AFG's insurance subsidiaries lease the majority of their office and storage facilities in numerous cities throughout the United States, including Great American's and GAFRI's home offices in Cincinnati and UTA's home office in Austin. In December 2007, AFG signed a 15-year lease for space in a new office tower currently under construction in downtown Cincinnati. The new building is scheduled for completion in 2011 and will enable AFG to consolidate operations from several leased locations. A property and casualty insurance subsidiary owns approximately 177,000 square feet of office space on 17.5 acres of land in Richfield, Ohio, approximately 80% of which it occupies; the remaining space is leased to unaffiliated tenants. See Item 1 - "Other Operations" for a discussion of AFG's other commercial real estate operations.
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 noncontrolling interests in earnings of subsidiaries having fixed charges and the undistributed equity in losses of investees. Fixed charges include interest (including annuity benefits 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.
The ratio of earnings to fixed charges excluding annuity benefits was 11.06, 4.75, 8.49, 9.15 and 4.58 for 2009, 2008, 2007, 2006 and 2005, respectively. Although the ratio of earnings to fixed charges excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, some investors and lenders may not consider interest credited to annuity policyholders' accounts a borrowing cost for an insurance company, and accordingly, believe this ratio is meaningful.
Please refer to "Forward-Looking Statements" following the Index in front of this Form 10-K.
AFG reported net earnings attributable to shareholders of $519 million ($4.45 per share diluted) in 2009 compared to $196 million ($1.67 per share diluted) in 2008. Results for 2009 reflect net realized gains on investments compared to net realized losses in 2008, higher investment income and improved underwriting results in the property and casualty insurance operations.
See "Liquidity and Capital Resources - Uncertainties" for a discussion of insurance reserves, recoverables from reinsurers, and contingencies related to American Premier's former operations and "Liquidity and Capital Resources - Investments" for a discussion of impairments on investments. Deferred policy acquisition costs ("DPAC") and certain liabilities related to annuities and universal life insurance products are amortized in relation to the present value of expected gross profits on the policies. Assumptions considered in determining expected gross profits involve significant judgment and include management's estimates of assumed interest rates and investment spreads, surrenders, annuitizations, renewal premiums and mortality. Should actual experience require management to change its assumptions (commonly referred to as "unlocking"), a charge or credit would be recorded to adjust DPAC or annuity liabilities to the levels they would have been if the new assumptions had been used from the inception date of each policy.
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, 2009, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements.
Management believes AFG has sufficient resources to meet its liquidity requirements. If funds generated from operations, including dividends, tax payments and borrowings from subsidiaries, are insufficient to meet fixed charges in any period, AFG would be required to utilize parent company cash and marketable securities or to generate cash through borrowings, sales of other assets, or similar transactions.
All debentures and notes issued by AFG (and AAG Holding Company, a GAFRI subsidiary) are rated investment grade by two nationally recognized rating agencies. Under a currently effective shelf registration statement, AFG can offer additional equity or debt securities. The shelf registration provides AFG with flexibility to access the capital markets from time to time as market and other conditions permit.
up to $75 million, subject to certain conditions. Amounts borrowed bear interest at rates ranging from .45% to .9% (currently .65%) over LIBOR based on NATL's credit rating. In 2008, NATL borrowed $15 million under the credit agreement to redeem its subordinated debentures at par. No additional amounts have been borrowed on this line.
For statutory accounting purposes, equity securities of non-affiliates are generally carried at fair value. At December 31, 2009, AFG's insurance companies owned publicly traded equity securities with a fair value of $385 million. In addition, GAI's investment in NATL common stock had a fair value of $173 million and a statutory carrying value of $137 million at December 31, 2009. Decreases in market prices could adversely affect the insurance group's capital, potentially impacting the amount of dividends available or necessitating a capital contribution. Conversely, increases in market prices could have a favorable impact on the group's dividend-paying capability.
Includes 15-year lease for new office space with rentals, including estimated operating costs, averaging approximately $16.9 million per year beginning in 2011.
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 one-third of AFG's fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the other two-thirds of AFG's fixed maturity portfolio, approximately 95% are priced using a pricing service and the balance is priced internally or by using non-binding broker quotes. When prices obtained for the same security vary, AFG's internal investment professionals select the price they believe is most indicative of an exit price.
The pricing services use a variety of observable inputs to estimate fair value of fixed maturities that do not trade on a daily basis. Based upon information provided by the pricing services, these inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data, and measures of volatility. Included in the pricing of MBS are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Due to the lack of transparency in the process that brokers use to develop prices, valuations that are based on brokers' prices are classified as Level 3 in the GAAP hierarchy unless the price can be corroborated, for example, by comparison to similar securities priced using observable inputs.
AFG's $5.5 billion investment in MBS represented approximately one-third of its fixed maturities at December 31, 2009. MBS are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates.
Summarized information for AFG's MBS (including those classified as trading) at December 31, 2009, is shown (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 4 and 5 years, respectively.
Issuers will sometimes purchase monoline insurance to "wrap" or enhance the credit of a security issuance in order to benefit from better market execution. At December 31, 2009, AFG owned approximately $1.1 billion of fixed maturity securities wrapped by monoline insurers. Of the credit enhancement, 31% was provided by MBIA Inc., 26% by Assured Guaranty Municipal Corp. and an additional 25% by Ambac Assurance Corporation. AFG's direct investment in monoline credit insurers was approximately $13 million at December 31, 2009.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at December 31, 2009, is shown in the following table (dollars in millions). Approximately $339 million of available for sale "Fixed maturities" and $46 million of "Equity securities" had no unrealized gains or losses at December 31, 2009.
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at December 31, 2009, 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.
When a decline in the value of a specific investment is considered to be "other-than-temporary," a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced by the amount of the charge. The determination of whether unrealized losses are "other-than-temporary" requires judgment based on subjective as well as objective factors. Factors considered and resources used by management include:
Estimating the liability for unpaid losses and loss adjustment expenses ("LAE") is inherently judgmental and is influenced by factors that are subject to significant variation. Determining the liability is a complex process incorporating input from many areas of the company including actuarial, underwriting, pricing, claims and operations management.
The period of time from the occurrence of a loss through the settlement of the liability is referred to as the "tail". Generally, the same actuarial methods are considered for both short-tail and long-tail lines of business because most of them work properly for both. The methods are designed to incorporate the effects of the differing length of time to settle particular claims. For short-tail 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
Within each line, results of individual methods are reviewed, supplementary statistical information is analyzed, and all data from underwriting, operating and claim management are considered in deriving management's best estimate of the ultimate liability. This estimate may be the result of one method, or a weighted average of several methods, or a judgmental selection as the management team determines is appropriate.
The following table shows (in millions) the breakdown of AFG's property and casualty reserves between case reserves, IBNR reserves and LAE reserves (estimated amounts required to adjust, record and settle claims, other than the claim payments themselves).
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, 2009, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
While, to some extent, the standard actuarial techniques reflect the expected impacts from the reforms and recent judicial decisions, future costs depend on the implementation and interpretation of these items 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 costs to determine the appropriate reserve level.
AFG recorded favorable prior year loss development of $26 million in 2009 and $29 million in 2008 on its directors' and officers' liability business as claim severity was significantly less than expected. The legal professional liability business, which is in run-off, had favorable development of $14 million in 2009 after several years of modest adverse development; as this run-off liability has matured, the claim severity trends have stabilized and the frequency is also less than expected.
AFG recorded favorable prior year loss development of $7 million in 2008 and adverse prior year loss development of $21 million in 2007 on its run-off homebuilders business (mostly from exposures in California and Nevada).
See Item 1 - "Business" - "Property and Casualty Operations - Reinsurance" for more information on AFG's reinsurance programs. For additional information on the effect of reinsurance on AFG's historical results of operations see Note O -
Asbestos reserves include claims asserting alleged injuries and damages from exposure to asbestos. Environmental reserves include claims relating to polluted waste sites.
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.
(*) The tax effects of reconciling items are shown below (in millions):
noncontrolling interests of ($4 million) in 2009, $10 million in 2008
Net earnings attributable to shareholders decreased in 2008 compared to 2007 due primarily to after-tax net realized losses of $270 million in 2008 compared to $47 million in 2007. Core net operating earnings decreased in 2008 as higher earnings from the annuity and supplemental insurance operations and higher investment income were more than offset by lower underwriting profits within the specialty property and casualty operations.
Gross and net written premiums increased 7% and 6%, respectively, in 2008 compared to 2007. Significantly higher premiums in the crop operations and premiums from the Marketform operations acquired in January 2008, more than offset declines in certain other Specialty operations resulting from a soft market and depressed economic conditions. Apart from rate decreases in the California workers' compensation business, average renewal rates in AFG's other specialty operations were down about 3% in 2008.
Gross and net written premiums increased significantly in 2008 due to the effect of higher spring commodity pricing on crop operations, partially offset by lower premiums in the property and inland marine operations resulting from a competitive marketplace. The property and transportation group reported an underwriting profit of $156 million in 2008, $89 million lower than in 2007. The combined ratio of 87.9% increased 10.0 points over 2007 as a result of lower underwriting profits in the crop operations and higher catastrophe losses, which were offset somewhat by higher favorable reserve development. There were 5.0 points of favorable reserve development in 2008 compared to 4.0 points in 2007. Results for 2008 include 3.9 points of catastrophe losses compared to minimal catastrophe losses in 2007.
gross and net written premiums decreased in 2009 due primarily to lower general liability coverages resulting from the softening in the homebuilders market and strong competition in the excess and surplus lines, partially offset by premium growth from Marketform, the start-up environmental operations and the executive liability business. This group reported an underwriting profit of $63 million in 2009, $136 million lower than in 2008. The combined ratio increased 16.3 points from the 2008 period to 91.5%. These results were considerably lower than 2008 due primarily to $56 million of adverse reserve development in Marketform's Italian public hospital medical malpractice business related to 2008 and prior years, which Marketform ceased writing in 2008. Also contributing to the Specialty casualty results were higher losses in a book of targeted program business, lower underwriting profits in the general liability and excess and surplus lines resulting from a depressed economy, particularly in the homebuilders' market, and competitive market conditions. Other businesses in this group produced excellent underwriting profit margins, but at lower levels than 2008.
Gross written premiums decreased in 2008 due primarily to stronger competition in the excess and surplus lines and softening in the homebuilders market, offset somewhat by the addition of Marketform in the first quarter of 2008. Net written premiums increased slightly in 2008 as greater retention in some of AFG's casualty operations more than offset the effect of these items. This group reported an underwriting profit of $199 million in 2008, 5% lower than in 2007. The combined ratio increased .5 points to 75.2% as improved results in the executive liability operations were more than offset by declines in underwriting profits due to lower premiums in the excess surplus lines and general liability operations. Results for 2008 include 15.3 points of favorable reserve development compared to 12.7 points in 2007.
Gross and net written premiums decreased in 2008 compared to 2007 as rate reductions in the traditional workers' compensation business were partially offset by increased sales of the recently targeted excess workers' compensation products. This group reported solid profitability with a combined ratio of 78.2%, a slight improvement over the 2007 period. The California renewal rate reductions averaged about 14% in 2008. There were 15.8 points of favorable reserve development in 2008 compared to 9.2 points in 2007.
AFG has undertaken periodic studies of its asbestos and environmental reserves. During the second quarter of 2009, AFG completed a comprehensive study of its asbestos and environmental exposures relating to the run-off operations of its property and casualty group and exposures related to former railroad and manufacturing operations and sites. The 2009 study was completed with the assistance of outside actuarial and engineering firms and specialty outside counsel and relied on a comprehensive exposure analysis. It considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development. Similar comprehensive studies have been completed every two years with an in-depth internal review during the intervening years. The 2009 study resulted in minor adjustments to A&E reserves. During the course of the 2009 study, there were no newly identified emerging trends or issues that management believes significantly impact the overall adequacy of AFG's A&E reserves.
Management believes that the asbestos legal climate remains very difficult to predict. While progress continues to be made in state asbestos tort reform and judicial rulings, that progress has been somewhat offset by the lack of reform in certain jurisdictions, increased claims costs, increased defense costs, the assertion of non-products theories and an expanding pool of plaintiffs and defendants. Environmental claims likewise present challenges in prediction, due to uncertainty regarding the interpretation of insurance policies, complexities regarding multi-party involvements at sites, evolving clean up standards and protracted time periods required to assess the level of clean up required at contaminated sites.
At December 31, 2009, AFG's three year survival ratios were 10.6 times paid losses for the asbestos reserves and 9.3 times paid losses for the total A&E reserves. Excluding amounts associated with the settlements of asbestos-related coverage litigation for A.P. Green Industries (see Item 3 - "Legal Proceedings") and another large claim, AFG's three year survival ratios were 9.1 and 8.0 times paid losses for the asbestos reserves and total A&E
reserves, respectively. These ratios compare favorably with data published by A.M. Best in December 2009, which indicate that industry survival ratios were 8.1 for asbestos reserves and 7.5 for total A&E reserves at December 31, 2008.
As a result of the in-depth internal review completed in the second quarter of 2008, AFG recorded a $12 million charge (net of reinsurance recoverables) to increase the property and casualty group's asbestos and environmental reserves. During the course of this review, there were no newly identified emerging trends or issues that management believes significantly impact the overall adequacy of AFG's A&E reserves. The modest increases were primarily due to reassessments of the potential losses on certain outstanding cases. The review relied on a comprehensive exposure analysis by AFG's internal A&E claims specialists and actuaries in consultation with external actuaries and outside specialty counsel. It considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development, as appropriate.
As a result of the 2007 study, AFG recorded a $44 million charge (net of reinsurance) to increase the property and casualty group's asbestos reserves by $31 million and its environmental reserves by $13 million. The primary causes of the increase
In addition to the property and casualty group, the 2008 internal review encompassed reserves for asbestos and environmental exposures of the former railroad and manufacturing operations. As a result, AFG recorded a second quarter 2008 charge of $3 million (included in other expenses) to increase environmental reserves related to GAFRI's former manufacturing operations. The 2007 study resulted in a charge of $43 million (included in other expenses), including a $19 million increase in asbestos reserves resulting from increasing estimates of the cost of mesothelioma claims partially offset by lower estimated overall claim counts and a $24 million increase in environmental reserves due primarily to increased clean up estimates at certain former railroad and manufacturing sites.
The favorable reserve development in the Property and transportation group is due primarily to lower than expected loss frequency in crop and ocean marine products and lower severity in farm and crop losses. Also contributing to the favorable reserve development in 2007 was lower than expected claim frequency and severity in specialty commercial automobile and inland marine products.
Favorable reserve development in the Specialty casualty group in 2009 reflects lower severity on claims in general liability and directors and officers liability as well as lower than expected frequency in the program (leisure camps, fairs and festivals, and sports and leisure) business; partially offset by adverse development on Italian public hospital medical malpractice liability products in Marketform.
Favorable reserve development in Specialty financial in 2009 related to lower than expected frequency and severity in the run-off RVI operations due to favorable trends in used car sale prices. Lower loss severity in AFG's surety, fidelity and crime products contributed to favorable development in all three years.
The favorable reserve development in California workers' compensation reflects lower than expected claim severity and frequency as a result of the workers' compensation reform legislation passed in 2003 and 2004, although at lower levels in 2009 than in 2008 and 2007 due to judicial decisions in early 2009 tending to moderate some of the improvements from the reforms.
The development in Other specialty reflects adjustments to the deferred gain on the retroactive insurance transaction entered into in connection with the sale of a business in 1998, net of related amortization.
Operating earnings before income taxes (excluding realized gains (losses)) of the annuity and supplemental insurance segment were 3% higher in 2009 than in 2008 as improved profitability in the annuity operations more than offset lower earnings in the supplemental insurance operations. The 2008 results were 29% higher than 2007 as a result of higher earnings in the fixed annuity operations, primarily the result of higher spreads, and improved results in both the supplemental insurance and run-off life operations.
Management believes that the decrease in annuity premiums in 2009 compared to 2008 is attributable to (i) the impact of the economy and new regulations on 403(b) business, (ii) the impact of lower interest rates and (iii) AFG's pricing discipline across its annuity business.
Realized gains (losses) on securities consisted of the following (in millions):
Approximately $221 million and $246 million of the impairment charges in 2009 and 2008, respectively, related to fixed maturity investments, primarily corporate bonds and MBS. See Note A - "Accounting Policies - Investments" for new accounting guidance adopted in 2009. In 2008, $199 million of the impairment charges were attributable to equity investments, primarily in financial institutions, including $47 million for National City Corporation. Impairment charges include $64 million in 2007 to write down AFG's equity investment in National City Corporation to fair value.
In the third quarter of 2009, AFG recorded an estimated pretax loss of $2 million related to the October 2009 sale of a subsidiary that represented less than 1% of AFG's 2009 assets and revenues. Realized losses on subsidiaries for 2009 also includes a $3 million impairment charge to write off the goodwill associated with an annuity and supplemental insurance agency subsidiary. See Note H - "Goodwill and Other Intangibles."
The $68 million decrease in other income for 2009 compared to 2008 reflects a $25 million decline in income from AFG's warranty business, lower income from real estate operations and lower fee income in certain other businesses. The $24 million decrease in other income for 2008 compared to 2007 reflects a $17 million decrease in income from AFG's warranty business and lower gains from the sale of real estate.
As a result of the 2009 review of actual results and future assumptions discussed above in "Annuity Benefits," AFG recorded an $8 million write-off of DPAC due primarily to the impact of changes in assumptions related to future investment yields on the fixed annuity business. As a result of the 2008 review, AFG recorded a $15 million reduction in annuity and supplemental insurance acquisition expenses due primarily to changes in assumptions related to investment yields. This reduction was partially offset by $10 million in DPAC write-offs due to the impact of poor stock market performance on the variable annuity business. As a result of the 2007 review, AFG recorded a $9 million write-off of DPAC due to increased mortality in the run-off life operations.
Interest expense decreased $3 million (5%) for 2009 compared to 2008 as the impact of the June 2009 issuance of $350 million in 9-7/8% Senior Notes was more than offset by the effect of lower average indebtedness and lower interest rates on floating rate borrowings. The proceeds from the issuance of the Senior Notes were used to pay down AFG's floating rate bank line that matures in 2011. This offering provides AFG with additional financial flexibility and liquidity, although at a higher rate of interest than available under the floating rate bank line.
In November 2008, the Securities and Exchange Commission ("SEC") issued a proposed roadmap regarding the use of International Financial Reporting Standards ("IFRS") by U.S. issuers of financial statements. Under the proposed roadmap, AFG would be required to prepare its financial statements in accordance with IFRS instead of U.S. GAAP beginning in 2014. IFRS is a comprehensive series of accounting standards published by the International Accounting Standards Board ("IASB"). While U.S. GAAP and IFRS have converged in many areas, the IASB is
currently considering methodologies for valuing insurance contract liabilities that may be significantly different from the methodologies currently required by GAAP. AFG is currently assessing the impact that the adoption of IFRS would have on its financial statements and will continue to monitor the development of the potential implementation of IFRS.
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 these controls and procedures are effective. In the ordinary course of business, AFG and its subsidiaries routinely enhance their information systems by either upgrading or implementing new systems such as the new billing system implemented by several of AFG's property and casualty insurance business units in the fourth quarter of 2009. There have been no changes in AFG's internal control over financial reporting during the fourth fiscal quarter of 2009 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.
Based on AFG's evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2009. The attestation report of AFG's independent registered public accounting firm on AFG's internal control over financial reporting as of December 31, 2009, is set forth below.
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the Company) as of December 31, 2009 and 2008, and the related consolidated statements of earnings, changes in equity and cash flows for each of the three years in the period ended December 31, 2009. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
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, 2009 and 2008, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, 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.
As discussed in Note A to the consolidated financial statements, in connection with implementing new accounting standards, the Company changed its methods of accounting for noncontrolling interests and for other-than-temporary impairments of investments in fixed maturity securities in 2009, and for unrecognized tax benefits in 2007.
As a result of a new accounting standard adopted on January 1, 2009, noncontrolling interests in subsidiaries (formerly referred to as minority interest) is reported in the Balance Sheet as a separate component of equity and in the Statement of Earnings as a deduction from net income (instead of as an expense) in deriving net earnings attributable to AFG's shareholders.
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.
Derivatives included in AFG's Balance Sheet are recorded at fair value and consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related call options (included in other investments) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products. Changes in the fair value of derivatives are included in earnings.
Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaires retain the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to these transactions are classified as "trading." The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of the related trading portfolios.
The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims; and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses and excess benefits expected to be paid on future deaths and annuitizations ("EDAR"). The liability for EDAR is accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and variable annuity policy charges, and unearned revenues once they are recognized as income.
AFG's variable annuity contracts contain a guaranteed minimum death benefit ("GMDB") to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder's account. A GMDB liability is established for future excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.
Earnings Per Share 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):
AFG's weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: 2009 - 5.7 million, 2008 - 4.4 million and 2007 - 1.4 million.
In January 2008, AFG paid $75 million in cash (including transaction costs) to acquire approximately 67% of Marketform Group Limited, an agency that focuses on medical malpractice and other specialty property and casualty insurance products outside of the United States using a Lloyd's platform. As part of the acquisition, AFG also provided a 23 million pounds sterling letter of credit and became a corporate member in Lloyd's Syndicate 2468, which is managed by Marketform. Approximately $36 million of the acquisition cost was recorded as an intangible asset for the present value of future profits from the acquired business and is being amortized over the estimated retention period of seven years.
AFG acquired Strategic Comp Holdings, LLC in January 2008 for $37 million in cash. 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. The entire purchase price was recorded as intangible renewal rights and is being amortized over the estimated retention period of seven years.
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 and customized programs for small to mid-sized businesses, (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions (including collateral and mortgage protection insurance), surety and fidelity products and trade credit insurance, and (iv) California workers' compensation. AFG's annuity and supplemental insurance business markets traditional fixed, indexed and variable annuities and a variety of supplemental insurance products. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
(b) Includes a charge of $8.5 million in 2009, a benefit of $8.1 million in 2008, and a
charge of $25.5 million in 2007 related to deferred gains on retroactive reinsurance.
(c) Includes second quarter special charges of $12.0 million in 2008 and $44.2 million
Level 1 - Quoted prices for identical assets or liabilities in active markets (markets in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis). AFG's Level 1 financial instruments consist primarily of publicly traded equity securities and highly liquid government bonds for which quoted market prices in active markets are available.
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets. AFG's Level 2 financial instruments include separate account assets, corporate and municipal fixed maturity securities and MBS priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, corroborated broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2.
AFG's management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. This data is reviewed by internal investment professionals who ensure the fair value is representative of an exit price and consistent with accounting standards.
(a) Variable annuity liabilities equal the fair value for variable annuity assets.
Approximately 4% of the total assets measured at fair value were Level 3 assets. Approximately 55% of these assets were MBS whose fair values were determined primarily using non-binding broker quotes; the balance was primarily private placement debt and equity securities whose fair values were determined internally using significant unobservable inputs, including the evaluation of underlying collateral and issuer creditworthiness, as well as certain Level 2 inputs such as comparable yields and multiples on similar publicly traded issues.
The following tables show gross unrealized losses (in millions) on fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2009 and 2008.
At December 31, 2009, the gross unrealized losses on fixed maturities of $488 million relate to approximately 1,263 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 61% of the gross unrealized loss and 84% of the fair value. MBS and all other corporate bonds comprised approximately 84% of the fair value of the available for sale fixed maturity portfolio at December 31, 2009, and 96% of the gross unrealized losses. Gross unrealized losses on these two groups
At December 31, 2009, gross unrealized losses on AFG's MBS represented 69% of the total gross unrealized loss on fixed maturity securities. Over 98% of AFG's commercial MBS are AAA-rated. Of the residential MBS that have been in an unrealized loss position ("impaired") for 12 months or more (429 securities), approximately 58% of the unrealized losses and 78% of the fair value relate to investment grade rated securities. AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. For 2009, AFG recorded in earnings $96 million in other-than-temporary impairment charges related to its residential MBS. For the same period, AFG recorded $256 million in other comprehensive income (loss) for the non-credit portion of these impairment charges.
AFG recognized in earnings approximately $122 million in other-than-temporary impairment charges on "all other corporate" securities during 2009. Management concluded that the unrealized losses were due primarily to widened credit spreads and sector related issues and that no additional charges for other-than-temporary impairment were required based on many factors, including AFG's ability and intent to hold the investments for a period of time sufficient to allow for anticipated recovery of its amortized cost, the length of time and the extent to which fair value has been below cost, analysis of historical and projected company-specific financial data, the outlook for industry sectors, and credit ratings.
The table below sets forth the scheduled maturities of available for sale fixed maturities as of December 31, 2009 (in millions). Securities with sinking funds and other securities that pay down principal over time are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. MBS had an average life of approximately four years at December 31, 2009.
In addition to adjusting equity securities and fixed maturity securities classified as "available for sale" to fair value, GAAP requires that deferred policy acquisition costs related to annuities and certain other balance sheet amounts be adjusted to the extent that unrealized gains and losses from securities would result in adjustments to those balances had the unrealized gains or losses actually been realized. The following table shows the components of the net unrealized gain (loss) on securities that is included in Accumulated Other Comprehensive Income (Loss) in AFG's Balance Sheet.
Realized gains includes net gains of $157.1 million in 2009, $81.0 million in 2008 and $5.2 million in 2007 from the mark-to-market of certain MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. Gross realized gains and losses (excluding impairment writedowns and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
Certain securities held in AFG's investment portfolio, primarily interest-only MBS with interest rates that float inversely with short-term rates, are considered to contain embedded derivatives. AFG has elected to measure these securities (in their entirety) at fair value in its financial statements. These investments are part of AFG's overall investment strategy and represent a small component of AFG's overall investment portfolio.
AFG has entered into $600 million notional amount of pay-fixed interest rate swaptions (options to enter into pay-fixed/receive floating interest rate swaps at future dates expiring between 2012 and 2015) to mitigate interest rate risk in its annuity operations. AFG paid $16.4 million to purchase these swaptions, which represents its maximum potential economic loss over the life of the contracts.
As discussed under "Reinsurance" in Note A, certain reinsurance contracts in AFG's annuity and supplemental insurance business are considered to contain embedded derivatives.
The following table summarizes the gain (loss) included in the Statement of Earnings for changes in the fair value of these derivatives for 2009 (in millions):
The change in unrealized DPAC during 2009 reflects improvement in the fair value of the fixed maturity portfolio.
The PVFP amounts in the table above are net of $147.9 million and $118.5 million of accumulated amortization at December 31, 2009 and 2008, respectively. Amortization of the PVFP was $29.4 million in 2009, $30.4 million in 2008 and $17.7 million in 2007. The increase in amortization for 2008 compared to 2007 reflects an increase in PVFP under purchase accounting for the September 2007 acquisition of the GAFRI stock not previously owned by AFG. 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.
Changes in the carrying value of goodwill during 2008 and 2009, by reporting segment, are presented in the following table (in millions):
AFG recorded a goodwill impairment charge of $2.6 million (included in realized gains (losses) on subsidiaries) in the third quarter of 2009 to write off the goodwill associated with an annuity and supplemental insurance agency subsidiary. A review for impairment was prompted by a decrease in estimated future earnings from this agency. Fair value of the agency was estimated using
the present value of expected future cash flows. The addition to goodwill in 2008 reflects primarily a refinement of the purchase price allocation for the acquisition of the GAFRI stock not previously owned by AFG.
At December 31, 2009, scheduled principal payments on debt for the subsequent five years were as follows: 2010 - $12.3 million, 2011 - $20.1 million, 2012 - $27.5 million, 2013 - $19.9 million and 2014 - $1.6 million.
AFG can borrow up to $500 million under its revolving credit facility, which expires in March 2011. Amounts borrowed bear interest at rates ranging from .5% to 1.25% (currently .75%) over LIBOR based on AFG's credit rating. At December 31, 2009, no borrowings were outstanding under the credit facility.
Notes due 2019 and used the proceeds to repay borrowings under the bank credit facility. As a result of this issuance, AFG terminated its 364 day bank credit facility under which it could borrow up to $120 million.
During 2009, AFG subsidiaries borrowed a total of $59.2 million at interest rates ranging from 3.8% to 4.25% over LIBOR (weighted average interest rate of 4.33% at December 31, 2009). The loans require principal payments over the next four years.
Cash interest payments on long-term debt were $64 million in 2009, $58 million in 2008 and $61 million in 2007. 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: 2009 - $7.4 million; 2008 - $8.3 million; and 2007 - $9.3 million.
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility over a period equal to the estimated term. Beginning in 2008, the expected term was estimated based on historical exercise patterns and post vesting cancellations. The weighted average fair value of options granted during 2009, 2008 and 2007 was $5.85 per share, $7.93 per share and $9.70 per share, respectively, based on the following assumptions:
Total compensation expense related to stock incentive plans of AFG and its subsidiaries for 2009, 2008 and 2007 was $13.3 million, $15.2 million (including $2 million in non-deductible stock awards) and $16.2 million (including $3.9 million in non-deductible stock awards), respectively. Related tax
(b) Includes $98.0 million in net pretax unrealized losses ($62.7 million net of tax) related to securities for
which only the credit portion of an other-than-temporary impairment has been recorded in earnings.
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2009 (in millions):
The change in the deferred tax asset/liability related to investment securities at year end 2009 compared to 2008 is due primarily to the change in unrealized gains/losses on fixed maturity securities. The gross deferred tax asset has been reduced by a valuation allowance including $50.1 million 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 total unrecognized tax benefits and related interest that, if recognized, would impact the effective tax rate is $46.2 million at December 31, 2009. This amount does not include tax and interest totaling $16.5 million paid to the IRS in 2005 and 2006 for which a suit for refund has been filed (discussed below). AFG's provision for income taxes for 2009, 2008 and 2007 included $1.5 million, $3.0 million and $2.3 million, respectively, of interest (net of federal benefit). The 2007 provision also included a $2.0 million benefit due to a reduction of penalties. AFG's liability for interest related to unrecognized tax benefits was $10.3 million at December 31, 2009 and $9.4 million at December 31, 2008 (net of federal benefit); no penalties were accrued at those dates.
AFG's 2008 and 2009 tax years remain subject to examination by the IRS. In addition, AFG has several tax years for which there are ongoing disputes. AFG filed a suit for refund in the U.S. District Court in Southern Ohio as a result of its dispute with the IRS regarding the calculation of tax reserves for certain annuity reserves pursuant to Actuarial Guideline 33. Oral arguments on joint motions for summary judgment were presented in June 2009. It is likely that within the next twelve months a final decision will be reached in this case. Ultimate resolution may require revised tax calculations for the years 1996-2005, possibly requiring a revised application of tax attribute carryovers or carrybacks, both capital and ordinary, to the affected years, and is contingent upon formal review and acceptance by the IRS. Resolution of the open years could result in a decrease in the liability for unrecognized tax benefits by up to $35.9 million.
The insurance group's liability for asbestos and environmental reserves was $457 million at December 31, 2009; related recoverables from reinsurers (net of allowances for doubtful accounts) at that date were $79 million.
At December 31, 2009, American Premier and its subsidiaries had liabilities for environmental and personal injury claims aggregating $89 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.
At December 31, 2009, GAFRI had a liability of approximately $6 million for environmental costs and certain other matters associated with the sales of its former manufacturing operations.
The operations of certain AFG 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, 2009 (in millions, except per share amounts). Quarterly earnings per share do not add to year-to-date amounts due to changes in shares outstanding.
Pretax realized gains (losses) on securities (including other-than-temporary impairments) and favorable (unfavorable) prior year development of AFG's liability for losses and loss adjustment expenses ("LAE") were as follows (in millions):
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). Favorable development in 2009 was primarily in the Specialty financial and Property and transportation sub-segments. In 2008 and 2007, AFG had significant favorable reserve development in the Specialty casualty and Property and transportation sub-segments.
Includes a charge of $2 million in 2009, a benefit of $12 million in 2008 and a charge of $23 million in 2007 related to deferred gains on retroactive reinsurance.
AFG has guaranteed all of the outstanding public debt of GAFRI and GAFRI's wholly-owned subsidiary, AAG Holding Company, Inc. In addition, GAFRI guarantees AAG Holding's public debt. The AFG and GAFRI guarantees are full and unconditional and joint and several. Condensed consolidating financial statements for AFG are as follows:
The information required by the following Items will be included in AFG's definitive Proxy Statement for the 2010 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission within 120 days after the end of the Registrant's fiscal year and is incorporated herein by reference.
(b) Reflects dividend of GAFRI Common Stock by GAI of $681.8 million in 2007.
(a) Includes amounts contributed in 2007 to fund GAFRI's acquisition of its