The following items highlight improvements in AFG's financial condition during 2004:
AFG and GAFRI issued just over $200 million in senior debentures in the first quarter of 2004, and used approximately $189 million of the proceeds to retire higher coupon debt due unconsolidated subsidiary trusts that, in turn, retired preferred securities.
At December 31, 2004, AFG (parent) had over $100 million in cash and short-term investments.
AFG's net earnings for 2004 were $360 million ($4.81 per share). Included in net earnings were the following items, net of tax and minority interest:
Deferred acquisition costs ("DAC") related to annuities and universal life insurance products are amortized in relation to the present value of expected gross profits on the policies. Assumptions considered in determining expected gross profits involve significant judgment and include management's estimates of assumed interest rates and investment spreads, surrenders, annuitizations, renewal premiums and mortality. Should actual experience require management to change its assumptions regarding the emergence of future revenues and profits (commonly referred to as "unlocking"), a charge or credit would be recorded to adjust DAC to the level it would have been if the new assumptions had been used from the inception date of each policy.
Management believes AFG has sufficient resources to meet its liquidity requirements. If funds generated from operations, including dividends and tax payments from subsidiaries, are insufficient to meet fixed charges in any period, AFG would be required to utilize parent company cash ($107 million at December 31, 2004) or to generate cash through borrowings, sales of securities or other assets, or similar transactions.
Through public offerings in the fourth quarter of 2004, AFG sold 2.7 million shares of Common Stock at an average price of $30.56 per share, net of commissions and fees. Net proceeds from the sales of $81.9 million will be used to support the growth of its subsidiaries. In addition, AFG's wholly-owned subsidiary, American Premier Underwriters ("APU"), sold an additional 1.3 million previously issued and outstanding AFG common shares. These shares were held for the benefit of certain Class M creditors of APU's predecessor, The Penn Central Transportation Company. Proceeds from that sale ($41.5 million) were placed in escrow to be used to pay APU environmental claims related to its former railroad operations.
All debentures issued by AFG (and GAFRI) are rated investment grade by three nationally recognized rating agencies. In February 2004, AFG issued $115 million in 7-1/8% Debentures due 2034 under a shelf registration statement and called for redemption $95.5 million in 9-1/8% trust preferred securities. Under a currently effective shelf registration statement, AFG can issue up to an aggregate of $517 million in additional equity or debt securities. The shelf registration provides AFG with greater flexibility to access the capital markets from time to time as market and other conditions permit.
In August 2004, GAFRI replaced its existing credit agreement with a $150 million four-year credit facility. 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, 2004. In addition, GAFRI can issue approximately $250 million in additional equity or debt securities under a currently effective shelf registration.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses, as well as meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies.
as follows: Within 1 year - $800 million; 2-3 years - $700 million;
4-5 years - $300 million; and thereafter - $434 million. Actual
The AFG Convertible Debentures due in 2033 are included in the above table at the first put date (2008). AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2004.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at December 31, 2004, is shown in the following table (dollars in millions). Approximately $66 million of available for sale "Fixed maturities" and $23 million of "Other stocks" had no unrealized gains or losses at December 31, 2004.
maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Higher impairment charges in 2002 reflect a rise in corporate defaults in the marketplace resulting from the weakened economy and other factors.
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
While current factors and reasonably likely changes in variable factors are considered in estimating the liability for unpaid losses, there is no method or system which can eliminate the risk of actual ultimate results differing from such estimates. As shown in the reserve development table (loss triangle) on page 10, the original estimates of AFG's liability for losses and loss adjustment expenses, net of reinsurance, over the past 10 years have developed through December 31, 2004, to be deficient (for seven years) by as much as 14.3% and redundant (for three years) by as much as 2.0% (excluding the effect of special charges for asbestos and environmental exposures). The average of such redundancies and deficiencies has been slightly (less than 4%) deficient. Management believes this development illustrates the variability in factors considered in estimating its insurance reserves.
Supplementary statistical information is reviewed to determine which methods are most appropriate to use or if adjustments are needed to particular methods. Such information includes:
The judicial climate in some states has had some effect on certain claims in recent years with more liberal coverage decisions, expanded concepts of liability
and higher jury awards. Significant case reserve strengthening has occurred in several books of business within this line. Stronger case reserves will cause future development on known claims to be less than recent historical patterns. Also, for some business in run-off, there have been significant changes in the procedures for managing outside counsel costs which should result in a reduction in future loss adjustment expenses compared to prior experience for this line of business.
In addition, AFG's strengthening of case reserves during 2002 and 2003 should cause future development of known claims to be less than prior historical patterns.
Over the years, certain portions of the homebuilders business has experienced adverse interpretations of coverage, coupled with certain statutory changes relating to liability, that caused an increase in the emergence of claims from older years. Management believes that changes in policy forms and endorsements implemented in 1998 will reduce AFG's exposure to such adverse interpretations.
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.
From time to time, AFG has engaged independent firms to work closely with its claims staff to study the A&E reserves of its insurance company subsidiaries. The most recent study was completed in the third quarter of 2001 and resulted in AFG recording a pretax charge of $100 million to increase its A&E reserves. Management believes that current practice of the property and casualty insurance industry is to commission a comprehensive study every three or four years. Accordingly, absent legislative reforms which may alter the need for an independent review, management plans to conduct such a routine study during 2005.
The settlement has received the approval of the bankruptcy court supervising the reorganization of A.P. Green. It remains subject to the confirmation by the bankruptcy court of a plan of reorganization that includes an injunction prohibiting the assertion against Great American of any present or future asbestos personal injury claims under policies issued to A.P. Green and related companies. No assurance can be made that a plan of reorganization will be confirmed; no payments are required until completion of the process. If there is no plan confirmation, the outcome of this litigation will again be subject to the complexities and uncertainties associated with a Chapter 11 proceeding and asbestos coverage litigation.
AFG's combined ratio has been better than the industry average for eighteen of the last nineteen years and excluding AFG's special A&E charges, for all nineteen years. Management believes that AFG's insurance operations have performed better than the industry as a result of product line diversification and stringent underwriting discipline.
As shown in Note Q under "Insurance Reserves," AFG's property and casualty operations recorded loss development of $140 million in 2004, $167 million in 2003 and $171 million in 2002 related to prior accident years. Major areas of adverse development were as follows (in millions):
The Specialty group's gross written premiums increased 12% for 2004 compared to 2003 reflecting volume growth in crop, California workers' compensation, collateral protection and other profitable product lines and the impact of continuing rate increases. Specialty rate increases averaged approximately 6% during 2004. The 20% increase in net written premiums during 2004 also reflects a decrease in reinsurance ceded.
Specialty casualty 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%.
The increase of approximately 19% in gross and net written premiums in 2003 compared to 2002 reflects rate increases as well as volume growth in the fidelity and crime products and certain collateral protection products. This group's combined ratio deterioration of 7 points is primarily a result of the decline in results related to the residual value products. Lower used car prices, dealer incentives on new cars and the volume of used cars available from expiring leases contributed to the deterioration in the residual value results.
California workers' compensation gross and net written premiums grew 31% and 25%, respectively, in 2004 compared to 2003, reflecting significant volume growth. The 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.
Gross and net written premiums increased 27% and 24%, respectively, in 2003 compared to 2002 related mostly to rate increases. The combined ratio for 2003 improved 4.4 points compared to 2002 as rate increases and a benefit related to the California reforms (mentioned above) were partially offset by increased claim costs.
Changes in investment income reflect fluctuations in market rates and changes in average invested assets. The increase in investment income for 2004 reflects an increase of about $1.4 billion (11%) in average cash and investments, partially offset by lower average yields on fixed maturity investments. Investment income decreased in 2003 compared to 2002 reflecting lower average yields on fixed maturity investments (due in part to an increase in tax-exempt bonds).
Realized gains (losses) on sales of securities include provisions for other than temporary impairment of securities still held of $16.7 million in 2004, $58.4 million in 2003 and $179.4 million in 2002. Impairment charges in 2004 and 2003 reflect primarily the downturn in the airline industry and writedowns of certain asset-backed securities. Impairment charges in 2002 reflect primarily the downturn in the communications and airline industries and writedowns of certain asset-backed securities.
Realized gains (losses) on securities include losses of $1.1 million in 2003 and $11.9 million in 2002 to adjust the carrying value of AFG's investment in warrants to market value under SFAS No. 133.
2003 compared to 2002 Other income increased $11.0 million (4%) in 2003 compared to 2002 due primarily to increased revenues earned by AFG's warranty business and higher fee income in certain other property and casualty insurance operations, partially offset by the absence of income from Infinity (following its sale in mid-February)and decreased gains on the sale of real estate.
Historically, management believes it has been able to react to changes in market interest rates and maintain a desired interest rate spread. Management believes that significant changes in projected investment yields could result in charges (or credits) to earnings in the period the projections are modified.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and life insurance lines of business. Continued spread compression, decreases in the stock market and adverse mortality could lead to write-offs of DPAC in the future.
2004 compared to 2003 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 and 2002. Interest on subsidiary trust obligations decreased $14 million for 2004 compared to 2003 due primarily to 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.
Other operating and general expenses for 2004 include a $52 million charge based on APU's settlement of litigation related to environmental clean-up costs at a former railroad site and a $4 million goodwill write-off in the annuity and life operations. In 2003, this expense includes a pretax charge of $35.5 million related to an agreement to settle a lawsuit alleging antitrust violations by a number of California workers' compensation insurers, including an AFG subsidiary. Excluding these items, other operating and general expenses increased $53.9 million (13%) for 2004 compared to 2003 due primarily to a $30.3 million increase in expenses of AFG's warranty business and a $9.5 million increase in expenses in certain other property and casualty insurance operations.
Equity in earnings (losses) of investees includes losses of two manufacturing businesses that were formerly subsidiaries. Equity in net earnings (losses) of investees includes $3.2 million in 2004 compared to $3.1 million in 2003 and $3.6 million in 2002 in losses of one of these businesses. Investee losses in 2002 include $5.4 million in losses of the other manufacturing business, which sold substantially all of its assets in December 2002.
Effective December 31, 2003, AFG implemented Interpretation No.46, "Consolidation of Variable Interest Entities." This interpretation sets forth the requirements for determining the status of entities that do not share economic risk and reward through typical equity ownership, but rather through contractual relationships that distribute economic risks and rewards among various parties. Once an entity is determined to be a variable interest entity, it is required to be consolidated by the primary beneficiary, which is deemed to be the party that is exposed to a majority of the expected losses, or benefits from a majority of the expected residual returns, or both.
The following accounting standards have been or may be implemented by AFG. The implementation of these standards is discussed under various subheadings of Note A to the Financial Statements; effects of each are shown in the relevant Notes.
The FASB has proposed an amendment to SFAS 128, "Earnings per Share." Currently, SFAS 128 allows companies issuing securities that can be settled in cash or stock (such as AFG's convertible notes) to exclude the issuable shares from the calculation of diluted earnings per share when there is a stated intent and ability to deliver cash in lieu of stock upon settlement or conversion. The proposed statement would require companies to assume settlement in stock (despite the ability and intent to settle in cash) and include those shares in the calculation of diluted earnings per share. Should the FASB proposal be adopted as proposed, AFG anticipates that it will amend its indenture to eliminate the option to settle the accreted value of the notes in shares, and thereby mitigate the proposal's impact on dilution.
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 principal executive officers and principal financial officer, AFG conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2004, based on the criteria set forth in "Internal Control - Integrated Framework" issued 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, 2004. Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is set forth below.
We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that American Financial Group, Inc. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). American Financial Group, Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment about the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
As indicated in the accompanying Management's Report on Internal Control Over Financial Reporting, management's assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of the fixed annuity business of National Health Insurance Company, which is included in the 2004 consolidated financial statements of American Financial Group, Inc. and constituted less than 4% of total assets as of December 31, 2004, and less than 1% of total revenues and net earnings for the year then ended. Management did not assess the effectiveness of internal control over financial reporting at this entity because the Company acquired this entity during 2004. Our audit of internal control over financial reporting of American Financial Group, Inc. also did not include an evaluation of the internal control over financial reporting of the entity referred to above.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of American Financial Group, Inc. as of December 31, 2004 and 2003, 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, 2004, and our report dated March 9, 2005, expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheet of American Financial Group, Inc. and subsidiaries as of December 31, 2004 and 2003, 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, 2004. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Financial Group, Inc. and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Fixed maturity 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. Short-term investments are carried at cost; 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. The most significant determinants of prepayments are the difference between interest rates on the underlying mortgages and current mortgage loan rates and the structure of the security. Other factors affecting prepayments include the size, type and age of underlying mortgages, the geographic location of the mortgaged properties and the creditworthiness of the borrowers. Variations from anticipated prepayments will affect the life and yield of these securities.
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 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 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.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues. DPAC includes the present value of future profits on business in force of insurance companies acquired by GAFRI, which represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. The present value of future profits is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
For balance sheet purposes, minority interest represents the interests of noncontrolling shareholders in consolidated entities. For income statement purposes, minority interest expense represents such shareholders' interest in the earnings of those entities. See "Payable to Subsidiary Trusts" above.
Prior to the AFG/AFC merger in November 2003, AFC filed consolidated federal income tax returns which included all 80%-owned U.S. subsidiaries, except for certain life insurance subsidiaries and their subsidiaries. Because holders of AFC Preferred Stock held in excess of 20% of AFC's voting rights, AFG (parent) and AFC Holding Company were not eligible to file consolidated returns with AFC, and therefore, filed separately. Following the merger, AFG files consolidated federal income tax returns which include the companies previously included in the AFC consolidated return.
As permitted under SFAS No. 123, "Accounting for Stock-Based Compensation," AFG accounts for stock options and other stock-based compensation plans using the intrinsic value based method prescribed by Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under AFG's stock option plan, options are granted to officers, directors and key employees at exercise prices equal to the fair value of the shares at the dates of grant. No compensation expense is recognized for stock option grants.
For SFAS No. 123 purposes, the "fair value" of $8.92 per option granted in 2004, $5.62 per option granted in 2003 and $8.52 in 2002 was calculated using the Black-Scholes option pricing model and the following assumptions: expected dividend yield of 2%; expected volatility of 29% for 2004 and 30% for 2003 and 2002; risk-free interest rate of 3.7% for 2004, 3.6% for 2003 and 4.9% for 2002; and expected option life of 7.5 years in 2004 and 7.4 years in 2003 and 2002. There is no single reliable method to determine the actual value of options at grant date. Accordingly, actual value of the option grants may be higher or lower than the SFAS No. 123 "fair value".
AFG provides retirement benefits to qualified employees of participating companies through the AFG Retirement and Savings Plan, a defined contribution plan. AFG makes all contributions to the retirement fund portion of the plan and matches a percentage of employee contributions to the savings fund. Employees have been permitted to direct the investment of their contributions to independently managed investment funds, while Company contributions have been initially invested primarily in securities of AFG and affiliates. Since 2002, employees have been permitted to direct the investment of their vested retirement fund account balances from securities of AFG and its affiliates to independently managed investment funds. The plan sells small amounts of AFG securities each day in a program intended to keep funds available for requested transfers to other funds. As of December 31, 2004, the Plan owned 9% of AFG's outstanding Common Stock. Company contributions are expensed in the year for which they are declared.
Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding during the period. The calculation of diluted earnings per share includes the following dilutive effect of common stock options: 2004 - 1,194,000 shares; 2003 - 335,000 shares; and 2002 - 403,000 shares.
For cash flow purposes, "investing activities" are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. "Financing activities" include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, benefits and withdrawals are also reflected as financing activities. All other activities are considered "operating". Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.
In September 2002, an AFG subsidiary entered into an agreement under which two unrelated entities assumed the subsidiary's obligations to renew its private passenger automobile insurance business written in New Jersey. AFG recognized a $10.8 million pretax loss on the transaction.
In June 2002, GAFRI paid $48.5 million for Manhattan National Life Insurance Company ("MNL"), which no longer was writing new business, but had approximately 90,000 policies in force (primarily term life). GAFRI has reinsured 90% of this in force business.
AFG manages its business as three segments: (i) property and casualty insurance, (ii) annuity, supplemental insurance and life products, and (iii) other, which includes holding company assets and costs, and beginning December 31, 2003, the assets and operations of the CDO that AFG manages.
AFG's businesses operate throughout the United States. In 2004, 2003, and 2002, AFG derived just over 2% of its revenues from the sale of life and supplemental health products in Puerto Rico and just over 1% of its revenues from the sale of property and casualty insurance in Mexico, Canada and Europe.
The following tables (in thousands) show AFG's assets, revenues and operating profit (loss) by significant business segment and sub-segment. Operating profit (loss) represents total revenues less operating expenses.
due to the sale of Infinity and the direct auto business during 2003, and the
$3 million) and Other lines (2004 premium of $14 million and underwriting loss of
(d) Includes realized gains (losses) of $60 million, ($5) million and ($59) million for
(e) Represents development of lines in "run-off" and includes a pretax charge of
(f) Includes a 2003 pretax charge of $35.5 million related to the settlement of litigation.
The following tables show gross unrealized losses on fixed maturities and other stocks by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2004 and 2003.
At December 31, 2004, the gross unrealized losses relate to nearly 400 securities with no single unrealized loss in excess of $1.6 million. Investment grade securities (as determined by nationally recognized rating agencies) represented about 93% and 97% of the total unrealized loss and market value, respectively. Of the mortgage-backed securities, more than 97% of the losses relate to AAA rated securities. Management believes that AFG will recover its cost basis in the securities having unrealized losses at December 31, 2004 and AFG has the ability and intent to hold such securities until they recover in value or mature.
The table below sets forth the scheduled maturities of fixed maturities based on market value as of December 31, 2004. Asset-backed securities and other securities with sinking funds are reported at average maturity. Data based on amortized cost is generally the same. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. Mortgage-backed securities had an average life of approximately
The only investment (other than U.S. Treasury Notes) which exceeded 10% of Shareholders' Equity at December 31, 2004 or 2003 was AFG's investment in Provident Financial Group, Inc., which had a market value of $227 million at December 31, 2003.
AFG has made investments in, and acts as investment manager for, three CDOs. The investments are primarily lowest tier securities (considered equity), credited with residual income of the CDO after it pays stated rates of interest on senior levels of securities. AFG is also paid management fees based on a percentage of the investments managed. Under FIN 46, AFG has been determined to be the "primary beneficiary" of one CDO and began consolidating it as of December 31, 2003. The two other CDOs (formed in 2000 and 2004) are not required to be consolidated and are included in fixed maturities. The following summarizes AFG's experience with the CDOs since inception (in millions):
Upon formation in 1999, the consolidated CDO issued securities in various senior and subordinate classes and the proceeds were invested in primarily floating rate, secured bank loans, and to a lesser extent, high yield bonds, all of which serve as collateral for the securities issued by the CDO. None of the collateral was purchased from AFG. Income from the CDO's investments is used to service its debt and pay other operating expenses including management fees to AFG. AFG's investment in this CDO is subordinate to the senior classes (approximately 92% of the total securities) issued by the CDO. To the extent there are defaults and unrecoverable losses on the underlying collateral resulting in reduced cash flows, AFG's class would bear losses first.
Beginning in 2004, the operating results of the CDO are included in AFG's Statement of Earnings. However, due to the non-recourse nature of the instruments issued by the CDO, any excess losses included in AFG's results that are not absorbed by AFG's investment over the life of the CDO would ultimately reverse when the CDO is liquidated. Accordingly, while implementation of FIN 46 impacts the timing of income recognition, it does not impact the overall amount of income recognized over the life of this investment.
In June 2003, AFG issued Senior Convertible Notes due in 2033 at an issue price of 37.153% of the principal amount due at maturity. AFG received $189.9 million before issue costs of $4.5 million. 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 prices 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), (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.
Cash interest payments of $62 million, $48 million and $47 million were made on long-term debt in 2004, 2003 and 2002, respectively. 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: 2004 - $5.2 million; 2003 - $7.8 million; and 2002 - $11.7 million.
Minority interest in AFG's Balance Sheet represents the interest of noncontrolling investors in the following (in thousands):
AFG sold 2,679,000 shares of its Common Stock through public offerings in the fourth quarter of 2004 at an average price of $30.56 per share, net of commissions and fees. In addition, APU sold 1,361,711 previously issued and outstanding AFG common shares that it was holding for the benefit of certain creditors and other claimants pursuant to the 1978 plan of reorganization of its predecessor, The Penn Central Transportation Company. The $41.5 million in proceeds were placed in escrow to be used to settle such claims. In November 2003, in conjunction with the AFG/AFC merger, AFG issued 3.3 million shares of Common Stock in exchange for all of the outstanding shares of AFC Series J preferred stock.
incentive stock options based on the difference between the market value of the
common stock and the option exercise price on the date the options are exercised. Such benefits are credited to capital surplus and amounted to $3.3 million in 2004, $32,000 in 2003 and $56,000 in 2002.
Total earnings before income taxes include income subject to tax in foreign jurisdictions of $26.6 million in 2004, $27.4 million in 2003 and $25.5 million in 2002.
The gross deferred tax asset has been reduced by a valuation allowance related to a portion of AFG's net operating loss carryforwards ("NOL") which is subject to the separate return limitation year ("SRLY") tax rules. A SRLY NOL can be used only by the entity that created it and only in years that both the entity and the consolidated group have taxable income. The likelihood of realizing this asset will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period in which the developments on which they are based become known.
In the fourth quarter of 2004, AFG completed the sale of Transport Insurance Company, an inactive property and casualty subsidiary with only run-off liabilities. In December 2003, AFG recorded a $55 million impairment charge to reduce its investment in Transport for its estimated loss on sale, which was determined based on negotiations with potential buyers.
Equity in net earnings (losses) of investees includes AFG's share of the losses from a manufacturing business ($3.2 million in 2004, $3.1 million in 2003 and $3.6 million in 2002). In 2002, equity in investees also includes a loss of $5.4 million representing AFG's share of the losses of another manufacturing business that was sold in December 2002. From the date of the initial sale of 61% of Infinity in February 2003 through the date of the sale of its remaining interest in Infinity in December 2003, AFG accounted for its ownership interest in Infinity as an investee using the equity method. Equity in Infinity's net earnings during this period was $12.2 million.
GAFRI has accrued approximately $7 million at December 31, 2004, for environmental costs and certain other matters associated with the sales of former operations.
The following are quarterly results of consolidated operations for the two years ended December 31, 2004 (in millions, except per share amounts).
Securities owned by insurance subsidiaries having a carrying value of approximately $880 million at December 31, 2004, 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). Adverse development recorded in 2004, 2003 and 2002 in prior year reserves related primarily to charges for asbestos and certain Specialty lines in run-off.
$15 million in 2003 and $20 million in 2002. Includes losses of
operations: 2004 - $7 million; 2003 and 2002 - $2 million.
The following table shows (in millions) investment income earned and investment expenses incurred by AFG's insurance companies.
Total rental expense for various leases of office space and equipment was $35 million, $38 million and $52 million for 2004, 2003 and 2002, respectively.
Future minimum rentals, related principally to office space, required under operating leases having initial or remaining noncancelable lease terms in excess of one year at December 31, 2004, were as follows: 2005 - $35 million; 2006 - $32 million; 2007 - $25 million; 2008 - $16 million; 2009 - $12 million; and $29 million thereafter. In addition, AFG has 99-year land leases (approximately 92 years remaining) at one of its real estate properties. Minimum lease payments under these leases are expected to total approximately $300,000 in 2005 and are adjusted annually for inflation.
Payments of dividends, loans and advances by AFG's subsidiaries are subject to various state laws, federal regulations and debt covenants which limit the amount of dividends, loans and advances that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 2005 from its insurance subsidiaries without seeking regulatory clearance is approximately $247 million. Additional amounts of dividends, loans and advances require regulatory approval.
AFG owns a 29% interest in an aircraft; the remaining interests in the aircraft are owned by AFG's chairman and his two brothers. Costs of operating the aircraft are being borne proportionately.
A. Selected Quarterly Financial Data is included in Note P to the
(a) Grossed up for reinsurance recoverables of $2,234 and $2,059 at December 31, 2004 and 2003, respectively.
(d) Includes amounts recorded in discontinued operations: 2004 - $7 million; 2003 and 2002 - $2 million.