Reflects the results of Transport Insurance Company, which was sold in 2004. The loss in 2005 represents the settlement of disputed amounts under the sales contract.
Fixed charges are computed on a "total enterprise" basis. For purposes of calculating the ratios, "earnings" have been computed by adding to pretax earnings the fixed charges and the minority interest in earnings of subsidiaries having fixed charges and the undistributed equity in losses of investees. Fixed charges include interest (including or excluding interest credited to annuity policyholders' accounts as indicated), amortization of debt premium/discount and expense, preferred dividend and distribution requirements of subsidiaries and a portion of rental expense deemed to be representative of the interest factor.
Although the ratio of earnings to fixed charges excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, some investors and lenders may not consider interest credited to annuity policyholders' accounts a borrowing cost for an insurance company, and accordingly, believe this ratio is meaningful.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance and in the sale of retirement annuities and supplemental insurance products. With the sale of Infinity in 2003, AFG narrowed the focus of its property and casualty business to its specialized commercial products for businesses.
The property and casualty business is cyclical in nature with periods of high competition resulting in low premium rates, sometimes referred to as a "soft market" or "downcycle" followed by periods of reduced competition and higher premium rates, referred to as a "hard market" or "upcycle." The 1990's were a soft market period; prices started to harden in 2000 and accelerated significantly following the terrorist attacks in 2001. Rate increases for AFG's specialty businesses moderated during the latter part of 2003 and that trend continued during 2004. While certain specialty operations experienced higher rate levels in 2005, overall average pricing was flat for the year.
AFG's net earnings for 2005 were $206.6 million ($2.62 per share). Included in net earnings were the following items, net of tax and minority interest:
A reserve charge of $121.6 million for asbestos, environmental and other mass tort exposures within AFG's run-off operations.
Gains of $45.9 million on the sale of real estate and other assets.
A charge of $29.3 million related to the residual value business.
A charge of $15.6 million reducing deferred acquisition costs and increasing insurance liabilities of the annuity and run-off life operations.
In November 2004, AFG replaced its existing credit line with a $300 million credit facility. No amounts have been borrowed under this credit facility through December 31, 2005. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on AFG's credit rating. AFG believes that this credit agreement provides ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent company.
All debentures issued by AFG (and GAFRI) are rated investment grade by three nationally recognized rating agencies. Under a currently effective shelf registration statement, AFG can issue up to an aggregate of $517 million in additional equity or debt securities including 2.3 million shares of common stock remaining under a 2004 equity distribution agreement with UBS Securities LLC. The shelf registration provides AFG with flexibility to access the capital markets from time to time as market and other conditions permit.
For statutory accounting purposes, equity securities of non-affiliates are generally carried at market value. At December 31, 2005, AFG's insurance companies owned publicly traded equity securities with a market value of $556 million. In addition, Great American Insurance Company owns GAFRI and National Interstate Corporation (NYSE: "NATL") common stock with a market value of $960 million and a statutory carrying value of $689 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.
GAFRI has a $165 million credit facility that matures in 2008. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on GAFRI's credit rating. There were no amounts borrowed under this agreement at December 31, 2005. In addition, GAFRI can issue approximately $250 million in additional equity or debt securities under a currently effective shelf registration.
In the fourth quarter of 2005, GAFRI repurchased $20.8 million of its 8-7/8% preferred securities for $22.6 million in cash. Through February 2006, GAFRI repurchased an additional $51.5 million of its 6-7/8% Notes for $53.4 million.
The liquidity requirements of AFG's insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have provided more than sufficient funds to meet these requirements without requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
benefit payments only. Projections do not include any impact for future
as follows: Within 1 year - $800 million; 2-3 years - $800 million;
Between January 1 and February 28, 2006, AFG repurchased $22.1 million of its 7-1/8% Debentures due 2009 and GAFRI repurchased $51.5 million of its 6-7/8% Notes due 2008. The scheduled principal payments in the above table have been adjusted to reflect these repurchases. The AFG Convertible Debentures due in 2033 are included in the above table at the first put date (2008).
See Note R - "Additional Information - Financial Instruments with Off-Balance Sheet Risk" to the financial statements.
Approximately 94% of the fixed maturities held by AFG were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies at December 31, 2005. Investment grade securities generally bear lower yields and
Investments in mortgage backed securities ("MBSs") represented 32% of AFG's fixed maturities at December 31, 2005. MBSs are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates. Substantially all of AFG's MBSs are investment grade quality, with approximately 98% rated "AAA" at December 31, 2005.
Based on its analysis of the factors enumerated above, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they mature or recover in value. Should either of these beliefs change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired,
charges for other than temporary impairment could be material to results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
amortization of deferred policy acquisition costs and to carry derivatives at
The liabilities for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon: (a) the accumulation of case estimates for losses reported prior to the close of the accounting periods on direct business written ("case reserves"); (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience("IBNR"); (d) estimates based on experience of expense for investigating and adjusting claims; and (e) the current state of law and coverage litigation. Using these items as well as historical trends adjusted for changes in underwriting standards, policy provisions, product mix and other factors, management, including Company actuaries, determines a single or "point" estimate that it records as its best estimate of the liabilities. Recorded amounts are analyzed and tested on a quarterly basis by Company actuaries. Ranges of loss reserves are not developed by Company actuaries.
Following is a discussion of certain variables affecting the estimation of the more significant lines of business (asbestos, environmental and other mass tort liabilities are separately discussed below). Many other variables may also impact ultimate claim costs.
reserves for ultimate liabilities. This unexpected change could arise from a variety of sources including a general increase in economic inflation, inflation from social programs, new medical technologies, or other factors such as those listed below in connection with our largest lines of business. Utilizing the effect of a 1% change in cost trends enables changes greater than 1% to be estimated by extrapolation. Each additional 1% change in the cost trend would increase the effect on net earnings by an amount slightly (about 6%) greater than the effect of the previous 1%. For example, if a 1% change in cost trends would change net earnings by $20 million, a 2% change would change net earnings by $41 million. The estimated cumulative impact that a one percent change would have on our net earnings is shown below (in millions).
This line of business consists of coverages protecting the insured against legal liability resulting from negligence, carelessness, or a failure to act causing property damage or personal injury to others. Some of the important variables affecting estimation of loss reserves for other liability - occurrence include:
AFG's workers' compensation business is written primarily in California. Significant reforms passed by the California state legislature in 2003 and in 2004 have favorably impacted settlement payments. The magnitude of future cost savings depends on the implementation and interpretation of the reforms throughout the California workers' compensation system over the next several years.
Approximately one-half of AFG's net asbestos reserves relate to policies written directly by AFG subsidiaries. Claims from these policies generally are product oriented claims with only a limited amount of non-product exposures, and are dominated by small to mid-sized commercial entities that are mostly regional policyholders with few national target defendants. The remainder is assumed reinsurance business that includes exposures for the periods 1954 to 1983. The asbestos and environmental assumed claims are ceded by various insurance companies under reinsurance treaties. A majority of the individual assumed claims have exposures of less than $100,000 to AFG. Asbestos losses assumed include some of the industry known manufacturers, distributors and installers. Pollution losses include industry known insured names and sites.
There is a growing interest at the state and federal level to attempt to legislatively address asbestos liabilities and the manner in which asbestos claims are resolved. These developments are fluid and could result in a comprehensive solution or piecemeal state by state solutions.
In February 2003, Great American Insurance Company entered into an agreement for the settlement of asbestos related coverage litigation under insurance polices issued during the 1970's and 1980's to Bigelow-Liptak Corporation and related companies, subsequently known as A.P. Green Industries, Inc. The settlement is for $123.5 million (Great American has the option to pay in cash or over time with
AFG tracks its A&E claims by policyholder. The following table shows, by type of claim, the number of policyholders that did not receive any payments in the calendar year separate from policyholders that did receive a payment. Policyholder counts represent policies written by AFG subsidiaries and do not include assumed reinsurance. The significant decline in policyholder counts in 2004 reflects the sale of Transport Insurance Company.
At December 31, 2005, American Premier had liabilities aggregating $89.3 million for various environmental and occupational injury and disease claims and other contingencies arising out of the railroad operations and certain manufacturing operations disposed of by American Premier and its predecessor. For a discussion of the uncertainties in determining American Premier's ultimate liability, see Note O - "Commitments and Contingencies" to the Financial Statements.
Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of underwriting losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. A combined ratio under 100% is indicative of an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.
AFG's combined ratio has been better than the industry average for nineteen of the last twenty years and excluding AFG's special A&E charges, for all twenty years. Management believes that AFG's insurance operations have performed better than the industry as a result of product line diversification, stringent underwriting discipline and, more recently, a specialty niche focus.
(a) Includes the operations of Infinity through its sale in mid-February
(c) Includes 12.4 points in 2005 for the effect of a charge related to the
(d) Includes 2.2 points in 2005 and 1.8 points in 2004 for the effect of
(e) Includes 7.6 points in 2005 for the effect of strengthening the A&E and other
mass tort loss reserves by $179 million and 2.3 points in 2003 for the effect of
an arbitration decision relating to a claim arising from a business in runoff.
The property and casualty specialty insurance operations generated an underwriting profit of $208 million for 2005, substantially higher than 2004. These results included a $45 million charge against the residual value business and $53 million for hurricane losses offset by strong profitability within the crop insurance operations and favorable reserve development within several operations.
Net written premiums increased 9% for 2004 compared to 2003 while gross written premiums were relatively flat. The increase is primarily a result of a decrease in reinsurance ceded and rate increases. The 2004 combined ratio includes 1.2 points for the effect of a charge related to the commutation of a reinsurance agreement. In addition, both 2004 and 2003 contain significant amounts of adverse prior year development. Despite these items, solid underwriting profits from other operations allowed this group to end 2004 with a combined ratio of 99.8%.
Gross and net written premiums grew 31% and 25%, respectively, in 2004 compared to 2003, reflecting significant volume growth. The 2004 combined ratio improved 2.5 points as this group continued to experience improving claims results due to the workers' compensation reform enacted in California. The reforms have enabled the group to offer coverage at lower rates while maintaining solid underwriting profits.
The Personal group wrote private passenger auto insurance and, to a lesser extent, homeowners' insurance. The Personal group's results represent primarily Infinity's underwriting results through the public offering in mid-February 2003 and the direct-to-consumer auto business, which was sold in April 2003. AFG's remaining personal lines business generated about 3% of net written premiums in 2003. Beginning in 2004, substantially all of the remaining former Personal business is included in Specialty transportation (2005 net written premium of $23 million and underwriting loss of $369,000; 2004 net written premium of $27 million and underwriting profit of $3 million).
AFG recently completed a comprehensive study of its asbestos and environmental exposures relating primarily to the run-off operations of its property and casualty group. AFG has undertaken periodic reviews of its A&E reserves with the aid of an independent actuarial firm and specialty outside counsel. As a result of its study, AFG recorded a 2005 third quarter pre-tax charge of $169 million, net of $32 million in reinsurance recoverables. This charge resulted in an increase in asbestos reserves of $124 million and environmental reserves of $45 million. At December 31, 2005, AFG's A&E reserves were $461 million, net of reinsurance recoverables. At that date, AFG's three year survival ratio was 21.0 times paid losses for the asbestos reserves and 11.5 times paid losses for the total A&E reserves (15.6 and 9.0 times paid losses, respectively, excluding amounts associated with the 2003 settlement of asbestos related coverage litigation for A.P. Green Industries).
A primary driver of the increase in AFG's asbestos reserves is the use by independent actuaries of evolving methodologies, including developing parameters for estimating loss adjustment expenses and reducing reliance on extrapolation techniques. In addition, the independent actuaries have indicated that their views have evolved regarding estimation of the potential exposure for both products and non-products claims. In the actuaries' view, this refined approach has increased estimates of the Company's indicated ultimate losses. The estimates of industry ultimate losses and AFG's historic premium market share have not changed since the 2001 study. In addition, there has been no significant change in AFG's payment patterns. In the 2005 study, the actuaries also have given additional weight to claims associated with peripheral defendants bringing direct insurance claims. The increase in the number of direct insurance claims from peripheral defendants has increased the projections of future defense cost and loss exposure.
Other Mass Tort Charge In connection with the review of A&E reserves in 2005, AFG reviewed its other mass tort exposures and recorded a $10 million pre-tax charge. At December 31, 2005, AFG's other mass tort reserves were $18 million, net of reinsurance recoverables.
Loss development As shown in Note Q under "Insurance Reserves," AFG's property and casualty operations recorded loss development of $181 million in 2005, $140 million in 2004 and $167 million in 2003 related to prior accident years. Major areas of favorable (adverse) development were as follows (in millions):
The favorable development in Property and transportation in 2005 related primarily to lower than expected claim frequency and severity in specialty commercial automobile and ocean marine products. This improvement was partially offset by continued adverse development on runoff homebuilders' liability business, which was the primary reason for the adverse development in 2004 and 2003. In 2004, the adverse development was partially offset by favorable development in inland marine and agricultural-related coverages.
The favorable development in California workers' compensation in 2005 reflects the impact of the workers' compensation reform legislation passed in 2003 and 2004. The adverse development in 2004 reflects the effect of additional information received on individual claims from prior years.
The increase in life, accident and health premiums and benefits in 2005 and 2004 reflects the addition of new distribution sources for GAFRI's supplemental insurance products.
Changes in investment income reflect fluctuations in market rates and changes in average invested assets. The increase in investment income for 2005 and 2004 reflects an increase of about $1.4 billion (10%) in average cash and investments in each year. The increase in 2004 was somewhat offset by lower average yields on fixed income securities. AFG's yield on fixed income securities, excluding realized gains, was about 5.7% in 2005 and 2004 and 6.2% in 2003.
Realized gains (losses) on sales of securities include provisions for other than temporary impairment of securities still held of $16.1 million in 2005, $16.7 million in 2004 and $58.4 million in 2003. Impairment charges over the last three years reflect primarily writedowns of certain asset-backed securities and in 2004 and 2003 the downturn in the airline industry.
During 2003, AFG recognized a gain of $56.5 million on the December 2003 sale of its remaining interest in Infinity which more than offset the $39.4 million loss it recognized when it sold a 61% interest in Infinity in February 2003. Additional net gains of $2.7 million were recognized in 2003 on the sale of three small insurance subsidiaries and the settlement of disputed amounts under a contract covering a prior year sale.
AFG's subsidiaries are engaged in a variety of real estate operations including hotels, apartments, office buildings and recreational facilities; they also own several parcels of land. Revenues and expenses of these operations, including gains and losses on disposal, are included in AFG's Statement of Earnings as shown below (in millions).
Other income increased $95.8 million (30%) in 2005 compared to 2004 due primarily to pretax gains of $73.6 million on the coal reserves and hotel sales mentioned above, a $10.1 million increase in other income from real estate (reflecting acquisitions) and a $12.7 million increase in revenues earned by AFG's warranty business.
Annuity benefits reflect amounts accrued on annuity policyholders' funds accumulated. On its deferred annuities (annuities in the accumulation phase), GAFRI generally credits interest to policyholders' accounts at their current stated interest rates. Furthermore, for "two-tier" deferred annuities (annuities under which a higher interest amount can be earned if a policy is annuitized rather than surrendered), GAFRI accrues additional reserves for (i) persistency and premium bonuses and (ii) excess benefits expected to be paid for future deaths and annuitizations. Changes in crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect this accrual.
Interest expense for 2004 increased $14.6 million compared to 2003 due primarily to higher average indebtedness and paydowns of lower variable-rate bank debt with the proceeds from fixed-rate debt offerings in 2003. The majority of the proceeds from debt issued in 2004 was used to retire higher coupon trust preferred securities. Accordingly, the increase in interest expense for 2004 was substantially offset by the $14 million reduction in interest on subsidiary trust obligations (see below).
Interest on subsidiary trust obligations issued prior to 2003 was included in minority interest expense in 2003. Interest on subsidiary trust obligations decreased $2.9 million for 2005 compared to 2004 and $14 million for 2004 compared to 2003 due primarily to GAFRI's November 2005 repurchase of $20.8 million of 8-7/8% preferred securities, the March 2004 redemption of AFG's 9-1/8% trust preferred securities and GAFRI's 9-1/4% trust preferred securities and GAFRI's first quarter 2004 repurchases of $27.2 million of 8-7/8% preferred securities.
The following accounting standards are to be implemented by AFG in 2006 or 2007.
AFG's management, with participation of its Co-Chief Executive Officers and its principal financial officer, has evaluated AFG's disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG's Co-CEOs and principal financial officer concluded that the controls and procedures are effective. In the ordinary course of business, AFG and its subsidiaries routinely enhance their information systems by either upgrading or implementing new systems such as the new SFAS 109 accounting software system implemented in the fourth quarter of 2005. There has been no change in AFG's internal control over financial reporting during the fourth fiscal quarter of 2005 that has materially affected, or is reasonably likely to materially affect, AFG's internal control over financial reporting. There have been no significant changes in AFG's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
In our opinion, management's assessment that American Financial Group, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, American Financial Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Financial Group, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of earnings, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2005, and our report dated February 28, 2006, expressed an unqualified opinion thereon.
As discussed in Note A to the consolidated financial statements, the Company changed its consolidation policy related to variable interest entities in 2003, and changed its method of accounting for certain nontraditional long duration insurance contracts and separate accounts and for limited liability companies in 2004, all related to implementing new accounting standards.
In 2003, AFG merged with two of its subsidiaries, American Financial Corporation ("AFC") and AFC Holding Company resulting in AFC's Series J Preferred stock being acquired and retired in exchange for approximately 3.3 million shares of AFG Common Stock (aggregate value of $75 million). In addition, approximately $170 million in deferred tax liabilities associated with AFC's holding of AFG stock were eliminated.
Fixed maturity securities and equity securities classified as "available for sale" are reported at fair value with unrealized gains and losses reported as a separate component of shareholders' equity. Fixed maturities classified as "trading" are reported at fair value with changes in unrealized holding gains or losses during the period included in investment income. Loans receivable are carried primarily at the aggregate unpaid balance. Premiums and discounts on mortgage-backed securities are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
In 2003, the Financial Accounting Standards Board's ("FASB") Emerging Issues Task Force ("EITF") reached a final consensus on Issue 03-16, "Accounting for Investments in Limited Liability Companies" under which limited liability companies ("LLCs") are deemed to be the same as limited partnerships for which the equity method of accounting is generally required for ownership levels of "more than 3 to 5 percent." EITF 03-16 became effective for periods beginning after June 15, 2004. The cumulative effect of changing from the cost method to the equity method of accounting for AFG's investment in an LLC is shown separately in the Statement of Earnings.
Through the first quarter of 2005, AFG consolidated one of its collateralized debt obligations ("CDO") under revised FASB Interpretation ("FIN") No. 46. Since AFG had no right to use the CDO assets and the CDO liabilities could be extinguished only by using CDO assets, the assets and liabilities of the CDO are shown separate from AFG's other assets and liabilities in the Balance Sheet. Income and expenses of the CDO are shown separately in the Statement of Earnings; related minority interest is included in "Minority Interest Expense." In the first half of 2005, the CDO liquidated its investment portfolio and distributed the proceeds to its senior debt and equity investors, including AFG.
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG's insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers as well as ceded premiums retained by AFG's property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG's insurance subsidiaries also assume reinsurance from other companies. Income on reinsurance assumed is recognized based on reports received from ceding companies.
The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
On September 30, 2005, AFG acquired the multi-peril crop insurance and the crop hail insurance business written through Farmers Crop Insurance Alliance, Inc. for $17.5 million in cash. AFG will pay additional amounts of up to 10% of annual premiums over the next three years based on certain customer retention criteria. Approximately $16.5 million of the initial Farmers Crop purchase price was recorded as intangible renewal rights and is being amortized over an estimated retention period of four years on a straight-line basis. Any future payments (not expected to exceed $30 million) based on customer retention will also be recorded as intangible renewal rights. While there is uncertainty as to the amount of premiums that ultimately will be retained due to the departure of several Farmers' employees in the months preceding the acquisition, AFG expects this business will generate gross written premiums of $200 million to $300 million in 2006.
An AFG majority-owned subsidiary, National Interstate Corporation ("NATL"), issued 3.4 million of its common shares in a February 2005 initial public offering. NATL used $15 million of the $40.4 million in proceeds to repay a loan to an AFG subsidiary and the balance for general corporate purposes. At December 31, 2005, AFG owned approximately 54% of NATL's common stock compared to 66% at December 31, 2004.
In November 2004, AFG completed the sale of Transport Insurance Company. See Note M - "Discontinued Operations."
AFG manages its business as three segments: (i) property and casualty insurance, (ii) annuity and supplemental insurance, and (iii) other, which includes holding company assets and costs and the assets and operations of a CDO that AFG managed.
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes inland and ocean marine, agricultural-related business and commercial automobile, (ii) Specialty casualty, which includes executive and professional liability, umbrella and excess liability and excess and surplus, (iii) Specialty financial, which includes fidelity and surety bonds and collateral protection and (iv) California workers' compensation. AFG's annuity and supplemental insurance business markets primarily retirement annuities and various forms of supplemental insurance. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
The following tables (in thousands) show AFG's assets, revenues and operating earnings before income taxes by significant business segment and sub-segment.
auto businesses that were sold in 2003. Beginning in 2004, the remaining former
environmental and other mass tort reserves and a 2003 charge of $43.8 million for an
(f) Includes a 2003 charge of $35.5 million related to the settlement of litigation.
(g) Includes a third quarter 2005 charge of $9.5 million related to environmental
At December 31, 2005, the gross unrealized losses relate to nearly 1,200 securities with no single unrealized loss in excess of $2.4 million. Investment grade securities (as determined by nationally recognized rating agencies) represented about 94% and 96% of the total unrealized loss and fair value, respectively. Of the mortgage-backed securities, more than 98% of the unrealized losses relate to AAA rated securities. Management believes that AFG will recover its cost basis in the securities having unrealized losses at December 31, 2005 and AFG has the ability and intent to hold such securities until they recover in value or mature.
There were no investments (other than U.S. Treasury Notes) that exceeded 10% of Shareholders' Equity at December 31, 2005 or 2004.
In addition to adjusting equity securities and fixed maturity securities classified as "available for sale" to fair value, SFAS 115 requires that certain other balance sheet amounts be adjusted to the extent that unrealized gains and losses from securities would result in adjustments had those gains or losses actually been realized. The following table shows the components of the unrealized gain (loss) on marketable securities, net of tax, and its effect on various balance sheet captions (in millions).
Included in deferred policy acquisition costs in AFG's Balance Sheet are $54.1 million and $72.7 million at December 31, 2005 and 2004, respectively, representing the present value of future profits ("PVFP") related to acquisitions by AFG's annuity and life business. The PVFP amounts are net of $82.5 million and $73.2 million of accumulated amortization. Amortization of the PVFP was $9.3 million in 2005, $7.4 million in 2004 and $8.5 million in 2003. During each of the next five years, the PVFP is expected to decrease at a rate of approximately one-sixth of the balance at the beginning of each respective year.
From 1999 to mid-2005, AFG had an investment in, and acted as investment manager for, a CDO of which AFG was determined to be the "primary beneficiary." Under FIN 46, AFG was required to consolidate the CDO beginning December 31, 2003. The cumulative effect of this change in accounting was an increase in income of $6.3 million in 2003.
AFG is the investment manager and has investments in four other CDOs with an aggregate carrying value of $13 million at December 31, 2005 (included in fixed maturities), which are not required to be consolidated. These CDOs were formed between 2000 and 2005 and had approximately $1.6 billion in investments at December 31, 2005.
Changes in the carrying value of goodwill during 2004 and 2005, by reporting segment, are presented in the following table (in thousands):
At December 31, 2005, sinking fund and other scheduled principal payments on debt for the subsequent five years (adjusted for repurchases through February 2006) were as follows: 2006 - $19.6 million, 2007 - $60.7 million, 2008 - $48.8 million, 2009 - $205.0 million and 2010 - $2.1 million.
During 2005, AFG repurchased $15.6 million of its 7-1/8% Debentures due 2007 and $71.2 million of its 7-1/8% Debentures due 2009 for $92.6 million in cash. Through February 2006, AFG repurchased an additional $22.1 million of its
AFG's Senior Convertible Notes were issued at a price of 37.153% of the principal amount due at maturity. Interest is payable semiannually at a rate of 4% of issue price per year through June 2008, after which interest at 4% annually will be accrued and added to the carrying value of the Notes. The Notes are redeemable at AFG's option at any time on or after June 2, 2008, at accreted value ranging from $371.53 per Note to $1,000 per Note at maturity. Holders may require AFG to purchase all or a portion of their Notes on five year anniversaries beginning in 2008, at the accreted value. Generally, holders may convert each Note into 11.5016 shares of AFG Common Stock (at $32.30 per share currently) (i) if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value ($38.76 per share currently) for a specified period, (ii) if the credit rating of the Notes is significantly lowered, or (iii) if AFG calls the notes for redemption. AFG intends to deliver cash in lieu of Common Stock upon conversion of the Notes; accordingly, shares that would have been issued upon conversion of the Notes are not treated as dilutive.
To achieve its desired balance between fixed and variable rate debt, GAFRI has entered into interest rate swaps that effectively convert its 6-7/8% fixed-rate Senior Notes to a floating rate of 3-month LIBOR plus 2.9%. In connection with
the 2006 debt repurchases discussed above, GAFRI paid $1.5 million to effectively cancel (settle) the portion of the interest rate swaps that covered the repurchased debt.
Cash interest payments on debt and trust preferred securities were $73 million in 2005, $75 million in 2004 and $70 million in 2003. Interest expense in the Statement of Earnings includes interest credited on funds held by AFG's insurance subsidiaries under reinsurance contracts and other similar agreements as follows: 2005 - $5.4 million; 2004 - $5.2 million; and 2003 - $7.8 million.
The preferred securities supported by the payable to subsidiary trusts consisted of the following (in thousands).
Minority interest expense represents the interest of non-controlling investors in the earnings or losses of consolidated subsidiaries. Included in minority interest expense in 2004 is $3.5 million for the interest of minority holders in the CDO entity that AFG consolidated prior to its liquidation in 2005. Minority interest expense for 2003 includes $14.2 million in accrued distributions by consolidated subsidiaries on trust preferred securities (as discussed in Note A, such distributions are now accounted for as interest) and $5.8 million in dividends on subsidiary preferred stock that was retired late in 2003.
Under AFG's 2005 Stock Incentive Plan, employees of AFG and its subsidiaries are eligible to receive equity awards in the form of stock options, stock appreciation rights, restricted stock awards, restricted stock units and stock awards. This plan will replace AFG's existing stock option plan in 2006.
in the investment increased, AFC recorded a deferred tax liability (aggregating $136 million) on the excess of book over tax basis in this investment. In April 1995, AFC received AFG shares in exchange for its investment in AFG's predecessor. AFC retained the deferred tax liability related to this investment because AFC and AFG were in separate tax groups. Between 1995 and 2003, dividends on the AFG shares were treated as "return of capital" for tax purposes, thereby reducing AFC's tax basis and resulting in increases (aggregating $34 million) in the liability for deferred income taxes. In AFG's consolidated financial statements, the increase in deferred taxes resulted in a corresponding decrease to capital surplus because AFG's dividends to AFC were, in substance, capital contributions. The 2003 merger eliminated AFC's investment in AFG in a tax-free transaction thereby allowing the reversal of the related deferred tax liabilities.
Total earnings before income taxes include income (losses) subject to tax in foreign jurisdictions of ($33.8 million) in 2005, $26.6 million in 2004 and $27.4 million in 2003.
For income tax purposes, AFG and certain members of its consolidated tax group had the following carryforwards available at December 31, 2005 (in millions):
Cash payments for income taxes, net of refunds, were $91.9 million, $55.1 million and $51.8 million for 2005, 2004 and 2003, respectively.
Transport's results are reflected as discontinued for all periods presented in the Statement of Earnings. A summary of Transport's discontinued operations follow (in millions):
AFG's insurance subsidiaries continue to receive claims related to environmental exposures, asbestos and other mass tort claims. As more fully described in Item 7, establishing reserves for these claims is subject to uncertainties that are significantly greater than those presented by other types of claims. The liability for asbestos and environmental reserves at December 31, 2005 and 2004, respectively, was $540 million and $386 million; related recoverables from reinsurers (net of allowances for doubtful accounts) at those dates were $79 million and $56 million, respectively. The liability for other mass tort reserves at December 31, 2005 and 2004, respectively, was $21 million and $15 million; related recoverables from reinsurers (net of allowances for doubtful accounts) at those dates were $3 million and $4 million, respectively.
Securities owned by insurance subsidiaries having a carrying value of approximately $1 billion at December 31, 2005, were on deposit as required by regulatory authorities.
The following table provides an analysis of changes in the liability for losses and loss adjustment expenses, net of reinsurance (and grossed up), over the past three years on a GAAP basis (in millions). In addition to the asbestos, environmental and other mass tort charge in 2005, adverse development in the specialty casualty sub-segment was offset by positive development in the property and transportation and California workers' compensation sub-segments. Adverse development in 2004 and 2003 was primarily due to the specialty casualty segment as well as an arbitration settlement in 2003.
$18 million in 2005, $1 million in 2004 and ($15 million) in 2003.
GAFRI has reinsured approximately $23 billion and $26 billion in face amount of life insurance (excluding GAPR) as of December 31, 2005 and 2004, respectively. Life premiums ceded (excluding GAPR) were $68 million, $86 million and $85 million for 2005, 2004 and 2003, respectively.
Total rental expense for various leases of office space and equipment was $31 million, $35 million and $38 million for 2005, 2004 and 2003, respectively.
Other operating and general expenses included charges for possible losses on agents' balances, other receivables and other assets in the following amounts: 2005 - $11.1 million; 2004 - $15.1 million; and 2003 - $1.3 million. Losses and loss adjustment expenses included charges for possible losses on reinsurance recoverables of $0.4 million in 2005, $12.7 million in 2004, and $4.7 million in 2003. The aggregate allowance for all such losses amounted to approximately $35 million and $82 million at December 31, 2005 and 2004, respectively.
Payments of dividends, loans and advances by AFG's subsidiaries are subject to various state laws, federal regulations and debt covenants that limit the amount of dividends, loans and advances that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 2006 from its insurance subsidiaries without seeking regulatory clearance is approximately $299 million. Additional amounts of dividends, loans and advances require regulatory approval.
AFG expensed approximately $20 million in 2005 and $17 million in 2004 and $20 million in 2003 for its retirement and employee savings plans.
In December 2004, AFG's Chairman and one of his brothers purchased 600,000 and 200,000 shares, respectively, of AFG's Common Stock as part of a public offering.
In January 2006, AFG recorded a pretax gain of $23.6 million on the sale of its 15% interest in The Cincinnati Reds, LLC.
A. Selected Quarterly Financial Data is included in Note P to
(a) Grossed up for reinsurance recoverables of $2,243 and $2,234 at December 31, 2005 and 2004, respectively.
(d) Includes amounts recorded in discontinued operations: 2004 - $7 million; and 2003 - $2 million.