Subsidiaries of AFG own several buildings in downtown Cincinnati. AFG and its affiliates occupy approximately half of the aggregate 675,000 square feet of commercial and office space in these buildings.
AFG’s net earnings per share (diluted), determined in accordance with GAAP, includes certain items that may not be indicative of its ongoing core operations. AFG believes that its core net operating earnings per share provides management, financial analysts, rating agencies and investors with an understanding of the results from the ongoing operations of the Company by excluding the impact of net realized investment gains and losses and other items that are not necessarily indicative of operating trends. AFG’s management uses core net operating earnings to evaluate financial performance against historical results because it believes this provides a more comparable measure of its continuing business. Core net operating earnings is also used by AFG’s management as a basis for strategic planning and forecasting. Core net operating earnings per share (diluted) is a non-GAAP financial measure. See
At December 31, 2016, AFG (parent) held approximately $260 million in cash and securities and had $500 million available under a bank line of credit, which expires in June 2021.
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.
the fourth quarter 2016 tax benefits from the National Interstate merger and Neon restructuring,
AFG’s ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.85 for the year ended December 31, 2016. Excluding annuity benefits, this ratio was 8.62. Although the ratio excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
net proceeds of which contributed $296 million in 2016 and $145 million in 2015 to net cash provided by financing activities. Redemptions of long-term debt was an $18 million use of cash in 2016 and a $192 million use of cash in 2015. During 2016, AFG repurchased $133 million of its Common Stock compared to $126 million repurchased in 2015, which accounted for a $7 million decrease in net cash provided by financing activities in 2016 compared to 2015. Additionally, during the fourth quarter of 2016, $315 million was used to fund the acquisition of the noncontrolling interest in National Interstate Corporation. Financing activities also include issuances and retirements of managed investment entity liabilities, which are nonrecourse to AFG and presented separately in AFG’s Balance Sheet. Issuances of managed investment entity liabilities exceeded retirements by $693 million in 2016 compared to $890 million in 2015, accounting for a $197 million decrease in net cash provided by financing activities in 2016 compared to 2015. See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements.
In June 2016, AFG replaced its bank credit facility with a five-year, $500 million revolving credit line. Amounts borrowed under this agreement bear interest at rates ranging from 1.00% to 1.875% (currently 1.375%) over LIBOR based on AFG’s credit rating. There were no borrowings under this agreement, or under any other parent company short-term borrowing arrangements, during 2016.
On November 10, 2016, AFG acquired the 49% of National Interstate Corporation (“NATL”) not previously owned by AFG’s wholly-owned subsidiary, Great American Insurance Company (“GAI”) for $315 million ($32.00 per share) in cash in a merger transaction. In addition, NATL paid a one-time special cash dividend of $0.50 per share to its shareholders immediately prior to the merger closing ($5 million was paid to noncontrolling shareholders). See Note B - “Acquisitions and Sale of Businesses” to the financial statements.
In November 2015, AFG issued $150 million of 6% Subordinated Debentures due 2055. In September 2015, AFG redeemed its $132 million of 7% Senior Notes due 2050 at par using cash on hand at the parent company.
Subsidiary Liquidity Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions, which provides the annuity operations with an additional source of liquidity. These advances further the FHLB’s mission of improving access to housing by increasing liquidity in the residential mortgage-backed securities market. At December 31, 2016, GALIC had $935 million in outstanding advances from the FHLB (included in annuity benefits accumulated), bearing interest at rates ranging from 0.03% to 0.53% over LIBOR (average rate of 1.18% at December 31, 2016). In the fourth quarter of 2016, GALIC extended the terms on advances totaling $200 million by four years. While these advances must be repaid between 2018 and 2021 ($285 million in 2018, $500 million in 2020 and $150 million in 2021), GALIC has the option to prepay all or a portion of the advances. GALIC has invested the proceeds from the advances in fixed maturity securities with similar expected lives as the advances for the purpose of earning a spread over the interest payments due to the FHLB. At December 31, 2016, GALIC estimated that it had additional borrowing capacity of approximately $300 million from the FHLB.
In the annuity business, where profitability is largely dependent on earning a spread between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG’s annuity products. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to contractually guaranteed minimum interest rates (“GMIRs”). AFG began selling policies with GMIRs below 2% in 2003; almost all new business since late 2010 has been issued with a 1% GMIR. At December 31, 2016, AFG could reduce the average crediting rate on approximately $22 billion of traditional fixed and fixed-indexed annuities without guaranteed withdrawal benefits by approximately 80 basis points (on a weighted average basis). Annuity policies are subject to 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.
latter part of 2016 in response to rising market investment yields. In addition to lowering the cost of funds, AFG reduced certain commission rates and guaranteed withdrawal benefits on annuities sold in 2016.
For statutory accounting purposes, equity securities of non-affiliates and equity call options used in the fixed-indexed annuity business are generally carried at fair value. At December 31, 2016, AFG’s insurance companies owned publicly traded equity securities with a fair value of $1.51 billion and equity call options with a fair value of $492 million. 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.
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 $560 million in 2016 compared to $33 million in 2015 and $432 million in 2014. The $560 million in net cash used in investing activities in 2016 as compared to the $33 million in 2015 is significantly higher due primarily to increased capital contributions to a subsidiary to fund the acquisition of the noncontrolling interest in National Interstate Corporation. The $33 million of parent holding company net cash used in investing activities in 2015 was significantly lower than the $432 million in net cash used in investing activities in 2014 due primarily to capital contributions made to a subsidiary to fund the $399 million investment in Summit in 2014.
Parent Net Cash Provided by (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 under “Parent Holding Company Liquidity.” Parent holding company net cash provided by financing activities was $13 million in 2016 compared to net cash used in financing activities of $232 million in 2015 and $171 million in 2014. The $245 million increase in net cash provided by financing activities in 2016 as compared to 2015 primarily reflects proceeds from additional long-term borrowings. The $61 million increase in net cash used in financing activities in 2015 as compared to 2014 reflects the 2015 redemption of $132 million of 7% Senior Notes due 2050, partially offset by a $65 million decrease in common stock repurchases.
Fixed income investment funds are generally invested in securities with intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions. At December 31, 2016, the average life of AFG’s fixed maturities was about 6-1/2 years.
Summarized information for the unrealized gains and losses recorded in AFG’s Balance Sheet at December 31, 2016, is shown in the following table (dollars in millions). Approximately $288 million of available for sale fixed maturity securities and $41 million of available for sale equity securities had no unrealized gains or losses at December 31, 2016.
The table below sets forth the scheduled maturities of AFG’s available for sale fixed maturity securities at December 31, 2016, 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.
The following table (dollars in millions) summarizes the unrealized losses for all securities with unrealized losses by issuer quality and the length of time those securities have been in an unrealized loss position:
Based on its analysis of the factors listed above, 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, 2016. Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers’ creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG’s ability or intent change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG’s investment portfolio could have a significant adverse effect on AFG’s liquidity. For information on AFG’s realized gains (losses) on securities, including charges for other-than-temporary impairment, see “Results of Operations - Consolidated Realized Gains (Losses) on Securities.”
Following is a discussion of certain critical variables affecting the estimation of loss reserves of the more significant long-tail lines of business (asbestos and environmental liabilities are separately discussed below). Many other variables may also impact ultimate claim costs.
The judgments and uncertainties surrounding management’s reserve estimation process and the potential for reasonably possible variability in management’s most recent reserve estimates may also be viewed by looking at how recent historical estimates of reserves have developed. The following table shows (dollars in millions) what the impact on AFG’s net earnings would be on the more significant lines of business if the December 31, 2016, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
AFG recorded adverse prior year reserve development of $61 million in 2016 related to its other liability - occurrence coverage due primarily to increased severity in New York contractor claims. AFG recorded favorable prior year reserve development of $7 million in 2015 and $15 million in 2014 as both the frequency and severity of claims in excess and umbrella liability coverages were lower than previously projected.
AFG recorded adverse prior year reserve development of $28 million in 2016, $20 million in 2015 and $28 million in 2014 for this line of business as claim severity has been significantly higher than expected in accident years 2010 and subsequent.
Reserves of foreign operations relate primarily to the operations of Neon Underwriting Limited (“Neon”), AFG’s wholly-owned United Kingdom-based Lloyd’s insurer. Historically, the largest line of business written by Neon was non-U.S. medical malpractice, which provides coverage for injuries and damages caused by medical care providers, including but not limited to, hospitals and their physicians. Although Neon offered this product in approximately 30 countries, the majority of the business has been written in the United Kingdom, Australia and Italy. In addition, Neon writes marine, equine, professional indemnity, directors and officers liability, catastrophe and cyber insurance and previously offered general liability policies. Significant variables in estimating the loss reserves include:
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, 2016, the property and casualty insurance segment’s three-year survival ratios compare favorably with industry survival ratios published by A.M. Best (as of December 31, 2015) as detailed in the following table:
$5 million (net of reinsurance) and its environmental reserves by $31 million (net of reinsurance). Over the past few years, the focus of AFG’s asbestos claims 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 insurance segment’s asbestos reserve increases in recent years. AFG is seeing modestly increasing estimates for indemnity and defense compared to prior studies. Overall, the rate of new asbestos cases received is down modestly. The increase in property and casualty environmental reserves was primarily associated with updated estimates of site investigation costs with respect to existing sites and newly identified sites. AFG is seeing increased legal defense costs in environmental claims generally, as well as a number of claims and sites where the estimated investigation and remediation costs have increased. As in past years, there were no new or emerging broad industry trends that were identified in the review.
Run-off Long-term Care Insurance In December 2015, AFG completed the sale of United Teacher Associates Insurance Company and Continental General Insurance Company, the legal entities containing substantially all of its run-off long-term care insurance business, to HC2 Holdings, Inc. (“HC2”) for approximately $13 million in net proceeds. AFG may also receive up to $13 million of additional proceeds from HC2 in the future contingent upon the release of certain statutory-basis liabilities of the legal entities sold by AFG. In connection with obtaining regulatory approval for the transaction, AFG agreed to provide up to an aggregate of $35 million of capital support for the insurance companies, on an as-needed basis to maintain specified surplus levels, subject to immediate reimbursement by HC2 through a five-year capital maintenance agreement. With the completion of this sale, AFG divested substantially all of its long-term care business (96% as measured by net statutory reserves as of November 30, 2015) and retained only a small block of long-term care insurance (1,600 policies) with approximately $37 million of reserves at December 31, 2016. AFG will continue to service and accept renewal premiums on its remaining outstanding policies, which are guaranteed renewable.
Includes a gain of $37 million in 2016 and a loss of $6 million in 2015, representing the change in fair value of AFG’s CLO investments plus $17 million and $15 million in 2016 and 2015, respectively, in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $29 million and $28 million in 2016 and 2015, respectively, in distributions recorded as interest expense by the CLOs.
Includes $16 million representing the change in fair value of AFG’s CLO investments plus $25 million in CLO management fees earned.
Net earnings attributable to shareholders increased $256 million in the fourth quarter of 2016 compared to the same period in 2015 due primarily to the fourth quarter 2016 tax benefits related to the National Interstate merger and Neon restructuring, net realized gains on securities in the 2016 period compared to net realized losses on securities in the 2015 period and higher core net operating earnings. Core net operating earnings increased $40 million in the fourth quarter of 2016 compared to the same period in 2015 reflecting higher operating earnings in the property and casualty and annuity segments.
Net earnings attributable to shareholders decreased $100 million for the full-year of 2015 compared to the same period in 2014 due primarily to the loss on the sale of substantially all of AFG’s run-off long-term care insurance business, higher special A&E charges and net realized losses on securities in 2015 compared to net realized gains on securities in 2014, partially offset by the gain on the sale of a hotel and an apartment property and higher core net operating earnings. Core net operating earnings increased $47 million for the full-year of 2015 compared to the same period in 2014 due primarily to higher underwriting profit and higher net investment income in the property and casualty insurance segment and improved core operating results in the run-off long-term care and life segment.
RESULTS OF OPERATIONS - QUARTERS ENDED DECEMBER 31, 2016 AND 2015
AFG’s property and casualty insurance operations contributed $182 million in GAAP pretax earnings in the fourth quarter of 2016 compared to $179 million in the fourth quarter of 2015, an increase of $3 million (2%). Property and casualty core pretax earnings were $182 million in the fourth quarter of 2016 compared to $164 million in the fourth quarter of 2015, an increase of
AFG’s combined ratio has been better than the industry average for 29 of the last 31 years. Management believes that AFG’s insurance operations have performed better than the industry as a result of its specialty niche focus, product line diversification, stringent underwriting discipline and alignment of compensation incentives.
Gross written premiums (“GWP”) for AFG’s property and casualty insurance segment were $1.44 billion for the fourth quarter of 2016 compared to $1.36 billion for the fourth quarter of 2015, an increase of $85 million (6%). 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 25% of gross written premiums for the fourth quarter of 2016 compared to 22% for the fourth quarter of 2015, an increase of 3 percentage points. 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 $1.08 billion for the fourth quarter of 2016 compared to $1.06 billion for the fourth quarter of 2015, an increase of $27 million (3%). 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 $1.14 billion for the fourth quarter of 2016 compared to $1.12 billion for the fourth quarter of 2015, an increase of $24 million (2%). Detail of AFG’s property and casualty net earned premiums is shown below (dollars in millions):
The $85 million increase in gross written premiums in the fourth quarter of 2016 compared to the fourth quarter of 2015 reflects growth in each of the Specialty property and casualty insurance sub-segments. Overall average renewal rates were up 1% in the fourth quarter of 2016.
Property and transportation Gross written premiums increased $62 million (12%) in the fourth quarter of 2016 compared to the fourth quarter of 2015. This increase was due primarily to higher year-over-year gross written premiums in the crop business. Excluding crop, gross written premiums were comparable to the prior year period. Average renewal rates increased approximately 2% for this group in the fourth quarter of 2016, including a 4% increase in National Interstate’s renewal rates. Reinsurance premiums ceded as a percentage of gross written premiums increased 5 percentage points in the fourth quarter of 2016 compared to the fourth quarter of 2015 reflecting higher cessions in the crop business, primarily related to growth in a rainfall-related product, which is heavily reinsured.
The Specialty property and casualty insurance operations generated an underwriting profit of $110 million for the fourth quarter of 2016 compared to $100 million in the fourth quarter of 2015, an increase of $10 million (10%). The higher underwriting profit in the fourth quarter of 2016 reflects improved underwriting results in the Property and transportation and Specialty financial sub-segments, partially offset by lower underwriting profit in the Specialty casualty sub-segment. Overall catastrophe losses were $12 million (1.1 points on the combined ratio) in the fourth quarter of 2016 compared to $9 million (0.8 points on the combined ratio) in the fourth quarter of 2015.
Property and transportation Underwriting profit for this group was $75 million for the fourth quarter of 2016 compared to $34 million in the fourth quarter of 2015, an increase of $41 million (121%) reflecting higher underwriting profit in the crop insurance business, primarily the result of favorable growing conditions and relatively stable commodity pricing.
Specialty financial Underwriting profit for this group was $20 million for the fourth quarter of 2016 compared to $15 million in the fourth quarter of 2015, an increase of $5 million (33%) reflecting higher underwriting profit in the financial institutions, surety and trade credit businesses.
AFG’s overall loss and LAE ratio was 63.7% for the fourth quarter of 2016 compared to 61.8% for fourth quarter of 2015, an increase of 1.9 percentage points. The components of AFG’s property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
The current accident year loss and LAE ratio, excluding catastrophe losses for AFG’s Specialty property and casualty insurance operations was 61.7% for the fourth quarter of 2016 compared to 61.4% for the fourth quarter of 2015, an increase of 0.3%.
Property and transportation The 4.8 percentage point decrease in the loss and LAE ratio for the current year, excluding catastrophe losses reflects a decrease in the loss and LAE ratio of the crop business and, to a lesser extent, the equine business and the Singapore branch in the fourth quarter of 2016 compared to the fourth quarter of 2015.
Specialty financial The 2.3 percentage point increase in the loss and LAE ratio for the current year, excluding catastrophe losses reflects an increase in the loss and LAE ratio of the financial institutions business.
Property and transportation Net adverse reserve development of $13 million in the fourth quarter of 2016 reflects reserve strengthening at National Interstate and higher than expected claim severity in the ocean marine business. Net adverse reserve development of $8 million in the fourth quarter of 2015 reflects higher than expected claim severity in commercial auto liability insurance at National Interstate and higher than expected claim frequency in the ocean marine business, partially offset by lower than expected claim severity in the property and inland marine business.
Specialty casualty Net adverse reserve development of $3 million in the fourth quarter of 2016 reflects higher than anticipated severity in New York contractor claims, adverse reserve development at Neon and higher than anticipated claim severity in the targeted programs business, partially offset by lower than anticipated claim frequency and severity in the workers’ compensation businesses. Net favorable reserve development of $7 million in the fourth quarter of 2015 reflects lower than anticipated claim severity in workers’ compensation business, excess liability insurance and directors and officers liability insurance, partially offset by adverse reserve development at Neon.
Other specialty In addition to the reserve development discussed above, total Specialty prior year reserve development includes net favorable reserve development of $1 million in the fourth quarter of 2015 reflecting amortization of the deferred gain on the retroactive insurance transaction entered into in connection with the sale of businesses in 1998 and 2001 and reserve development associated with AFG’s internal reinsurance program.
AFG’s property and casualty commissions and other underwriting expenses (“U/W Exp”) were $305 million in the fourth quarter of 2016 compared to $327 million for the fourth quarter of 2015, a decrease of $22 million (7%). AFG’s underwriting expense ratio, calculated as commissions and other underwriting expenses divided by net premiums earned, was 26.7% for the fourth quarter of 2016 compared to 29.2% for the fourth quarter of 2015, a decrease of 2.5 percentage points. Detail of AFG’s property and casualty commissions and other underwriting expenses and underwriting expense ratios is shown below (dollars in millions):
AFG’s overall expense ratio decreased 2.5% in the fourth quarter of 2016 as compared to the fourth quarter of 2015 reflecting an increase in ceding commissions received from reinsurers.
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums decreased 5.4 percentage points in the fourth quarter of 2016 compared to the fourth quarter of 2015 reflecting an increase in ceding commissions received from reinsurers in the crop business.
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.1 percentage points in the fourth quarter of 2016 compared to the fourth quarter of 2015.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums decreased 2.3 percentage points in the fourth quarter of 2016 compared to the fourth quarter of 2015 reflecting an increase in ceding commissions received from reinsurers and the impact of higher premiums on the ratio in the financial institutions business.
Net investment income in AFG’s property and casualty operations was $85 million in the fourth quarter of 2016 compared to $74 million in the fourth quarter of 2015, an increase of $11 million (15%). In recent years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG’s investment portfolio yield. The average invested assets and overall yield earned on investments held by AFG’s property and casualty operations are provided below (dollars in millions):
AFG’s annuity operations contributed $132 million in pretax earnings in the fourth quarter of 2016 compared to $101 million in the fourth quarter of 2015, an increase of $31 million (31%). AFG’s annuity segment results for the fourth quarter of 2016 as compared to the fourth quarter of 2015 reflect higher investment income from certain investments that are required to be carried at fair value through earnings and an 11% increase in average annuity investments (at amortized cost). In addition, the annuity segment’s earnings in the fourth quarter of 2016 benefitted from the positive impact of a significant increase in interest rates on the fair value accounting for fixed-indexed annuities (“FIAs”). Both periods reflect the positive impact of strong stock market performance on fair value accounting for FIAs. These improved results were partially offset by the impact of lower investment yields due to the run-off of higher yielding investments. AFG’s periodic detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations resulted in a net annuity expense reduction of $1 million in the fourth quarter of 2016 compared to $10 million in the fourth quarter of 2015.
Net investment income for the fourth quarter of 2016 was $346 million compared to $309 million for the fourth quarter of 2015, an increase of $37 million (12%). This increase reflects primarily the growth in AFG’s annuity business and higher income from certain investments that are required to be carried at fair value through earnings, partially offset by the impact of lower investment yields. The overall yield earned on investments in AFG’s fixed annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), increased by 0.07 percentage points to 4.72% from 4.65% in the fourth quarter of 2016 compared to the fourth quarter of 2015. This increase in net investment yield reflects higher income from certain investments that are required to be carried at fair value through earnings, partially offset by (i) the investment of new premium dollars at lower yields as compared to the existing investment portfolio and (ii) the impact of the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets. During 2016, $4.0 billion in annuity segment investments with an average yield of 5.51% were redeemed or sold while the investments purchased during 2016 (with new premium dollars and the redemption/sale proceeds) had an average yield at purchase of 4.21%.
AFG’s net interest spread increased 0.17 percentage points to 2.70% from 2.53% in the fourth quarter of 2016 compared to the same period in 2015 due primarily to the impact of lower crediting rates and higher income from certain investments that are required to be carried at fair value through earnings, partially offset by lower in-force investment yields. Features included in current annuity product offerings allow AFG to achieve its desired profitability at a lower net interest spread than historical product offerings. As a result, AFG expects its net interest spread to narrow in the future.
Annuity policy charges and other miscellaneous income, which consist primarily of surrender charges, amortization of deferred upfront policy charges (unearned revenue) and income from sales of real estate were $13 million in the fourth quarter of 2016 compared to $11 million in the fourth quarter of 2015, an increase of $2 million (18%). The fourth quarter of 2016 includes gains of $2 million from the sale of real estate. Excluding the impact of unlocking charges related to unearned revenue, annuity policy charges and other miscellaneous income as a percentage of average fixed annuity benefits accumulated were 0.15% in both the fourth quarter of 2016 and 2015.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) for the fourth quarter of 2016 were $28 million compared to $19 million for the fourth quarter of 2015, an increase of $9 million (47%). As a percentage of average fixed annuity benefits accumulated, these net expenses increased 0.07 percentage points to 0.38% from 0.31% in the fourth quarter of 2016 compared to the fourth quarter of 2015. In addition to interest credited to policyholders’ accounts and the change in fair value of derivatives related to fixed-indexed annuities, annuity benefits expense also includes the following expenses (in millions, net of guaranteed withdrawal benefit fees):
Annuity other expenses were $27 million for the fourth quarter of 2016 compared to $22 million for the fourth quarter of 2015, an increase of $5 million (23%). Annuity other expenses represent primarily general and administrative expenses, as well as selling and issuance expenses that are not deferred. The increase in annuity other expenses reflects primarily growth in the business and an increase in the number of sales personnel focused on new initiatives and increased market share within existing financial institutions and retail marketing organizations in the fourth quarter of 2016 compared to the fourth quarter of 2015. As
AFG’s fixed-indexed annuities 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 the change in the fair value of the call option assets will generally offset the economic change in the liabilities from the index participation. Both the index-based component of the annuities and the related call options are considered derivatives that must be adjusted for changes in fair value 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 $54 million in the fourth quarter of 2016 and had a nominal impact on annuity benefits in the fourth quarter of 2015. The $54 million decrease in annuity benefits in the fourth quarter of 2016 reflects the positive impact of significantly higher than anticipated interest rates and strong market performance on the fair value of these derivatives. As a percentage of average fixed annuity benefits accumulated, this net expense reduction increased 0.71 percentage points to 0.73% in the fourth quarter of 2016 from 0.02% in the fourth quarter of 2015.
AFG’s net spread earned on fixed annuities increased 0.43 percentage points to 1.82% from 1.39% in the fourth quarter of 2016 compared to the same period in 2015 due primarily to the net impact of changes in the fair value of derivatives and related DPAC amortization offset discussed above and the 0.17 percentage points increase in AFG’s net interest spread.
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, excess benefits expected to be paid on future deaths and annuitizations (“EDAR”) and guaranteed withdrawal benefits. Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati. The following table is a progression of AFG’s annuity benefits accumulated liability for the three months ended December 31, 2016 and 2015 (in millions):
Assuming the rule becomes effective in its current form, AFG believes the biggest impact will be on insurance-only licensed agents whose sales represented less than 10% of its fourth quarter annuity premium. While AFG’s management continues to believe the adjustments required of AFG and its distribution partners to comply with the rule will impact 2017 annuity premiums, management does not believe the new rule will have a material impact on AFG’s results of operations.
In the fourth quarters of 2016 and 2015, AFG conducted a detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded net expense reductions related to its annuity business of $1 million in 2016 and $10 million in 2015, which impacted AFG’s financial statements as follows (in millions):
The net expense reduction from unlocking annuity assumptions in the fourth quarter of 2016 reflects the favorable impact of an increase in projected net interest spreads on in-force business, substantially offset by the unfavorable impact of (i) changes in projected policyholder annuitization and lapse behavior, (ii) an increase in the risk premium for the uncertainty in the cash flows component of the discount rates used to value the FIA-related embedded derivative and (iii) a slight decrease in projected stock market growth over the next three years. Reinvestment rate assumptions are based primarily on 7-year and 10-year corporate bond yields. For the 2016 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 4.24% in 2017, grading up ratably to an ultimate net reinvestment rate of 5.55% in 2022 and beyond.
The table below compares the reinvestment rate assumed in AFG’s fourth quarter unlockings for the next calendar year to the actual reinvestment rate achieved in that period (both net of investment expenses):
The 2015 net expense reduction was due primarily to the impact of changes in assumptions to reflect higher than previously projected net interest spreads as well as the impact of higher assets under management and expense discipline. For the 2015 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 3.87% in 2016, grading up ratably to an ultimate net reinvestment rate of 5.53% in 2022 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, 2016 and 2015 (in millions):
Net investment income (as a % of investments) of 4.72% and 4.65% for the three months ended December 31, 2016 and 2015, 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 AFG’s run-off long-term care and life segment reported GAAP pretax earnings of $2 million for the fourth quarter of 2016 compared to a loss of $4 million for the fourth quarter of 2015. Results for the 2015 period include a $4 million pretax non-core realized loss adjustment to the previously recognized $162 million estimated pretax loss on the sale of substantially all of AFG’s run-off long-term care insurance business that was recorded in the first quarter of 2015. See Note B - “Acquisitions and Sale of Businesses” to the financial statements. The following table details AFG’s GAAP and core earnings (loss) before income taxes from its run-off long-term care and life operations for the three months ended December 31, 2016 and 2015 (dollars in millions):
The decrease in long-term care net earned premiums and benefit expense in the fourth quarter of 2016 compared to the fourth quarter of 2015 is due to the sale of subsidiaries containing substantially all of AFG’s run-off long-term care insurance business in December of 2015.
Holding Company, Other and Unallocated - Results of Operations AFG’s net pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $50 million for the fourth quarter of 2016 compared to $45 million for the fourth quarter of 2015, an increase of $5 million (11%).
AFG recorded net investment income on investments held outside of its insurance operations of less than $1 million in the fourth quarter of 2016 compared to $3 million in the fourth quarter of 2015.
Consolidated Realized Gains (Losses) on Securities AFG’s consolidated realized gains (losses) on securities, which are not allocated to segments, were gains of $51 million in the fourth quarter of 2016 compared to losses of $21 million in the fourth quarter of 2015, an increase of $72 million (343%). Realized gains (losses) on securities consisted of the following (in millions):
In connection with the ongoing reorganization of AFG’s Neon Lloyd’s business, in December 2016, AFG undertook a restructuring that included the liquidation for tax purposes of the foreign subsidiary that is the parent of the Neon Lloyd’s operations, resulting in a taxable loss for U.S. tax purposes. AFG reported the $111 million tax benefit associated with this loss in the fourth quarter of 2016. See Note L - “Income Taxes” to the financial statements.
Excluding the tax benefit related to the acquisition of the noncontrolling interest in NATL and the tax benefit related to the Neon restructuring, AFG’s effective tax rate for the three months ended December 31, 2016 was 33%.
compared to $480 million in 2014, an increase of $97 million (20%). The increase in GAAP and core pretax earnings reflects higher underwriting profit across each of AFG’s property and casualty insurance sub-segments, higher net investment income (due primarily to the investment of cash acquired in the Summit acquisition on April 1, 2014) and lower net expenses. The increase in GAAP pretax earnings in 2015 also reflects pretax non-core gains of $51 million on the sale of a hotel and $15 million on the sale of an apartment property, partially offset by higher non-core special A&E charges in 2015 as compared to 2014.
The following table details AFG’s GAAP and core earnings before income taxes from its property and casualty insurance operations for the years ended December 31, 2016, 2015 and 2014 (dollars in millions):
Reinsurance premiums ceded (“Ceded”) for AFG’s property and casualty insurance segment were 27%, 26% and 27% of gross written premiums for the years ended December 31, 2016, 2015 and 2014, respectively. Detail of AFG’s property and casualty reinsurance premiums ceded is shown below (dollars in millions):
Specialty financial Gross written premiums increased $48 million (8%) in 2016 compared to 2015 due primarily to growth in the financial institutions and surety businesses. Average renewal rates for this group decreased approximately 1% in 2016. Reinsurance premiums ceded as a percentage of gross written premiums increased 1 percentage point in 2016 compared to 2015, reflecting higher cessions in the financial institutions business, partially offset by a decline in auto dealer business, which is heavily reinsured.
The Specialty property and casualty insurance operations generated an underwriting profit of $337 million in 2016 compared to $295 million in 2015, an increase of $42 million (14%). The higher underwriting profit in 2016 reflects higher underwriting profit in the Property and transportation sub-segment, partially offset by lower underwriting profit in the Specialty casualty and Specialty financial sub-segments. Overall catastrophe losses were $55 million (1.3 points on the combined ratio) in 2016 compared to $35 million (0.8 points on the combined ratio) in 2015.
Property and transportation Underwriting profit for this group was $166 million in 2016 compared to $48 million in 2015, an increase of $118 million (246%). This improvement reflects higher underwriting profit in the crop insurance business, primarily the result of favorable growing conditions and relatively stable commodity pricing and higher underwriting profits in the transportation and property and inland marine businesses. These improved results were partially offset by an increase of $10 million in catastrophe losses in 2016 compared to 2015.
Underwriting profit for this group was $87 million in 2015 compared to $64 million in 2014, an increase of $23 million (36%). This increase was driven by higher favorable prior year reserve development across the group and higher current year underwriting profitability in the fidelity and financial institutions businesses, partially offset by an increase of $6 million in catastrophe losses in 2015 compared to 2014.
Other specialty Underwriting profit for this group was $9 million in 2016 compared to $14 million in 2015, a decrease of $5 million (36%). The decrease is due primarily to lower favorable prior year loss development in the business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments.
AFG’s overall loss and LAE ratio was 63.8% in both 2016 and 2015 and 64.3% in 2014. The components of AFG’s property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
Property and transportation The 3.9 percentage point decrease in the loss and LAE ratio for the current year, excluding catastrophe losses in 2016 compared to 2015 reflects a decrease in the loss and LAE ratio of the crop, equine, transportation and property and inland marine businesses and the Singapore branch.
The 2.4 percentage point decrease in the loss and LAE ratio for the current year, excluding catastrophe losses in 2015 compared to 2014 reflects higher profitability in the agricultural businesses.
Net adverse reserve development of $16 million in 2014 reflects higher than expected severity in commercial auto liability losses written in the transportation businesses, partially offset by lower than expected claim frequency and severity in the property and inland marine business and lower than expected claim frequency in the agricultural operations.
Specialty casualty Net favorable reserve development of $13 million in 2016 reflects lower than anticipated claim frequency and severity in workers’ compensation business, lower than expected claim severity in directors and officers liability insurance and lower than expected claim frequency and severity in excess liability business, partially offset by adverse reserve development at Neon, higher than anticipated severity in New York contractor claims, higher than anticipated claim frequency and severity in general liability insurance and higher than expected claim frequency and severity in the targeted markets business.
Net favorable reserve development of $11 million in 2015 includes lower than anticipated claim severity in workers’ compensation business, lower than anticipated claim severity and frequency in excess liability insurance and lower than expected claim severity in directors and officers liability insurance, partially offset by adverse reserve development at Neon.
Net favorable reserve development of $7 million in 2014 reflects lower than expected claim severity in directors and officers liability insurance, lower than expected claim severity and frequency in excess liability insurance and lower than anticipated claim severity in specialty workers’ compensation business, partially offset by higher than expected severity in contractor claims and in a run-off book of casualty business and adverse reserve development at Neon.
amortization of the deferred gain on the retroactive insurance transaction entered into in connection with the sale of businesses in 1998 and 2001 and reserve development associated with AFG’s internal reinsurance program.
Asbestos and environmental reserve charges As previously discussed under “Uncertainties” - “Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG has established property and casualty reserves for claims related to environmental exposures and asbestos claims. Total charges recorded to increase reserves (net of reinsurance recoverable) for A&E exposures of AFG’s property and casualty group (included in loss and loss adjustment expenses) were $36 million in 2016, $67 million in 2015 and $24 million in 2014.
AFG’s property and casualty U/W Exp were $1.30 billion in 2015 compared to $1.17 billion in 2014, an increase of $132 million (11%). AFG’s underwriting expense ratio was 30.9% in 2015 compared to 30.2% in 2014, an increase of 0.7 percentage points.
The $132 million increase in commissions and other underwriting expenses in 2015 compared to 2014 reflects the acquisition of Summit in April 2014. The overall increase of 0.7% in AFG’s expense ratio in 2015 as compared to 2014 reflects higher profitability-based commissions paid to agents and brokers, partially offset by the impact of higher premiums on the ratio.
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums decreased 1.5 percentage points in 2016 compared to 2015 reflecting an increase in ceding commissions received from reinsurers in the crop business.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.7 percentage points in 2015 compared to 2014 reflecting higher profitability-based commissions paid to agents and brokers, 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 increased 0.5 percentage points in 2016 compared to 2015 due primarily to the impact of lower premiums at Neon on the ratio, partially offset by the impact of a charge in the second quarter of 2015 to write off certain previously capitalized project costs.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.2 percentage points in 2015 compared to 2014 due primarily to a charge of $6 million in the second quarter of 2015 to write off certain previously capitalized project costs, partially offset by the impact of higher premiums on the ratio.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.8 percentage points in 2015 compared to 2014 reflecting higher profitability-based commissions paid to agents, partially offset by the impact of higher premiums on the ratio.
Aggregate Aggregate commissions and other underwriting expenses for AFG’s property and casualty insurance segment includes $8 million of restructuring charges recorded as part of the $65 million non-core charge related to the exit of certain lines of business within Neon, AFG’s Lloyd’s-based insurer recorded in the second quarter of 2016. See “Net prior year reserve development” under “Property and Casualty Insurance Segment - Results of Operations” for the years ended December 31, 2016, 2015 and 2014.
The increase in average invested assets in the property and casualty insurance segment in 2016 as compared to 2015 is due primarily to growth in the segment. The $31 million increase in the property and casualty insurance segment’s net investment income reflects a $13 million increase in income from certain investments that are required to be carried at fair value through earnings, an $11 million increase in equity in the earnings of limited partnerships and similar investments and the increase in
average invested assets, partially offset by slightly higher investment expenses and lower yields available in the financial markets. The property and casualty segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 3.66% in 2016 compared to 3.56% in 2015, reflecting the higher income from investments carried at fair value and partnership earnings discussed above, partially offset by the impact of the lower current market yields discussed above.
GAAP other income and expenses, net for AFG’s property and casualty operations was a net expense of $9 million in 2016, net income of $32 million in 2015, and a net expense of $50 million in 2014. Core other income and expenses, net for AFG’s property and casualty operations was a net expense of $41 million, $34 million and $50 million in 2016, 2015 and 2014, respectively. The table below details the items included in GAAP and core other income and expenses, net for AFG’s property and casualty operations (in millions):
Excludes pretax non-core gains of $32 million on the sale of an apartment property in 2016 and $51 million on the sale of a hotel and $15 million on the sale of an apartment property in 2015.
AFG’s annuity operations contributed $368 million in pretax earnings in 2016 compared to $331 million in 2015, an increase of $37 million (11%). The increase in AFG’s annuity segment results in 2016 compared to 2015 reflects higher investment income
from certain investments that are required to be carried at fair value through earnings and a 12% increase in average annuity investments (at amortized cost), partially offset by lower investment yields due to the run-off of higher yielding investments and higher general and administrative expenses. Included in these results is the change in fair value of derivatives related to FIAs, which had a negative impact of $27 million in 2016 compared to $23 million in 2015. For 2016, the negative impact of a significant drop in interest rates on fair value accounting for FIAs was partially offset by the positive impact of an increase in the stock market. For 2015, fair value accounting for FIAs was negatively impacted by a significant decrease in the stock market and a slightly lower than expected increase in interest rates. AFG’s periodic detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations resulted in a net annuity expense reduction of $1 million in 2016 compared to $10 million in 2015.
Net investment income in 2016 was $1.36 billion compared to $1.22 billion in 2015, an increase of $132 million (11%). This increase reflects primarily the growth in AFG’s annuity business and higher income from certain investments that are required to be carried at fair value through earnings, partially offset by the impact of lower in-force investment yields. The overall yield earned on investments in AFG’s annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), decreased by 0.06 percentage points to 4.77% from 4.83% in 2016 compared to 2015. This decline in net investment yield reflects (i) the investment of new premium dollars at lower yields as compared to the existing investment portfolio and (ii) the impact of the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets, partially offset by higher investment income from certain investments that are required to be carried at fair value through earnings. During 2016, $4.0 billion in annuity segment investments with an average yield of 5.51% were redeemed or sold while the investments purchased during 2016 (with new premium dollars and the redemption/sale proceeds) had an average yield at purchase of 4.21%.
Net investment income in 2015 was $1.22 billion compared to $1.14 billion in 2014, an increase of $88 million (8%). This increase reflects primarily the growth in AFG’s annuity business, partially offset by the run-off of higher yielding investments. The overall yield earned on investments in AFG’s annuity operations declined by 0.20 percentage points to 4.83% from 5.03% in 2015 compared to 2014. This decline in net investment yield reflects (i) the investment of new premium dollars at lower yields as compared to the existing investment portfolio and (ii) the impact of the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets.
Interest credited - fixed in 2015 was $532 million compared to $497 million in 2014, an increase of $35 million (7%). 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 decreased 0.11 percentage points to 2.14% from 2.25% in 2015 compared to 2014.
AFG’s net interest spread increased 0.04 percentage points to 2.73% from 2.69% in 2016 compared to 2015 as the impact of lower in-force investment yields was more than offset by lower crediting rates and higher income from certain investments that are required to be carried at fair value through earnings. In addition, features included in current annuity product offerings allow AFG to achieve its desired profitability at a lower net interest spread than historical product offerings. As a result of these items, AFG expects its net interest spread to narrow in the future.
AFG’s net interest spread decreased 0.09 percentage points to 2.69% from 2.78% in 2015 compared to 2014 due primarily to the run-off of higher yielding investments, partially offset by lower crediting rates.
Annuity policy charges and other miscellaneous income were $55 million in 2015 compared to $63 million in 2014, a decrease of $8 million (13%). Excluding the impact of unlocking charges of $2 million in 2015 and unlocking income of $10 million in 2014 related to unearned revenue, annuity policy charges and other miscellaneous income were $57 million in 2015 and $53 million in 2014, an increase of $4 million (8%). This increase reflects the impact of $6 million in income from the sale of real estate recorded in 2015.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) were $92 million in 2016, $87 million in 2015 and $63 million in 2014, representing an increase of $5 million (6%) in 2016 compared to 2015 and an increase of $24 million (38%) in 2015 compared to 2014. As a percentage of average fixed annuity benefits accumulated, these net expenses decreased 0.02 percentage points to 0.33% from 0.35% in 2016 compared to 2015 and increased 0.07 percentage points to 0.35% from 0.28% in 2015 compared to 2014. In addition to interest credited to policyholders’ accounts and the change in fair value of derivatives related to fixed-indexed annuities, annuity benefits expense also includes the following expenses (in millions, net of guaranteed withdrawal benefit fees):
The $5 million increase in other annuity benefits, net of guaranteed withdrawal benefit fees in 2016 compared to 2015 primarily reflects growth in the business.
The table below illustrates the estimated impact of fair value accounting for derivatives related to fixed-indexed annuities on annuity acquisition expenses as a percentage of average fixed annuity benefits accumulated:
AFG’s fixed-indexed annuities 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 the change in the fair value of the call option assets will generally offset the economic change in the liabilities from the index participation. Both the index-based component of the annuities and the related call options are considered derivatives that must be adjusted for changes in fair value through earnings each period. The fair values of these derivatives are impacted by actual and expected stock market performance and interest rates as well as other factors. For a list of other factors impacting the fair value of the index-based component of AFG’s annuity benefits accumulated, see Note D - “Fair Value Measurements” to the financial statements. Excluding the impact of unlocking charges, the net change in fair value of derivatives related to fixed-indexed annuities increased annuity benefits by $53 million in 2016, $45 million in 2015 and $59 million in 2014. The increase in 2016 is due primarily to significantly lower than expected interest rates, partially offset by the impact of an increase in the stock market. The increase in 2015 reflects the negative impact of the decline in the stock market and lower than anticipated interest rates on these derivatives. The increase in 2014 is due primarily to the impact of lower than anticipated interest rates on these derivatives. As a percentage of average fixed annuity benefits accumulated, this net expense increased 0.01 percentage points to 0.19% from 0.18% in 2016 compared to 2015, and decreased 0.09 percentage points to 0.18% from 0.27% in 2015 compared to 2014.
AFG’s net spread earned on fixed annuities decreased 0.15 percentage points to 1.26% from 1.41% in 2015 compared to 2014 due primarily to the 0.09 percentage points decrease in AFG’s net interest spread, the impact of the decline in the stock market on guaranteed withdrawal benefit reserves, and higher general and administrative expenses, partially offset by income from the sale of real estate recorded primarily in the first quarter of 2015.
Management believes the 7% increase in annuity premiums in 2016 compared to 2015 is consistent with overall growth in the annuity industry, as sales of traditional fixed and fixed-indexed annuities have increased while sales of variable annuities have decreased. In addition, the increase reflects new products, additional staffing, and increased market share within existing financial institutions. This growth slowed in the second half of 2016 as a result of AFG’s reduction in crediting rates on its annuities in 2016 due to the decline in market interest rates; these crediting rate reductions were made to maintain appropriate returns on new business.
In 2016, 2015 and 2014, AFG conducted its detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded net expense reductions related to its annuity business of $1 million in 2016, $10 million in 2015 and $1 million in 2014, which impacted AFG’s financial statements as follows (in millions):
See “Results of Operations - Quarters ended December 31, 2016 and 2015 - Annuity Segment - Results of Operations - Annuity Unlocking” for a discussion of the overall net expense reduction from the periodic review of actuarial assumptions in 2016 and 2015.
The following table reconciles the net spread earned on AFG’s fixed annuities to overall annuity pretax earnings for 2016, 2015 and 2014 (in millions):
Net investment income (as a % of investments) of 4.77%, 4.83% and 5.03% in 2016, 2015 and 2014, 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 AFG’s run-off long-term care and life segment incurred GAAP pretax earnings of $4 million in 2016 compared to losses of $152 million and $10 million in 2015 and 2014, respectively. Results for 2015 include a $166 million pretax non-core realized loss on the sale of the subsidiaries containing substantially all of AFG’s run-off long-term care insurance business. See Note B - “Acquisitions and Sale of Businesses” to the financial statements. The following table details AFG’s GAAP and core earnings (loss) before income taxes from its run-off long-term care and life operations in 2016, 2015 and 2014 (dollars in millions):
Substantially all of the core earnings before income taxes in AFG’s run-off long-term care and life segment in 2015 represent earnings from AFG’s long-term care business and reflect the impact of improved claims experience, rate increases, and lower persistency. The 2014 GAAP and core pretax loss includes a $5 million loss on the commutation of a reinsurance agreement.
Holding Company, Other and Unallocated - Results of Operations AFG’s net GAAP pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $181 million in 2016 compared to compared to $176 million in 2015, an increase of $5 million (3%). AFG’s net core pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $176 million in 2016 compared to $160 million in 2015, an increase of $16 million (10%).
Other income in the table above includes $17 million, $15 million and $25 million in 2016, 2015 and 2014, respectively in management fees paid to AFG by the AFG-managed CLOs (AFG’s consolidated managed investment entities). The $25 million of management fees in 2014 includes $13 million of incentive management fees earned in connection with the liquidation of three CLOs. The management fees are eliminated in consolidation - see the other income line in the Consolidated MIEs column under “Results of Operations - Segmented Statement of Earnings.” Excluding amounts eliminated in consolidation,
The increase in average indebtedness for 2015 as compared to 2014 reflects the following financing transactions completed by AFG between January 1, 2014 and December 31, 2015:
AFG’s impairment charges on securities in 2016 consist of $93 million on equity securities and $38 million on fixed maturities. Approximately $70 million in impairment charges in 2016 are related to financial institutions, $19 million are on energy related investments and $7 million relates to a pharmaceutical company.
Consolidated Income Taxes AFG’s consolidated provision for income taxes was $119 million in 2016 compared to $195 million in 2015, a decrease of $76 million (39%). AFG’s consolidated provision for income taxes was $195 million in 2015 compared to $220 million in 2014, a decrease of $25 million (11%). See Note L - “Income Taxes” to the financial statements for an analysis of items affecting AFG’s effective tax rate.
Other noncontrolling interests includes $4 million related to the gain on the sale of an apartment property in the second quarter of 2016 and $6 million related to the gain on the sale of a hotel in the second quarter of 2015. Both properties were owned by an 80%-owned subsidiary of GAI.
guidance adopted in 2015 that affects the measurement of the fair value of CLO liabilities. Under the new guidance, there are no longer any CLO earnings or losses to be attributed to noncontrolling interests in AFG’s Statement of Earnings.
In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall: Recognition and Measurement of Financial Assets and Financial Liabilities which, among other things, requires equity investments that are not accounted for under the equity method of accounting to be measured at fair value with changes in fair value recognized in net income, clarifies that the need for a valuation allowance on a deferred tax asset related to available for sale securities should be evaluated with other deferred tax assets and modifies disclosure requirements for financial instruments. AFG will be required to adopt the updated guidance effective January 1, 2018 (early adoption is not permitted). Although recording changes in the fair value of investments in equity securities in net income will result in more volatility in AFG’s Statement of Earnings, it is not expected to have a material effect on the carrying value of AFG’s investments or on overall shareholders’ equity as AFG’s investments in equity securities are currently carried at fair value through accumulated other comprehensive income.
In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments, which provides a new credit loss model for determining credit-related impairments for financial instruments measured at amortized cost (e.g. mortgage loans or reinsurance recoverables) and requires an entity to estimate the credit losses expected over the life of an exposure or pool of exposures. The estimate of expected credit losses considers historical information, current information, as well as reasonable and supportable forecasts, including estimates of prepayments. The expected credit losses, and subsequent increases or decreases in such losses, will be recorded immediately through realized gains (losses) as an allowance that is deducted from the amortized cost basis of the financial asset, with the net carrying value of the financial asset presented on the balance sheet at the amount expected to be collected. The updated guidance also amends the current other-than-temporary impairment model for available for sale debt securities by requiring the recognition of impairments relating to credit losses through an allowance account and limits the amount of credit loss to the difference between a security’s amortized cost basis and its fair value. Subsequent increases or decreases in expected credit losses will be
Consolidated Statement of Comprehensive Income for the years ended December 31, 2016, 2015 and 2014
Consolidated Statement of Changes in Equity for the years ended December 31, 2016, 2015 and 2014
AFG’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including AFG’s Co-Chief Executive Officers and Chief Financial Officer, AFG conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2016, based on the criteria set forth in “Internal Control - Integrated Framework” issued in 2013 by the Committee of Sponsoring Organizations of the Treadway Commission.
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, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 24, 2017 expressed an unqualified opinion thereon.
Basis of Presentation The consolidated financial statements include the accounts of American Financial Group, Inc. and its subsidiaries (“AFG”). Certain reclassifications have been made to prior years to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to December 31, 2016, and prior to the filing of this Form 10-K, have been evaluated for potential recognition or disclosure herein.
Reinsurance Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG’s property and casualty insurance subsidiaries report as assets (i) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (ii) amounts paid or due to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers, as well as ceded premiums retained by AFG’s property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG’s insurance subsidiaries also assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.
Effective January 1, 2015, AFG adopted (on a modified retrospective basis) ASU 2014-13, which addresses the diversity in practice regarding the accounting for assets and liabilities of a consolidated collateralized financing entity (such as a CLO)
At December 31, 2016, assets and liabilities of managed investment entities included $23 million in assets and $18 million in liabilities of a temporary warehousing entity that was established in connection with the formation of a new CLO that is expected to close in the first half of 2017. Upon closing, all warehoused assets are expected to be transferred to the new CLO and the liabilities will be repaid.
Life, Accident and Health Reserves Liabilities for future policy benefits under traditional life, accident and health policies are computed using the net level premium method. Computations are based on the original projections of investment yields, mortality, morbidity and surrenders and include provisions for unfavorable deviations unless a loss recognition event (premium
deficiency) occurs. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.
In the fourth quarter of 2016, AFG early adopted ASU 2016-09, which, among other things, requires excess tax benefits or deficiencies for share-based payments to be recorded through income tax expense in the statement of earnings instead of directly to capital surplus (as required under the previous guidance). As a result, AFG’s Statement of Earnings for 2016 includes a tax benefit of $9 million that under the previous guidance would have been recorded directly to capital surplus. In addition, the new guidance allows entities to elect to account for forfeitures of awards when they occur rather than accruing expense based on an estimate of expected forfeitures (as required under the previous guidance). AFG has elected to account for forfeitures as they occur. The resulting cumulative effect of accounting change of less than $1 million was recorded directly to retained earnings.
AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: 2016 - 0.4 million, 2015 - 1.1 million and 2014 - 1.0 million. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2016, 2015 and 2014 periods.
Revenue Recognition Guidance Effective in 2018 In May 2014, the FASB issued ASU 2014-09, which requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Revenue is recognized when (or as) the entity satisfies a performance obligation under the contract. The new guidance also updates the accounting for certain costs associated with obtaining and fulfilling contracts with customers and requires disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Revenue recognition for insurance contracts and financial instruments, which are AFG’s primary sources of revenue, is excluded from the scope of the new guidance. AFG will adopt the new guidance effective January 1, 2018. Because the new guidance does not apply to the vast majority of AFG’s business, management does not expect the adoption of this guidance to have a material impact on AFG’s results of operations or
financial position. Based on implementation efforts to date, management believes that the new standard will only apply to 2% of AFG’s consolidated revenues.
Acquisition of Summit Holding Southeast, Inc. In April 2014, AFG acquired Summit Holding Southeast, Inc. and its related companies (“Summit”), from Liberty Mutual Insurance for $259 million using cash on hand at the parent company. Immediately following the acquisition, AFG made a capital contribution of $140 million, bringing its total capital investment in the Summit business to $399 million. Summit is based in Lakeland, Florida and is a leading provider of specialty workers’ compensation solutions in the southeastern United States. Summit continues to operate under the Summit brand as a member of AFG’s Great American Insurance Group. Summit is included in the Specialty casualty sub-segment and generated $540 million and $529 million in net earned premiums in 2016 and 2015, respectively, and $410 million in net earned premiums during the nine months subsequent to AFG’s acquisition in 2014.
Acquisition of Renewal Rights In March 2014, AFG completed a renewal rights agreement with Selective Insurance Company of America to acquire Selective’s pooled public entity book of business for $8 million. At the acquisition date, this book of business had approximately $38 million in in-force gross written premiums. The acquired business generated $34 million in gross written premiums and $16 million in net written premiums in 2016.
In addition to the $18 million in cash and securities received at closing and the $13 million of potential additional proceeds in the future from the release of statutory liabilities, AFG received a total of $97 million in tax benefits in 2016 related to the sale
through reduced estimated tax payments and a tax refund resulting from the carryback of the tax-basis capital loss. The receivables for these tax benefits were reflected in AFG’s financial statements at December 31, 2015.
Other In addition to the loss on the sale of substantially all of AFG’s run-off long-term care insurance business (discussed above), AFG recorded a $5 million pretax realized gain in the third quarter of 2015 representing an adjustment to a previously recognized realized loss on a small property and casualty subsidiary sold several years ago.
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, professional liability, umbrella and excess liability, specialty coverage in targeted markets, customized programs for small to mid-sized businesses and workers’ compensation insurance, and (iii) Specialty financial, which includes risk management insurance programs for leasing and financing institutions (including collateral and lender-placed mortgage property insurance), surety and fidelity products and trade credit insurance. Premiums and underwriting profit included under Other specialty represent business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments and amortization of deferred gains on retroactive reinsurance transactions related to the sales of businesses in prior years. AFG’s annuity business markets traditional fixed and fixed-indexed annuities in the retail, financial institutions and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
Includes pretax income of $32 million (before noncontrolling interest) from the sale of an apartment property in the second quarter of 2016, $51 million (before noncontrolling interest) from the sale of a hotel in the second quarter of 2015 and $15 million from the sale of an apartment property in the fourth quarter of 2015.
Primarily holding company interest and expenses, including a $4 million loss on retirement of debt in the third quarter of 2015, and special charges to increase A&E reserves related to AFG’s former railroad and manufacturing operations ($5 million in 2016, $12 million in 2015 and $6 million in 2014) and losses of managed investment entities attributable to noncontrolling interests ($51 million in 2014). Following the adoption of new guidance in the first quarter of 2015, there are no longer earnings (losses) of managed investment entities that are attributable to noncontrolling interests. See Note A - “Accounting Policies - Managed Investment Entities.”
Under new guidance adopted in the first quarter of 2015, discussed in Note A - “Accounting Policies - Managed Investment Entities,” AFG has elected to set the carrying value of the CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at separately measured fair values. Following the adoption of the new guidance, the CLO liabilities are categorized within the fair value hierarchy on the same basis (proportionally) as the related CLO assets. Since the portion of the CLO liabilities allocated to Level 3 is derived from the fair value of the CLO assets, these amounts are excluded from the progression of Level 3 financial instruments.
The transfers between Level 1 and Level 2 for the years ended December 31, 2016, 2015 and 2014 are reflected in the table below at fair value as of the end of the reporting period (dollars in millions):
The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AFG’s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $1.76 billion at December 31, 2016. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note F - “Derivatives.”
Changes in balances of Level 3 financial assets and liabilities carried at fair value during 2016, 2015 and 2014 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.
Total realized/unrealized gains (losses) included in net income for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $17 million in 2016.
As discussed above, these tables exclude the portion of MIE liabilities allocated to Level 3, which are derived from the fair value of the MIE assets.
Excludes $204 million and $200 million of life contingent annuities in the payout phase at December 31, 2016 and 2015, respectively.
AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. During 2016, AFG recorded $3 million in other-than-temporary impairment charges related to its residential MBS.
In 2016, AFG recorded approximately $23 million and $12 million in other-than-temporary impairment charges related to corporate bonds and other fixed maturities, respectively.
The table below sets forth the scheduled maturities of available for sale fixed maturities as of December 31, 2016 (dollars in millions). Securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Gross realized gains and losses (excluding impairment write-downs 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):
AFG’s fixed-indexed annuities 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 ($380 million at December 31, 2016 and $211 million at December 31, 2015) 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 the change in the fair value of the call option assets will generally offset the economic change in the liabilities from the index participation. 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.
Derivatives Designated and Qualifying as Cash Flow Hedges As of December 31, 2016, AFG has entered into seven interest rate swaps that are designated and qualify as highly effective cash flow hedges to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities. The purpose of each of these swaps is to effectively convert a portion of AFG’s floating-rate fixed maturity securities to fixed rates by offsetting the variability in cash flows attributable to changes in short-term LIBOR.
The present value of future profits (“PVFP”) amounts in the table above are net of $134 million and $125 million of accumulated amortization at December 31, 2016 and 2015, respectively. During each of the next five years, the PVFP is expected to decrease at a rate of approximately one-sixth of the balance at the beginning of each respective year.
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 $216 million (including $144 million invested in the most subordinate tranches) at December 31, 2016, and $266 million at December 31, 2015.
In 2016, AFG formed two new CLOs, which issued an aggregate of $866 million face amount of liabilities (including $64 million face amount purchased by subsidiaries of AFG). During 2016, AFG subsidiaries also purchased $24 million face amount of senior debt and subordinate tranches of existing CLOs for $17 million. During 2016, AFG subsidiaries received $115 million in sale and redemption proceeds from its CLO investments. In 2015, AFG formed two new CLOs, which issued an aggregate of $869 million face amount of liabilities (including $81 million face amount purchased by subsidiaries of AFG). During 2015, AFG subsidiaries also received $77 million in redemption proceeds from its CLO investments. In 2014, AFG formed two new CLOs, which issued an aggregate of $917 million face amount of liabilities (including $94 million face amount purchased by subsidiaries of AFG). During 2014, AFG subsidiaries also purchased $13 million face amount of senior debt tranches of existing CLOs for $13 million and received $81 million in redemption proceeds from its CLO investments. In 2014, four AFG CLOs were substantially liquidated as permitted by the CLO indentures.
Changes in the carrying value of goodwill during 2014, 2015 and 2016, by reporting segment, are presented in the following table (in millions):
Goodwill increased by $16 million in the second quarter of 2014 due to the purchase of Summit and decreased by $2 million in the fourth quarter of 2015 due to the sale of UTA and CGIC as discussed in Note B - “Acquisitions and Sale of Businesses.”
Included in other assets in AFG’s Balance Sheet is $34 million at December 31, 2016 and $41 million at December 31, 2015 of amortizable intangible assets related to property and casualty insurance acquisitions, primarily the acquisition of Summit in 2014. These amounts are net of accumulated amortization of $25 million and $18 million, respectively. Amortization of intangibles was $8 million in 2016 and 2015 and $19 million in 2014. Future amortization of intangibles (weighted average amortization period of 4 years) is estimated to be $8 million per year in each of 2017 through 2020 and $2 million in 2021.
To achieve a desired balance between fixed and variable rate debt, AFG entered into an interest rate swap in June 2015, which effectively converts its 9-7/8% Senior Notes to a floating rate of three-month LIBOR plus 8.099% (9.0624% at December 31, 2016 and 8.6110% at December 31, 2015). The fair value of the interest rate swap (asset of $1 million and $2 million at December 31, 2016 and December 31, 2015, respectively) and the offsetting adjustment to the carrying value of the notes are both included in the carrying value of the 9-7/8% Senior Notes in the table above.
As shown below at December 31 (principal amount, in millions), the majority of AFG’s long-term debt is unsecured obligations of the holding company and its subsidiaries:
In August 2016, AFG issued $300 million in 3.50% Senior Notes due in 2026 at a price of 99.608%. The net proceeds of the offering were used to fund a portion of the November 10, 2016 acquisition of the noncontrolling interest in NATL (discussed in Note B - “Acquisitions and Sale of Businesses”). At the acquisition date, the $18 million outstanding under NATL’s bank credit facility, including $6 million borrowed in September 2016, was repaid and the credit agreement was terminated.
In June 2016, AFG replaced its existing credit facility with a new five-year, $500 million revolving credit facility which expires in June 2021. Amounts borrowed under this agreement bear interest at rates ranging from 1.00% to 1.875% (currently 1.375%) over LIBOR based on AFG’s credit rating. No amounts were borrowed under this facility at December 31, 2016 or AFG’s previous credit facility at December 31, 2015.
In September 2014, AFG issued $150 million in 6-1/4% Subordinated Debentures due 2054.
Data for stock options issued under AFG’s stock incentive plans is presented below:
The total intrinsic value of options exercised during 2016, 2015 and 2014 was $38 million, $52 million and $38 million, respectively. During 2016, 2015 and 2014, AFG received $32 million, $47 million and $35 million, respectively, in cash from the exercise of stock options. The total tax benefit related to the exercises was $11 million, $16 million and $12 million
(including $12 million and $9 million credited directly to capital surplus in 2015 and 2014, respectively) during those years, respectively.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries for 2016, 2015 and 2014 was $28 million, $27 million and $25 million, respectively. AFG’s provision for income tax includes tax benefits of $19 million in 2016 and $8 million in 2015 and 2014 related to AFG’s stock incentive plans. The $19 million tax benefit in 2016 includes $9 million that under previous guidance would have been credited to capital surplus. At December 31, 2016, there was $16 million and $24 million of unrecognized compensation expense related to nonvested stock options and restricted stock awards, respectively. Both of these amounts are expected to be recognized over a weighted average of 2.3 years.
Includes net unrealized gains of $52 million at December 31, 2016 compared to net unrealized gains of $51 million and $58 million at December 31, 2015 and 2014, related to securities for which only the credit portion of an other-than-temporary impairment has been recorded in earnings.
Other represents the impact on AOCI of the November 2016 acquisition of the noncontrolling interest in NATL (see Note B - “Acquisitions and Sale of Businesses”).
Excluding a $65 million charge related to the exit of certain lines of business within Neon and the tax benefits related to the acquisition of the noncontrolling interest in NATL and the Neon restructuring, AFG’s effective tax rate for the year ended December 31, 2016, was 35%.
AFG’s 2012 - 2016 tax years remain subject to examination by the IRS.
Total earnings before income taxes include losses subject to tax in foreign jurisdictions of $160 million in 2016, $66 million in 2015 and $4 million in 2014.
AFG increased its liability for uncertain tax positions by $1 million in 2015 due to uncertainty in state taxation of its surplus lines insurance subsidiaries.
AFG’s provision for income taxes included an expense of less than $1 million in 2016 and 2015 and a benefit of $1 million in 2014 of interest (net of federal benefit or expense). AFG’s liability for interest related to unrecognized tax benefits was less than $1 million at December 31, 2016 and December 31, 2015 (net of federal benefit); no interest was accrued at December 31, 2014. AFG’s provision for income taxes in 2016 included an expense of less than $1 million for penalties; no penalties were recorded in 2015 or 2014. AFG’s liability for penalties related to unrecognized tax benefits was less than $1 million at December 31, 2016; no penalties were accrued at December 31, 2015 or December 31, 2014.
AFG completed an in-depth internal review of its asbestos and environmental (“A&E”) exposures in the third quarter of 2016. The review resulted in special A&E charges of $36 million for the property and casualty group and $5 million for the former
At December 31, 2016, American Premier and its subsidiaries had liabilities for environmental and personal injury claims and other contingencies aggregating $77 million. The environmental claims consist of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs related to certain sites formerly owned or operated by the railroad and manufacturing operations. Remediation costs are difficult to estimate for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. The personal injury claims and other contingencies include pending and expected claims, primarily by former employees of PCTC, for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the workplace and other labor disputes.
At December 31, 2016, GAFRI had a liability of approximately $9 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, severe storms, 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.
During the second quarter of 2016, AFG recorded a pretax charge of $65 million related to Neon’s claims review of its exited lines of business, including $57 million to increase loss reserves primarily related to its medical malpractice and general liability classes. Adverse prior year development for the third quarters of 2016 and 2015 include pretax special charges of $36 million and $67 million, respectively, to strengthen property and casualty insurance A&E reserves.
Results include pretax gains (included in other income) of $32 million from the sale of an apartment property in the second quarter of 2016, $51 million from the sale of a hotel in the second quarter of 2015 and $15 million from the sale of an apartment property in the fourth quarter of 2015.
Results for the third quarter of 2016 and 2015 include pretax special charges of $5 million and $12 million, respectively, to strengthen reserves for A&E exposures related to AFG’s former railroad and manufacturing operations.
Net earnings in the fourth quarter of 2016 includes $177 million in tax benefits related to the NATL merger and Neon restructuring. See Note L - “Income Taxes.”
Cash and securities owned by U.S.-based insurance subsidiaries, having a carrying value of approximately $1.00 billion at December 31, 2016, were on deposit as required by regulatory authorities. In addition, $215 million was on deposit in support of AFG’s underwriting activities at Lloyd’s. At December 31, 2016, AFG and its subsidiaries had $332 million in undrawn letters of credit (none of which was collateralized) supporting the underwriting capacity of its U.K.-based Lloyd’s insurer, Neon.
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 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.
Within each business, results of individual methods are reviewed, supplementary statistical information is analyzed, and 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, a weighted average of several methods, or a judgmental selection as the management team determines is appropriate.
Reflects the November 2016 reinsurance to close transaction at Neon (discussed below) and the acquisition of Summit in April 2014 (discussed in Note B - “Acquisitions and Sale of Businesses”).
The net increase in the provision for claims of prior years in 2016 reflects (i) reserve strengthening at National Interstate (within the Property and transportation sub-segment), (ii) adverse reserve development at Neon and higher than anticipated severity in New York contractor claims (within the Specialty casualty sub-segment), (iii) the $57 million special charge to increase loss reserves related to Neon’s exit of its UK and international medical malpractice and general liability lines of business, and (iv) the $36 million special charge to increase asbestos and environmental reserves. This adverse development was partially offset by (i) lower than expected losses in crop operations and lower than expected claim severity in the property and inland marine and trucking businesses (all within the Property and transportation sub-segment), (ii) lower than anticipated claim frequency and severity in workers’ compensation business, lower than expected claim severity in directors and officers liability insurance and lower than expected claim frequency and severity in excess liability business (all within the Specialty casualty
sub-segment), and (iii) lower than anticipated claim severity in the fidelity and crime business and lower than expected claim frequency and severity in the surety business (within the Specialty financial sub-segment).
The net increase in the provision for claims of prior years in 2015 reflects (i) higher than expected claim severity at National Interstate and higher than anticipated claim frequency in the ocean marine business (all within the Property and transportation sub-segment), (ii) adverse reserve development at Neon (within the Specialty casualty sub-segment), and (iii) the $67 million special charge to increase asbestos and environmental reserves. This adverse development was partially offset by (i) lower than expected claim severity in the property and inland marine business, agricultural operations and a run-off book of homebuilders business (all within the Property and transportation sub-segment), (ii) lower than anticipated claim severity in workers’ compensation business, lower than anticipated claim severity and frequency in excess liability insurance and lower than expected claim severity in directors and officers liability insurance (all within the Specialty casualty sub-segment), and (iii) lower than anticipated claim frequency and severity in the surety business and products for financial institutions and lower than expected claim severity in the fidelity business and run-off collateral value insurance (all within the Specialty financial sub-segment).
In November 2016, the Neon Lloyd’s syndicate completed a reinsurance to close transaction for its 2007 year of account with StarStone Underwriting Limited, a subsidiary of Enstar Group Limited. The transaction included a quota share of the Italian public hospital business written in Neon’s 2008 year of account and represents Neon’s complete exit from the Italian public hospital medical malpractice business. In the Lloyd’s market, a reinsurance to close transaction transfers the responsibility for discharging all of the liabilities that attach to the transferred year of account plus the right to any income due to the closing year of account in return for a premium.
Represents the cumulative percentage paid of incurred claims and allocated LAE (net of reinsurance, as estimated at December 31, 2016).
FHLB Funding Agreements Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions. Members are required to purchase stock in the FHLB in addition to maintaining collateral deposits that back any funds advanced. GALIC’s $44 million investment in FHLB capital stock at December 31, 2016, is included in other investments at cost. Membership in the FHLB provides the annuity operations with an additional source of liquidity. These advances further the FHLB’s mission of improving access to housing by increasing liquidity in the residential mortgage-backed securities market. In 2016, the FHLB advanced GALIC $150 million, increasing the total amount advanced to $935 million (included in annuity benefits accumulated) at December 31, 2016. In the fourth quarter of 2016, GALIC extended the terms on advances totaling $200 million by four years. Interest rates under the various funding agreements on these advances range from 0.03% to 0.53% over LIBOR (average rate of 1.18% at December 31, 2016). While these advances must be repaid between 2018 and 2021 ($285 million in 2018, $500 million in 2020 and $150 million in 2021), GALIC has the option to prepay all or a portion of the advances. The advances on these agreements are collateralized by mortgage-backed securities, which have a total fair value of $1.08 billion (included in available for sale fixed maturity securities) at December 31, 2016 and which have similar expected lives as the advances. Interest credited on the funding agreements, which is included in annuity benefits, was $8 million in 2016, $3 million in 2015 and $1 million in 2014.
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 and capital and surplus on a statutory basis for the insurance subsidiaries were as follows (in millions):
AFG paid common stock dividends to shareholders totaling $187 million, $178 million and $169 million in 2016, 2015 and 2014, respectively. Currently, there are no regulatory restrictions on AFG’s retained earnings or net income that materially impact its ability to pay dividends. Based on shareholders’ equity at December 31, 2016, AFG could pay dividends in excess of $1 billion without violating its most restrictive debt covenant. However, the payment of future dividends will be at the discretion of AFG’s Board of Directors and will be dependent on many factors including AFG’s financial condition and results of operations, the capital requirements of its insurance subsidiaries, and rating agency commitments.
Variable Annuities At December 31, 2016, 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 $20 million, compared to $27 million at December 31, 2015. 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 $67 million in 2016, $70 million in 2015 and $65 million in 2014. 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, 2016, were as follows: 2017 - $66 million; 2018 - $60 million; 2019 - $53 million; 2020 - $45 million; 2021 - $37 million; and $128 million thereafter.
The information required by the following Items will be included in AFG’s definitive Proxy Statement for the 2017 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.
Agreement and Plan of Merger dated July 25, 2016 by and among Great American Insurance Company and National Interstate Corporation, filed as Exhibit 2.1 to AFG’s Form 8-K on July 25, 2016.
2011 Equity Bonus Plan (formerly known as the 2011 Co-CEO Equity Bonus Plan), filed as Exhibit 10 to the Form S-8 Registration Statement (File No. 333-184915) filed by AFG on November 13, 2012.
The following financial information from American Financial Group’s Form 10-K for the year ended December 31, 2016, formatted in XBRL (Extensible Business Reporting Language):