Fixed charges are computed on a "total enterprise" basis. For purposes of calculating the ratios, "earnings" have been computed by adding to pretax earnings the fixed charges and the minority interest in earnings of subsidiaries having fixed charges and the undistributed equity in losses of investees. Fixed charges include interest (including interest credited to annuity policyholders' accounts as indicated), amortization of debt premium/discount and expense, preferred dividend and distribution requirements of subsidiaries and a portion of rental expense deemed to be representative of the interest factor.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance, focusing on specialized commercial products for businesses and in the sale of traditional fixed, indexed and variable annuities and a variety of supplemental insurance products.
The property and casualty business is cyclical in nature with periods of high competition resulting in low premium rates, sometimes referred to as a "soft market" or "downcycle" followed by periods of reduced competition and higher premium rates, referred to as a "hard market" or "upcycle." The 1990's were a soft market period; prices started to harden in 2000 and accelerated significantly following the terrorist attacks in 2001. Rate increases for AFG's specialty businesses moderated during the latter part of 2003 and that trend continued during 2004. While AFG's workers' compensation operations experienced significant rate decreases from 2005 through 2007, reflecting the improved claims environment from reform legislation, overall average renewal pricing was flat for 2005 and down about 2% in 2006 and 4% in 2007.
AFG and AAG Holding can borrow a combined $500 million under their revolving credit facility, which expires in 2011. AFG and AAG Holding had a total of $116 million in borrowings outstanding under this agreement at December 31, 2007, bearing interest at a rate of 5.9% at December 31, 2007. AFG believes that this credit agreement provides ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent company.
During 2006, AFG repurchased $43.5 million of its 7-1/8% debentures due 2009 for $45.6 million in cash. During 2005, AFG repurchased $15.6 million of its 7-1/8% Debentures due 2007 and $71.2 million of its 7-1/8% Debentures due 2009 for $92.6 million in cash.
On March 1, 2007, AAG Holding used funds borrowed under the bank credit line to redeem its $22 million in outstanding 8-7/8% Subordinated Debentures for $22.9 million in cash.
do not include any impact for future earnings or additional premiums.
(b) Dollar amounts and time periods are estimates based on historical net payment
$700 million; 2-3 years - $800 million; 4-5 years - $400 million; and
thereafter - $400 million. Actual payments and their timing could differ
(c) AFG's $43 million liability for unrecognized tax benefits as of December 31, 2007,
is not included because the period of payment cannot be reliably estimated.
The accreted value of the AFG Senior Convertible Notes due in 2033 is included in the above table at the first put date (2008). AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2007.
See Note N - "Additional Information - Financial Instruments with Off-Balance Sheet Risk" to the financial statements.
Nearly two-thirds of AFG's consolidated assets are invested in marketable securities. AFG's investment portfolio at December 31, 2007, contained $15.1 billion in "Fixed maturities" classified as available for sale and $923 million in "Equity securities", all carried at fair value with unrealized gains and losses included in a separate component of shareholders' equity on an after tax basis. The fair value of approximately 98% of AFG's fixed maturity and equity security portfolio is based on values provided by pricing services or quotes from brokers. At December 31, 2007, AFG had pretax net unrealized losses of $47.4 million on fixed maturities and net unrealized gains of $8.8 million on equity securities.
Approximately 94% of the fixed maturities held by AFG at December 31, 2007, were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and
AFG's $4.8 billion investment in mortgage backed securities ("MBSs") represented approximately one-third of its available for sale fixed maturities at December 31, 2007. MBSs are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates. Approximately 99% of AFG's mortgage-backed securities are rated "AAA." At December 31, 2007, AFG owned $483 million (representing 3% of AFG's total fixed maturity portfolio) of mortgage-backed securities in which the underlying collateral is subprime mortgages. At that date, the net unrealized loss on these securities was approximately $28.6 million. The securities are collateralized by fixed-rate mortgages and have an overall average life of approximately 4 years. At December 31, 2007, AFG had no collateralized debt obligations secured by residential mortgages.
At December 31, 2007, AFG owned $855 million in securities with credit enhancement provided by bond insurers, including $596 million of insured municipal bonds, $152 million in insured subprime securities (included in the $483 million in total subprime exposure discussed above), $99 million in insured corporate bonds and $8 million in insured residential mortgage-backed securities. Approximately 90% of the insured municipal bonds carry an explicit underlying rating (i.e. without credit enhancement) with an average of A+, and 50% of the corporate bonds carry an explicit underlying rating with an average of BBB+. None of the insured subprime securities or the residential mortgage-backed securities carry an explicit underlying rating. Management does not believe the risk of loss on the securities without underlying credit ratings is material to AFG's financial condition.
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at December 31, 2007, based on their fair values. Asset- backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Based on its analysis of the factors enumerated above, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they mature or recover in value. Although AFG has the ability to continue holding its 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 with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately
(a) Adjustments to reflect the impact of realized gains and losses on the
(b) Includes fourth quarter charge of $64.2 million to reduce AFG's investment
Management (including Company actuaries) considers items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, the nature and maturity of lines of insurance, general economic trends and the legal environment in determining the Company's best estimate of the ultimate liability. In addition, historical trends adjusted for changes in underwriting standards, policy provisions, product mix and other factors are analyzed using actuarial reserve development techniques. Weighing all of the factors, the management team determines a single or "point" estimate that it records as its best estimate of the liabilities. Ranges of loss reserves are not developed by Company actuaries. This reserve analysis and review is completed each quarter and for every line of business.
The judgments and uncertainties surrounding management's reserve estimation process and the potential for reasonably possible variability in management's most recent reserve estimates may also be viewed by looking at how recent historical estimates of reserves have developed. The following table shows (in millions) what the impact on AFG's net earnings would be on the more significant lines of business if the December 31, 2007, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
AFG recorded favorable development of $34 million in 2007, $21 million in 2006 and $16 million in 2005 related to its nursing home coverage where both the frequency and severity of claims were lower than previously projected. In addition, favorable development of $59 million in 2007 and $15 million in 2006 was recorded in Mid-Continent's general liability business due to claim severity being less than predicted.
AFG recorded adverse loss development of $26 million in 2005 on prior year umbrella and excess liability business as outside counsel costs exceeded expectations and certain judicial decisions and jury awards were worse than expected. In addition, $8 million in adverse development was recorded in 2005 on a run-off book of casualty business due to the frequency and severity of claims being significantly greater than predicted.
While the standard actuarial techniques do reflect expected favorable impacts from the reforms, the magnitude of future cost savings depends on the implementation and interpretation of the reforms throughout the workers' compensation system over the next several years. While management applies the actuarial methods mentioned above, more judgment is involved in arriving at the final reserve to be held. For recent accident years, more weight is given to the methods based on claim count and severity. Management reviewed the frequency, severity and loss and LAE ratios implied by the projections from the standard tests in light of the uncertainties of future cost savings and recent rate actions since the reforms, to determine the appropriate reserve level. Due to the long-tail nature of this business, AFG has been conservative in reserving for the favorable effects of the reform legislation until a higher percentage of claims have been paid and the ultimate impact of reforms can be estimated with more precision.
AFG recorded adverse prior year loss development of $1 million in 2007, $13 million in 2006 and $15 million in 2005 on its legal professional liability business as claim severity continued to be higher than previous underlying assumptions.
Emerging trends, such as those named below, could impact AFG's reserves and payments:
From time to time, AFG has engaged independent firms to work closely with its claims staff to study the A&E reserves of its insurance company subsidiaries. The most recent study was completed in the second quarter of 2007 and resulted in AFG recording a pretax charge of $44.2 million to increase its insurance A&E reserves. A similar study in 2005 resulted in a pretax charge of $169 million to strengthen insurance A&E reserves. Management expects to conduct an internal comprehensive review of its A&E reserves in 2008 and an independent study in 2009. For a discussion of the 2007 and 2005 A&E reserve strengthening, see Management's Discussion and Analysis - "Results of Operations - Asbestos and Environmental Reserve Charges."
claims and contingencies arising from these former operations. Management expects to conduct a comprehensive review of these liabilities in conjunction with the property and casualty group's A&E studies every two years. For a discussion of the uncertainties in determining American Premier's and GAFRI's ultimate liability, see Note K - "Commitments and Contingencies" to the Financial Statements.
(a) Includes after tax gains on sales of two hotel operations of $25.8 million
Excluding the effects of items shown in the table above, net earnings increased in 2007 and 2006 due primarily to improved property and casualty underwriting results and increased investment income.
Over the last several years, AFG has been realigning its property and casualty business mix and focusing on rate adequacy in order to improve its operating profitability. Management has continued to direct capital in order to take advantage of certain specialty market opportunities. Management believes these actions have been successful and that the current mix of specialty businesses positions the Company for solid growth and continued profitability.
(a) Includes 5.7 points in 2007, 21.5 points in 2006 and 28.7 points in 2005 for
charges to strengthen the A&E and other mass tort loss reserves.
Gross written premiums for the specialty insurance operations increased 8% and net written premiums increased 9% in 2006 compared to 2005. Significant premium growth from the Property and transportation and Specialty financial groups was partially offset by a decline in California workers' compensation premiums.
Property and transportation gross and net written premiums increased in 2007 compared to 2006 primarily as a result of growth in the crop and transportation operations. The 2007 underwriting profit of $245 million was 41% higher than in 2006. These results were primarily due to significantly higher crop insurance earnings and minimal catastrophe losses in 2007 compared to $19.3 million (2.0 points) in 2006.
Net written premiums for 2006 were 13% higher than in 2005 due primarily to volume growth and higher premium retention within several of the group's businesses as well as third quarter 2006 changes to reinsurance agreements within the specialized program business line, which resulted in the recapture of $26 million in premiums previously ceded to reinsurers. This group's combined ratio improved 6.4 points for 2006 compared to 2005. Results for 2005 included 4.0 points of unfavorable reserve development.
Specialty financial gross and net written premiums increased in 2007 primarily due to growth in the financial institutions, lease and loan, and fidelity and surety operations, which was partly offset by lower premiums resulting from the run-off of the RVI business. The higher net written premium growth rate reflects a decrease in premiums ceded under reinsurance agreements within the lease and loan businesses. This group's combined ratio of 94.6% improved 15.6 points compared with 2006. This improvement is due primarily to lower losses in the run-off RVI business. Each of the business units within this group produced solid underwriting profits for the year. Excluding the effect of RVI, the group's combined ratio would have been 88.9% for 2007, about the same as in 2006.
California workers' compensation gross and net written premiums decreased in 2007 due to renewal rate reductions averaging about 22% for the year. This business produced excellent profitability throughout 2007, reflecting the ongoing positive effects of the California workers' compensation reforms that have resulted in an improving claims environment while also providing reduced workers' compensation costs for employers through lower premium levels. The 2007 combined ratio was 4.2 points higher than the same period a year earlier, reflecting the results of rate reductions, which have been responsive to the improved claims environment. This business continued to benefit from favorable prior year reserve development. The 2007 results include $21.5 million (9.2 points) of favorable development compared to $23.3 million (8.0 points) in 2006. Due to the long-tail nature of this business, AFG has been conservative in reserving for the favorable effects of the reform legislation until a higher percentage of claims are paid and the ultimate impact of reforms can be estimated with more precision.
The 17% decrease in net written premiums and 4.1 point increase in the combined ratio for 2006 compared to 2005 reflect the effects of the California workers' compensation reforms discussed above. Renewal rate decreases averaged about 32% in 2006 and 16% in 2005. Underwriting results include favorable prior year loss development of $23.3 million in 2006 and $24.4 million in 2005.
Asbestos and Environmental Reserve Charges AFG has undertaken periodic reviews of its asbestos and environmental reserves with the aid of independent actuarial and engineering firms and specialty outside counsel. In July 2007, AFG completed its most recent comprehensive study of its asbestos and environmental exposures relating to the run-off operations of its property and casualty group and its exposures related to former railroad and manufacturing operations and sites.
As a result of the study, AFG recorded a $44.2 million charge (net of reinsurance) in the second quarter of 2007 to increase the property and casualty group's asbestos reserves by $30.8 million and its environmental reserves by $13.4 million. The primary causes of the increase
environmental reserves was due primarily to increased clean up estimates at certain former railroad and manufacturing sites.
With respect to the environmental claims, the 2005 study considered both direct insurance and assumed reinsurance, projected exposure at both National Priorities List ("NPL") sites and non-NPL sites, historic payment patterns, patterns of new claims, settlements and projected development. The increase in environmental reserves in 2005 was primarily due to an increase in clean up costs at certain sites above prior expectations and an unexpected increase in the number of new claims reported to the Company. In addition, projected development on a few claims exceeded estimates in the previous 2001 study.
Loss development As shown in Note M - "Insurance - Insurance Reserves," AFG's property and casualty operations recorded favorable loss development of $99 million in 2007 compared to $57 million in 2006 and unfavorable development of $199 million in 2005 related to prior accident years. Major areas of favorable (adverse) development were as follows (in millions):
The favorable development in Property and transportation related primarily to lower than expected claim frequency and severity in specialty commercial automobile, ocean marine and inland marine products. Also contributing to the favorable development in 2007 and 2006 was lower than expected claim frequency and severity in the crop business.
The favorable development in Specialty casualty during 2007 was the result of lower than expected frequency and severity in the nursing home liability product and general liability business. The nursing home liability product also contributed to the favorable development in 2006, along with insurance products for not-for-profit organizations, partially offset by adverse development in professional liability and certain run-off businesses. The adverse development in 2005 was mainly in the professional liability and runoff casualty businesses partially offset by favorable development in the excess and surplus and not-for-profit businesses. Adverse development in excess casualty runoff impacted 2005, reflecting higher frequency and severity of claims related to the 1999 through 2001 accident years.
The favorable development in Specialty financial in 2007 was in the fidelity and crime products where the severity of loss was less than expected. The adverse development in 2005 related to higher than expected severity on claims from accident years 2000 to 2003.
The favorable development in California workers' compensation reflects the impact of the workers' compensation reform legislation passed in 2003 and 2004.
The increase in life, accident and health premiums in 2007 reflects the August 2006 acquisition of Ceres. The decrease in life, accident and health premiums in 2006 reflects the January 2006 sale of GA Life of Puerto Rico partially offset by the effect of the acquisition of Ceres.
Changes in investment income reflect fluctuations in market rates and changes in average invested assets. The increase in investment income for 2007 and 2006 reflects increases of $1.1 billion (7%) in average cash and investments in each year compared to the prior year. AFG's yield on fixed income securities, excluding realized gains, was approximately 5.8% in 2007 and 2006 and 5.7% in 2005.
AFG's subsidiaries are engaged in a variety of real estate operations including hotels, marinas, apartments and office buildings; they also own several parcels of land. Revenues and expenses of these operations, including gains and losses on disposal, are included in AFG's Statement of Earnings as shown below (in millions).
In June 2006, GAFRI sold Chatham Bars Inn, a resort hotel located on Cape Cod, Massachusetts, for $166 million. After sales expenses, contingencies and the write-off of certain deferred acquisition costs on annuities associated with the gain recognition, GAFRI recognized a pretax gain of approximately $48.7 million. In the second quarter of 2007, GAFRI received an additional escrow payment in connection with the sale. In October 2005, GAFRI sold the Driskill Hotel in Austin, Texas for $53 million. After sale expenses, profit sharing payments and a write-off of DPAC associated with the gain, GAFRI recognized a pretax gain of $16.5 million. The operating results and gains on the sales of Chatham and Driskill are included in discontinued operations in the Statement of Earnings. See Note J - "Discontinued Operations."
Annuity benefits reflect amounts accrued on annuity policyholders' funds accumulated. On deferred annuities (annuities in the accumulation phase), interest is generally credited to policyholders' accounts at their current stated interest rates. Furthermore, for "two-tier" deferred annuities (annuities under which a higher interest amount can be earned if a policy is annuitized rather than surrendered), additional reserves are accrued for (i) persistency and premium bonuses and (ii) excess benefits expected to be paid for future deaths and annuitizations. Changes in crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect these additional reserves. Significant changes in projected investment yields could result in charges (or credits) to earnings in the period the projections are modified.
Annuity and supplemental insurance acquisition expenses include amortization of annuity, supplemental insurance and life business deferred policy acquisition costs ("DPAC") as well as a portion of commissions on sales of insurance products. Annuity and supplemental insurance acquisition expenses also include amortization of the present value of future profits of businesses acquired ("PVFP"). The $33.3 million increase in annuity and supplemental insurance acquisition expenses in 2007 compared to 2006 reflects the growth in the annuity and supplemental insurance business, the acquisition of Ceres in August 2006 and the fourth quarter 2007 DPAC write-off discussed below. The $8.4 million decrease in annuity and supplemental insurance acquisition expenses for 2006 compared to 2005 reflects the effect of the fourth quarter 2005 DPAC write-offs discussed below and the January 2006 sale of GAPR, partially offset by the Ceres and Old Standard Life acquisitions and other growth in the annuity and supplemental insurance businesses.
The vast majority of the annuity and supplemental insurance group's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Unanticipated spread compression, decreases in the stock market, adverse mortality experience, and higher than expected lapse rates could lead to further write-offs of DPAC or PVFP in the future.
Interest expense decreased $7 million (9%) in 2006 compared to 2005 due primarily to the retirement of debt in 2006 and late 2005.
Other operating expenses for 2007 include a $43.0 million special charge to increase liabilities for asbestos and environmental exposures related to AFG's former railroad and manufacturing operations, a $16.0 million increase in the expenses of AFG's warranty business compared to 2006 and $1.4 million in losses on retirement of debt. For a discussion of the study that resulted in the A&E charge, see "Asbestos and Environmental Reserve Charges" under Results of Operations - "Property and Casualty Insurance - Underwriting."
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," which permits entities to irrevocably elect to report certain financial assets and liabilities (including most insurance contracts) at fair value and recognize the unrealized gains and losses on such items in earnings. SFAS No. 159 is effective January 1, 2008, for calendar year companies. AFG did not elect the fair value option for any of its eligible assets or liabilities at the effective date.
In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements," which is effective January 1, 2009, for calendar year companies. Under SFAS No. 160, noncontrolling (minority) interest ($99.9 million at December 31, 2007) will be reported in AFG's Balance Sheet as a separate component of shareholders' equity; net earnings attributable to noncontrolling (minority) interests will be recorded in AFG's Statement of Earnings as a deduction from net income (instead of as an expense) in deriving net income attributable to AFG. In addition, SFAS No. 160 requires that purchases and sales of equity interests in less than 100%-owned subsidiaries that do not result in a change of control be accounted for as equity transactions and, upon loss of control, requires any interest retained to be recorded at fair value with a gain or loss recognized in earnings.
The FASB has proposed an amendment to SFAS No. 128, "Earnings per Share." Currently, SFAS No. 128 allows companies issuing securities that can be settled in cash or stock (such as AFG's Senior Convertible Notes) to exclude the issuable shares from the calculation of diluted earnings per share when there is a stated intent and ability to deliver cash in lieu of stock upon settlement or conversion. The proposed statement would require companies to assume settlement in stock (despite the ability and intent to settle in cash) and include those shares in the calculation of diluted earnings per share. The proposed amendment would reduce 2007 diluted earnings per share by $.11 to $2.99.
AFG's management, with participation of its Co-Chief Executive Officers and its principal financial officer, has evaluated AFG's disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG's Co-CEOs and principal financial officer concluded that the controls and procedures are effective. There have been no changes in AFG's internal control over financial reporting during the fourth fiscal quarter of 2007 that materially affected, or are reasonably likely to materially affect, AFG's internal control over financial reporting. There have been no significant changes in AFG's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
AFG's management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including AFG's principal executive officers and principal financial officer, AFG conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2007, based on the criteria set forth in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have audited American Financial Group, Inc.'s (the Company's) internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of internal control over financial reporting, included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
In our opinion, American Financial Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Financial Group, Inc. and subsidiaries at December 31, 2007 and 2006, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
All share and per share amounts (except number of shares authorized and the stated value of $1.00 per share) presented in the financial statements have been adjusted for all periods presented to reflect the effect of a three-for-two Common Stock split on December 15, 2006.
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses)) and the cost basis of that investment is reduced.
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG's property and casualty insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers as well as ceded premiums retained by AFG's property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG's insurance subsidiaries also assume reinsurance from other companies. Income on reinsurance assumed is recognized based on reports received from ceding companies.
Policy acquisition costs (principally commissions, premium taxes and other marketing and underwriting expenses) related to the production of new business are deferred. For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses, unamortized acquisition costs and policy maintenance costs exceed the related unearned premiums. A premium deficiency would first be recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency was greater than unamortized acquisition costs, a liability would be accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. To the
extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains. DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains on marketable securities, a component of "Accumulated Other Comprehensive Income, net of tax" in the shareholders' equity section of the Balance Sheet.
Property and casualty premiums are earned generally over the terms of the policies on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. On reinsurance assumed from other insurance companies or written through various underwriting organizations, unearned premiums are based on reports received from such companies and organizations. For traditional life, accident and health products, premiums are recognized as revenue when legally collectible from policyholders. For interest-sensitive life and universal life products, premiums are recorded in a policyholder account, which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses.
For Balance Sheet purposes, minority interest represents the interests of noncontrolling shareholders in consolidated entities. In the Statement of Earnings, minority interest expense represents such shareholders' interest in the earnings of those entities.
AFG implemented FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes (an interpretation of FASB Statement No. 109)" ("FIN 48") on January 1, 2007. FIN 48 sets forth criteria for recognition and measurement of tax positions taken or expected to be taken in a tax return. FIN 48 requires that companies recognize the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest, penalties, accounting in interim periods and disclosure. The cumulative effect of applying FIN 48 was recorded as a reduction to retained earnings at January 1, 2007 and is shown separately in the Statement of Changes in Shareholders' Equity. See Note I - "Income Taxes."
Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding during the period. The calculation of diluted earnings per share includes (in millions):
In January 2008, AFG paid $74 million (subject to adjustment pending completion of the beginning balance sheet) to acquire approximately 67% of Marketform Group Limited, a Lloyd's insurer that focuses on medical malpractice and other specialty property and casualty insurance products outside of the United States. As part of the acquisition, AFG became a corporate member in Lloyd's Syndicate 2468, which is managed by Marketform.
AFG also acquired Strategic Comp Holdings, LLC in January 2008 for $40 million (subject to adjustment pending completion of the beginning balance sheet). Additional contingent consideration could be due after seven years based on achieving certain operating milestones. Strategic Comp, headquartered in Louisiana, is a provider of workers' compensation programs for mid-size to large commercial accounts.
On September 28, 2007, Great American Financial Resources, Inc. ("GAFRI") completed the acquisition of the 9.2 million shares (19%) of its common stock not previously owned by AFG at a price of $24.50 per share in cash. Total cost of the acquisition ($239 million), including cash paid for vested options and merger costs, was provided by AFG (parent company). The acquisition resulted in a $217 million reduction of minority interest and an increase of $22 million in goodwill. Pro forma results of operations for AFG, assuming the acquisition had taken place at the beginning of 2007, would not differ materially from actual reported results.
In January 2006, GAFRI acquired the fixed annuity business written by Old Standard Life Insurance Company through a reinsurance transaction. In total, the transaction resulted in an increase of approximately $280 million in both annuity benefits accumulated and cash and investments.
In 2007, 2006, and 2005, less than 2% of AFG's revenues were derived from the sale of property and casualty insurance in Canada, Mexico and Europe. In 2005 just over 2% of AFG's revenues were derived from the sale of life and supplemental health
products in Puerto Rico. The Puerto Rico business was sold in January 2006.
(b) Includes charges of $25.5 million in 2007 and $19.9 million in 2005 for
of 2007 and third quarter of 2005, respectively, to increase asbestos,
(d) Includes holding company expenses and a second quarter 2007 charge of
At December 31, 2007, the gross unrealized losses on fixed maturities relate to over 1,100 securities. At that date, investment grade securities (as determined by nationally recognized rating agencies) represented approximately 86% of the total unrealized loss and 92% of the fair value. Of the mortgage-backed securities, substantially all of the unrealized losses relate to AAA rated securities. Management believes that AFG will recover its cost basis in the securities having unrealized losses at December 31, 2007 and that AFG has the ability and intent to hold such securities until they recover in value or mature.
The table below sets forth the scheduled maturities of fixed maturities as of December 31, 2007 (in millions). Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. Mortgage-backed securities had an average life of approximately six years at December 31, 2007.
There were no investments (other than U.S. Treasury Notes) that exceeded 10% of Shareholders' Equity at December 31, 2007 or 2006. An AFG subsidiary held collateral for securities on loan of approximately $139 million and $159 million at December 31, 2007 and 2006, respectively; fair value of securities loaned (plus accrued interest) was approximately $139 million and $156 million at those dates.
Included in deferred policy acquisition costs in AFG's Balance Sheet are $249.1 million and $95.0 million at December 31, 2007 and 2006, respectively, representing the present value of future profits ("PVFP") related to acquisitions in AFG's annuity and supplemental insurance business. The September 2007 acquisition of the GAFRI common stock not previously owned by AFG resulted in a $183.8 million increase in PVFP and a similar reduction in other DPAC. In addition, PVFP was reduced by $12.3 million in 2007 due to a refinement of the purchase price allocation for the August 2006 Ceres acquisition. The PVFP amounts are net of $88.1 million and $70.5 million of accumulated amortization at December 31, 2007 and 2006, respectively. Amortization of the PVFP was $17.7 million in 2007, $9.0 million in 2006 and $9.3 million in 2005. The increase in amortization for 2007 reflects the GAFRI and Ceres acquisitions. During each of the next five years, the PVFP is expected to decrease at a rate of approximately one-seventh of the balance at the beginning of each respective year.
Long-term debt consisted of the following at December 31 (in millions):
At December 31, 2007, scheduled principal payments on debt for the subsequent five years were as follows: 2008 - $218.9 million, 2009 - $174.6 million, 2010 - $2.8 million, 2011 - $125.1 million and 2012 - $1.4 million. AFG's Convertible Notes are included in scheduled principal payments for 2008 (at the first call date).
During 2006, AFG repurchased $43.5 million of its 7-1/8% Debentures due 2009 for $45.6 million in cash and AAG Holding repurchased $68.5 million of its 6-7/8% Notes for $70.8 million in cash. In July 2006, an AFG subsidiary borrowed $42 million under a 6.3% 10-year mortgage loan secured by one of its hotel properties.
ranging from 0.5% to 1.25% over LIBOR based on AFG's credit rating. At December 31, 2007, $116 million in borrowings were outstanding under the credit facility (average interest rate of 5.9% at December 31, 2007).
Cash interest payments on long-term debt were $61 million in 2007 and 2006 and $73 million in 2005. Interest expense in the Statement of Earnings includes interest credited on funds held by AFG's insurance subsidiaries under reinsurance contracts and other similar agreements as follows: 2007 - $9.3 million;
Under AFG's Stock Incentive Plan, 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.
The total intrinsic value of options exercised during 2007, 2006 and 2005 was $10.5 million, $24.2 million and $12.0 million, respectively. During 2007, 2006 and 2005, AFG received $15.9 million, $35.1 million and $25.1 million in cash from the exercise of stock options. The total tax benefit related to the exercises was $2.5 million, $7.7 million and $3.9 million, respectively.
Total earnings before income taxes include income (losses) subject to tax in foreign jurisdictions of $24.1 million in 2007, $24.4 million in 2006 and ($33.8 million) in 2005.
As of December 31, 2007, AFG's 2004 through 2007 tax years remain subject to examination by the IRS. In addition, AFG has several tax years for which there
The American Jobs Creation Act of 2004 provides a special one-time dividends received deduction on the repatriation of certain foreign earnings. AFG subsidiaries paid $91.8 million in dividends that qualified for this special tax treatment during 2005. Since deferred taxes had previously been accrued on most of these earnings, only $846,000 in additional income tax was recognized in 2005 on the earnings remitted.
In the second quarter of 2006, GAFRI sold Chatham Bars Inn, a resort-hotel property located on Cape Cod for $166 million. The results of operations of this investment property and the $25.8 million gain on sale (after tax and minority interest) are presented as discontinued operations in the Statement of Earnings. Discontinued operations for 2007 represent additional gains on operations sold in previous years, primarily the settlement of a contingency associated with the Chatham sale. Discontinued operations also include the operating results for a smaller hotel property that was sold in 2005.
At December 31, 2007, American Premier had liabilities for environmental and personal injury claims aggregating $102 million. The environmental claims consist of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs related to certain sites formerly owned or operated by the railroad and manufacturing operations. Remediation costs are difficult to estimate for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. The personal injury claims include pending and expected claims, primarily by former employees of PCTC, for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the workplace.
The operations of certain of AFG's business segments are seasonal in nature. While insurance premiums are recognized on a relatively level basis, claim losses related to adverse weather (snow, hail, hurricanes, tornadoes, etc.) may be seasonal. The profitability of AFG's crop insurance business is primarily recognized during the second half of the year as crop prices and yields are determined. Quarterly results necessarily rely heavily on estimates. These estimates and certain other factors, such as the discretionary sales of assets, cause the quarterly results not to be necessarily indicative of results for longer periods of time.
The following are quarterly results of consolidated operations for the two years ended December 31, 2007 (in millions, except per share amounts). Quarterly earnings per share do not add to year-to-date amounts due to the convertible notes being dilutive in the fourth quarter of 2007 and changes in shares outstanding.
The following table provides an analysis of changes in the liability for losses and loss adjustment expenses, net of reinsurance (and grossed up), over the past three years on a GAAP basis (in millions). In 2007, favorable reserve development in property and transportation, specialty casualty, specialty financial and California workers' compensation more than offset charges to strengthen asbestos and environmental reserves in the property and casualty run-off operations. In 2006, favorable development in property and transportation, specialty casualty and California workers' compensation was slightly offset by unfavorable development in the specialty financial sub-segment. In addition to the asbestos, environmental and other mass tort charge in 2005, adverse development in the specialty casualty sub-segment was offset by positive development in the property and transportation and California workers' compensation sub-segments.
AFG's insurance subsidiaries are required to file financial statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Net earnings and policyholders' surplus on a statutory basis for the insurance subsidiaries were as follows (in millions):
(*) The increase in reinsurance assumed in 2006 compared to 2005
AFG has reinsured approximately $21 billion and $23 billion in face amount of life insurance at December 31, 2007 and 2006, respectively. Life premiums ceded were $64 million, $65 million and $68 million for 2007, 2006 and 2005, respectively.
Future minimum rentals, related principally to office space, required under operating leases having initial or remaining noncancelable lease terms in excess of one year at December 31, 2007, were as follows: 2008 - $34 million; 2009 - $30 million; 2010 - $25 million; 2011 - $22 million; 2012 - $12 million; and $30 million thereafter.
Fair values for fixed maturity and equity securities are based on quoted market prices, where available. For fixed maturity securities that are not actively traded, fair values are primarily estimated using values obtained from independent pricing services whose estimates are based on discounted cash flow models, fair value of comparable securities, or similar methods. The fair value of the liability for annuities in the payout phase is assumed to be the present value of the anticipated cash flows, discounted at current interest rates. Fair value of annuities in the accumulation phase is assumed to be the policyholders' cash surrender amount. Fair values of long-term debt are based primarily on quoted market prices. Fair value of shareholders' equity is based on the quoted market price of AFG's Common Stock.
On occasion, AFG and its subsidiaries have entered into financial instrument transactions that may present off-balance-sheet risks of both a credit and market risk nature. These transactions include commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. At December 31, 2007, AFG and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling up to $90 million.
AFG is the investment manager and has investments in six collateralized debt obligations ("CDOs") with an aggregate carrying value of $20 million at December 31, 2007 (included in fixed maturities), which are not required to be consolidated. These CDOs were formed between 2004 and 2007 and had investments with a fair value of approximately $2.4 billion at December 31, 2007.
Payments of dividends, loans and advances by AFG's subsidiaries are subject to various state laws, federal regulations and debt covenants that limit the amount of dividends, loans and advances that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 2008 from its insurance subsidiaries without seeking regulatory clearance is approximately $464 million. Additional amounts of dividends, loans and advances require regulatory approval.
AFG expensed approximately $21 million in 2007 and $18 million in 2006 and $20 million in 2005 for its retirement and employee savings plans.
The information required by the following Items will be included in AFG's definitive Proxy Statement for the 2008 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission within 120 days after the end of Registrant's fiscal year and is incorporated herein by reference.
(a) Grossed up for reinsurance recoverables of $2,300 and $2,309 at December 31, 2007 and 2006, respectively.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: