term performance of the FIA business. The table below highlights the impact of changes in the fair value of derivatives related to FIAs and the other impacts of the stock market and interest rates (excluding the impact of unlocking) over or under the cost of the equity index options (discussed above) on earnings before income taxes for the annuity segment (dollars in millions):
During 2019, the negative impact of significantly lower than anticipated interest rates, partially offset by the positive impact of strong stock market performance, reduced the annuity segments’ earnings before income taxes (excluding unlocking) by $46 million compared to the $17 million negative impact of the stock market and interest rates (excluding unlocking) on annuity earnings before income taxes for 2018, an increase of $29 million (171%). In 2018, the positive impact of higher than expected interest rates was more than offset by higher interest on the embedded derivative, the negative impact of higher than expected option costs and significantly lower stock market performance. In 2017, the negative impact of significantly lower than anticipated interest rates was partially offset by the positive impact of strong stock market performance. As a percentage of average fixed annuity benefits accumulated, the impact of changes in the fair value of derivatives related to FIAs and other impacts of changes in the stock market and interest rates on the accounting for FIAs over or under the cost of the equity index options purchased to mitigate the risk in the indexed-based component of those FIAs was a net expense of 0.12%, 0.04% and 0.01% in 2019, 2018 and 2017, respectively.
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 2019, 2018 and 2017 (in millions):
The net charge from unlocking annuity assumptions in 2019 is due primarily to the unfavorable impacts of a decrease in projected net interest spreads on in-force business (due primarily to lower than previously anticipated reinvestment rates and the impact of lower than previously anticipated interest rates on floating rate investments) and higher assumed persistency in certain blocks of business, offset by lowering projected FIA option costs, including anticipated renewal rate actions. For the 2019 unlocking, reinvestment rate assumptions are based primarily on the expectation that the 7-year U.S. Treasury rate will increase to 3.20% and the 10-year U.S. Treasury rate will increase to 3.50% over time. For the unlocking in the third quarter of 2019, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 3.38% for the fourth quarter of 2019, grading up ratably to an ultimate net reinvestment rate of 5.34% in 2029 and beyond.
Excludes pretax non-core special A&E charges of $11 million, $9 million and $24 million in 2019, 2018 and 2017, respectively, and a pretax non-core loss on retirement of debt of $5 million in 2019 and $51 million in 2017.
Other income in the table above includes $15 million, $16 million and $18 million in 2019, 2018 and 2017, respectively, in management fees paid to AFG by the AFG-managed CLOs (AFG’s consolidated managed investment entities). The management fees are eliminated in consolidation - see the other income line in the Consolidated MIEs column under “Results of Operations - Segmented Statement of Earnings.” Excluding amounts eliminated in consolidation, AFG recorded other income outside of its property and casualty insurance and annuity segments of $13 million in both 2019 and 2018 and $9 million in 2017.
Excluding the non-core special A&E charges and the non-core loss on retirement of debt discussed below, AFG’s holding companies and other operations outside of its property and casualty insurance and annuity segments recorded other expenses of $158 million in 2019 compared to $126 million in 2018, an increase of $32 million (25%). This increase reflects a $3 million charitable donation in 2019 and higher holding company expenses related to employee benefit plans that are tied to stock market performance in 2019 compared to 2018, partially offset by a $5 million charge to increase liabilities related to the environmental exposures of AFG’s former railroad and manufacturing operations in 2018.
AFG’s holding companies and other operations outside of its property and casualty insurance and annuity segments recorded other expenses of $126 million in 2018 compared to $144 million in 2017, a decrease of $18 million (13%). This decrease reflects lower holding company expenses related to employee benefits plans that are tied to stock market performance, partially offset by a $5 million charge to increase liabilities related to the environmental exposures of AFG’s former railroad and manufacturing operations in 2018.
The following table details the principal amount of AFG’s long-term debt balances as of December 31, 2019, December 31, 2018 and January 1, 2017 (dollars in millions):
AFG’s holding companies and other operations outside of its property and casualty insurance and annuity segments recorded interest expense of $68 million in 2019, $62 million in 2018 and $85 million in 2017. The $6 million (10%) increase in interest expense in 2019 compared to 2018 primarily reflects the issuance of $125 million of 5.875% Subordinated Debentures in March 2019. The $23 million (27%) decrease in interest expense in 2018 compared to 2017 reflects a lower weighted average interest rate on AFG’s outstanding debt.
As a result of the comprehensive external studies and internal reviews of A&E exposures discussed under “Uncertainties - Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG’s holding companies and other operations outside of its property and casualty insurance and annuity segments recorded non-core special charges of $11 million in 2019, $9 million in 2018 and $24 million in 2017 to increase liabilities related to the A&E exposures of AFG’s former railroad and manufacturing operations. The charges in 2019, 2018 and 2017 are due to relatively small movements across several sites that primarily reflect changes in the scope and costs of investigation. AFG has also increased its reserve for asbestos and toxic substance exposures arising out of these operations. Total charges recorded to increase liabilities for A&E exposures of AFG’s former railroad and manufacturing operations (included in other expenses) were $19 million in 2019, $21 million in 2018 and $31 million in 2017.
In December 2019, AFG redeemed its $150 million outstanding principal amount of 6-1/4% Subordinated Debentures due 2054 at par value and wrote off unamortized debt issuance costs of $5 million.
As discussed in Note A - “Accounting Policies - Investments,” beginning in January 2018, all equity securities other than those accounted for under the equity method are carried at fair value through net earnings. These
AFG’s consolidated net earnings (losses) attributable to noncontrolling interests was a net loss of $28 million in 2019 compared to $13 million in 2018, an increase of $15 million (115%). AFG’s consolidated net earnings (losses) attributable to noncontrolling interests was a net loss of $13 million in 2018 compared to net earnings of $2 million in 2017, a change of $15 million (750%). The following table details net earnings (losses) in consolidated subsidiaries attributable to holders other than AFG (dollars in millions):
Net losses attributable to noncontrolling interests in 2019 includes $18 million related to the $76 million non-core charge for costs associated with AFG’s plans to exit the Lloyd’s of London insurance market in 2020. See “Neon exited lines charge” under “Property and Casualty Insurance Segment - Results of Operations” for the quarters ended December 31, 2019 and 2018.
See Note A - “Accounting Policies - Credit Impairment Guidance Effective in 2020” to the financial statements for a discussion of accounting guidance adopted on January 1, 2020, which provides a new credit loss model for determining credit-related impairments for financial instruments measured at amortized cost (mortgage loans, premiums receivable and reinsurance recoverables) and requires an entity to estimate the credit losses expected over the life of an exposure or pool of exposures. The new guidance is not expected to have a material impact on AFG’s results of operations or financial position.
Consolidated Statement of Earnings for the years ended December 31, 2019, 2018 and 2017
Based on AFG’s evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2019. The attestation report of AFG’s independent registered public accounting firm on AFG’s internal control over financial reporting as of December 31, 2019, is set forth on the next page.
We have audited American Financial Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the “COSO criteria”). In our opinion, American Financial Group, Inc. and subsidiaries (the “Company”) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on the COSO criteria.
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the “Company”) as of December 31, 2019 and 2018, the related consolidated statements of earnings, comprehensive income, changes in equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and financial statement schedules listed in the Index at Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 25, 2020 expressed an unqualified opinion thereon.
As discussed in Note A to the consolidated financial statements, the Company changed its method of accounting for equity investments, other than those accounted for under the equity method, to measure equity investments at fair value with changes in fair value recognized in net earnings in 2018.
As of December 31, 2019, the fair value of the Company’s fixed-income and equity securities totaled $48.56 billion, a portion of which are valued based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, observable market information. The fair value of these securities are determined by management applying the methodologies outlined in Note D to the consolidated financial statements. The lack of visibility into assumptions used in non-binding broker quotes and the credit spread applied by management for internally developed fixed-income investments are significant unobservable inputs, which create greater subjectivity when determining the fair values. Credit spread inputs are developed based on management’s review of trade activity for comparable securities and credit spreads over the treasury yield of securities with a similar duration.
To test the Company’s investment fair values, our audit procedures included, among others, comparing the fair values for a sample of securities to pricing service values or internally developed cash flow models. With the assistance of our valuation specialists, we evaluated the valuation methodologies used by the Company and compared the Company’s fair value estimate to an independently calculated range of fair value estimates for a sample of securities. We evaluated information that corroborated or contradicted the Company’s fair value estimates, including observable yields, transaction data for similar securities, and historical collateral performance data.
As of December 31, 2019, the Company’s unpaid losses and loss adjustment expenses reserve liabilities net of reinsurance recoverables, net of allowance, (“reserves”) totaled $7.21 billion as disclosed in Note P to the consolidated financial statements. This liability represents management’s best estimate of the ultimate net cost of all unpaid losses and loss adjustment expenses and is determined by using case-basis evaluations, actuarial projections, and management’s judgment. Estimating the reserves is inherently judgmental and is influenced by factors that are subject to significant variation, particularly for lines of business that develop or are paid over a long period of time or that contain exposures with high potential severities, such as workers’ compensation, other liability, and asbestos and environmental.
At December 31, 2019, deferred policy acquisition costs totaled $1.04 billion, of which $696 million related to annuity contracts. As described in Notes A and G to the consolidated financial statements, the carrying amount of the annuity deferred policy acquisition costs is the total of costs deferred less amortization that is calculated in relation to the present value of estimated gross profits of the underlying annuity policies. There is a significant amount of uncertainty inherent in calculating estimated gross profits as the calculation is sensitive to management’s best estimate of assumptions, such as future investment yields, lapse rates, mortality, and morbidity. Management’s assumptions are adjusted, also known as unlocking, over time for emerging experience and expected trends. The unlocking results in amortization being recalculated, using the new assumptions for estimated gross profits, that results either in additional or less cumulative amortization expense.
At December 31, 2019, the liability for annuity benefits accumulated included $3.73 billion for the embedded derivatives related to the equity participation feature of the Company’s fixed-indexed annuity products. As described in Note F to the consolidated financial statements, there is a significant amount of estimation uncertainty inherent in measuring the fair value of the embedded derivatives as it includes management’s assumptions of various factors, such as future interest rates, expected stock market performance, budgeted option costs, lapses, and annuitizations. Management’s assumptions are adjusted for emerging experience and expected trends, resulting in changes to the estimated fair value of the embedded derivatives.
We obtained an understanding, evaluated the design, and tested the operating effectiveness of controls over the process for estimating the embedded derivatives. This included, among others, the review and approval processes that management has in place for the methods and assumptions used in the valuation process of the embedded derivatives.
On January 1, 2018, AFG adopted Accounting Standards Update (“ASU”) 2014-09, which provides guidance on recognizing revenue when (or as) performance obligations under the contract are satisfied. The guidance also updates the accounting for certain costs associated with obtaining and fulfilling contracts with customers and requires certain new disclosures. Because revenue recognition for insurance contracts and financial instruments (AFG’s primary sources of revenue) were excluded from the scope of the new guidance, the adoption of ASU 2014-09 did not have a material impact on AFG’s results of operations or financial position.
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. AFG did not have any material nonrecurring fair value measurements in 2019 or 2018.
An AFG subsidiary cedes life insurance policies to a third-party on a funds withheld basis whereby the subsidiary retains the assets (securities) associated with the reinsurance contract. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. This reinsurance contract is considered to contain an embedded derivative (that must be adjusted to fair value) because the yield on the payable is based on a specific block of the ceding company’s assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolio of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to this contract are classified as “trading.” The adjustment to fair value on the embedded derivative offsets the investment income recorded on the adjustment to fair value of the related trading portfolio.
Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati.
exclude leases with a term of 12 months or less from the calculation of lease assets and liabilities,
interests that are redeemable at the option of the holder are presented separately in the mezzanine section of the balance sheet (between liabilities and equity).
The effect of a change in tax rates on deferred tax assets and liabilities is recorded in net earnings in the period that includes the enactment date. This includes the impact on deferred tax assets or liabilities established through AOCI, which results in an amount equal to the difference between the deferred tax at the historical corporate rate and the newly enacted rate stranded in AOCI. As permitted under guidance adopted effective December 31, 2017 (ASU 2018-02), AFG reclassified the $145 million stranded in AOCI from accounting for the Tax Cuts and Jobs Act of 2017 to retained earnings at December 31, 2017. See Note M - “Income Taxes” for further information.
Stock-Based Compensation All share-based grants are recognized as compensation expense on a straight-line basis over their vesting periods based on their calculated fair value at the date of grant. AFG uses the Black-Scholes pricing model to measure the fair value of employee stock options.
AFG records excess tax benefits or deficiencies for share-based payments through income tax expense in the statement of earnings. In addition, AFG accounts for forfeitures of awards when they occur.
Statement of Cash Flows For cash flow purposes, “investing activities” are defined as making and collecting loans and acquiring and disposing of debt or equity instruments, property and equipment and businesses. “Financing activities” include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, surrenders, benefits and withdrawals are also reflected as financing activities. All other activities are considered “operating.” Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.
Credit Impairment Guidance Effective in 2020 In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments, which provides a new loss model for determining credit-related impairments for financial instruments measured at amortized cost (mortgage loans, premiums receivable and reinsurance recoverables) and requires an entity to estimate the credit losses expected over the life of an exposure or pool of exposures. The estimate of expected credit losses considers historical information, current information, as well as reasonable and supportable forecasts, including estimates of prepayments. Expected credit losses, and subsequent increases or decreases in such expected losses, will be recorded immediately through net earnings as an allowance that is deducted from the amortized cost basis of the financial asset, with the net carrying value of the financial asset presented on the balance sheet at the amount expected to be collected. The updated guidance also amends the current other-than-temporary impairment model for available for sale debt securities by requiring the recognition of impairments relating to credit losses through an allowance account and limits the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. Subsequent increases or decreases in expected credit losses will be recorded immediately in net earnings through realized gains (losses). AFG will adopt this guidance effective January 1, 2020. The new guidance is not expected to have a material impact on AFG’s results of operations or financial position.
Atlas Financial Holdings, Inc. In June 2019, National Interstate, a property and casualty insurance subsidiary of AFG, entered into an agreement with Atlas Financial Holdings, Inc. (“AFH”) to become the exclusive underwriter of AFH’s paratransit book of business. National Interstate estimates that the majority of AFH’s $110 million paratransit business will be eligible for quotation under this arrangement over the first 12 months following inception of the agreement. Under the terms of the agreement, AFH will act as an underwriting manager for National Interstate for at least 12 months, after which time National Interstate is entitled to acquire the renewal rights for the business from AFH for a purchase price equal to 15% of the in force gross written premiums at that date. The majority of the purchase price ultimately paid for the renewal rights will be recorded as an intangible renewal rights asset and will be amortized over the estimated life of the business acquired. In connection with the transaction, AFG was granted a five-year warrant to acquire approximately 2.4 million shares of AFH (19.9% at the acquisition date). The estimated fair value of the warrant was approximately $1 million at the date it was received.
The allocation of the purchase price is shown in the table below (in millions):
Approximately $25 million of the purchase price was recorded as a finite lived customer relationship intangible asset, which will be amortized over its estimated life of 9 years. The fair value of this intangible was estimated using a multi-period excess earnings method, which is a form of the income approach. The acquisition resulted in the recognition of $8 million in goodwill based on the excess of the purchase price over the fair value of the net assets acquired. The goodwill represents the fair value of acquired intangible assets that do not qualify for separate recognition, including the value of ABAIS’s assembled workforce. Business generated by ABAIS is included in the Specialty casualty sub-segment.
Neon Lloyd’s Business In December 2017, AFG completed the sale of an indirect noncontrolling interest in Neon, its United Kingdom-based Lloyd’s insurer, to certain Neon executives for cash equal to the fair value of the interest sold as determined by a third-party valuation firm. Because AFG continues to have a controlling interest in Neon, the sale was accounted for as an equity transaction with the excess of the carrying value of the net assets attributable to the noncontrolling interest sold over the consideration received recorded as a $3 million reduction in AFG’s Capital Surplus. As discussed in Note M - “Income Taxes,” the sale of the noncontrolling interest also resulted in the recognition of a $56 million tax benefit, including a $48 million tax benefit previously deferred in the 2016 restructuring of the Neon Lloyd’s operations.
Includes special charges to increase asbestos and environmental (“A&E”) reserves of $18 million in both 2019 and 2018 and $89 million in 2017, respectively. Also includes a $76 million charge in 2019 and $18 million in favorable development recorded in 2017 related to the Neon exited lines.
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets. AFG’s Level 2 financial instruments include separate account assets, corporate and municipal fixed maturity securities, asset-backed securities (“ABS”), mortgage-backed securities (“MBS”), certain non-affiliated common stocks, equity index options and investments of managed investment entities priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, corroborated broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2.
Transfers between Level 1 and Level 2 for all periods presented were a result of increases or decreases in observable trade activity.
Approximately 7% of the total assets carried at fair value on December 31, 2019, were Level 3 assets. Approximately 57% ($2.17 billion) of the Level 3 assets were priced using non-binding broker quotes, for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AFG.
The derivatives embedded in AFG’s fixed-indexed and variable-indexed annuity liabilities are measured using a discounted cash flow approach and had a fair value of $3.73 billion at December 31, 2019. The following table presents information about the unobservable inputs used by management in determining fair value of these Level 3 liabilities. See Note F - “Derivatives.”
Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives includes a favorable adjustment related to the unlocking of actuarial assumptions of $181 million in 2019.
Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives includes losses related to the unlocking of actuarial assumptions of $44 million in 2018.
Excludes $247 million and $232 million of life contingent annuities in the payout phase at December 31, 2019 and 2018, respectively.
AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. During 2019, 2018 and 2017, AFG recorded other-than-temporary impairment charges related to its residential MBS of $1 million, $6 million and $1 million, respectively.
In 2019, AFG recorded other-than-temporary impairment charges of $17 million on third-party collateralized loan obligations and $11 million on corporate bonds. Other-than-temporary impairment charges on fixed maturities other than residential MBS were $20 million in 2018 and $19 million in 2017. In addition, AFG recorded $4 million in other-than-temporary impairment charges in 2017 on investments that are included in other investments on the balance sheet.
There were no investments in individual issuers that exceeded 10% of shareholders’ equity at December 31, 2019 or 2018.
Net Unrealized Gain on Marketable Securities In addition to adjusting fixed maturity securities classified as “available for sale” to fair value, GAAP requires that deferred policy acquisition costs and certain other balance sheet amounts related to annuity, long-term care and life businesses be adjusted to the extent that unrealized gains and losses from securities would result in adjustments to those balances had the unrealized gains or losses actually been realized. The following table shows (in millions) the components of the net unrealized gain on securities that is included in AOCI in AFG’s Balance Sheet.
Net unrealized gains on fixed maturity investments supporting AFG’s annuity benefits accumulated.
Although the change in the fair value of the majority of AFG’s equity securities is recorded in realized gains (losses) on securities, AFG records holding gains and losses in net investment income on equity securities classified as “trading” under previous guidance and on a small portfolio of limited partnership and similar investments that do not qualify for the equity method of accounting.
The following table summarizes the gains (losses) included in AFG’s Statement of Earnings for changes in the fair value of derivatives that do not qualify for hedge accounting for 2019, 2018 and 2017 (in millions):
The change in fair value of the embedded derivative includes a favorable adjustment related to unlocking of actuarial assumptions of $181 million in 2019 and losses of $44 million in 2018 and $25 million in 2017.
Derivatives Designated and Qualifying as Cash Flow Hedges As of December 31, 2019, AFG has thirteen active interest rate swaps that are designated and qualify as highly effective cash flow hedges to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities. The purpose of each of these swaps is to effectively convert a portion of AFG’s floating-rate fixed maturity securities to fixed rates by offsetting the variability in cash flows attributable to changes in short-term LIBOR.
During 2019, AFG subsidiaries received less than $1 million in redemption proceeds from their CLO investments. In 2018, AFG formed a new CLO, which issued $463 million face amount of liabilities (including $31 million face amount purchased by subsidiaries of AFG). During 2018, AFG subsidiaries also purchased $7 million face amount of a senior debt tranche of an existing CLO for $7 million and received $45 million in sale and redemption proceeds from its CLO investments. In 2017, AFG formed two new CLOs, which issued an aggregate of $865 million face amount of liabilities (including $48 million face amount purchased by subsidiaries of AFG). During 2017, AFG subsidiaries also purchased $71 million face amount of senior debt and subordinate tranches of existing CLOs for $71 million and received $103 million in sale and redemption proceeds from its CLO investments. In 2018 and 2017, one and two AFG CLOs, respectively, were substantially liquidated, as permitted by the CLO indentures.
The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $146 million and $232 million at December 31, 2019 and 2018, respectively. The aggregate unpaid principal balance of the CLOs’ debt exceeded its carrying value by $129 million and $241 million at those dates. The CLO assets include loans with an aggregate fair value of $10 million at December 31, 2019, for which the CLOs are not accruing interest because the loans are in default (aggregate unpaid principal balance of $25 million; none at December 31, 2018).
Included in other assets in AFG’s Balance Sheet is $43 million at December 31, 2019 and $54 million at December 31, 2018 of amortizable intangible assets related to property and casualty insurance acquisitions. These amounts are net of accumulated amortization of $50 million and $39 million, respectively. The increase in amortizable intangible assets in 2018 relates to the November 2018 acquisition of ABAIS (discussed in Note B - “Acquisitions and Sale of Businesses”) and a renewal rights intangible asset established in connection with the acquisition of a small property and casualty book of business in January 2018. Amortization of intangibles was $11 million in 2019, $9 million in 2018 and $8 million in 2017. Future amortization of intangibles (weighted average amortization period of 4 years) is estimated to be $12 million in 2020, $6 million in 2021, $4 million per year in 2022, 2023 and 2024 and $13 million thereafter.
In December 2019, AFG issued $200 million in 5.125% Subordinated Debentures due in 2059. The net proceeds of the offering were used, in part, to redeem AFG’s $150 million outstanding principal amount of 6-1/4% Subordinated Debentures due September 2054 at par value in December 2019.
The following table details AFG’s lease activity for the year ended December 31, 2019 (in millions):
Other operating lease information for the year ended December 31, 2019 (in millions):
Stock Incentive Plans Under AFG’s stock incentive plans, employees of AFG and its subsidiaries are eligible to receive equity awards in the form of stock options, stock appreciation rights, restricted stock awards, restricted stock units and stock awards. At December 31, 2019, there were 4.5 million shares of AFG Common Stock reserved for issuance under AFG’s stock incentive plans.
The restricted Common Stock that AFG has granted generally vests over a four-year period. Data relating to grants of restricted stock is presented below:
The total fair value of restricted stock that vested during 2019, 2018 and 2017 was $11 million, $10 million and $14 million, respectively.
AFG has not granted any stock options since 2015. Options granted in prior years have an exercise price equal to the market price of AFG Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant and expire ten years after the date of grant.
The total intrinsic value of options exercised during 2019, 2018 and 2017 was $46 million, $57 million and $65 million, respectively. During 2019, 2018 and 2017, AFG received $31 million, $29 million and $34 million, respectively, in cash from the exercise of stock options. The total tax benefit related to the exercises was $8 million, $9 million and $18 million during those years, respectively.
(a) The reclassification adjustment out of net unrealized gains (losses) on securities affected the following lines in AFG’s Statement of Earnings:
On January 1, 2018, AFG adopted new guidance that requires all equity securities other than those accounted for under the equity method to be reported at fair value with holding gains and losses recognized in net earnings. At the date of adoption, the $221 million net unrealized gain on equity securities classified as available for sale (with unrealized holding gains and losses reported in AOCI) under the prior guidance was reclassified from AOCI to retained earnings as the cumulative effect of an accounting change. Other also includes the December 2017 reclassification of $145 million stranded in AOCI from accounting for the Tax Cuts and Jobs Act of 2017 to retained earnings (see Note A - “Accounting Policies - Income Taxes”) and the impact on AOCI of the December 2017 sale of redeemable noncontrolling interests in Neon.
tax benefit is expected to be received in 2020 as a result of the filing of a refund claim in 2018 to carry back tax basis capital losses to offset prior year tax basis capital gains.
At the time it was enacted, the TCJA was subject to further clarification and interpretation by the U.S. Treasury Department and the Internal Revenue Service. AFG’s deferred tax assets and liabilities were recorded at December 31, 2017 using reasonable estimates based on available information and were considered provisional in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 118 (“SAB 118”). In accordance with SAB 118, changes in deferred taxes resulting from clarification and interpretation of the TCJA were recorded in 2018 in the period in which the guidance was published and did not have a material impact on AFG’s effective tax rate. As a result, AFG’s implementation of the TCJA was complete as of December 31, 2018.
Total earnings before income taxes include losses subject to tax in foreign jurisdictions of $109 million in 2019, $69 million in 2018 and $58 million in 2017, primarily related to the Neon Lloyd’s operations.
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2019 (in millions):
AFG completed an in-depth internal review of its asbestos and environmental (“A&E”) exposures in the third quarter of 2019. The review resulted in special A&E charges of $18 million for the property and casualty group and $11 million for the former railroad and manufacturing operations. AFG also completed an in-depth internal review of its A&E exposures in the third quarter of 2018, which resulted in special A&E charges of $18 million for the property and casualty group and $9 million for the former railroad and manufacturing operations. AFG completed a comprehensive external study of its A&E exposures in the third quarter of 2017 with the aid of specialty actuarial, engineering and consulting firms and outside counsel. The study resulted in special A&E charges of $89 million for the property and casualty group and $24 million for the former railroad and manufacturing operations.
The property and casualty group’s liability for A&E reserves was $529 million at December 31, 2019; related recoverables from reinsurers (net of allowances for doubtful accounts) at that date were $146 million.
At December 31, 2019, American Premier and its subsidiaries had liabilities for environmental and personal injury claims and other contingencies aggregating $84 million. The environmental claims consist of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs related to certain sites formerly owned or operated by the railroad and manufacturing operations. Remediation costs are difficult to estimate for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. The personal injury claims and other contingencies include pending and expected claims, primarily by former employees of PCTC, for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the workplace and other labor disputes.
At December 31, 2019, GAFRI had a liability of $8 million for environmental costs and certain other matters associated with the sales of its former manufacturing operations.
In December 2015, AFG completed the sale of substantially all of its run-off long-term care insurance business to HC2 Holdings, Inc. (“HC2”). In connection with obtaining regulatory approval for the transaction, AFG agreed to provide up to an aggregate of $35 million of capital support for the insurance companies, on an as-needed basis to maintain specified surplus levels, subject to immediate reimbursement by HC2 through a five-year capital maintenance agreement expiring in 2020.
While management believes AFG has recorded adequate reserves for the items discussed above, the outcome is uncertain and could result in liabilities that may vary from amounts AFG has currently recorded. Such amounts could have a material effect on AFG’s future results of operations and financial condition.
Pretax realized gains (losses) on securities, which resulted primarily from changes in the fair value of equity securities, were as follows (in millions):
In the fourth quarter of 2019, AFG recorded a pretax charge of $76 million for reserve strengthening and expenses related to exit costs incurred with AFG’s plans to exit the Lloyd’s of London insurance market in 2020.
AFG’s property and casualty operations recorded catastrophe losses, including reinstatement premiums, as follows (in millions):
AFG recorded a pretax loss on the retirement of debt of $5 million in the fourth quarter of 2019.
Cash and securities owned by U.S.-based insurance subsidiaries, having a carrying value of approximately $1.04 billion at December 31, 2019, were on deposit as required by regulatory authorities. In addition, $217 million was on deposit in support of AFG’s underwriting activities at Lloyd’s. At December 31, 2019, AFG and its subsidiaries had $414 million in undrawn letters of credit (none of which was collateralized) and similar agreements supporting the underwriting capacity of its U.K.-based Lloyd’s insurer, Neon.
discounting did not materially impact AFG’s total liability for unpaid losses and loss adjustment expenses (net reductions from discounting of $12 million and $13 million at December 31, 2019 and 2018, respectively).
The following table provides an analysis of changes in the liability for losses and loss adjustment expenses over the past three years (in millions):
FHLB Funding Agreements Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions. Members are required to purchase stock in the FHLB in addition to maintaining collateral deposits that back any funds advanced. GALIC’s $52 million investment in FHLB capital stock at December 31, 2019 is included in other investments at cost. Membership in the FHLB provides the annuity operations with an additional source of liquidity. These advances further the FHLB’s mission of improving access to housing by increasing liquidity in the residential mortgage-backed securities market.
In the fourth quarter of 2018, GALIC, AFG’s primary annuity subsidiary, entered into a reinsurance treaty with Hannover Life Reassurance Company of America that transfers the risk of certain surrender activity in GALIC’s fixed-indexed annuity business. This treaty meets the statutory risk transfer rules and resulted in a $510 million increase in statutory surplus (through an after-tax reserve credit), which is reflected in the life insurance companies capital and surplus in the table above. Under GAAP, this transaction does not meet the GAAP insurance risk transfer criteria and did not have a material impact on AFG’s financial statements.
In June 2017, AFG’s property and casualty insurance subsidiaries entered into a reinsurance agreement to obtain supplemental catastrophe protection through a catastrophe bond structure with Riverfront Re Ltd. (“Riverfront”). The reinsurance agreement provides supplemental reinsurance coverage up to 95% of $200 million (fully collateralized) for catastrophe losses in excess of $134 million of traditional catastrophe reinsurance (per occurrence and annual aggregate) occurring until December 31, 2020. In connection with the reinsurance agreement, Riverfront issued notes to unrelated investors for the full amount of coverage provided under the reinsurance agreement. Through December 31, 2019, AFG’s incurred catastrophe losses have not reached the level of attachment for the catastrophe bond structure. Riverfront is a variable interest entity in which AFG does not have a variable interest because the variability in Riverfront’s results will be absorbed entirely by the investors in Riverfront. Accordingly, Riverfront is not consolidated in AFG’s financial statements and the reinsurance agreement is accounted for as ceded reinsurance. AFG’s cost for this coverage is approximately $11 million per year.
AFG has reinsured approximately $6.23 billion of its $9.53 billion in face amount of life insurance at December 31, 2019 compared to $7.69 billion of its $10.82 billion in face amount of life insurance at December 31, 2018. Life written premiums ceded were $20 million, $22 million and $28 million for 2019, 2018 and 2017, respectively. Reinsurance recoveries on ceded life policies were $32 million, $38 million and $35 million for 2019, 2018 and 2017, respectively.
Variable Annuities At December 31, 2019, 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 $13 million, compared to $35 million at December 31, 2018. Death benefits paid in excess of the variable annuity account balances were less than $1 million in each of the last three years ended December 31, 2019, 2018 and 2017.
Annual Senior Executive Bonus Plan, filed as Exhibit 10(d) to AFG’s 10-K for 2017.