AFG and its insurance subsidiaries lease the majority of their office and storage facilities in numerous cities throughout the United States and internationally, including the Company’s headquarters in Cincinnati, Ohio. Subsidiaries of AFG own several other buildings in downtown Cincinnati. AFG and its affiliates occupy approximately half of the aggregate 670,000 square feet of commercial and office space in these buildings. A property and casualty insurance subsidiary occupies approximately 93% of the 281,000 square feet of rentable office space on 17.5 acres of land that it owns in Richfield, Ohio. See Item 1 - Business - “Other Operations” for a discussion of AFG’s other commercial real estate operations.
Following is a discussion and analysis of the financial statements and other statistical data that management believes will enhance the understanding of AFG’s financial condition and results of operations. This discussion should be read in conjunction with the financial statements beginning on page.
At December 31, 2018, AFG (parent) held approximately $223 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 traditional fixed, fixed-indexed and variable-indexed annuities in the retail, financial institutions, broker-dealer and registered investment advisor markets.
AFG reported a fourth quarter 2018 net loss attributable to shareholders of $29 million ($0.33 per share, diluted) compared to net earnings attributable to shareholders of $166 million ($1.84 per share, diluted) in the fourth quarter of 2017, reflecting:
the fourth quarter 2017 tax benefit related to the Neon Underwriting Ltd. (“Neon”) restructuring, and
Full year 2018 net earnings attributable to AFG’s shareholders were $530 million ($5.85 per share, diluted) compared to $475 million ($5.28 per share, diluted) in 2017, reflecting:
higher underwriting profit in the property and casualty insurance segment due primarily to lower catastrophe losses and lower special charges to increase asbestos and environmental reserves,
Significant accounting policies are summarized in Note A - “Accounting Policies” to the financial statements. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions change and, thus, impact amounts reported in the future. The areas where management believes the degree of judgment required to determine amounts recorded in the financial statements is most significant are as follows:
The ratio of debt to total capital is a non-GAAP measure that management believes is useful for investors, analysts and independent ratings agencies to evaluate AFG’s financial strength and liquidity and to provide insight into how AFG finances its operations. In addition, maintaining a ratio of debt, excluding subordinated debt and debt secured by real estate (if any), to total capital of 35% or lower is a financial covenant in AFG’s bank credit facility. The ratio is calculated by dividing the principal amount of AFG’s long-term debt by its total capital, which includes long-term debt, noncontrolling interests and shareholders’ equity (excluding unrealized gains (losses) related to fixed maturity investments).
AFG’s ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.54 for the year ended December 31, 2018. Excluding annuity benefits, this ratio was 7.86. The ratio excluding annuity benefits is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
The NAIC’s model law for risk based capital (“RBC”) applies to both life and property and casualty companies. RBC formulas determine the amount of capital that an insurance company needs so that it has an acceptable expectation of not becoming financially impaired. At December 31, 2018, the capital ratios of all AFG insurance companies exceeded the RBC requirements.
decrease in net cash used in investing activities in 2018 compared to 2017. See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements.
Net Cash Provided by Financing Activities AFG’s financing activities consist primarily of transactions with annuity policyholders, issuances and retirements of long-term debt, repurchases of common stock and dividend payments. Net cash provided by financing activities was $2.44 billion in 2018 compared to $1.72 billion in 2017, an increase of $725 million. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $2.76 billion in 2018 compared to $1.99 billion in 2017, resulting in a $773 million increase in net cash provided by financing activities in 2018 compared to 2017. During 2018, AFG had no additional long-term borrowings or repayments as compared to $712 million of additional long-term debt borrowings and $745 million of debt repayments in 2017. During 2018, AFG repurchased $6 million of its Common Stock compared to no shares in 2017. In addition to its regular quarterly cash dividends, AFG paid special cash dividends of $3.00 per share and $3.50 per share of American Financial Group Common Stock in 2018 and 2017, respectively, which resulted in total cash dividends of $394 million in 2018 compared to $417 million in 2017. 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 $48 million in 2018 compared to $146 million in 2017, accounting for a $98 million decrease in net cash provided by financing activities in 2018 compared to 2017. See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements.
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, 2018, AFG could reduce the average crediting rate on approximately $28 billion of traditional fixed, fixed-indexed and variable-indexed annuities without guaranteed withdrawal benefits by approximately 119 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.
For statutory accounting purposes, equity securities of non-affiliates and equity call and put options used in the fixed-indexed annuity business are generally carried at fair value. At December 31, 2018, AFG’s insurance companies owned publicly traded equity securities with a fair value of $1.76 billion and equity index call and put options with a net fair value of $183 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 Provided by Operating Activities Parent holding company cash flows from operating activities consist primarily of dividends and tax payments received from AFG’s insurance subsidiaries, reduced by tax payments to the IRS and holding company interest and other expenses. Parent holding company net cash provided by operating activities was $215 million in 2018 compared to $578 million in 2017 and $555 million in 2016. The $363 million decrease in net cash provided by operating activities in 2018 as compared to 2017 was due to lower dividends received from subsidiaries in 2018 as compared to 2017. The $23 million increase in net cash provided by operating activities in 2017 as compared to 2016 was due to lower taxes paid, partially offset by lower dividends received from subsidiaries for those comparable periods.
investing activities of $63 million in 2017 and $560 million in 2016. The $10 million in net cash provided by investing activities in 2018 and the $63 million of net cash used in investing activities in 2017 are significantly lower than the $560 million in net cash used in investing activities in 2016 due primarily to 2016 capital contributions to a subsidiary to fund the acquisition of the noncontrolling interest in National Interstate Corporation.
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 used in financing activities was $366 million in 2018 compared to $413 million in 2017 and net cash provided by financing activities of $13 million in 2016. The $47 million decrease in net cash used in financing activities in 2018 as compared to 2017 reflects lower net redemptions of long-term debt in 2018 and decreased dividends (due primarily to special dividends of $3.00 per share in 2018 compared to $3.50 per share in 2017). The $426 million increase in net cash used in financing activities in 2017 as compared to 2016 reflects higher net redemptions of long-term debt in 2017 and increased dividends (due primarily to special dividends of $3.50 per share in 2017 compared to $1.00 per share in 2016), partially offset by the absence of American Financial Group, Inc. Common Stock repurchases in 2017.
AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2018.
holding gains and losses included in realized gains (losses) on securities and $187 million in equity securities carried at fair value with holding gains and losses included in net investment income.
As detailed in Note E - “Investments - Net Unrealized Gain on Marketable Securities” to the financial statements, unrealized gains and losses on AFG’s fixed maturity securities are included in shareholders’ equity after adjustments for related changes in DPAC and certain liabilities related to annuity, long-term care and life businesses, noncontrolling interests and deferred income taxes. DPAC and certain other balance sheet amounts applicable to annuity, long-term care and life businesses are adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding increases or decreases (net of tax) included in accumulated other comprehensive income in AFG’s Balance Sheet.
Fair values for AFG’s portfolio are determined by AFG’s internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on published closing prices. For mortgage-backed securities (“MBS”), which comprise approximately 9% of AFG’s fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the remainder of AFG’s fixed maturity portfolio, approximately 74% are priced using pricing services and the balance is priced primarily by using non-binding broker quotes. When prices obtained for the same security vary, AFG’s internal investment professionals select the price they believe is most indicative of an exit price.
In general, the fair value of AFG’s fixed maturity investments is inversely correlated to changes in interest rates. The following table demonstrates the sensitivity of such fair values to reasonably likely changes in interest rates by illustrating the estimated effect on AFG’s fixed maturity portfolio and accumulated other comprehensive income that an immediate increase of 100 basis points in the interest rate yield curve would have at December 31, 2018 (dollars in millions). Effects of increases or decreases from the 100 basis points illustrated would be approximately proportional.
Summarized information for AFG’s MBS (including those classified as trading) at December 31, 2018, is shown in the table below (dollars in millions). Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The average life of both the residential and commercial MBS is approximately 4-1/2 years.
Municipal bonds represented approximately 17% of AFG’s fixed maturity portfolio at December 31, 2018. AFG’s municipal bond portfolio is high quality, with 99% of the securities rated investment grade at that date. The portfolio is well diversified across the states of issuance and individual issuers. At December 31, 2018, approximately 78% of the municipal bond portfolio was held in revenue bonds, with the remaining 22% held in general obligation bonds. AFG does not own general obligation bonds issued by Puerto Rico.
As discussed in Note A - “Accounting Policies - Investments” to the financial statements, effective January 1, 2018, all equity securities previously classified as “available for sale” are now required to be carried at fair value through net earnings instead of accumulated other comprehensive income and will therefore no longer be evaluated for other-than-temporary impairment.
The process used to determine the total reserve for liabilities involves estimating the ultimate incurred losses and LAE, adjusted for amounts already paid on the claims. The IBNR reserve is derived by first estimating the ultimate unpaid reserve liability and subtracting case reserves for loss and LAE. See Note O - “Insurance - Property and Casualty Insurance Reserves” to the financial statements for a discussion of the factors considered and actuarial methods used in determining management’s best estimate of the ultimate liability for unpaid losses and LAE.
AFG recorded adverse prior year reserve development of $48 million in 2018 related to its other liability - occurrence coverage due to continued claim severity increases in excess and umbrella liability coverages as well as late emergence of excess workers’ compensation and Texas non-subscribers workers’ injury claims. AFG recorded adverse prior year reserve development of $37 million in 2017 due to continued severity increases in New York contractor claims, as well as increased claim severity across other excess and umbrella liability coverages and general liability coverages. AFG recorded adverse prior year reserve development of $61 million in 2016 due primarily to increased severity in New York contractor claims.
AFG recorded favorable prior year reserve development of $127 million in 2018 related to its workers’ compensation coverage due to lower than anticipated claim severity in the southeastern United States and improving claim closure rates in California. AFG recorded favorable prior year reserve development of $79 million in 2017 due to lower than anticipated claim severity and improving claim closure rates, particularly in the southeastern United States and California. AFG recorded favorable prior year reserve development of $85 million in 2016 due to lower than anticipated claim severity and improving claim closure rates.
AFG recorded favorable prior year reserve development of $9 million in 2018, $5 million in 2017 and $24 million in 2016 on its D&O business as claim severity was less than expected across several prior accident years.
at December 31, 2017) as well as any income due to the closing year of account in return for a premium. The reinsurance to close agreement eliminates any remaining reserve volatility from years of account 2015 and prior, including all medical malpractice exposure. As a result of the reinsurance to close transaction, Neon recorded favorable reserve development of approximately $42 million, including $24 million related to its ongoing lines of business and $18 million that relates to the exited lines of business discussed below. In addition to the prior year reserve development related to the reinsurance to close transaction, Neon recorded favorable prior year reserve development of $29 million in 2017 related to the retained loss reserves across all of Neon’s ongoing lines of business, particularly property lines.
Asbestos reserves include claims asserting alleged injuries and damages from exposure to asbestos. Environmental reserves include claims relating to polluted sites.
owners or operators who allegedly had asbestos on their property, under the premises or operations section of their policies. Unlike products exposures, these non-products exposures typically had no aggregate limits, creating potentially greater exposure for insurers. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify previously settled products claims as non-products claims to restore a portion of previously exhausted products aggregate limits. AFG, along with other insurers, is and will be subject to such non-products claims. It is difficult to predict whether insureds will be successful in asserting claims under non-products coverage or whether AFG and other insurers will be successful in asserting additional defenses. Therefore, the future impact of such efforts is uncertain.
While management believes that AFG’s reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims, the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, how claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims. A 1% variation in loss cost trends, caused by any of the factors previously described, would change net earnings by approximately $33 million.
its environmental reserves by $36 million (net of reinsurance). The increase in property and casualty asbestos reserves reflects increasing life expectancies in the U.S., which have allowed more time for the impacts of asbestos exposure to emerge. AFG’s comprehensive external study incorporates, among other factors, the increase in projected industry ultimate losses attributable to asbestos exposures, as well as revised estimates for future claims emergence. The increase in property and casualty environmental reserves was attributed primarily to increased legal defense costs and a number of claims and sites where the estimated investigation and remediation costs have increased.
As a result of the in-depth internal review completed in the third quarter of 2016, AFG’s property and casualty insurance segment recorded a $36 million pretax special charge to increase its asbestos reserves by $5 million (net of reinsurance) and its environmental reserves by $31 million (net of reinsurance). The increase in property and casualty asbestos reserves was due primarily to increased estimates for indemnity and defense costs. The increase in property and casualty environmental reserves was attributed primarily to increased defense costs and a number of claims and sites where the estimated investigation and remediation costs have increased.
Includes income of $7 million and $23 million in 2018 and 2017, respectively, representing the change in fair value of AFG’s CLO investments plus $16 million and $18 million in 2018 and 2017, respectively, in CLO management fees earned.
AFG reported a net loss attributable to shareholders of $29 million in the fourth quarter of 2018 compared to net earnings attributable to shareholders of $166 million in the fourth quarter of 2017. Results for the fourth quarter of 2018 include $188 million in non-core net realized losses on securities. Comparatively, net earnings in the 2017 fourth quarter were
adversely impacted by $31 million in net non-core items. The change in the U.S. corporate tax rate from 35% to 21%, effective January 1, 2018, contributed to a lower effective tax rate in 2018 as compared to 2017. Core net operating earnings decreased $38 million in the fourth quarter of 2018 compared to the same period in 2017 reflecting lower earnings in the annuity segment and lower underwriting profit in the property and casualty insurance segment, partially offset by higher net investment income in the property and casualty insurance segment, lower holding company expenses and the lower corporate income tax rate. Realized losses on securities in the fourth quarter of 2018 includes the decline in fair value of equity securities that are required to be carried at fair value through net earnings under new accounting guidance adopted on January 1, 2018. Included in the $188 million of non-core net realized losses on securities in the fourth quarter of 2018 were $179 million in net losses on equity securities that AFG continued to own at December 31, 2018.
Net earnings attributable to shareholders decreased $174 million for the full-year of 2017 compared to the same period in 2016 due primarily to the 2017 tax expense related to the change in the U.S. corporate tax rate, the 2016 tax benefits related to the National Interstate merger and Neon restructuring, higher special A&E charges recorded in 2017 compared to 2016, lower net realized gains on securities in 2017 compared to 2016, a gain on the sale of an apartment property in 2016 and losses on the retirement of debt in 2017, partially offset by a 2016 charge related to the exit of certain lines of business within Neon and favorable development in 2017 on the Neon exited lines in connection with a reinsurance to close transaction, the 2017 tax benefit from restructuring at Neon and higher core net operating earnings. Core net operating earnings increased $54 million in 2017 compared to 2016 reflecting higher earnings in the property and casualty insurance and annuity segments.
RESULTS OF OPERATIONS - QUARTERS ENDED DECEMBER 31, 2018 AND 2017
Effective January 1, 2018, the results of AFG’s run-off long-term care and life businesses are included in the “Other” segment instead of as a separate reportable segment based on the immaterial size of the remaining operations. Prior periods amounts were reclassified for consistent presentation.
earnings from limited partnerships and similar investments. The high returns from limited partnerships and similar investments should not be expected to repeat in future periods. The decrease in GAAP pretax earnings also reflects the impact of favorable development in the fourth quarter of 2017 in the Neon exited lines in connection with a reinsurance to close transaction.
The following table details AFG’s earnings before income taxes from its property and casualty insurance operations for the three months ended December 31, 2018 and 2017 (dollars in millions):
AFG’s statutory combined ratio has been better than the U.S. industry average for 31 of the last 33 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.
To understand the overall profitability of particular lines, the timing of claims payments and the related impact of investment income must be considered. Certain “short-tail” lines of business (primarily property coverages) generally have quick loss payouts, which reduce the time funds are held, thereby limiting investment income earned thereon. In contrast, “long-tail” lines of business (primarily liability coverages and workers’ compensation) generally have payouts that are either structured over many years or take many years to settle, thereby significantly increasing investment income earned on related premiums received.
Net written premiums (“NWP”) for AFG’s property and casualty insurance segment were $1.21 billion for the fourth quarter of 2018 compared to $1.16 billion for the fourth quarter of 2017, an increase of $47 million (4%). Detail of AFG’s property and casualty net written premiums is shown below (dollars in millions):
The $42 million (3%) increase in gross written premiums in the fourth quarter of 2018 compared to the fourth quarter of 2017 reflects growth in the Property and transportation and Specialty casualty sub-segments, partially offset by lower gross written premiums in the Specialty financial sub-segment. Excluding the impact of the timing of renewal of two large accounts in the Property and transportation sub-segment, gross written premiums increased approximately 1% in the fourth quarter of 2018 compared to the prior year period. Overall average renewal rates increased approximately 2% in the fourth quarter of 2018. Excluding the workers’ compensation business, renewal pricing increased approximately 4%.
Specialty casualty Gross written premiums increased $41 million (6%) in the fourth quarter of 2018 compared to the fourth quarter of 2017. Higher premiums within Neon, resulting from the growth of its portfolio in targeted classes of business, along with growth in several other businesses and the addition of ABA Insurance Services, were partially offset by lower premiums in the workers’ compensation businesses. Average renewal rates for this group were flat in the fourth quarter of 2018. Excluding the workers’ compensation businesses, renewal rates for this group increased approximately 4%. Reinsurance premiums ceded as a percentage of gross written premiums were comparable between periods. Higher cessions to AFG’s internal reinsurance program, which is included in Other specialty and higher cessions in the workers’ compensation businesses were offset by lower reinstatement premiums resulting from reinsured hurricane losses in the 2018 period compared to the 2017 period.
Specialty financial Gross written premiums decreased $24 million (12%) in the fourth quarter of 2018 compared to the fourth quarter of 2017, due primarily to the timing of several new accounts in the lending and leasing businesses in 2017. Average renewal rates for this group increased approximately 5% in the fourth quarter of 2018. Reinsurance premiums ceded as a percentage of gross written premiums decreased 2 percentage points for the fourth quarter of 2018 compared to the fourth quarter of 2017 reflecting lower cessions in the equipment leasing business.
AFG’s overall loss and LAE ratio was 62.7% for the fourth quarter of 2018 compared to 58.5% for fourth quarter of 2017, an increase of 4.2 percentage points. The components of AFG’s property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
Property and transportation The 1.4 percentage points increase in the loss and LAE ratio for the current year, excluding catastrophe losses reflects an increase in the loss and LAE ratio in the aviation business and the Singapore branch, partially offset by a decrease in the loss and LAE ratio in the trucking business.
Property and transportation Net favorable reserve development of $7 million in the fourth quarter of 2018 reflects lower than expected claim frequency and severity at National Interstate and lower than expected losses in the crop business. Net favorable reserve development of $4 million in the fourth quarter of 2017 reflects lower than expected losses in the crop business and lower than expected claim severity in the property and inland marine and trucking businesses, partially offset by higher than expected claim severity and frequency in the ocean marine business.
Specialty casualty Net favorable reserve development of $52 million in the fourth quarter of 2018 reflects lower than anticipated claim severity in the workers’ compensation businesses and lower than expected emergence in assumed 2017 property catastrophe losses at Neon. Net favorable reserve development of $52 million in the fourth quarter of 2017 reflects favorable reserve development on ongoing lines of business within Neon recorded in connection with the reinsurance to close agreement entered into in December 2017 for the 2015 and prior years of account, lower than anticipated claim severity in the workers’ compensation businesses and lower than expected losses in the executive liability business, partially offset by higher than anticipated claim severity in the targeted markets businesses and higher than anticipated severity in New York contractor claims.
In the fourth quarter of 2017, Neon entered into a reinsurance to close agreement for its 2015 and prior years of account, which transfers the responsibility for all of the liabilities that attach to the transferred year of account as well as any income due to the closing year of account in return for a premium. As a result of the reinsurance to close agreement, Neon recorded favorable development of $42 million, of which $24 million related to its ongoing lines of business (included in Specialty casualty) and $18 million related to the exited lines of business (treated as non-core). See “Net prior year reserve development” under “Results of Operations - Property and Casualty Insurance Segment” for the years ended 2018, 2017 and 2016.
AFG generally seeks to reduce its exposure to catastrophes through individual risk selection, including minimizing coastal and known fault-line exposures, and the purchase of reinsurance. Based on data available at December 31, 2018, AFG’s exposure to a catastrophic earthquake or windstorm that industry models indicate should statistically occur once in every 100, 250 or 500 years as a percentage of AFG’s Shareholders’ Equity is shown below:
partially offset by favorable development related to third quarter 2017 catastrophe losses, specifically Hurricanes Harvey, Irma and Maria, and two earthquakes in Mexico.
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums increased 2.8 percentage points in the fourth quarter of 2018 compared to the fourth quarter of 2017 reflecting lower premiums in the crop business, which has a lower expense ratio than AFG’s overall Property and transportation group and an increase in the expense ratio in the transportation businesses.
The following table details AFG’s earnings before income taxes from its annuity operations for the three months ended December 31, 2018 and 2017 (dollars in millions):
The vast majority of AFG’s FIAs are indexed to the S&P 500, which decreased 14% in the fourth quarter of 2018. As highlighted in the table below, this poor stock market performance adversely impacted AFG’s earnings before income taxes from its annuity operations beyond the impact on derivatives related to FIAs by $30 million, particularly related to FIAs with guaranteed withdrawal benefits. If the stock market performance reverts back to AFG’s long-term expectation over the life of these policies, management expects a substantial portion of this unfavorable impact to reverse.
An estimate of the related acceleration/deceleration of the amortization of deferred policy acquisition costs and deferred sales inducements.
Net investment income for the fourth quarter of 2018 was $419 million compared to $376 million for the fourth quarter of 2017, an increase of $43 million (11%). This increase reflects the growth in AFG’s annuity business and higher earnings from limited partnerships and similar investments, partially offset by the impact of lower fixed maturity 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 0.02 percentage points to 4.64% from 4.62% in the fourth quarter of 2018 compared to the fourth quarter of 2017. The net investment yield between periods reflects higher earnings from limited partnerships and similar investments, offset by the impact of the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets. For the period from October 1, 2017 through December 31, 2018, $5.8 billion in annuity segment investments with an average yield of approximately 4.9% were redeemed or sold with the proceeds reinvested at an approximately 0.5% lower yield.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) for the fourth quarter of 2018 were $45 million compared to $18 million for the fourth quarter of 2017, an increase of $27 million (150%). As a percentage of average fixed annuity benefits accumulated, these net expenses increased 0.30 percentage points to 0.51% from 0.21% in the fourth quarter of 2018 compared to the fourth quarter of 2017. 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 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 (excluding the impact of unlocking):
As illustrated in the table above, changes in the fair value of derivatives related to FIAs decreased annuity acquisition expenses as a percentage of average fixed annuity benefits accumulated by 0.36% in the fourth quarter of 2018 compared to 0.14% in the fourth quarter of 2017. In the fourth quarter of 2018, the favorable impact of the deceleration in the amortization of DPAC related to changes in the fair value of derivatives related to FIAs on annuity acquisition expenses as a percentage of average fixed annuity benefits accumulated was substantially offset by the unfavorable impact of poor stock market performance on projected future investment income generated by the investment of the projected net proceeds from the call and put options used in the FIA business. Depending on the timing and extent of a recovery in the stock market, a portion of this unfavorable impact would be expected to reverse.
Annuity other expenses were $36 million for the fourth quarter of 2018 compared to $31 million for the fourth quarter of 2017, an increase of $5 million (16%). 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 2018 compared to the fourth quarter of 2017. As a percentage of average fixed annuity benefits accumulated, these expenses increased 0.01 percentage points to 0.38% from 0.37% for the fourth quarter of 2018 as compared to the fourth quarter of 2017 due primarily to growth in the business.
Change in Fair Value of Derivatives Related to Fixed-Indexed (Including Variable-Indexed) Annuities
Excluding the impact of unlocking charges, the net change in fair value of derivatives related to fixed-indexed annuities increased annuity benefits by $80 million in the fourth quarter of 2018 and $22 million in the fourth quarter of 2017. The change in the fair value of these derivatives includes $11 million in the fourth quarter of 2018 and $5 million in the fourth quarter of 2017 in interest accreted on the embedded derivative (before DPAC amortization), an increase of $6 million (120%). AFG expects both the size of the embedded derivative and interest rates to rise, resulting in continued increases in interest on the embedded derivative. The $80 million increase in annuity benefits in the fourth quarter of 2018 reflects the negative impact of the significant decline in the stock market on the fair value of these derivatives. The $22 million increase in annuity benefits in the fourth quarter of 2017 reflects the negative impact of lower than anticipated interest rates on the fair value of these derivatives, partially offset by the positive impact of strong stock market performance. As a percentage of average fixed annuity benefits accumulated, this net expense increased 0.62 percentage points to 0.89% in the fourth quarter of 2018 from 0.27% in
The following table provides analysis of the primary factors impacting the change in the fair value of derivatives related to FIAs. Each factor is presented net of the estimated related impact on amortization of DPAC (dollars in millions).
AFG’s annuity operations generated statutory premiums of $1.48 billion in the fourth quarter of 2018 compared to $909 million in the fourth quarter of 2017, an increase of $573 million (63%). The following table summarizes AFG’s annuity sales (dollars in millions):
Management attributes the 63% increase in annuity premiums in the fourth quarter of 2018 compared to the fourth quarter of 2017 to the introduction of new products, efforts to expand in the retail and broker dealer markets and an overall improving interest rate environment during 2018.
Net investment income (as a % of investments) of 4.64% and 4.62% for the three months ended December 31, 2018 and 2017, respectively, multiplied by the difference between average fixed annuity investments (at amortized cost) and average fixed annuity benefits accumulated in each period.
Excludes a pretax non-core loss on retirement of debt of $40 million in the fourth quarter of 2017.
Summit, a workers’ compensation insurance subsidiary, collects fees from a small group of unaffiliated insurers for providing underwriting, policy administration and claims services. In addition, certain of AFG’s property and casualty insurance businesses collect fees from customers for ancillary services such as workplace safety programs and premium financing. In the fourth quarter of 2018, AFG collected $19 million in fees for these services compared to $20 million in the fourth quarter of 2017. Management views this fee income, net of the $13 million in the fourth quarter of 2018 and $11 million in the fourth quarter of 2017, in expenses incurred to generate such fees, as a reduction in the cost of underwriting its property and casualty insurance policies. Consistent with internal management reporting, these fees and the related expenses are netted and recorded as a reduction of commissions and other underwriting expenses in AFG’s segmented results.
AFG’s holding companies and other operations outside of its insurance operations recorded interest expense of $16 million in the fourth quarter of 2018 compared to $20 million in the fourth quarter of 2017, a decrease of $4 million (20%). This decrease is due primarily to a lower weighted average interest rate on AFG’s outstanding debt. The following table details the principal amount of AFG’s long-term debt balances as of October 1, 2018 compared to October 1, 2017 (dollars in millions):
The decrease in the weighted average interest rate for the fourth quarter of 2018 as compared to the fourth quarter of 2017 reflects the following financing transactions completed by AFG between October 1, 2017 and December 31, 2017:
Issued an additional $125 million of 3.50% Senior Notes on November 9, 2017
RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 2018, 2017 AND 2016
AFG’s net earnings attributable to shareholders, determined in accordance with GAAP, include certain items that may not be indicative of its ongoing core operations. The following tables for the years ended December 31, 2018, 2017 and 2016 identify such items by segment and reconcile net earnings attributable to shareholders to core net operating earnings, a non-GAAP financial measure that AFG believes is a useful tool for investors and analysts in analyzing ongoing operating trends (in millions):
Property and Casualty Insurance Segment - Results of Operations AFG’s property and casualty insurance operations contributed $709 million in GAAP pretax earnings in 2018 compared to $591 million in 2017, an increase of $118 million (20%). Property and casualty core pretax earnings were $727 million in 2018 compared to $662 million in 2017, an increase of $65 million (10%). The increase in GAAP and core pretax earnings reflects higher underwriting profit in 2018 compared to 2017 due primarily to higher favorable prior year reserve development and lower catastrophe losses, higher net investment income, due primarily to higher earnings from limited partnerships and similar investments and growth in the business, partially offset by the impact of income from the sale of real estate in 2017. The high returns on limited partnerships and similar
AFG’s property and casualty insurance operations contributed $591 million in GAAP pretax earnings in 2017 compared to $577 million in 2016, an increase of $14 million (2%). Property and casualty core pretax earnings were $662 million in 2017 compared to $646 million in 2016, an increase of $16 million (2%). The increase in GAAP and core pretax earnings reflects higher underwriting profit in the Specialty casualty sub-segment, higher net investment income and lower other expenses, partially offset by lower underwriting profits in the Property and transportation and Specialty financial sub-segments. The increase in GAAP pretax earnings also reflects the impact of a pretax non-core charge of $65 million in the second quarter of 2016 related to the exit of certain lines of business within Neon and favorable development of $18 million in the fourth quarter of 2017 in the Neon exited lines in connection with a reinsurance to close transaction, partially offset by the impact of a $32 million pretax non-core gain on the sale of an apartment property in the second quarter of 2016 and special A&E charges of $89 million in 2017 compared to $36 million in 2016.
AFG reports the underwriting performance of its Specialty property and casualty insurance business in the following sub-segments: (i) Property and transportation, (ii) Specialty casualty and (iii) Specialty financial.
Reinsurance premiums ceded (“Ceded”) for AFG’s property and casualty insurance segment were 27% of gross written premiums for each of the years ended December 31, 2018, 2017 and 2016. 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 $5.02 billion in 2018 compared to $4.75 billion in 2017, an increase of $272 million (6%). NWP increased $365 million (8%) in 2017 compared to 2016. 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 $4.87 billion in 2018 compared to $4.58 billion in 2017, an increase of $286 million (6%). NEP increased $251 million (6%) in 2017 compared to 2016. Detail of AFG’s property and casualty net earned premiums is shown below (dollars in millions):
The $338 million (5%) increase in gross written premiums in 2018 compared to 2017 reflects growth in the Specialty casualty and Specialty financial sub-segments. Overall average renewal rates increased approximately 1% in 2018. Excluding the workers’ compensation business, renewal pricing increased approximately 3%.
Gross written premiums increased $295 million (11%) in 2017 compared to 2016. New accounts written in the targeted markets businesses and higher gross written premiums at Neon, resulting from the growth of its portfolio in targeted classes of business were the primary drivers of the increase. Additionally, higher gross written premiums in the workers’ compensation businesses, primarily the result of rate increases in the state of Florida, coupled with growth in the executive liability and excess and surplus businesses contributed to the growth in gross written premiums in 2017. Average renewal rates were flat for this group in 2017. Reinsurance premiums ceded as a percentage of gross written premiums decreased 1 percentage point in 2017 compared to 2016, reflecting a change in the mix of business.
Gross written premiums increased $42 million (6%) in 2017 compared to 2016 due primarily to higher premiums in the lending and leasing, fidelity and surety businesses. Average renewal rates for this group decreased approximately 2% in 2017. Reinsurance premiums ceded as a percentage of gross written premiums increased 2 percentage points in 2017 compared to 2016, reflecting higher cessions in the lending and leasing businesses.
Property and transportation Underwriting profit for this group was $120 million in 2018 compared to $154 million in 2017, a decrease of $34 million (22%). Lower underwriting profits in the agricultural, property and inland marine and aviation businesses and the Singapore branch were partially offset by higher underwriting profit at National Interstate and improved
Underwriting profit for this group was $154 million in 2017 compared to $166 million in 2016, a decrease of $12 million (7%). Lower underwriting profits in the crop and ocean marine businesses were the primary drivers of these lower results, partially offset by higher underwriting profit in the transportation businesses. The crop insurance operations reported strong underwriting profitability in 2017, albeit at lower levels than in 2016. Catastrophe losses were $36 million (2.1 points on the combined ratio) and related reinstatement premiums were $2 million in 2017 compared to catastrophe losses of $31 million (1.9 points) in 2016.
Specialty casualty Underwriting profit for this group was $141 million in 2018 compared to $104 million in 2017, an increase of $37 million (36%). These results reflect higher underwriting profits in the executive liability and targeted markets businesses and lower adverse prior year reserve development in run-off businesses. Catastrophe losses were $45 million (1.9 points on the combined ratio) and related net reinstatement premiums were $1 million in 2018 compared to catastrophe losses of $71 million (3.3 points) and related net reinstatement premiums of $6 million in 2017.
Underwriting profit for this group was $61 million in 2017 compared to $84 million in 2016, a decrease of $23 million (27%), reflecting lower underwriting profitability in the financial institutions business due primarily to higher catastrophe losses and adverse prior year reserve development. Catastrophe losses were $30 million (5.2 points on the combined ratio) in 2017 compared to $11 million (2.0 points) in 2016. In connection with catastrophe losses incurred in 2017, the Specialty financial sub-segment reduced profit-based commissions payable to agents by $8 million (1.1 points on the combined ratio) and paid $2 million in reinstatement premiums.
Other specialty This group reported an underwriting loss of $5 million in 2018 compared to $2 million in 2017, an increase of $3 million (150%). The lower results are due primarily to losses in the business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments in 2018, partially offset by the impact of a $14 million charge recorded in 2017 to adjust the deferred gain on the retroactive reinsurance transaction entered into in connection with the sale of businesses in 1998.
Property and transportation The 1.6 percentage points increase in the loss and LAE ratio for the current year, excluding catastrophe losses in 2018 compared to 2017 reflects an increase in the loss and LAE ratio of the aviation business and the Singapore branch.
The 2.4 percentage points increase in the loss and LAE ratio for the current year, excluding catastrophe losses in 2017 compared to 2016 reflects an increase in the loss and LAE ratio of the crop and property and inland marine businesses and the Singapore branch.
Specialty casualty The loss and LAE ratio for the current year, excluding catastrophe losses is comparable in 2018 and 2017.
The 3.8 percentage points increase in the loss and LAE ratio for the current year, excluding catastrophe losses in 2017 compared to 2016 reflects an increase in the loss and LAE ratio of the financial institutions business.
AFG’s Specialty property and casualty insurance operations recorded net favorable reserve development related to prior accident years of $212 million in 2018 compared to $139 million in 2017 and $61 million in 2016, an increase of $73 million (53%) and $78 million (128%), respectively.
Property and transportation Net favorable reserve development of $50 million in 2018 reflects lower than expected losses in the crop business and lower than expected claim severity at National Interstate, partially offset by higher than expected claim frequency and severity in the Singapore branch and aviation operations.
Specialty casualty Net favorable reserve development of $139 million in 2018 reflects lower than anticipated claim severity in the workers’ compensation businesses and lower than expected emergence in assumed 2017 property catastrophe losses at Neon, and to a lesser extent, lower than expected claim severity in the executive liability business.
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.
Specialty financial Net favorable reserve development of $26 million in 2018 reflects lower than expected claim frequency and severity in the surety business, lower than expected claim severity in the fidelity business and lower than expected claim frequency in run-off businesses.
Other specialty In addition to the reserve development discussed above, total Specialty prior year reserve development includes net adverse reserve development of $3 million in 2018, net adverse reserve development of $8 million in 2017 and net
favorable reserve development of $4 million in 2016. The adverse reserve development in 2018 reflects $10 million of adverse reserve development associated with AFG’s internal reinsurance program, partially offset by amortization of the deferred gains on the retroactive reinsurance transactions entered into in connection with the sale of businesses in 1998 and 2001. The adverse reserve development in 2017 reflects a $14 million charge to adjust the deferred gain on the retroactive reinsurance transaction entered into in connection with the sale of businesses in 1998, partially offset by the amortization of deferred gains on retroactive reinsurance and favorable reserve development associated with AFG’s internal reinsurance program. Favorable reserve development in 2016 reflects amortization of deferred gains on retroactive reinsurance and reserve development associated with AFG’s internal reinsurance program.
AFG’s property and casualty U/W Exp were $1.38 billion in 2017 compared to $1.33 billion in 2016, an increase of $52 million (4%). AFG’s underwriting expense ratio was 30.2% in 2017 compared to 30.7% in 2016, a decrease of 0.5 percentage points.
Detail of AFG’s property and casualty commissions and other underwriting expenses and underwriting expense ratios is shown below (dollars in millions):
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums increased 1.6 percentage points in 2018 compared to 2017 reflecting lower premiums in the crop business, which has a lower expense ratio than AFG’s overall Property and transportation group and an increase in the expense ratio in the transportation businesses.
Commissions and other underwriting expenses as a percentage of net earned premiums decreased 0.5 percentage points in 2017 compared to 2016 reflecting the impact of higher crop premiums on the ratio.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.4 percentage points in 2017 compared to 2016 reflecting the impact of reinstatement premiums on the ratio.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums increased 1.3 percentage points in 2018 compared to 2017 reflecting higher profitability-based commissions paid to agents in the financial institutions business compared to 2017, which included an $8 million commission expense reduction due to hurricane losses in the 2017 period, partially offset by the impact of higher premiums on the ratio in the international operations.
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 insurer, recorded in the second quarter of 2016. See “Net prior year reserve development” under “Results of Operations - Property and Casualty Insurance Segment” for the years ended December 31, 2018, 2017 and 2016.
Net investment income in AFG’s property and casualty insurance operations was $438 million in 2018 compared to $362 million in 2017, an increase of $76 million (21%). Net investment income in AFG’s property and casualty operations was $362 million in 2017 compared to $350 million in 2016, an increase of $12 million (3%). In recent years, yields available in the financial markets on fixed maturity securities have generally been lower than yields on maturing investments, 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 insurance operations are provided below (dollars in millions):
The increase in average invested assets and net investment income in the property and casualty insurance segment in 2018 compared to 2017 reflects growth in the property and casualty insurance segment and very strong earnings from limited partnerships and similar investments. The property and casualty insurance segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 4.17% in 2018 compared to 3.64% in 2017, an increase of 0.53 percentage points due primarily to the higher earnings from limited partnerships and similar investments. AFG’s property and casualty insurance operations recorded $80 million in earnings from partnerships and similar investments and AFG-managed CLOs in 2018 compared to $34 million in 2017, an increase of $46 million (135%). The yield earned on these investments was 13.9% in 2018 compared to 7.9% in 2017. The high returns from limited partnerships and similar investments should not be expected to repeat in future periods.
GAAP other income and expenses, net for AFG’s property and casualty insurance operations was a net expense of $31 million in 2018, $13 million in 2017, and $9 million in 2016. Core other income and expenses, net for AFG’s property and casualty insurance operations was a net expense of $31 million, $13 million and $41 million in 2018, 2017 and 2016, respectively. The table below details the items included in GAAP and core other income and expenses, net for AFG’s property and casualty insurance operations (in millions):
Excludes a pretax non-core gain of $32 million on the sale of an apartment property in 2016.
AFG and its consolidated subsidiaries incurred $10 million in transaction expenses in 2016 related to GAI’s acquisition of all of the NATL common stock that it did not already own. These expenses consisted primarily of financial advisory and legal services. See Note B - “Acquisitions and Sale of Businesses” to the financial statements.
The fair value of derivatives related to FIAs was favorably impacted by higher than anticipated interest rates in 2018 compared to the negative impact of lower than anticipated interest rates in 2017. The favorable impact of interest rates between periods was offset by the negative impact of higher interest on the embedded derivative (from growth in the FIA business and higher interest rates), higher than expected option costs in 2018 and the impact of lower stock market performance in the 2018 period. AFG monitors the major actuarial assumptions underlying its annuity operations throughout the year and conducts detailed reviews (“unlocking”) of its assumptions in the fourth quarter of each year. If changes in the economic environment of actual experience would cause material revisions to future estimates, these assumptions are updated (unlocked) in an interim quarter. In addition to the fourth quarter detailed review, AFG unlocked its assumptions for option costs and interest rates in the second quarter of 2018 due to the continued higher FIA option costs (resulting primarily from higher than expected risk-free rates). AFG’s unlocking of the actuarial assumptions underlying its annuity operations resulted in a net charge of $31 million in 2018 compared to $3 million in 2017.
See “Annuity Unlocking” below for a discussion of the impact that the unlocking of actuarial assumptions had on annuity benefit expense.
Net investment income in 2018 was $1.64 billion compared to $1.46 billion in 2017, an increase of $180 million (12%). This increase reflects the growth in AFG’s annuity business and higher earnings from limited partnerships and similar investments, partially offset by the impact of lower investment yields. The overall yield earned on investments in AFG’s annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), increased by 0.10 percentage points to 4.73% from 4.63% in 2018 compared to 2017. This increase in net investment yield reflects higher earnings from limited partnerships and similar investments, partially offset by (i) the investment of new premium dollars at lower yields as compared to the existing investment portfolio and (ii) the impact of the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets. AFG’s annuity operations recorded $114 million in earnings from partnerships and similar investments and AFG-managed CLOs in 2018 compared to $53 million in 2017, an increase of $61 million (115%). The yield earned on these investments was 12.4% in 2018 compared to 8.2% in 2017. The high returns from limited partnerships and similar investments should not be expected to repeat in future periods. For the period from October 1, 2017 through December 31, 2018, $5.8 billion in annuity segment investments with an average yield of approximately 4.9% were redeemed or sold with the proceeds reinvested at an approximately 0.5% lower yield.
AFG’s net interest spread increased 0.08 percentage points to 2.70% from 2.62% in 2018 compared to 2017 due primarily to higher earnings from limited partnerships and similar investments, partially offset by lower investment yields. Features included in current annuity offerings allow AFG to achieve its desired profitability at a lower net interest spread than historical product offerings. As a result, AFG expects its net interest spread to narrow in the future.
AFG’s net interest spread decreased 0.11 percentage points to 2.62% in 2017 from 2.73% in 2016 due primarily to lower fixed maturity investment yields, partially offset by the impact of lower crediting rates.
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 $42 million in 2018 compared to $43 million in 2017, a decrease of $1 million (2%). Excluding the impact of unlocking charges of $1 million in 2018 and $3 million in 2017 related to unearned revenue, annuity policy charges and other miscellaneous income were $43 million in 2018 compared to $46 million in 2017, a decrease of $3 million (7%). Other miscellaneous income includes $1 million from the sale of real estate in 2017. 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 decreased 0.01 percentage points to 0.10% in 2018 from 0.11% in 2017.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) were $114 million in 2018, $89 million in 2017 and $92 million in 2016, representing an increase of $25 million (28%) in 2018 compared to 2017 and a decrease of $3 million (3%) in 2017 compared to 2016. As a percentage of average fixed annuity benefits accumulated, these net expenses increased 0.05 percentage points to 0.33% in 2018 from 0.28% in 2017 and decreased 0.05 percentage points to 0.28% in 2017 from 0.33% in 2016. 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):
See “Annuity Unlocking” below for a discussion of the impact that the unlocking of actuarial assumptions had on annuity benefits expense.
See “Annuity Unlocking” below for a discussion of the impact that the unlocking of actuarial assumptions had on annuity and supplemental insurance acquisition expenses. Unanticipated spread compression, decreases in the stock market, adverse mortality experience, and higher than expected lapse rates could lead to write-offs of DPAC or PVFP in the future.
Annuity other expenses were $131 million in 2018, $121 million in 2017 and $110 million in 2016, representing an increase of $10 million (8%) in 2018 compared to 2017 and an increase of $11 million (10%) in 2017 compared to 2016. Annuity other expenses represent primarily general and administrative expenses, as well as selling and issuance expenses that are not deferred. As a percentage of average fixed annuity benefits accumulated, these expenses remained unchanged at 0.37% in 2018 and 2017 and decreased 0.01 percentage points to 0.37% in 2017 from 0.38% in 2016. The increase in annuity other expenses in 2017 compared to 2016 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.
Excluding the impact of unlocking charges, the net change in fair value of derivatives related to fixed-indexed annuities increased annuity benefits by $51 million in 2018, $70 million in 2017 and $53 million in 2016. The change in the fair value of these derivatives includes $36 million in 2018, $16 million in 2017 and $7 million in 2016 in interest accreted on the embedded derivative (before DPAC amortization). AFG expects both the size of the embedded derivative and interest rates to rise, resulting in continued increases in interest on the embedded derivative. During 2018, the positive impact of higher than expected interest rates on the fair value of these derivatives was more than offset by the higher interest on the embedded derivative, the negative impact of higher than expected option costs and significantly lower stock market performance. The increase in 2017 and 2016 reflects the negative impact of significantly lower than anticipated interest rates on the fair value of these derivatives, partially offset by the positive impact of strong stock market performance in both periods. As a percentage of average fixed annuity benefits accumulated, this net expense decreased 0.07 percentage points to 0.15% in 2018 from 0.22% in 2017, and increased 0.03 percentage points to 0.22% in 2017 from 0.19% in 2016.
See “Annuity Unlocking” below for a discussion of the impact that the unlocking of actuarial assumptions had on the change in the fair value of the embedded derivative liability.
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 2018, 2017 and 2016 (in millions):
AFG monitors the major actuarial assumptions underlying its annuity operations throughout the year and conducts detailed reviews (“unlocking”) of its assumptions in the fourth quarter of each year. If changes in the economic environment or actual experience would cause material revisions to future estimates, these assumptions are updated (unlocked) in an interim period. AFG recorded net unlocking charges related to its annuity business of $31 million and $3 million in 2018 and 2017, respectively, and a net expense reduction of $1 million in 2016, which impacted AFG’s financial statements as follows (in millions):
See “Annuity Unlocking” under “Annuity Segment - Results of Operations” for the quarters ended December 31, 2018 and 2017 for a discussion of the overall net expense reduction from the periodic review of actuarial assumptions in the fourth quarter of 2018 and 2017.
In addition to the $4 million net charge from the periodic review of annuity assumptions in the fourth quarter of 2018, AFG recorded a $27 million net unlocking charge in the second quarter of 2018 due primarily to the unfavorable impact of higher projected option costs, partially offset by the favorable impact of an increase in projected net interest spreads on in-force business (due primarily to higher than previously anticipated reinvestment rates). Reinvestment rate assumptions are based primarily on 7-year and 10-year corporate bond yields.
The following table reconciles the net spread earned on AFG’s fixed annuities to overall annuity pretax earnings for 2018, 2017 and 2016 (in millions):
Net investment income (as a % of investments) of 4.73%, 4.63% and 4.77% in 2018, 2017 and 2016, respectively, multiplied by the difference between average fixed annuity investments (at amortized cost) and average fixed annuity benefits accumulated in each period.
Holding Company, Other and Unallocated - Results of Operations AFG’s net GAAP pretax loss outside of its property and casualty insurance and annuity operations (excluding realized gains and losses) totaled $165 million in 2018 compared to $252 million in 2017, a decrease of $87 million (35%). AFG’s net core pretax loss outside of its property and casualty insurance and annuity operations (excluding realized gains and losses) totaled $156 million in 2018 compared to $177 million in 2017, a decrease of $21 million (12%).
The following table details AFG’s GAAP and core loss before income taxes from operations outside of its insurance operations in 2018, 2017 and 2016 (dollars in millions):
Excludes pretax non-core special A&E charges of $9 million, $24 million and $5 million in 2018, 2017 and 2016, respectively, and a pretax non-core loss on retirement of debt of $51 million in 2017.
AFG’s run-off long-term care and life insurance operations recorded net earned premiums of $24 million and related benefits and acquisition expenses of $46 million in 2018 compared to net earned premiums of $22 million and related benefits and acquisition expenses of $31 million in 2017. The $14 million (54%) increase in life, accident and health benefits reflects higher claims in both the run-off long-term care and run-off life insurance businesses in 2018 compared to 2017.
Summit, a workers’ compensation insurance subsidiary, collects fees from a small group of unaffiliated insurers for providing underwriting, policy administration and claims services. In addition, certain of AFG’s property and casualty businesses collect fees from customers for ancillary services such as workplace safety programs and premium financing. In 2018, AFG collected $69 million in fees for these services compared to $66 million in 2017 and $60 million in 2016. Management views this fee income, net of the $46 million in 2018 and $41 million in both 2017 and 2016, in expenses incurred to generate such fees, as a reduction in the cost of underwriting its property and casualty insurance policies. Consistent with internal management reporting, these fees and the related expenses are netted and recorded as a reduction of commissions and other underwriting expenses in AFG’s segmented results.
Other income in the table above includes $16 million, $18 million and $17 million in 2018, 2017 and 2016, respectively, in management fees paid to AFG by the AFG-managed CLOs (AFG’s consolidated managed investment entities). The management fees are eliminated in consolidation - see the other income line in the Consolidated MIEs column under “Results of Operations - Segmented Statement of Earnings.” Excluding amounts eliminated in consolidation, AFG recorded other income outside of its property and casualty insurance and annuity operations of $13 million in 2018, $9 million in 2017 and $10 million in 2016.
AFG’s holding companies and other operations outside of its property and casualty insurance and annuity operations recorded interest expense of $62 million in 2018, $85 million in 2017 and $77 million in 2016. The $23 million (27%) decrease in interest expense in 2018 compared to 2017 is due primarily to a lower weighted average interest rate on AFG’s outstanding debt. The $8 million (10%) increase in interest expense in 2017 compared to 2016 reflects higher average indebtedness during 2017 compared to 2016, partially offset by a lower weighted average interest rate on outstanding debt.
The decrease in the weighted average interest rate for 2018 compared to 2017 and 2017 compared to 2016 reflects the following financing transactions completed by AFG in 2016 and 2017:
As a result of the comprehensive external studies and internal reviews of A&E exposures discussed under “Uncertainties - Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG’s holding companies and other operations outside of its property and casualty insurance and annuity operations recorded non-core special charges of $9 million in 2018, $24 million in 2017 and $5 million in 2016 to increase liabilities related to the A&E exposures of AFG’s former railroad and manufacturing operations. The charges in 2018, 2017 and 2016 are due to relatively small movements across several sites that primarily reflect changes in the scope and costs of investigation. In addition, AFG has seen a small increase in claims arising from exposure to deleterious substances other than asbestos, which has caused it to increase its estimated future liability. Total charges recorded to increase liabilities for A&E exposures of AFG’s former railroad and manufacturing operations (included in other expenses) were $21 million in 2018, $31 million in 2017 and $20 million in 2016.
In December 2017, AFG redeemed its $350 million outstanding principal amount of 9-7/8% Senior Notes due 2019 and recorded a pretax loss on retirement of debt of $40 million, primarily a $38 million make-whole premium. In addition, AFG wrote off unamortized debt issuance costs of $7 million related to the redemption of its $230 million outstanding 6-3/8% Senior Notes due 2042 at par value in June 2017 and $4 million related to the redemption of its $125 million outstanding 5-3/4% Senior Notes due 2042 at par value in August 2017.
The $262 million net realized loss from the change in the fair value of equity securities in 2018 includes losses of $92 million on banks and financing companies, $31 million on real estate investment trusts, $30 million on energy exploration and production companies and $27 million on asset management companies. AFG’s impairment charges on securities in 2018 all relate to fixed maturities. Approximately $19 million of impairment charges were taken on corporate bonds and $6 million were taken on residential MBS.
Consolidated Income Taxes AFG’s consolidated provision for income taxes was $122 million in 2018 compared to $247 million in 2017, a decrease of $125 million (51%). AFG’s consolidated provision for income taxes was $247 million in 2017 compared to $119 million in 2016, an increase of $128 million (108%). See Note L - “Income Taxes” to the financial statements for an analysis of items affecting AFG’s effective tax rate.
Other noncontrolling interests includes $2 million related to the gain on the sale of a hotel property in the first quarter of 2017 and $4 million related to the gain on the sale of an apartment property in the second quarter of 2016. Both properties were owned by an 80%-owned subsidiary of GAI.
See Note A - “Accounting Policies - Investments” to the financial statements for a discussion of accounting guidance adopted on January 1, 2018, 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 earnings, 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.
In August 2018, the FASB issued ASU 2018-12, Financial Services - Insurance: Targeted Improvements to the Accounting for Long-Duration Contracts, which changes the assumptions used to measure the liability for future policy benefits for traditional and limited pay contracts (e.g. life, accident and health benefits) from being locked in at inception to being updated at least annually and standardizes the liability discount rate to be used and updated each reporting period, requires the measurement of market risk benefits associated with deposit contracts (e.g. annuities) to be recorded at fair value, simplifies the amortization of deferred policy acquisition costs to a constant level basis over the expected life of the related contracts and requires enhanced disclosures. AFG will be required to adopt this guidance effective January 1, 2022. AFG cannot estimate the impact that the updated guidance will have on its results of operations, financial position or liquidity until the updated guidance is adopted.
Consolidated Statement of Earnings for the years ended December 31, 2018, 2017 and 2016
AFG’s management, with participation of its Co-Chief Executive Officers and its Chief Financial Officer, has evaluated AFG’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG’s Co-CEOs and CFO concluded that the controls and procedures are effective. There have been no changes in AFG’s internal control over financial reporting during the fourth fiscal quarter of 2018 that materially affected, or are reasonably likely to materially affect, AFG’s internal control over financial reporting.
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, 2018, based on the criteria set forth in “Internal Control - Integrated Framework” issued in 2013 by the Committee of Sponsoring Organizations of the Treadway Commission.
Based on AFG’s evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2018. The attestation report of AFG’s independent registered public accounting firm on AFG’s internal control over financial reporting as of December 31, 2018, is set forth on the next page.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company’s internal control over financial reporting as of December 31, 2018, 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 26, 2019 expressed an unqualified opinion thereon.
As discussed in Note A to the consolidated financial statements, the Company changed its method of accounting for equity investments, other than those accounted for under the equity method, to measure equity investments at fair value with changes in fair value recognized in net earnings for the year ended December 31, 2018.
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, 2018, and prior to the filing of this Form 10-K, have been evaluated for potential recognition or disclosure herein.
Holding gains and losses on equity securities carried at fair value under ASU 2016-01 are generally recorded in realized gains (losses) on securities. However, prior to the adoption of the new guidance, AFG classified a small portion of its equity securities as “trading” and reported those investments at fair value with holding gains and losses recognized in net investment income. These investments consisted primarily of equity securities held to offset the impact of changes in the stock market on employee benefit plans that are impacted by stock market performance and totaled $62 million at December 31, 2017. Following the adoption of the new guidance, AFG continues to record holding gains and losses on these securities, as well as its small portfolio of limited partnerships and similar investments carried at fair value under the new guidance and certain other securities classified at purchase as “fair value through net investment income” in net investment income.
securities impacted by the new guidance were carried at fair value through AOCI under the prior guidance, the adoption of the new guidance did not have a material impact on AFG’s financial position.
Fixed maturity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in AOCI in AFG’s Balance Sheet. Fixed maturity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in net investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.
Gains or losses on fixed-maturity securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other-than-temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses) on securities) and the cost basis of that investment is reduced. If management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then the other-than-temporary impairment is separated into two components: (i) the amount related to credit losses (recorded in earnings) and (ii) the amount related to all other factors (recorded in other comprehensive income). The credit-related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are shown in the statement of earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is recorded to reduce the amortized cost of that security to fair value.
Derivatives Derivatives included in AFG’s Balance Sheet are recorded at fair value. Changes in fair value of derivatives are included in earnings, unless the derivatives are designated and qualify as highly effective cash flow hedges. Derivatives that do not qualify for hedge accounting under GAAP consist primarily of (i) components of certain fixed maturity securities (primarily interest-only and principal-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related equity index options designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products.
DPAC and certain other balance sheet amounts related to annuity and life businesses are also adjusted, net of tax, for the change in expense that would have been recorded if the unrealized gains (losses) from securities had actually been realized. These adjustments are included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.
Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG’s Balance Sheet. AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The net gain or loss from accounting for the CLO assets and liabilities at fair value is presented separately in AFG’s Statement of Earnings.
Annuity Benefits Accumulated Annuity receipts and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited are charged to annuity benefits expense and decreases for annuity policy charges are recorded in other income. For traditional fixed annuities, the liability for annuity benefits accumulated represents the account value that had accrued to the benefit of the policyholder as of the balance sheet date. For fixed-indexed annuities, the liability for annuity benefits accumulated includes an embedded derivative that represents the estimated fair value of the index participation with the remaining component representing the discounted value of the guaranteed minimum contract benefits.
Unearned Revenue Certain upfront policy charges on annuities are deferred as unearned revenue (included in other liabilities) and recognized in net earnings (included in other income) using the same assumptions and estimated gross profits used to amortize DPAC.
Noncontrolling Interests For balance sheet purposes, noncontrolling interests represent the interests of shareholders other than AFG in consolidated entities. In the statement of earnings, net earnings and losses attributable to noncontrolling interests represents such shareholders’ interest in the earnings and losses of those entities. Noncontrolling interests that are redeemable at the option of the holder are presented separately in the mezzanine section of the balance sheet (between liabilities and equity).
Revenue Recognition Guidance Effective in 2018 On January 1, 2018, AFG adopted ASU 2014-09, which provides guidance on recognizing revenue when (or as) performance obligations under the contract are satisfied. The new guidance also updates the accounting for certain costs associated with obtaining and fulfilling contracts with customers and requires certain new disclosures. Because revenue recognition for insurance contracts and financial instruments (AFG’s primary sources of revenue) were excluded from the scope of the new guidance, the adoption of ASU 2014-09 did not have a material impact on AFG’s results of operations and financial position.
Lease Accounting Guidance Effective in 2019 In February 2016, the FASB issued ASU 2016-02, which requires entities that lease assets for terms longer than one year to recognize the assets and liabilities for the rights and obligations created by those leases on the balance sheet based on the present value of contractual cash flows. Qualitative and quantitative disclosures of the amount, timing and uncertainty of cash flows arising from leases will also be required. AFG will adopt the updated guidance effective January 1, 2019. The new guidance will not have a material effect on AFG’s results of operations because it does not change the manner in which lease-related expenses are recognized in the statement of earnings. In addition, the new guidance will not have a material effect on AFG’s financial position as recognizing the assets and liabilities related to operating leases upon adoption of the new guidance in January 2019 will increase AFG’s consolidated assets and consolidated liabilities by less than one-half of 1% as compared to AFG’s Balance Sheet at December 31, 2018.
Neon Lloyd’s Business On December 29, 2017, AFG completed the sale of an indirect noncontrolling interest in Neon, its United Kingdom-based Lloyd’s insurer, to certain Neon executives for cash equal to the fair value of the interest sold as determined by a third-party valuation firm. Because AFG continues to have a controlling interest in Neon, the sale was accounted for as an equity transaction with the excess of the carrying value of the net assets attributable to the noncontrolling interest sold over the consideration received recorded as a $3 million reduction in AFG’s Capital Surplus. As discussed in Note L - “Income Taxes,” the sale of the noncontrolling interest also resulted in the recognition of a $56 million tax benefit, including a $48 million tax benefit previously deferred in the 2016 restructuring of the Neon Lloyd’s operations.
Acquisition of Noncontrolling Interest in National Interstate Corporation 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 for $315 million ($32.00 per share) 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). Expenses related to the merger were approximately $10 million and were expensed as incurred.
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 equipment leasing and 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, fixed-indexed and variable-indexed annuities in the retail, financial institutions, registered investment advisor and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services. Effective January 1, 2018, the results of AFG’s run-off long-term care and life businesses are included in the “Other” segment instead of as a separate reportable segment based on the immaterial size of the remaining operations. Prior period amounts were reclassified for consistent presentation.
Sales of property and casualty insurance outside of the United States represented 7% of AFG’s revenues in 2018, 5% of AFG’s revenues in 2017 and 4% of AFG’s revenues in 2016.
Includes income of $32 million (before noncontrolling interest) from the sale of an apartment property in 2016.
Assets and liabilities measured and carried at fair value in the financial statements are summarized below (in millions):
The derivatives embedded in AFG’s fixed-indexed and variable-indexed annuity liabilities are measured using a discounted cash flow approach and had a fair value of $2.72 billion at December 31, 2018. The following table presents information about the unobservable inputs used by management in determining fair value of these Level 3 liabilities. See Note F - “Derivatives.”
Excludes $232 million and $206 million of life contingent annuities in the payout phase at December 31, 2018 and 2017, respectively.
ability and intent to hold the investment for a period of time sufficient to allow for anticipated recovery in fair value.
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 2018, 2017 and 2016, AFG recorded other-than-temporary impairment charges related to its residential MBS of $6 million, $1 million and $3 million, respectively.
In 2018, AFG recorded approximately $20 million in other-than-temporary impairment charges related to fixed maturities other than residential MBS, including $14 million related to aircraft financing. Other-than-temporary impairment charges on fixed maturities other than residential MBS were $19 million in 2017 and $35 million in 2016. In addition, AFG recorded $4 million in other-than-temporary impairment charges in 2017 on investments that are included in other investments on the balance sheet.
The table below sets forth the scheduled maturities of available for sale fixed maturities as of December 31, 2018 (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.
There were no investments in individual issuers that exceeded 10% of shareholders’ equity at December 31, 2018 or 2017.
As discussed in Note A - “Accounting Policies - Investments,” effective January 1, 2018, all equity securities other than those accounted for under the equity method are carried at fair value through net earnings.
The change in fair value of the embedded derivative includes losses related to unlocking of actuarial assumptions of $44 million in 2018, $25 million in 2017 and $17 million in 2016.
$3 million in 2018 compared to income of $6 million in 2017 and $7 million in 2016. There was no ineffectiveness recorded in net earnings during these periods. A collateral receivable supporting these swaps of $135 million at December 31, 2018 and $70 million at December 31, 2017 is included in other assets in AFG’s Balance Sheet.
loans, which serve as collateral for the debt securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG’s investments in the subordinate debt tranches of these entities receive residual income from the CLOs only after the CLOs pay expenses (including management fees to AFG) and interest on and returns of capital to senior levels of debt securities. There are no contractual requirements for AFG to provide additional funding for these entities. AFG has not provided and does not intend to provide any financial support to these entities.
Changes in the carrying value of goodwill during 2016, 2017 and 2018, by reporting segment, are presented in the following table (in millions):
Goodwill increased by $8 million in the fourth quarter of 2018 due to the purchase of ABAIS as discussed in Note B - “Acquisitions and Sale of Businesses.”
Included in other assets in AFG’s Balance Sheet is $54 million at December 31, 2018 and $26 million at December 31, 2017 of amortizable intangible assets related to property and casualty insurance acquisitions. These amounts are net of accumulated amortization of $39 million and $30 million, respectively. The increase in amortizable intangible assets in 2018 relates to the November 2018 acquisition of ABAIS (discussed in Note B - “Acquisitions and Sale of Businesses”) and a renewal rights intangible asset established in connection with the acquisition of a small property and casualty book of business in January 2018. Amortization of intangibles was $9 million in 2018 and $8 million in both 2017 and 2016. Future amortization of intangibles (weighted average amortization period of 7 years) is estimated to be $12 million per year in 2019 and 2020, $6 million in 2021, $4 million per year in 2022 and 2023 and $16 million thereafter.
AFG can borrow up to $500 million under its 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, 2018 or December 31, 2017.
Stock Incentive Plans Under AFG’s stock incentive plans, employees of AFG and its subsidiaries are eligible to receive equity awards in the form of stock options, stock appreciation rights, restricted stock awards, restricted stock units and stock awards. At December 31, 2018, there were 7.0 million shares of AFG Common Stock reserved for issuance under AFG’s stock incentive plans.
The total fair value of restricted stock that vested during 2018, 2017 and 2016 was $10 million, $14 million and $10 million, respectively.
AFG did not grant any stock options in 2018, 2017 or 2016. Options granted in years prior to 2016 have an exercise price equal to the market price of AFG Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant and expire ten years after the date of grant.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries for 2018, 2017 and 2016 was $23 million, $30 million and $28 million, respectively. AFG’s provision for income tax includes tax benefits of $13 million in 2018, $27 million in 2017 and $19 million in 2016 related to AFG’s stock incentive plans. At December 31, 2018, there was $3 million and $35 million of unrecognized compensation expense related to nonvested stock options and restricted stock awards, respectively. The nonvested stock options and restricted stock awards amounts are expected to be recognized over a weighted average of 1.0 year and 2.5 years, respectively.
The following is a reconciliation of income taxes at the statutory rate (21% in 2018 and 35% in both 2017 and 2016) to the provision for income taxes as shown in AFG’s Statement of Earnings (dollars in millions):
Approximately $14 million of the $21 million impact of “foreign operations” for 2017 in the table above relates to a reduction in the “foreign underwriting losses” deferred tax asset as a result of the sale of the noncontrolling interest in Neon. Since AFG maintains a full valuation allowance against the deferred tax assets related to Neon, this reduction in deferred tax assets was offset by a corresponding reduction in the valuation allowance and had no overall impact on AFG’s income tax expense or results of operations.
In connection with the reorganization of the 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 a $111 million tax benefit associated with this loss in the fourth quarter of 2016. Approximately $29 million of the $111 million tax benefit recorded in 2016 reduced current taxes payable for 2016, while the remaining tax benefit was received in 2017 from the carry-back of the tax-basis capital loss to offset capital gains in prior years. An additional loss associated with the 2016 restructuring was deferred under U.S. tax laws, resulting in an unrecognized potential tax benefit of $48 million at December 31, 2016. The sale of the noncontrolling interest in Neon resulted in the recognition of an additional tax benefit of $56 million in the fourth quarter of 2017, including the recognition of the deferred loss from the 2016 restructuring. Approximately $20 million of the $56 million tax benefit recorded in 2017 reduced current taxes payable for 2017. The majority of the remaining 2017 tax benefit is expected to be received in 2019 as a result of the filing of a refund claim in 2018 to carry back tax basis capital losses to offset prior year tax basis capital gains.
The Tax Cuts and Jobs Act of 2017 (“TCJA”), which was enacted on December 22, 2017, lowered the U.S corporate tax rate to 21% and made other widespread changes to the U.S. tax code effective in 2018. Because the TCJA was enacted in December 2017, AFG recorded the $83 million decrease in its net deferred tax asset resulting from the changes in the tax code (primarily the lower corporate tax rate applicable to 2018 and future years) in the fourth quarter of 2017.
At the time it was enacted, the TCJA was subject to further clarification and interpretation by the U.S. Treasury Department and the Internal Revenue Service. For example, the TCJA changed the way that companies calculate their insurance claims and reserves for tax purposes, including revaluing those tax basis liabilities as of January 1, 2018, based on a methodology and discount factors that had not been published. The resulting transitional deferred tax liability (taxes payable over eight years under the TCJA) and offsetting increase in AFG’s insurance claims and reserves deferred tax assets, were recorded at December 31, 2017 using reasonable estimates based on available information and were considered provisional in accordance with Securities and Exchange Commission Staff Accounting Bulletin No. 118 (“SAB 118”). Because the established transition liability was completely offset by an increase in related deferred tax assets, the adjustment to the final amount when the factors were published in 2018 did not impact AFG’s effective tax rate. In accordance with SAB 118, the insurance claims and reserves transitional deferred tax liability (and offsetting adjustment to the related deferred tax assets) and all other changes in deferred taxes resulting from clarification and interpretation of the TCJA were recorded in 2018 in the period in which the guidance was published and did not have a material impact on AFG’s effective tax rate. As a result, AFG’s implementation of the TCJA is complete as of December 31, 2018.
Excluding the tax benefit related to the Neon restructuring and the impact of the change in the U.S. corporate tax rate, AFG’s effective tax rate for the year ended December 31, 2017 was 31%. 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 - 2018 tax years remain subject to examination by the IRS.
Total earnings before income taxes include losses subject to tax in foreign jurisdictions of $69 million in 2018, $58 million in 2017 and $160 million in 2016, primarily related to the Neon Lloyd’s operations.
“Foreign underwriting losses” in the table above include the net operating loss carryforward and other deferred tax assets related to the Neon Lloyd’s insurance business. Due to uncertainty concerning the realization of the deferred tax benefits associated with these losses, AFG maintains a full valuation allowance of $93 million against these deferred tax assets at December 31, 2018. In addition to the valuation allowance related to the Neon Lloyd’s insurance business, the gross deferred tax asset has also been reduced by a $23 million valuation allowance related to AFG’s net operating loss carryforwards (“NOL”) subject to the separate return limitation year (“SRLY”) tax rules. A SRLY NOL can be used only by the entity that created it and only in years that both it and the consolidated group have taxable income. Approximately $19 million of AFG’s SRLY NOLs expired unutilized at December 31, 2018. Since AFG maintains a full valuation allowance against its SRLY NOLs, the expiration of these loss carryforwards was offset by corresponding reduction in the valuation allowance and had no overall impact on AFG’s income tax expense or results of operations.
The total unrecognized tax benefits and related interest and penalties that, if recognized, would impact the effective tax rate is less than $1 million at December 31, 2018 and December 31, 2017. AFG’s provision for income taxes in 2018, 2017 and 2016 included interest expense related to unrecognized tax benefits of less than $1 million in each year (net of federal benefit or expense). There was no liability for interest related to unrecognized tax benefits at December 31, 2018. AFG’s liability for interest related to unrecognized tax benefits was less than $1 million at December 31, 2017 (net of federal benefit). AFG’s provision for income taxes in 2018, 2017 and 2016 included penalties of less than $1 million in each year. AFG’s liability for penalties related to unrecognized tax benefits was less than $1 million at December 31, 2018 and December 31, 2017.
Cash payments for income taxes, net of refunds, were $156 million, $194 million and $308 million for 2018, 2017 and 2016, respectively.
AFG completed an in-depth internal review of its asbestos and environmental (“A&E”) exposures in the third quarter of 2018. The review resulted in special A&E charges of $18 million for the property and casualty group and $9 million for the former railroad and manufacturing operations. AFG completed a comprehensive external study of its A&E exposures in the third quarter of 2017 with the aid of specialty actuarial, engineering and consulting firms and outside counsel. The study resulted in special A&E charges of $89 million for the property and casualty group and $24 million for the former railroad and manufacturing operations. AFG completed an in-depth internal review of its 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 railroad and manufacturing operations.
The property and casualty group’s liability for A&E reserves was $524 million at December 31, 2018; related recoverables from reinsurers (net of allowances for doubtful accounts) at that date were $129 million.
At December 31, 2018, GAFRI had a liability of $8 million for environmental costs and certain other matters associated with the sales of its former manufacturing operations.
Pretax realized gains on subsidiaries and securities (including other-than-temporary impairments), favorable (adverse) prior year development of AFG’s liability for losses and loss adjustment expenses (“LAE”) and the impact of derivatives related to fixed-indexed and variable-indexed annuities (“FIAs”) were as follows (in millions):
Prior year development in the third quarters of 2018 and 2017 includes pretax special charges of $18 million and $89 million, respectively, to strengthen property and casualty insurance A&E reserves. As a result of the Neon reinsurance to close agreement discussed in Note O - “Insurance,” Neon recorded $42 million in favorable development in the fourth quarter of 2017, of which $24 million related to its ongoing lines of business and $18 million related to its exited lines of business.
AFG recorded net charges as a result of updating (unlocking) actuarial assumptions underlying its annuity operations of $27 million in the second quarter of 2018, $4 million in the fourth quarter of 2018 and $3 million in the fourth quarter of 2017.
The liability for losses and LAE for a very limited number of claims with long-term scheduled payments under certain workers’ compensation policies has been discounted at 4.5% at both December 31, 2018 and 2017, which represents an approximation of long-term investment yields. Because of the limited amount of claims involved, the net impact of discounting did not materially impact AFG’s total liability for unpaid losses and loss adjustment expenses (net reductions from discounting of $13 million and $15 million at December 31, 2018 and 2017, respectively).
The net decrease in the provision for claims of prior years in 2017 reflects (i) lower than expected losses in the crop and equine businesses and lower than expected claim severity in the property and inland marine and transportation businesses (all within the Property and transportation sub-segment), (ii) favorable reserve development of $18 million on Neon’s exited lines, as well as additional favorable development on ongoing lines of business within Neon, recorded in connection with the reinsurance to close agreement entered into in December 2017 for the 2015 and prior years of account, lower than anticipated claim severity in the workers’ compensation businesses and lower than expected losses in the executive liability business (all within the Specialty casualty sub-segment) and (iii) lower than anticipated claim severity in the fidelity business and lower than expected claim frequency and severity in the surety business (both within the Specialty financial sub-segment). This favorable development was partially offset by (i) the $89 million special charge to increase asbestos and environmental reserves, (ii) higher than expected claim frequency and severity in the ocean marine business (within the Property and transportation sub-segment), (iii) higher than anticipated claim severity in the targeted markets and general liability businesses and higher than anticipated severity in New York contractor claims (all within the Specialty casualty sub-segment) and (iv) a charge to adjust to the deferred gain on the retroactive reinsurance transaction entered into in connection with the sale of businesses in 1998 (included in Other specialty sub-segment).
The net increase in the provision for claims of prior years in 2016 reflects (i) the $36 million special charge to increase asbestos and environmental reserves, (ii) reserve strengthening at National Interstate and higher than expected claim frequency in the ocean marine business (within the Property and transportation sub-segment), (iii) 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 (within the Specialty casualty sub-segment) and (iv) 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. This adverse development was partially offset by (i) lower than expected losses in the crop business 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, lower than expected claim frequency and severity in the surety business and lower than anticipated claim frequency in the financial institutions business (within the Specialty financial sub-segment).
The following claims development tables and associated disclosures related to short-duration insurance contracts are prepared by sub-segment within the property and casualty insurance business for the most recent 10 accident years. AFG determines its claim counts at the claimant or policy feature level depending on the particular facts and circumstances of the underlying claim. While the methodology is generally consistent within each sub-segment, there are minor differences between and within the sub-segments. The methods used to summarize claim counts have not changed significantly over the time periods reported in the tables below.
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 $47 million investment in FHLB capital stock at December 31, 2018 is included in other investments at cost. Membership in the FHLB provides the annuity operations with an additional source of liquidity. These advances further the FHLB’s mission of improving access to housing by increasing liquidity in the residential mortgage-backed securities market. In the fourth quarter of 2018, GALIC refinanced the terms on a $40 million advance to extend the maturity and the FHLB advanced GALIC $225 million, increasing the total amount advanced to $1.10 billion (included in annuity benefits accumulated) at December 31, 2018. In 2017, GALIC refinanced the terms on advances totaling $831 million, which lowered the weighted average spread over LIBOR. Interest rates under the various funding agreements on the advances range from 0.15% to 0.24% over LIBOR (average rate of 2.68% at December 31, 2018). While these advances must be repaid between 2019 and 2021 ($445 million in 2019, $40 million in 2020 and $611 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. The advances on these agreements are collateralized by fixed maturity investments, which have a total fair value of $1.28 billion (included in available for sale fixed maturity securities) at December 31, 2018. Interest credited on the funding agreements, which is included in annuity benefits, was $20 million in 2018, $14 million in 2017 and $8 million in 2016.
Payments of dividends by AFG’s insurance companies are subject to various state laws that limit the amount of dividends that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 2019 from its insurance subsidiaries without seeking regulatory approval is $1.30 billion. Additional amounts of dividends require regulatory approval.
Holding Company Dividends AFG declared and paid common stock dividends to shareholders totaling $397 million, $421 million and $187 million in 2018, 2017 and 2016, respectively. Currently, there are no regulatory restrictions on AFG’s retained earnings or net earnings that materially impact its ability to pay dividends. Based on shareholders’ equity at December 31, 2018, AFG could pay dividends of nearly $2 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.
AFG has reinsured approximately $7.69 billion of its $10.82 billion in face amount of life insurance at December 31, 2018 compared to $8.32 billion of its $12.05 billion in face amount of life insurance at December 31, 2017. Life written premiums ceded were $22 million, $28 million and $31 million for 2018, 2017 and 2016, respectively. Reinsurance recoveries on ceded life policies were $38 million, $35 million and $41 million for 2018, 2017 and 2016, respectively.
Fixed Annuities For certain products, the liability for “annuity benefits accumulated” includes reserves for excess benefits expected to be paid on future deaths and annuitizations guaranteed withdrawal benefits and accrued persistency and premium bonuses. The liabilities included in AFG’s Balance Sheet for these benefits, excluding the impact of unrealized gains on securities, were as follows at December 31 (in millions):
Variable Annuities At December 31, 2018, 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 $35 million, compared to $15 million at December 31, 2017. Death benefits paid in excess of the variable annuity account balances were less than $1 million in each of the last three years ended December 31, 2018, 2017 and 2016.
Allowance for Uncollectible Reinsurance AFG’s aggregate allowance for uncollectible reinsurance recoverables was $18 million at December 31, 2018 and $20 million at December 31, 2017. AFG reviews the allowance quarterly and adjusts it as necessary to reflect changes in estimates of uncollectible balances. AFG recorded net expense reductions against the allowance of $2 million in 2018 and less than $1 million in both 2017 and 2016. In 2017, the allowance was reduced by reinsurance recoverable write-offs of $2 million.
The following financial information from American Financial Group’s Form 10-K for the year ended December 31, 2018, formatted in XBRL (Extensible Business Reporting Language):