Subsidiaries of AFG own several buildings in downtown Cincinnati. AFG and its affiliates occupy approximately 40% of the aggregate 675,000 square feet of commercial and office space in these buildings.
Includes special cash dividends of $1.00 and $0.25 per share paid in December 2013 and 2012, respectively.
Adjusted shareholders’ equity and adjusted book value per share exclude appropriated retained earnings and net unrealized gains related to fixed maturity securities. Management believes that investors find a measurement of shareholders’ equity excluding these items to be meaningful as (i) the unrealized gain on fixed maturities fluctuates with changes in interest rates in a way that is primarily only meaningful to AFG if it sells those investments and (ii) appropriated retained earnings represents amounts that will ultimately inure to the benefit of the debt holders of the collateralized loan obligations managed by AFG.
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 fixed and fixed-indexed annuities in the retail, financial institutions and education markets.
Net earnings attributable to AFG’s shareholders were $471 million ($5.16 per share) in 2013 compared to $488 million ($5.09 per share) in 2012. Significantly higher profits in the annuity segment and improved underwriting results in the Specialty property and casualty businesses were partially offset by higher special A&E charges and the absence of earnings from the Medicare supplement and critical illness segment, which was sold in August 2012. The $17 million overall decrease in net earnings attributable to shareholders reflects the net impact of the following items recorded during 2012: (i) the gain on the sale of the Medicare supplement and critical illness segment, (ii) tax benefits related to the favorable resolution of certain tax litigation and settlement of open tax years, and (iii) a fourth quarter charge to write off deferred policy acquisition costs and strengthen reserves in AFG’s closed block of long-term care insurance.
The NAIC’s model law for risk based capital (“RBC”) applies to both life and property and casualty companies. RBC formulas determine the amount of capital that an insurance company needs so that it has an acceptable expectation of not becoming financially impaired. At December 31, 2013, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements.
Condensed Consolidated Cash Flows AFG's principal sources of cash include insurance premiums, income from its investment portfolio and proceeds from the maturities, redemptions and sales of investments. Insurance premiums in excess of acquisition expenses and operating costs are invested until they are needed to meet policyholder obligations or made available to the parent company through dividends to cover debt obligations and corporate expenses, and to provide returns to shareholders through share repurchases and dividends. AFG’s cash flows from operating, investing and financing activities as detailed in its Consolidated Statement of Cash Flows are shown below (in millions):
Net Cash Used in Investing Activities AFG's investing activities consist primarily of the investment of funds provided by its property and casualty and annuity products. Net cash used in investing activities was $2.92 billion in 2013 compared to $1.43 billion in 2012, an increase of $1.49 billion. The $1.15 billion increase in net cash flows from annuity policyholders in 2013 as compared to 2012 (discussed below under net cash provided by financing activities) increased the amount of cash available for investment in 2013 compared to 2012. In addition, the increase in net cash used in investing activities reflects the use of cash and cash equivalents held in the property and casualty operations to purchase fixed maturity and equity securities during 2013. Investing activities also include the purchase and disposal of managed investment entity (collateralized loan obligation) investments, which are presented separately in AFG's Balance Sheet. Net investment activity in the managed investment entities was a $478 million source of cash in 2013 compared to an $8 million source of cash in 2012. See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements.
Net Cash Provided by Financing Activities AFG's financing activities consist primarily of transactions with annuity policyholders, issuances and retirements of long-term debt, repurchases of common stock and dividend payments. Net cash provided by financing activities was $2.09 billion in 2013 compared to $989 million in 2012, an increase of $1.10 billion. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $2.68 billion in 2013 compared to $1.53 billion in 2012, resulting in a $1.15 billion increase in net cash provided by financing activities. During 2013, AFG repurchased 1.4 million shares of its Common Stock for $70 million compared to 10.9 million shares repurchased in 2012 for $415 million, which accounted for $345 million of the increase in net cash provided by financing activities in 2013 compared to 2012. Financing activities also include the issuance and retirement of managed investment entity liabilities, which are nonrecourse to AFG and presented separately in AFG's Balance Sheet. The retirement of managed investment entity liabilities exceed issuances by $368 million in 2013 compared to $49 million in 2012, accounting for a $319 million reduction in net cash provided by financing activities in 2013 compared to 2012. See Managed Investment Entities in Note A - “Accounting Policies” and Note H - “Managed Investment Entities” to the financial statements.
Subsidiary Liquidity In February 2014, Great American Insurance Company (“GAI”), AFG’s wholly-owned property and casualty insurance subsidiary, initiated a tender offer to acquire the 9.5 million shares of National Interstate Corporation (“NATL”) that it does not currently own for $286 million ($30.00 per share, as adjusted). NATL is a 52%-owned property and casualty insurance subsidiary of GAI.
The liquidity requirements of AFG’s insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have generally provided more than sufficient funds to meet these requirements. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
In the annuity business, where profitability is largely dependent on earning a “spread” between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG’s annuity products. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to contractually guaranteed minimum interest rates (“GMIRs”). AFG began selling policies with GMIRs below 2% in 2003; almost all new business since late 2010 has been issued with a 1% GMIR. At December 31, 2013, AFG could reduce the average crediting rate of its $16 billion of traditional fixed and fixed-indexed deferred annuities without guaranteed withdrawal benefits by approximately 48 basis points (on a weighted average basis).
Parent Net Cash Provided by Operating Activities Parent holding company cash flows from operating activities consist primarily of dividends and tax payments received from AFG's insurance subsidiaries, reduced by tax payments to the IRS and holding company interest and other expenses. Parent holding company net cash provided by operating activities was $428 million in 2013 compared to $380 million in 2012 and $462 million in 2011. Higher dividends from subsidiaries received in 2013 and 2011 as compared to 2012 were the primary driver of the $48 million increase in net cash provided by operating activities in 2013 compared to 2012 and the $82 million decrease in net cash provided by operating activities in 2012 compared to 2011.
Parent Net Cash Used in Investing Activities Parent holding company investing activities consist of capital contributions to and returns of capital from subsidiaries and, to a much lesser extent, parent company investment activity. Parent holding company net cash used in investing activities was $4 million in 2013 compared to $284 million in 2012 and $72 million in 2011. The $284 million in net cash used in investing activities in 2012 is significantly higher than the cash used in investing activities in 2013 and 2011 due primarily to capital contributions made to AAG Holding Company, Inc. to fund the July 2012 redemption of $199 million of AAG Holding senior debentures.
Parent Net Cash Used in Financing Activities Parent company financing activities consist primarily of repurchases of AFG Common Stock, dividends to shareholders, the issuance and retirement of long-term debt and, to a lesser extent, proceeds from employee stock option exercises. Significant long-term debt and common stock transactions are discussed above. Parent holding company net cash used in financing activities was $180 million in 2013 compared to $232 million in 2012 and $345 million in 2011. The $52 million decrease in net cash used in financing activities in 2013 as compared to 2012 reflects a $345 million decrease in common stock repurchases partially offset by the impact of $229 million in cash provided in 2012 from debt issuances in excess of debt retirements and a $70 million increase in cash dividends paid. The $113 million decrease in net cash used in financing activities in 2012 compared to 2011 was due primarily to cash provided by the net debt issuances in 2012, partially offset by a $100 million increase in common stock repurchases.
Contractual Obligations The following table shows an estimate (based on historical patterns and expected trends) of payments to be made for insurance reserve liabilities, as well as scheduled payments for major contractual obligations (in millions).
Reserve projections include anticipated cash benefit payments only. Projections do not include any impact for future earnings or additional premiums. Based on the same assumptions, AFG projects reinsurance recoveries related to life, accident and health reserves totaling $953 million as follows: Within 1 year - $114 million; 2-3 years - $142 million; 4-5 years - $124 million; and thereafter - $573 million. Actual payments and their timing could differ significantly from these estimates.
Dollar amounts and time periods are estimates based on historical net payment patterns applied to the gross reserves and do not represent actual contractual obligations. Based on the same assumptions, AFG projects reinsurance recoveries related to these reserves totaling $2.1 billion as follows: Within 1 year - $500 million; 2-3 years - $500 million; 4-5 years - $300 million; and thereafter - $800 million. Actual payments and their timing could differ significantly from these estimates.
As detailed in Note E - “Investments - Net Unrealized Gain on Marketable Securities” to the financial statements, unrealized gains and losses on AFG’s fixed maturity and equity securities are included in shareholders’ equity after adjustments for related changes in DPAC and certain liabilities related to annuity, long-term care and life businesses, noncontrolling interests and deferred income taxes. DPAC and certain other balance sheet amounts applicable to annuity, long-term care and life businesses are adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding increases or decreases (net of tax) included in accumulated other comprehensive income in AFG’s Balance Sheet.
Fair values for AFG’s portfolio are determined by AFG’s internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on closing prices obtained from the pricing services. For mortgage-backed securities (“MBS”), which comprise approximately 26% of AFG’s fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the remainder of AFG’s fixed maturity portfolio, approximately 86% are priced using pricing services and the balance is priced primarily by using non-binding broker quotes. When prices obtained for the same security vary, AFG’s internal investment professionals select the price they believe is most indicative of an exit price.
In general, the fair value of AFG’s fixed maturity investments is inversely correlated to changes in interest rates. The following table demonstrates the sensitivity of such fair values to reasonably likely changes in interest rates by illustrating the estimated effect on AFG’s fixed maturity portfolio that an immediate increase of 100 basis points in the interest rate yield curve would have at December 31, 2013 (dollars in millions). Effects of increases or decreases from the 100 basis points illustrated would be approximately proportional.
Summarized information for AFG’s MBS (including those classified as trading) at December 31, 2013, is shown (dollars in millions) in the table below. Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The majority of the Alt-A securities and substantially all of the subprime securities are backed by fixed-rate mortgages. The average life of the residential and commercial MBS is approximately 5 years and 4 years, respectively.
Municipal bonds represented approximately 20% of AFG’s fixed maturity portfolio at December 31, 2013. AFG’s municipal bond portfolio is high quality, with 99% of the securities rated investment grade at that date. The portfolio is well diversified across the states of issuance and individual issuers. At December 31, 2013, approximately 73% of the municipal bond portfolio was held in revenue bonds, with the remaining 27% held in general obligation bonds. General obligation securities of California, Illinois, Michigan, New Jersey, New York and Puerto Rico collectively represented less than 2% of this portfolio.
Summarized information for the unrealized gains and losses recorded in AFG’s Balance Sheet at December 31, 2013, is shown in the following table (dollars in millions). Approximately $187 million of available for sale fixed maturity securities and $75 million of equity securities had no unrealized gains or losses at December 31, 2013.
The table below sets forth the scheduled maturities of AFG’s available for sale fixed maturity securities at December 31, 2013, based on their fair values. 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.
lines, management tends to give more weight to the Case Incurred and Paid Development methods, although the various methods tend to produce similar results. For long-tail lines, more judgment is involved, and more weight may be given to the Bornhuetter-Ferguson method. Liability claims for long-tail lines are more susceptible to litigation and can be significantly affected by changing contract interpretation and the legal environment. Therefore, the estimation of loss reserves for these classes is more complex and subject to a higher degree of variability.
During 2012, AFG recorded $28 million of favorable reserve development on claims related to the use of Chinese drywall in residential construction in prior years. Much of the uncertainty in estimating the potential exposure and possible liabilities for such claims was clarified during 2012 by favorable judicial decisions and the announcements of settlements of class action lawsuits making the potential liabilities better defined and more effectively anticipated.
Approximately 44% of AFG's workers compensation business is currently written in California. Over the last 11 years, there have been numerous reforms, revisions and interpretations of regulations. Reforms in 2003 and 2004 tended to reduce costs and benefits. During the economic downturn, these trends were reversed and costs began to increase, causing results to differ from expectations. In recent years, AFG has experienced an improved pricing environment leading to improved results for this business. At this time, there is uncertainty around the impact of California Senate Bill 863, which was passed in August 2012. The legislation has led to increased benefits for injured workers, while cost-saving efficiencies have yet to be implemented. Such frequent, significant changes in the operating environment make it difficult to appropriately price these insurance policies and estimate related liabilities.
conditions led to higher frequency and severity of claims, particularly in the D&O policies for small account and not-for-profit organizations. Recently, claim frequency has decreased from its peak in 2010.
AFG recorded favorable prior year loss development of $41 million in 2013, $16 million in 2012 and $66 million in 2011 on its D&O business as claim severity was less than expected across several prior accident years.
AFG’s legal professional liability business has been in run-off since 2008 with only 41 claims remaining open at December 31, 2013. These claims are expected to settle within the existing reserves. AFG recorded favorable reserve development of $2 million in 2013 compared to less than $1 million in 2012 and $17 million in 2011 on the run-off legal and professional liability business.
AFG recorded adverse prior year reserve development of less than $1 million in 2013, $35 million in 2012 and $13 million in 2011 on this line of business. The adverse development resulted from higher claim frequency and severity in a block of program business related to motel/hotel, apartments, restaurants, taverns and recreation. This adverse development more than offset favorable development in coverage for non-profit organizations of $4 million in 2013, $6 million in 2012 and $6 million in 2011 as claim severity was less than anticipated.
Marketform recorded adverse prior year reserve development of $1 million in 2013, $10 million in 2012 and $44 million in 2011. Development in 2012 and 2011 related primarily to Italian public hospital medical malpractice business, which Marketform ceased writing in 2008. The development resulted from significant issues related to third party administration of claims and a challenging legal environment in Italy. Management believes that current reserves, which represent its best estimate of future liabilities, are adequate. Nonetheless, it concluded that sufficient uncertainty exists with respect to Italian public hospital medical malpractice reserves to leave open the 2007 year of account, in accordance with Lloyd’s provisions until a larger percentage of claims have been paid and the ultimate liabilities can be estimated with greater certainty.
The following table illustrates the effect that purchasing property and casualty reinsurance has had on AFG’s combined ratio over the last three 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 recent years, a number of asbestos claims are being presented as “non-products” claims, such as those by installers of asbestos products and by property owners or operators who allegedly had asbestos on their property, under the premises or operations section of their policies. Unlike products exposures, these non-products exposures typically had no aggregate limits, creating potentially greater exposure for insurers. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify previously settled products claims as non-products claims to restore a portion of previously exhausted products aggregate limits. AFG, along with other insurers, is and will be subject to such non-products claims. It is difficult to predict whether insureds will be successful in asserting claims under non-products coverage or whether AFG and other insurers will be successful in asserting additional defenses. Therefore, the future impact of such efforts is uncertain.
While management believes that AFG’s reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims, the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, how claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims. A 1% variation in loss cost trends, caused by any of the factors previously described, would change net income by approximately $15 million.
Asbestos claims paid in 2013 include payments totaling $106 million associated with the settlement of A.P. Green Industries and another large claim. Substantially all of the settlement amounts had been accrued for in prior years. The survival ratio is a measure often used by industry analysts to compare A&E reserves strength among companies. This ratio is typically calculated by dividing reserves for A&E exposures by the three year average of paid losses, and therefore measures the number of years that it would take to pay off current reserves based on recent average payments. Because this ratio can be significantly impacted by a number of factors such as loss payout variability, caution should be exercised in attempting to determine reserve adequacy based simply on the survival ratio. At December 31, 2013, the property and casualty insurance segment’s three year survival ratios, excluding amounts associated with the settlements of A.P. Green Industries and another large claim, were 16.6 times paid losses for the asbestos reserves, 5.7 times paid losses for environmental reserves and 10.5 times paid losses for total A&E reserves. Overall, these ratios compare favorably with data published by A.M. Best in October 2013, which indicate that industry survival ratios were 10.0 for asbestos, 5.8 for environmental, and 8.8 for total A&E reserves at December 31, 2012.
AFG has periodically conducted comprehensive external studies of its asbestos and environmental exposures relating to the run-off operations of its property and casualty insurance segment and exposures related to its former railroad and manufacturing operations with the aid of specialty actuarial, engineering and consulting firms and outside counsel, generally every two years, with an in-depth internal review during the intervening years.
As a result of the comprehensive external study completed in the third quarter of 2013, AFG’s property and casualty insurance segment recorded a $54 million pretax special charge to increase its asbestos reserves by $16 million (net of reinsurance) and its environmental reserves by $38 million (net of reinsurance). The increase in the property and casualty segment’s asbestos reserves was driven primarily by slightly higher than expected loss experience, higher defense costs and some increased claim
severity. As the overall industry exposure to asbestos has matured, the focus of litigation has shifted to smaller companies and companies with ancillary exposures. AFG’s insureds with these exposures have been the driver of the property and casualty segment’s asbestos reserve increases. The increase in property and casualty environmental reserves was attributed primarily to a small number of claims where the estimated costs of remediation have increased. There were no newly identified or emerging broad industry trends that were identified in this study.
Run-off Long-term Care Insurance AFG, as well as other companies that sell long-term care products, have accumulated relatively limited claims, lapse and mortality experience, making it difficult to predict future claims. Long-term care claims tend to be much higher in dollar amount and longer in duration than other health care products. In addition, long-term care claims are incurred much later in the life of a policy than most other health products. These factors made it difficult to appropriately price this product and were instrumental in AFG’s decision to stop writing new policies in January 2010. AFG’s outstanding long-term care policies have level premiums and are guaranteed renewable. Premium rates can potentially be increased in reaction to adverse experience; however, any rate increases would require regulatory approval.
At December 31, 2012, loss recognition testing assumptions for claim costs, expenses and persistency were updated based on the results of AFG's periodic internal analysis of claim experience, including the impact of supplemental data from an external actuarial study that used a large, uniform database of industry experience. Ultimate voluntary lapse rates for most in-force business range from 0.5% to 2.5%, varying by policy form, marital status, and the presence of inflation protection. Projected reinvestment rates are based on assumptions about future treasury rates, investment spreads and the types and duration of future investments. In aggregate, net reinvestment rates (net of expense and default assumptions) in the 2012 loss recognition testing were estimated at 4.54% for 2013, and projected to increase gradually to 6.00% in 2023. After 2023, reinvestment rates were projected to be relatively flat. As a result of the updated assumptions discussed above, AFG recorded a $153 million pretax loss recognition charge in the fourth quarter of 2012 to write off all of the remaining deferred policy acquisition costs and strengthen reserves in this business. As part of the loss recognition charge, policy benefit assumptions were reset to the 2012 assumptions and will not be changed again unless a future loss recognition event occurs.
At December 31, 2013, the most significant loss recognition testing assumption update was to projected reinvestment rates. Due to higher than anticipated increases in interest rates, net reinvestment rates (net of expense and default assumptions) were estimated at 5.01% for 2014 and projected to increase gradually to 6.25% in 2022. After 2022, reinvestment rates were projected to be relatively flat. As a result of the updated assumptions, the existing contract liabilities plus the present value of future premiums (including reasonably expected rate increases) exceeded the present value of future claims payments and related settlement and maintenance costs by approximately $64 million (a loss recognition margin). As a result, no additional
Conversely, favorable changes in the assumptions above would increase the loss recognition margin. For example, the increase in the loss recognition margin that occurred in 2013 resulted primarily from an increase in projected reinvestment rates.
Includes $8 million and $10 million in 2013 and 2012, respectively, in net investment income representing the change in fair value of AFG’s CLO investments plus $4 million in each period in CLO management fees earned.
Includes $35 million and $31 million in 2013 and 2012, respectively, in net investment income representing the change in fair value of AFG’s CLO investments plus $16 million and $18 million in 2013 and 2012, respectively, in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $25 million and $18 million in 2013 and 2012, respectively, in distributions recorded as interest expense by the CLOs.
Net earnings attributable to shareholders increased $108 million in the fourth quarter of 2013 compared to the same period as 2012 reflecting significantly improved core net operating earnings and the impact of the fourth quarter 2012 long-term care reserve charge offset by the impact of the tax benefit recorded in the fourth quarter of 2012 related to the settlement of open tax years. Core net operating earnings increased $56 million in the fourth quarter of 2013 compared to the fourth quarter of 2012
due to significantly higher profits in the annuity segment and higher underwriting profits in the property and casualty insurance segment.
For the full-year of 2013 compared to 2012, net earnings attributable to shareholders decreased compared to 2012 as higher core net operating earnings were more than offset by the net impact of the following items recorded in 2012: (i) a $114 million after tax gain on the sale of AFG’s Medicare supplement and critical illness businesses, (ii) tax benefits of $67 million related to the favorable resolution of certain tax litigation and settlement of open tax years, and (iii) an after tax charge of $99 million to write off deferred acquisition costs and strengthen reserves in the closed block of long-term care insurance. Net earnings attributable to shareholders were also impacted by special A&E charges, which were higher in 2013 compared to 2012. Core net operating earnings increased $71 million in 2013 compared to 2012 reflecting significantly higher profits in both the annuity segment and Specialty property and casualty insurance operations, partially offset by the absence of earnings from the Medicare supplement and critical illness businesses, which were sold in August 2012.
Net earnings attributable to shareholders increased in 2012 compared to 2011 due primarily to the gain on the sale of AFG’s Medicare supplement and critical illness businesses, favorable tax benefits and partially offsetting long-term care charge discussed above, as well as higher realized gains on securities. Core net operating earnings decreased in 2012 compared to 2011 as higher earnings in the annuity segment were more than offset by lower underwriting profits and lower investment income in the property and casualty insurance segment.
Property and Casualty Insurance Segment - Results of Operations Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their financial statements better understand the company's performance. Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of losses and loss adjustment expenses, and commissions and other underwriting expenses to premiums. A combined ratio under 100% indicates an underwriting profit. The combined ratio does not reflect net investment income, other income, other expenses or federal income taxes. AFG's property and casualty insurance operations contributed $136 million in GAAP pretax earnings in the fourth quarter of 2013 compared to $72 million in the fourth quarter of 2012, an increase of $64 million
The following table details AFG's earnings before income taxes from its property and casualty operations for the three months ended December 31, 2013 and 2012 (dollars in millions):
To understand the overall profitability of particular lines, the timing of claims payments and the related impact of investment income must be considered. Certain “short-tail” lines of business (primarily property coverages) generally have quick loss payouts, which reduce the time funds are held, thereby limiting investment income earned thereon. In contrast, “long-tail” lines of business (primarily liability coverages and workers' compensation) generally have payouts that are either structured over many years or take many years to settle, thereby significantly increasing investment income earned on related premiums received.
Net earned premiums ("NEP") for AFG's property and casualty insurance segment were $859 million for the fourth quarter of 2013 compared to $756 million for the fourth quarter of 2012, an increase of $103 million (14%). Detail of AFG's property and casualty net earned premiums is shown below (dollars in millions):
Property and transportation Gross written premiums increased $16 million (4%) in the fourth quarter of 2013 compared to the same period in 2012 reflecting growth in nearly every business unit, partially offset by lower premiums in the crop operations. Delayed planting of winter wheat resulted in late acreage reporting, the effect of which is expected to shift a portion of AFG’s crop premiums from the fourth quarter of 2013 to the first quarter of 2014. Excluding crop premiums, fourth quarter 2013 gross and net written premiums grew by 10% and 13%, respectively, when compared to the 2012 fourth quarter. Average renewal rates for this group were up approximately 5% in the fourth quarter of 2013. Reinsurance premiums ceded as a percentage of gross written premiums declined 5 percentage points in the fourth quarter of 2013 compared to the fourth quarter of 2012 due to lower cessions of winter wheat premiums related to the delayed acreage reporting and lower reinstatement premiums due to the impact of large reinsured losses in 2012 (related to Superstorm Sandy).
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 sub-components.
Specialty financial Underwriting profit was $17 million for the fourth quarter of 2013 compared to $16 million in the fourth quarter of 2012, an increase of $1 million (6%). Higher underwriting profits in the financial institutions business were partially offset by lower underwriting profitability in the surety and fidelity businesses. In addition, results for the fourth quarter of 2012 include a loss of $6 million in the vehicle services business, primarily from foreclosed and real estate owned property and collateral insurance.
Aggregate Aggregate results for AFG’s property and casualty segment also include $5 million of adverse development in the fourth quarter of 2012 related to asbestos and environmental reserves.
AFG's overall loss and LAE ratio was 62.5% for the fourth quarter of 2013 compared to 73.6% for fourth quarter of 2012, an improvement of 11.1 percentage points. The components of AFG's property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
AFG's Specialty property and casualty operations recorded net favorable reserve development related to prior accident years of $5 million in the fourth quarter of 2013 compared to $12 million in the fourth quarter of 2012, a decrease of $7 million (58%).
Specialty casualty Net adverse reserve development of $2 million in the fourth quarter of 2013 reflects higher than expected claim severity in products liability claims and contractor claims as well as adverse reserve development at Marketform, substantially offset by lower frequency of severe claims in the directors and officers and workers’ compensation businesses. Net adverse reserve development of $7 million in the fourth quarter of 2012 reflects higher claim frequency and severity in a run-off book of U.S.-based program (motel/hotel, restaurants, taverns and recreational) business and adverse development in the excess and surplus lines, partially offset by lower than expected claim severity in the California workers’ compensation and directors and officers liability insurance businesses.
Specialty financial Net favorable reserve development of $4 million in the fourth quarter of 2013 reflects lower than expected frequency of significant claims in the foreign credit business where economic conditions did not affect this line as adversely as previously anticipated. Net favorable reserve development of $13 million in the fourth quarter of 2012 reflects lower than expected claim frequency and severity in the foreign credit and financial institution businesses as economic conditions did not affect these lines as adversely as had been anticipated.
Other specialty In addition to the development discussed above, total specialty net favorable reserve development reflects amortization of the deferred gain on the retroactive insurance transaction entered into in connection with the sale of a business in 1998 and favorable reserve development associated with AFG’s internal reinsurance program.
Aggregate Aggregate net prior accident years reserve development for AFG’s property and casualty segment includes $5 million of adverse development in the fourth quarter of 2012 related to asbestos and environmental reserves.
AFG's property and casualty commissions and other underwriting expenses ("U/W Exp") were $247 million in the fourth quarter of 2013 compared to $190 million for the fourth quarter of 2012, an increase of $57 million (30%). AFG's underwriting expense ratio, calculated as commissions and other underwriting expenses divided by net premiums earned, was 28.9% for the fourth quarter of 2013 compared to 25.1% for the fourth quarter of 2012, an increase of 3.8 percentage points. Detail of AFG's property and casualty commissions and other underwriting expenses and underwriting expense ratios is shown below (dollars in millions):
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums increased 6.1 percentage points for the fourth quarter of 2013 compared to the fourth quarter of 2012 reflecting the timing of the
determination of reimbursements for administrative and operating expenses under the Federal crop insurance program, partially offset by the impact of higher premiums on the ratio.
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums decreased 0.2 percentage points for the fourth quarter of 2013 compared to the fourth quarter of 2012, reflecting the impact of higher premiums on the ratio, partially offset by higher profitability-based commissions paid to agents/brokers and lower ceding commissions from reinsurers.
The following table details AFG's earnings before income taxes from its annuity operations for the three months ended December 31, 2013 and 2012 (dollars in millions).
Interest credited - fixed for the fourth quarter of 2013 was $118 million compared to $109 million for the fourth quarter of 2012, an increase of $9 million (8%). The impact of growth in the annuity business was partially offset by lower interest crediting rates on new premiums as compared to the crediting rates on policyholder funds surrendered or withdrawn. The average interest rate credited to policyholders, calculated as interest credited divided by average fixed annuity benefits accumulated, declined 0.21 percentage points in the fourth quarter of 2013 compared to the fourth quarter of 2012. During the fourth quarter of 2013, interest rates credited on new premiums generally ranged from 1.00% to 2.00%.
Excluding those annuities that have guaranteed withdrawal benefits, at December 31, 2013, AFG could reduce the average crediting rate on approximately $16 billion of traditional fixed and fixed-indexed deferred annuities by an additional 0.48% (on a weighted average basis). Annuity policies are subject to Guaranteed Minimum Interest Rates (“GMIRs”) at policy issuance. The table below shows the breakdown of annuity reserves by GMIR. The current interest crediting rates on substantially all of AFG's annuities with a GMIR of 3% or higher are at their minimum.
AFG’s fixed-indexed annuities, which represented approximately 47% of annuity benefits accumulated at December 31, 2013, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG’s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will generally be offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives that must be marked-to-market through earnings each period. The fair values of these derivatives are impacted by actual and expected stock market performance and interest rates as well as other factors. For a list of other factors impacting the fair value of the index-based component of AFG’s annuity benefits accumulated, see Note D - “Fair Value Measurements” to the financial statements. Excluding the impact of unlocking charges, the net change in fair value of derivatives related to fixed-indexed annuities decreased annuity benefits by $11 million and $3 million in the fourth quarter of 2013 and 2012, respectively. The decrease in 2013 reflects the positive impact of higher interest rates and strong stock market performance on the fixed-indexed annuity business.
The 147% increase in annuity premiums as compared to the fourth quarter of 2012 reflects continued successful distribution channel expansion, primarily in the financial institutions market, as well as new product offerings. Management also believes
In the fourth quarters of 2013 and 2012, AFG conducted a detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded charges (expense reductions) in annuity benefits expense and annuity and supplemental insurance acquisition expenses related to its annuity business. AFG’s net annuity unlocking charge of $2 million in 2013 and $14 million in 2012 impacted AFG’s financial statements as follows (in millions):
Although the table above includes the impact of assumption changes in both the fixed and variable annuity businesses, the vast
majority of the net charge in each period relates to the fixed (including fixed-indexed) annuity business. The 2013 net charge was due primarily to the impact of changes in assumptions to reflect increased future investment yields being more than offset by an increase in future expected call option costs related to the fixed-indexed annuity business, and higher crediting rates and lapse assumptions. Reinvestment rates used to project future investment yields are based primarily on 7-year and 10-year corporate bond yields. For the 2013 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 4.05% in 2014, grading up to an ultimate net reinvestment rate of 5.52% in 2020 and beyond.
The following table reconciles the net spread earned on AFG’s fixed annuities to overall annuity pretax earnings for the three months ended December 31, 2013 and 2012 (in millions):
Excludes the pretax non-core loss recognition charge recorded in the fourth quarter of 2012, which increased life, accident and health benefits by $74 million and acquisition expenses by $79 million.
Other income in the table above includes $4 million in both the fourth quarter of 2013 and 2012 in management fees paid to AFG by the AFG-managed CLOs (AFG's consolidated managed investment entities). These fees are eliminated in consolidation - see the other income line in the Consolidate MIEs column under “Results of Operations - Segmented Statement of Earnings.” Results for the fourth quarter of 2013 and 2012 include losses related to the sale of fixed assets of $2 million and $3 million, respectively.
AFG's holding companies and other operations outside of its insurance operations recorded interest expense of $17 million in both the fourth quarter of 2013 and 2012. The following table details AFG's long-term debt balances as of December 31, 2013 compared to October 1, 2012 (dollars in millions):
Consolidated Realized Gains (Losses) on Securities AFG's consolidated realized gains on securities, which are not allocated to segments, were $67 million in the fourth quarter of 2013 compared to $65 million in the fourth quarter of 2012, an increase of $2 million (3%). Realized gains (losses) on securities consisted of the following (in millions):
Consolidated Income Taxes AFG's consolidated provision for income taxes was $81 million for the fourth quarter of 2013 compared to a tax benefit of $49 million in the fourth quarter of 2012, an increase of $130 million (265%). The income tax benefit recorded in the fourth quarter of 2012 includes a $39 million non-core tax benefit related to the settlement of open tax years following the resolution of the tax litigation with the IRS. See Note L - “Income Taxes” to the financial statements. The following is a reconciliation of income taxes at the statutory rate of 35% to the provision (benefit) for income taxes as shown in the Segmented Statement of Earnings (dollars in millions):
Consolidated Noncontrolling Interests AFG's consolidated net earnings attributable to noncontrolling interests were $7 million for the fourth quarter of 2013 compared to a net loss of $31 million for the fourth quarter of 2012. The following table details net earnings (loss) in consolidated subsidiaries attributable to holders other than AFG (dollars in millions):
AFG's property and casualty insurance operations contributed $322 million in GAAP pretax earnings in 2012 compared to $442 million in 2011, a decrease of $120 million (27%). Property and casualty core pretax earnings were $353 million in 2012 compared to $492 million in 2011, a decrease of $139 million (28%). The decrease is due mainly to lower underwriting profits
The following table details AFG's GAAP and core earnings before income taxes from its property and casualty operations for the years ended December 31, 2013, 2012 and 2011 (dollars in millions):
Gross written premiums ("GWP") for AFG's property and casualty insurance segment were $4.81 billion in 2013 compared to $4.32 billion in 2012, an increase of $484 million (11%). GWP increased $215 million (5%) in 2012 compared to 2011. Detail of AFG's property and casualty gross written premiums is shown below (dollars in millions):
Reinsurance premiums ceded ("Ceded") for AFG's property and casualty insurance segment were 30%, 32% and 33% of gross written premiums for the years ended December 31, 2013, 2012 and 2011, respectively. Detail of AFG's property and casualty reinsurance premiums ceded is shown below (dollars in millions):
Net written premiums ("NWP") for AFG's property and casualty insurance segment were $3.34 billion in 2013 compared to $2.95 billion in 2012, an increase of $392 million (13%). NWP increased $179 million (6%) in 2012 compared to 2011. Detail of AFG's property and casualty net written premiums is shown below (dollars in millions):
Net earned premiums ("NEP") for AFG's property and casualty insurance segment were $3.20 billion in 2013 compared to $2.85 billion in 2012, an increase of $357 million (13%). NEP increased $88 million (3%) in 2012 compared to 2011. Detail of AFG's property and casualty net earned premiums is shown below (dollars in millions):
The Specialty insurance operations generated an underwriting profit of $206 million in 2013 compared to $131 million in 2012, an increase of $75 million (57%). The higher profit in 2013 is primarily the result of higher underwriting profits in the Specialty casualty and Specialty financial groups partially offset by lower underwriting profits in the Property and transportation businesses. Overall catastrophe losses were $31 million (1.0 points on the combined ratio) in 2013 compared to $46 million, including $9 million of reinstatement premiums (1.3 points) in 2012.
Property and transportation This group reported an underwriting profit of $12 million in 2013 compared to $19 million in 2012, a decrease of $7 million (37%). This decline is due primarily to lower profitability in the transportation businesses, partially offset by improved profitability in the crop operations. Catastrophe losses were $27 million (1.8 points) for this group in 2013 compared to $35 million, including $8 million of reinstatement premiums (1.9 points) in 2012.
This group reported an underwriting profit of $19 million in 2012 compared to $113 million in 2011, a decrease of $94 million (83%). This decline is due primarily to the effects of the Midwest drought on the crop operations and losses from Superstorm Sandy. Catastrophe losses were $35 million, including $8 million of reinstatement premiums (1.9 points) in 2012 compared to $29 million (2.1 points) in 2011.
Underwriting profit was $53 million in 2012 compared to $35 million in 2011, an increase of $18 million (51%). Improved 2012 accident year results in several operations and increased favorable reserve development in the general liability lines were partially offset by lower favorable reserve development in the executive liability and excess and surplus businesses.
Specialty financial Net favorable reserve development of $14 million in 2013 is due to lower than expected frequency and severity in the foreign credit and financial institution services businesses as economic conditions did not affect these lines as adversely as had been anticipated. Net favorable reserve development of $29 million in 2012 and $10 million in 2011 reflects lower than expected frequency and severity in the surety, fidelity, crime, foreign credit and financial institution services businesses as economic conditions did not affect these lines as adversely as had been anticipated.
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. AFG has also recorded liabilities for various environmental and occupational injury and disease claims arising out of former railroad and manufacturing operations. 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) and its former railroad and manufacturing operations (included in other operating and general expenses) were as follows (in millions):
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. The $27 million in catastrophe losses in the Property and transportation group in 2013 resulted primarily from spring storms in the southeastern United States. The $27 million in
AFG's property and casualty commissions and other underwriting expenses ("U/W Exp") were $1.02 billion in 2013 compared to $887 million in 2012, an increase of $132 million (15%). AFG's underwriting expense ratio was 31.8% in 2013 compared to 31.1% in 2012, an increase of 0.7 percentage points.
Detail of AFG's property and casualty commissions and other underwriting expenses and underwriting expense ratios is shown below (dollars in millions):
The overall increase of 0.9% in AFG's expense ratio in 2012 as compared to 2011, as well as the fluctuations in AFG's sub-components, reflects the impact of higher premiums on the ratio was more than offset by changes in the mix of AFG's business and the impact of certain reinsurance ceding commissions received that are partially based on the profitability of the business ceded.
Commissions and other underwriting expenses as a percentage of net earned premiums decreased 1.8 percentage points in 2012 compared to 2011 primarily due to the impact of higher premiums on the ratio.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 3.4 percentage points in 2012 compared to 2011 primarily due to a change in mix of business.
Net investment income in AFG's property and casualty operations was $263 million in 2013 compared to $275 million in 2012, a decrease of $12 million (4%). Net investment income in AFG's property and casualty operations was $275 million in 2012 compared to $291 million in 2011, a decrease of $16 million (5%). In recent years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG's investment portfolio yield. The average invested assets and overall earned yield on investments held by AFG's property and casualty operations are provided below (dollars in millions):
The property and casualty segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 3.83% in 2013 compared to 4.12% in 2012, a decline of 0.29% percentage points. In addition to the impact of lower yields available in the financial markets, the $188 million increase in average invested assets reflects primarily higher average balances of cash and cash equivalents.
Other income and expenses, net for AFG's property and casualty operations was a net expense of $33 million in 2013, $40 million in 2012 and $29 million in 2011, representing a decrease of $7 million (18%) in 2013 compared to 2012 and an increase of $11 million (38%) in 2012 compared to 2011. The table below details the items included in other income and expenses, net for AFG's property and casualty operations (in millions):
AFG's annuity operations contributed $323 million in GAAP pretax earnings in 2013 compared to $256 million in 2012, an increase of $67 million (26%). AFG’s annuity operations contributed $328 million in core pretax earnings in 2013 compared to $256 million in 2012, an increase of $72 million (28%). The increase in both GAAP and core pretax earnings was a result of growth in the annuity business and the positive impact of higher interest rates and strong stock market performance in 2013 on AFG’s FIA business. Results for 2012 reflect the negative impact of sharply lower interest rates on the FIA business. AFG’s periodic detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations resulted in a charge of $2 million in 2013 compared to a $14 million charge in 2012.
AFG's annuity operations contributed $256 million in GAAP pretax earnings in 2012 compared to $188 million in 2011, an increase of $68 million (36%). The increase is due primarily to AFG’s ability to maintain spreads on a larger base of invested assets as well as exceptionally strong investment results. Lower interest rates negatively impacted earnings in AFG’s FIA business in both 2012 and 2011. Operating earnings also include a net unlocking charge of $14 million in 2012 compared to $1 million in 2011.
In the second quarter of 2013, AFG recorded a pretax charge of $5 million in its annuity operations to cover expected assessments from state guaranty funds related to the insolvency and liquidation of Executive Life Insurance Company of New York (“ELNY”), an unaffiliated life insurance company. ELNY was placed into rehabilitation by the New York Insurance Department in 1991. In April 2012, ELNY was declared insolvent and ordered into liquidation. AFG’s life insurance subsidiaries are required under the solvency or guaranty laws of most states in which they do business to pay assessments up to certain prescribed limits to fund policyholder losses or liabilities of insolvent insurance companies such as ELNY and started receiving guaranty fund assessments related to ELNY from various states in the second quarter of 2013. AFG does not expect to record significant additional charges for ELNY guaranty fund assessments in future quarters.
The following table details AFG's GAAP and core earnings before income taxes from its annuity operations for 2013, 2012 and 2011 (dollars in millions):
(b) Other expenses exclude the $5 million pretax non-core charge for ELNY guaranty fund assessments in 2013.
Net investment income in 2013 was $1.03 billion compared to $976 million in 2012, an increase of $58 million (6%). This increase reflects primarily the growth in AFG’s annuity business. The overall yield earned on investments in AFG's annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), declined by 0.45 percentage points in 2013 compared to 2012. This decline in net investment yield reflects (i) the investment of new premium dollars in the recent low interest rate environment and (ii) the impact of the maturity and redemption of higher yielding investments.
Net investment income in 2012 was $976 million compared to $859 million in 2011, an increase of $117 million (14%). This increase reflects primarily the growth in AFG’s annuity business and exceptionally strong investment results in 2012. The overall yield earned on investments in AFG's annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), declined by 0.19 percentage points in 2012 compared to 2011. This decline in net investment yield reflects (i) the investment of new premium dollars in the recent low interest rate environment and (ii) the impact of the maturity and redemption of higher yielding investments, partially offset by (iii) exceptionally strong investment results.
Interest credited - fixed in 2012 was $438 million compared to $417 million in 2011, an increase of $21 million (5%). The impact of growth in the annuity business was partially offset by lower interest crediting rates on new premiums as compared to the crediting rates on policyholder funds surrendered or withdrawn as well as the impact of crediting rate reductions on existing policyholder funds that were implemented in the second half of 2012. The average interest rate credited to policyholders, calculated as interest credited divided by average fixed annuity benefits accumulated, decreased 0.31 percentage points in 2012 compared to 2011. During 2012, interest rates credited on new premiums generally ranged from 1.00% to 2.00%.
The $8 million increase in other annuity benefits, net of guaranteed withdrawal benefit fees in 2013 compared to 2012 primarily reflects increased sales of products with guaranteed withdrawal benefit features.
consistent with industry experience. In addition, AFG was impacted by aggressive participants and new entrants in certain of its markets.
In 2013, 2012 and 2011, AFG conducted its detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded charges (expense reductions) in annuity benefits expense and annuity and supplemental insurance acquisition expenses related to its annuity business. AFG’s net annuity unlocking charges of $2 million in 2013, $14 million in 2012 and $1 million in 2011 impacted AFG’s financial statements as follows (in millions):
(b) Net investment income (as a % of investments) of 5.35% and 5.80% and 5.99% in 2013, 2012 and 2011, respectively, multiplied by the difference between average fixed annuity investments (at amortized cost) and average fixed annuity benefits accumulated in each period.
Run-off Long-Term Care and Life Segment - Results of Operations As previously discussed under “Uncertainties - Run-off Long-term Care Insurance,” AFG recorded a $153 million loss recognition charge in the fourth quarter of 2012 to write off deferred policy acquisition costs and strengthen reserves in its closed block of long-term care insurance. The charge was due primarily to lower projected future investment rates resulting from the continued low interest rate environment, as well as changes in claims, expenses and persistency assumptions. Excluding this charge, pretax core operating losses for the run-off long-term care and life segment were $10 million in 2013 and $4 million in 2012 compared to pretax operating earnings of less than $1 million in 2011. The following table details AFG's GAAP and core earnings (losses) before income taxes from its run-off long-term care and life operations in 2013, 2012 and 2011 (dollars in millions):
The increase in long-term care benefits expense in 2012 as compared to 2011 is due primarily to charges recorded in 2012 to increase reserves related to existing open claims and certain policyholder benefit features. The decrease in life benefits expense in 2012 as compared to 2011 is due primarily to improved claims experience.
AFG's holding companies and other operations outside of its insurance operations recorded interest expense of $68 million in 2013 compared to $71 million in 2012, a decrease of $3 million (4%). In 2012, AFG issued new Senior Notes and used the proceeds to redeem higher rate debt.
AFG's holding companies and other operations outside of its insurance operations recorded interest expense of $71 million in 2012 compared to $69 million in 2011, an increase of $2 million (3%).
Consolidated Realized Gains (Losses) on Securities AFG's consolidated realized gains on securities, which are not allocated to segments, were $221 million in 2013 compared to $210 million in 2012, an increase of $11 million (5%). AFG's consolidated realized gains on securities were $210 million in 2012 compared to $76 million in 2011, an increase of $134 million (176%). Realized gains (losses) on securities consisted of the following (in millions):
Consolidated Income Taxes AFG's consolidated provision for income taxes was $236 million in 2013 compared to $135 million in 2012, an increase of $101 million (75%). The provision for income taxes recorded in 2012 includes a $67 million non-core tax benefit related to the favorable resolution of certain tax litigation and settlement of open tax years. AFG's consolidated provision for income taxes was $135 million in 2012 compared to $239 million in 2011, a decrease of $104 million (44%). See Note L - “Income Taxes” to the financial statements for an analysis of items affecting AFG’s effective tax rate.
Consolidated Noncontrolling Interests AFG’s consolidated net loss attributable to noncontrolling interests was $18 million in 2013 compared to $86 million in 2012, a decrease of $68 million (79%). AFG’s consolidated net loss attributable to noncontrolling interests was $86 million in 2012 compared to $23 million in 2011, an increase of $63 million (274%). The following table details net earnings (loss) in consolidated subsidiaries attributable to holders other than AFG (dollars in millions):
See Note A - “Accounting Policies - Accounting Standard Adopted in 2013” to the financial statements for a discussion of a recent accounting standard adopted by AFG.
Based on AFG’s evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2013. The attestation report of AFG’s independent registered public accounting firm on AFG’s internal control over financial reporting as of December 31, 2013, is set forth below.
We have audited American Financial Group, Inc. and subsidiaries’ (the Company’s) internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) (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 Company’s internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Financial Group, Inc. and subsidiaries as of December 31, 2013 and 2012, and 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, 2013, and our report dated February 28, 2014, expressed an unqualified opinion thereon.
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, 2013 and 2012 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2013, 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Financial Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) and our report dated February 28, 2014 expressed an unqualified opinion thereon.
Accounting Standard Adopted in 2013 Effective January 1, 2013, AFG prospectively adopted Accounting Standards Update (“ASU”) 2013-02, which requires companies to disclose, in a single location within the financial statements or footnotes, reclassifications out of accumulated other comprehensive income (“AOCI”) separately for each component of other comprehensive income. For significant reclassifications, the disclosure is required to include the respective line items in net earnings affected by the reclassification. Disclosures required by the guidance are included in Note K - “Shareholders’ Equity.” This new disclosure requirement had no impact on AFG’s results of operations or financial position.
Investments Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in AOCI in AFG’s Balance Sheet. Fixed maturity and equity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in net investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.
DPAC and certain other balance sheet amounts related to annuity, long-term care and life businesses are also adjusted, net of tax, for the change in expense that would have been recorded if the unrealized gains (losses) from securities had actually been realized. These adjustments are included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.
Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG’s Balance Sheet (at fair value). AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The excess of fair value of the CLOs’ assets over the fair value of the liabilities is recorded in AFG’s Balance Sheet as appropriated retained earnings - managed investment entities, representing amounts that ultimately will inure to the benefit of the CLO debt holders.
The net gain or loss from accounting for the CLO assets and liabilities at fair value is separately presented in AFG’s Statement of Earnings. CLO earnings attributable to AFG’s shareholders represent the change in fair value of AFG’s investments in the CLOs (including distributions) and management fees earned. All other CLO earnings (losses) are not attributable to AFG’s shareholders and will ultimately inure to the benefit of the CLO debt holders. As a result, such CLO earnings (losses) are included in net earnings (loss) attributable to noncontrolling interests in AFG’s Statement of Earnings and in appropriated retained earnings - managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2026), it is expected that losses attributable to noncontrolling interests will reduce appropriated retained earnings towards zero as the fair values of the assets and liabilities converge and the CLO assets are used to pay the CLO debt.
At December 31, 2012, assets and liabilities of managed investment entities include $107 million in assets and $87 million in liabilities of a temporary warehousing entity that was established in connection with the formation of a new CLO that closed in April 2013. Upon closing, all warehoused assets were transferred to the new CLO and the liabilities were repaid.
Premium Recognition 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 information 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.
Earnings Per Share Although basic earnings per share only considers shares of common stock outstanding during the period, the calculation of diluted earnings per share includes the following adjustments to weighted average common shares related to stock-based compensation plans: 2013 - 1.9 million, 2012 - 1.7 million and 2011 - 1.6 million.
AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: 2013 - 1.1 million, 2012 - 1.8 million and 2011 - 2.3 million. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2013, 2012 and 2011 periods.
The impact of the August 2012 sale of the Medicare supplement and critical illness segment on AFG’s financial statements is shown below (in millions):
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, umbrella and excess liability, customized programs for small to mid-sized businesses and workers’ compensation, and (iii) Specialty financial, which includes risk management insurance programs for leasing and financing institutions (including collateral and lender-placed mortgage property insurance), surety and fidelity products and trade credit insurance. AFG’s annuity business markets traditional fixed and fixed-indexed annuities in the retail, financial institutions and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
The transfers from Level 2 to Level 1 are due to increases in trade frequency, resulting in trade data sufficient to warrant classification in Level 1. The transfers from Level 1 to Level 2 are due to decreases in trade frequency, resulting in lack of available trade data sufficient to warrant classification in Level 1. Approximately 3% of the total assets carried at fair value on December 31, 2013, were Level 3 assets. Approximately 78% ($699 million) 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. Since internally developed Level 3 asset fair values represent less than one-half of 1% of the total assets measured at fair value and less than 2% of AFG’s shareholders’ equity, changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.
The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AFG’s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $804 million at December 31, 2013. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note F - “Derivatives.”
The range of adjustments for insurance subsidiary’s credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AFG’s individual fixed-indexed annuity products with an expected range of 6% to 12% in the majority of future calendar years (4% to 16% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flows assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.
Total realized/unrealized loss included in net income includes gains of $7 million related to liabilities outstanding as of December 31, 2013. See Note H - “Managed Investment Entities.”
Total realized/unrealized loss included in net income for the embedded derivatives reflects gains related to the unlocking of actuarial assumptions of $2 million in 2013.
The carrying amount of cash and cash equivalents approximates fair value. Fair values for mortgage loans are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with
At December 31, 2013, the gross unrealized losses on fixed maturities of $305 million relate to approximately 1,200 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 89% of the gross unrealized loss and 90% of the fair value.
Management believes AFG will recover its cost basis in the securities with unrealized losses and that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, 2013.
There were no investments in individual issuers that exceeded 10% of Shareholders’ Equity at December 31, 2013 or 2012.
AFG’s fixed-indexed annuities, which represented approximately half of annuity benefits accumulated at December 31, 2013, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG receives collateral from its counterparties to support its purchased call option assets. This collateral ($248 million at December 31, 2013) is included in other assets in AFG’s Balance Sheet with an offsetting liability to return the collateral, which is included in other liabilities. AFG’s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be generally offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives. Fluctuations in interest rates and the stock market, among other factors, can cause volatility in the periodic measurement of fair value of the embedded derivative that management believes can be inconsistent with the long-term economics of these products. For example, the impact of lower interest rates in 2011 resulted in both the embedded derivative and call options to decline in value. The decline in fair value of the options reflects the relatively flat stock market during 2011. However, the negative impact of lower interest rates more than offset the positive impact of the flat stock market on the fair value of the fixed-indexed annuities embedded derivative.
AFG is the investment manager and its subsidiaries have investments ranging from 7.5% to 51.2% of the most subordinate debt tranche of eleven collateralized loan obligation entities or “CLOs,” which are considered variable interest entities. AFG’s subsidiaries also own portions of the senior debt tranches of certain of these CLOs. Upon formation between 2004 and 2013, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG’s investments in the subordinate debt tranches of these entities receive residual income from the CLOs only after the CLOs pay expenses (including management fees to AFG), and interest on and returns of capital to senior levels of debt securities. There are no contractual requirements for AFG to provide additional funding for these entities. AFG has not provided and does not intend to provide any financial support to these entities.
AFG’s maximum exposure to economic loss on its CLOs is limited to its investment in the CLOs, which had an aggregate fair value of $271 million (including $88 million invested in the most subordinate debt tranches) at December 31, 2013, and $257 million at December 31, 2012.
Included in other assets in AFG’s Balance Sheet is $14 million at December 31, 2013 and $28 million at December 31, 2012 in amortizable intangible assets related to property and casualty insurance acquisitions. These amounts are net of accumulated amortization of $75 million and $61 million, respectively. Amortization of these intangibles was $14 million in each of 2013 and 2012 and $12 million in 2011. Future amortization of intangibles is estimated to be $13 million in 2014 and $1 million in 2015. Other assets also include $8 million in non-amortizable intangible assets related to property and casualty insurance acquisitions.
Cash interest payments on long-term debt were $71 million in 2013, $75 million in 2012 and $74 million in 2011.
At December 31, 2013, there were 11.7 million shares of AFG Common Stock reserved for issuance under AFG’s stock incentive plans. Options are granted with 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 2013, 2012 and 2011 was $35 million, $25 million and $23 million, respectively. During 2013, 2012 and 2011, AFG received $44 million, $40 million and $33 million, respectively, in cash from the exercise of stock options. The total tax benefit related to the exercises was $11 million, $8 million and $7 million, respectively.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries for 2013, 2012 and 2011 was $36 million, $26 million and $22 million, respectively. Related tax benefits totaled $12 million in 2013, $8 million in 2012 and $7 million in 2011. At December 31, 2013, there was $27 million and $12 million of unrecognized compensation expense related to nonvested stock options and restricted stock awards, respectively. These amounts are expected to be recognized over a weighted average of 3.3 and 2.4 years, respectively.
AFG’s 2008 - 2013 tax years remain subject to examination by the IRS.
Total earnings before income taxes include income subject to tax in foreign jurisdictions of $12 million in 2013 compared to losses of $3 million in 2012 and $26 million in 2011.
“Foreign underwriting losses” in the table above include the net operating loss carryforward and other deferred tax assets related to the Marketform Lloyd’s insurance business, which resulted primarily from underwriting losses in its run-off Italian public hospital medical malpractice business that has not been written since 2008. Due to uncertainty concerning the realization of the deferred tax benefits associated with these losses, AFG recorded a $44 million valuation allowance against the deferred tax assets related to the Lloyd’s insurance business in 2011, approximately $34 million of which related to prior year losses. AFG will be able to reduce this valuation allowance in future periods when income is generated by the Lloyd’s business.
In addition to the valuation allowance related to the Marketform Lloyd’s insurance business discussed above, the gross deferred tax asset has also been reduced by a $50 million valuation allowance related to a portion of AFG’s net operating loss carryforwards (“NOL”) that is subject to the separate return limitation year (“SRLY”) tax rules. A SRLY NOL can be used only by the entity that created it and only in years that the consolidated group has taxable income.
The changes in the deferred tax liabilities related to investment securities and deferred policy acquisition costs at year end 2013 compared to 2012 are due primarily to the decrease in unrealized gains on fixed maturity securities.
AFG increased its liability for uncertain tax positions by $1 million in 2013, $3 million in 2012 and $7 million in 2011, exclusive of interest, to reflect uncertainty as to the timing of tax return inclusion of income related to certain securities. Because the ultimate recognition of income with respect to these securities is highly certain, any adjustments to this liability will result in offsetting adjustments to AFG’s deferred tax liability. Accordingly, the ultimate resolution of this item will not impact AFG’s annual effective tax rate but could accelerate the payment of taxes. During 2012, AFG also increased its liability for uncertain tax positions by $2 million related to the deductibility of certain financing expenses.
Cash payments for income taxes, net of refunds, were $204 million, $277 million and $157 million for 2013, 2012 and 2011, respectively.
AFG paid $124 million in the second quarter of 2013 related to the settlement of the A.P. Green asbestos claim in its property and casualty operations that had been accrued in prior years. AFG completed a comprehensive study of its asbestos and environmental (“A&E”) exposures in the third quarter of 2013 with the assistance of specialty actuarial, engineering and consulting firms and outside counsel. The study resulted in A&E charges of $54 million for the property and casualty group and $22 million for the former railroad and manufacturing operations. In the third quarter of 2012, AFG completed an in-depth internal review of its A&E exposures, which resulted in A&E charges of $31 million for the property and casualty group and $2 million for the former railroad and manufacturing operations. In the second quarter of 2011, AFG completed a comprehensive study of A&E exposures with the assistance of specialty actuarial, engineering and consulting firms and outside counsel, which resulted in A&E charges of $50 million for the property and casualty group and $9 million for the former railroad and manufacturing operations.
At December 31, 2013, GAFRI had a liability of approximately $10 million for environmental costs and certain other matters associated with the sales of its former manufacturing operations.
While management believes AFG has recorded adequate reserves for the items discussed above in this note, 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.
Statutory Information AFG’s U.S.-based insurance subsidiaries are required to file financial statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Net earnings (loss) and capital and surplus on a statutory basis for the insurance subsidiaries were as follows (in millions):
The National Association of Insurance Commissioners' (“NAIC”) model law for risk based capital (“RBC”) applies to both life and property and casualty insurance companies. RBC formulas determine the amount of capital that an insurance company needs so that it has an acceptable expectation of not becoming financially impaired. Companies below specific trigger points or ratios are subject to regulatory action. At December 31, 2013 and 2012, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements. AFG's insurance companies did not use any prescribed or permitted statutory accounting practices that differed from the NAIC statutory accounting practices at December 31, 2013 or 2012.
Variable Annuities At December 31, 2013, 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 $26 million, compared to $40 million at December 31, 2012. Death benefits paid in excess of the variable annuity account balances were less than $1 million in each of the last three years.
Operating Leases Total rental expense for various leases of office space and equipment was $57 million in 2013, $51 million in 2012 and $54 million in 2011. 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, 2013, were as follows: 2014 - $57 million; 2015 - $50 million; 2016 - $44 million; 2017 - $35 million; 2018 - $30 million; and $173 million thereafter.
Financial Instruments - Unfunded Commitments On occasion, AFG and its subsidiaries have entered into financial instrument transactions that may present off-balance-sheet risks of both a credit and market risk nature. These transactions include commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. At December 31, 2013, AFG and its subsidiaries had commitments to fund credit facilities and contribute capital to limited partnerships and limited liability corporations of approximately $280 million.
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:
Stock Purchase Agreement dated January 9, 2014 by and between Liberty Mutual Group Inc. and Great American Holding, Inc. (Summit Holdings Southeast, Inc.)