Subsidiaries of AFG own several buildings in downtown Cincinnati. AFG and its affiliates occupy about half of the aggregate 650,000 square feet of commercial and office space in these buildings.
The ratio of earnings to fixed charges excluding interest credited to annuity policyholders' accounts was 9.15, 4.58, 7.02, 3.66 and 2.35 for 2006, 2005, 2004, 2003 and 2002, respectively. 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.
At December 31, 2006, AFG (parent) had over $220 million in cash and securities and no amounts borrowed under its bank line of credit.
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 AFG's workers' compensation operations experienced significant rate decreases in 2005 and 2006, certain of AFG's other specialty operations experienced higher rate levels. Overall average pricing was flat for 2005 and 2006.
See "Liquidity and Capital Resources - Uncertainties" for a discussion of insurance reserves, recoverables from reinsurers, and contingencies related to American Premier's former operations and "Liquidity and Capital Resources - Investments" for a discussion of impairments on investments. Deferred policy acquisition costs ("DPAC") and certain liabilities related to annuities and universal life insurance products are amortized in relation to the present value of expected gross profits on the policies. Assumptions considered in determining expected gross profits involve significant judgment and include management's estimates of assumed interest rates and investment spreads, surrenders, annuitizations, renewal premiums and mortality. Should actual experience require management to change its assumptions regarding the emergence of future revenues and profits (commonly referred to as "unlocking"), a charge or credit would be recorded to adjust DPAC or annuity liabilities to the levels they would have been if the new assumptions had been used from the inception date of each policy.
AFG's debt to total capital ratio on a consolidated basis is shown below (dollars in millions). This ratio has improved from more than 40% at December 31, 2002. Management intends to maintain the ratio of debt to capital at or below 25% and intends to maintain the capital of its significant insurance subsidiaries at or above levels currently indicated by rating agencies as appropriate for the current ratings.
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 2.62 for the year ended December 31, 2006. Excluding annuity benefits, this ratio was 9.15 for 2006. Although the ratio excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
As discussed above under "Parent Holding Company Liquidity", in March 2006, AFG and GAFRI replaced their existing credit agreements. In addition, GAFRI can offer approximately $250 million in additional equity or debt securities under a currently effective shelf registration. See Note Q - "Subsequent Event" to the financial statements.
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.
The excess cash flow of AFG's property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In January 2005, NATL, a majority-owned subsidiary that specializes in property and casualty insurance for the passenger transportation industry, issued 3,350,000 shares of its common stock in an initial public offering. A portion of the $40.4 million of net proceeds from this offering was used to repay NATL's $15 million promissory note to another AFG subsidiary. The remainder was used for other general corporate purposes. At December 31, 2006, AFG owned approximately 53% of NATL's common stock.
In GAFRI's 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. With declining rates, GAFRI receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on GAFRI's annuity products.
Projections do not include any impact for future earnings or additional
payment patterns applied to the gross reserves and do not represent actual
The AFG Senior Convertible Notes due in 2033 are included in the above table at the first put date (2008).
Nearly two-thirds of AFG's consolidated assets are invested in marketable securities. AFG's investment portfolio at December 31, 2006, contained $14.6 billion in "Fixed maturities" classified as available for sale and $729 million in "Other stocks", all carried at fair value with unrealized gains and losses reported as a separate component of shareholders' equity on an after tax basis. At December 31, 2006, AFG had pretax net unrealized losses of $38.7 million on fixed maturities and net unrealized gains of $123 million on other stocks.
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, 2006. Investment grade securities generally bear lower yields and
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at December 31, 2006, is shown in the following table (dollars in millions). Approximately $147 million of available for sale "Fixed maturities" had no unrealized gains or losses at December 31, 2006.
Management believes that each method has particular strengths and weakness and that no single estimation method is most accurate in all situations. When applied to a particular group of claims, the relative strengths and weaknesses of each method can change over time based on the facts and circumstances. Ultimately, the estimation methods chosen are those which management believes produce the most reliable indication for the particular liabilities under review.
The period of time from the occurrence of a loss through the settlement of the liability is referred to as the "tail". Generally, the same actuarial methods are considered for both short-tail and long-tail lines of business because most of them work properly for both. The methods are designed to incorporate the effects of the differing length of time to settle particular claims. For short-tail lines, management tends to give more weight to the Case Incurred and Paid Development methods, although the various methods tend to produce similar results. For long-tail lines, more judgment is involved, and more weight may be given to the Bornhuetter-Ferguson method and the Projected Claim Count times Projected Claim Severity method. Liability claims for long-tail lines are more susceptible to litigation and can be significantly affected by changing contract interpretation and the legal environment. Therefore, the estimation of loss reserves for these classes is more complex and subject to a higher degree of variability.
Within each line, results of individual methods are reviewed, supplementary statistical information is analyzed, and all data from underwriting, operating and claim management are considered, in deriving the point estimate of the ultimate liability. This estimate may be the result of one test, or a weighted average of several tests, or a judgmental selection as the management team determines is appropriate.
An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. However, future results could vary due to an unexpected change in the underlying cost trends. 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. It is not possible to isolate and measure the potential impact of just one of these variables and future cost trends could be partially impacted by several such variables. However, it is reasonable to address the sensitivity of the reserves to potential impact from changes in these variables by measuring the effect of a possible overall 1% change in future cost trends that may be caused by one or more variables. Utilizing the effect of a 1% change in overall 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 5%) greater than the effect of the previous 1%. For example, if a 1% change in cost trends in a line of business would change net earnings by $20 million, a 2% change would change net earnings by $41 million.
The judgments and uncertainties surrounding management's reserve estimation process and the potential for reasonably possible variability in management's most recent reserve estimates may also be viewed by looking at how recent historical estimates of reserves have developed. The following table shows (in millions) what the impact on AFG's net earnings would be on the more significant lines of business if the December 31, 2006, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
The following discussion describes key assumptions and important variables that materially affect the estimate of the reserve for loss and loss adjustment expenses of the more significant lines of business and explains what caused them to change from assumptions used in the preceding period.
AFG recorded favorable development of $21 million in 2006, $16 million in 2005 and $9 million in 2004 related to its nursing home coverage where both the frequency and severity of claims were lower than previously projected. In addition, favorable development of $15 million was recorded in 2006 in Mid-Continent's general liability business due to claim severity being less than predicted.
AFG recorded adverse prior year loss development of $13 million in 2006 and $15 million in 2005 on its legal professional liability business as claim severity continued to be higher than previous underlying assumptions.
This line of business is a mix of coverage protecting the insured against legal liability for property damage or personal injury to others arising from the
operation of commercial motor vehicles. The property damage liability exposure is usually short-tail with relatively quick reporting and settlement of claims. The bodily injury and medical payments exposures are longer-tailed; although the claim reporting is relatively quick, the final settlement can take longer to achieve.
AFG recorded $25 million in favorable prior year loss development in 2006 and $10 million in 2005 for this line of business as claim severity was significantly lower than in prior assumptions.
This long-tail line of business consists of two or more coverages protecting the insured from various property and liability risk exposures. The commercial multi-peril line of business includes coverage similar to other liability - occurrence, so in general, variables affecting estimation of loss reserves for commercial multi-peril include those mentioned above for other liability - occurrence. In addition, this line also includes reserves for a run-off book of homebuilders business covering contractors' liability for construction defects. Variables unique to estimating the liabilities for this coverage include:
Over the years, certain portions of the homebuilders business have experienced adverse interpretations of coverage, coupled with certain statutory changes relating to liability, causing higher than expected emergence of claims from older years. AFG recorded adverse prior year loss development of $15 million in 2005 and $30 million in 2004 on its run-off homebuilders business (mostly from exposures in California and Nevada). Management believes that changes in policy forms and endorsements implemented in 1998 will reduce AFG's exposure to such adverse interpretations.
Asbestos claims against manufacturers, distributors or installers of asbestos products were presented under the products liability section of their policies which typically had aggregate limits that capped an insurer's liability. In recent years, a number of asbestos claims are being presented as "non-products" claims, such as those by installers of asbestos products and by property owners or operators who allegedly had asbestos on their property, under the premises or operations section of their policies. Unlike products exposures, these non-products exposures typically had no aggregate limits, creating potentially greater exposure for insurers. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify previously settled products claims as non-products claims to restore a portion of previously exhausted products aggregate limits. We, along with other insurers, are 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 we and other insurers will be successful in asserting additional defenses. Therefore, the future impact of such efforts is uncertain.
Establishing reserves for A&E claims relating to policies and participations in reinsurance treaties and former operations is subject to uncertainties that are significantly greater than those presented by other types of claims. For this group of claims, traditional actuarial techniques that rely on historical loss development trends cannot be used and a meaningful range of loss cannot be estimated. Case reserves and expense reserves are established by the claims department as specific policies are identified. In addition to the case reserves established for known claims, management establishes additional reserves for claims not yet known or reported and for possible development on known claims. These additional reserves are management's best estimate based on periodic detailed "ground up" studies adjusted for payments and identifiable changes, supplemented by management's review
of industry information about such claims, with due consideration to individual claim situations. Estimating ultimate liability for asbestos claims presents a unique and difficult challenge to the insurance industry 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. The casualty insurance industry is engaged in extensive litigation over these coverage and liability issues as the volume and severity of claims against asbestos defendants continue to increase.
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 5.25% interest), all of which was covered by reserves established prior to 2003, and anticipated reinsurance recoverables for this matter. The agreement allows up to 10% of the settlement to be paid in AFG Common Stock. 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. The Bankruptcy Court has ruled that the Debtors' plan of reorganization will require a resolicitation of votes from silica claimants as a condition of the Court's approval of the plan. The Court has set a further hearing on plan confirmation for March, 2007.
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.
$25.8 million ($.21 per share) in 2006 and $8.8 million ($.07 per share) in 2005.
AFG reports its Specialty insurance business in the following components: (i) Property and Transportation, (ii) Specialty Casualty, (iii) Specialty Financial, and (iv) California Workers' Compensation.
AFG's combined ratio has been better than the industry average for twenty of the last twenty-one years and excluding AFG's special A&E charges, for all twenty-one years. Management believes that AFG's insurance operations have performed better than the industry as a result of product line diversification, stringent underwriting discipline, alignment of incentives, and, more recently, a specialty niche focus.
$53 million for hurricane losses offset by strong profitability within the crop insurance operations and favorable reserve development within several operations. Results for 2004 included $37 million for hurricane losses.
Specialty casualty net written premiums for 2006 were 13% higher than in 2005 due primarily to volume growth and higher premium retention within several of the group's businesses as well as third quarter 2006 changes to reinsurance agreements within the specialized program business line, which resulted in the recapture of $26 million in premiums previously ceded to reinsurers. This group's combined ratio improved 6.4 points for 2006 compared to 2005. Results for 2006 included about 1.2 points of favorable reserve development whereas the prior year period included 4.0 points of unfavorable reserve development.
net written premiums for 2006 increased 10% above the 2005 period reflecting premium growth principally in the financial institutions, lender services and surety and fidelity businesses. The group experienced disappointing results in 2006 resulting from losses within the automobile residual value business ("RVI"), which is in run-off. These losses were primarily attributable to lower than expected proceeds from the sale (at auction) of certain luxury cars and sport utility vehicles. Excluding the effect of the RVI business, this group's combined ratio was 88.7%, as the group's other operations are generating solid underwriting profits.
related unearned premium reserves, and accordingly, a premium deficiency was recognized. Excluding the effect of the RVI business, this group's 2005 combined ratio was 92.6%. Losses from the residual value business were partially offset by strong profitability in the fidelity and crime and financial institutions operations.
Gross and net written premiums for 2005 were about the same as 2004 as volume growth was offset by lower rates. The combined ratio for 2005 improved 19.5 points from 2004 reflecting the benefit of the improving claims environment resulting from the workers' compensation reforms enacted in California. The 2005 underwriting results included favorable prior year reserve development (discussed above) compared to unfavorable prior year reserve development in 2004 of $21.8 million (6.4 points).
AFG has undertaken periodic reviews of its asbestos and environmental reserves with the aid of an independent actuarial firm and specialty outside counsel. In 2005, AFG completed a comprehensive study of its A&E exposures relating primarily to the run-off operations of its property and casualty group. As a result of this study, AFG recorded a 2005 third quarter pretax 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. AFG's A&E reserves were $432 million and $461 million (net of reinsurance recoverables) at December 31, 2006 and 2005, respectively. Management expects to engage an independent actuarial firm to assist in conducting another study in 2007.
A primary driver of the increase in AFG's asbestos reserves in 2005 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.
With respect to the environmental claims, the 2005 study considered both direct insurance and assumed reinsurance, projected exposure at both National Priorities List ("NPL") sites and non-NPL sites, historic payment patterns, patterns of new claims, settlements and projected development. The increase in environmental reserves in 2005 is primarily due to an increase in clean up costs at certain sites above prior expectations and a recent unexpected increase in the number of new claims that have been reported to the Company. In addition, projected development on a few claims exceeded estimates in the previous 2001 study.
In connection with the review of A&E reserves in 2005, AFG reviewed its other mass tort exposures and recorded a $10 million pretax charge. AFG's other mass tort reserves were $16 million and $18 million (net of reinsurance recoverables) at December 31, 2006 and 2005, respectively.
Loss development As shown in Note O - "Insurance - Insurance Reserves," AFG's property and casualty operations recorded favorable loss development of $59 million in 2006 compared to unfavorable development of $181 million in 2005 and $140 million in 2004 related to prior accident years. Major areas of favorable (adverse) development were as follows (in millions):
The favorable development in Specialty casualty in 2006 was driven by lower than expected frequency and severity in liability products for nursing homes and not-for-profit organizations partially offset by adverse development in professional liability (which mostly covers lawyers) and certain run-off businesses. Professional liability had higher than expected increases in claim severity in 2006 and 2005. The adverse development in 2005 was mainly in the professional liability and runoff casualty businesses partially offset by favorable development in the excess and surplus and not-for-profit businesses. Adverse development in excess casualty runoff impacted 2005 and 2004, reflecting higher frequency and severity of claims related to the 1999 through 2001 accident years. Adverse development in 2004 also includes amounts related to executive liability and the commutation of reinsurance. Adverse executive liability development resulted primarily from increased severity on one claim under a directors' and officers' liability policy, as both settlement and defense costs from a shareholder lawsuit increased beyond estimates.
The adverse development in Specialty financial in 2005 and 2004 related to higher than expected severity on claims from accident years 2000 to 2003.
The favorable development in California workers' compensation in 2006 and 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 $16.3 million decrease in life, accident and health premiums in 2006 reflects the January 2006 sale of GAPR partially offset by the effect of the August 2006 acquisition of Ceres. In addition to these transactions, the increase in life, accident and health benefits for 2006 reflects an increase in loss experience in GAFRI's supplemental insurance business. The Ceres acquisition broadens GAFRI's distribution in both the independent agent and captive agent channels. The increase in life, accident and health premiums and benefits in 2005 reflects the addition of new distribution sources for GAFRI's supplemental insurance products.
Realized gains (losses) on sales of securities include provisions for other than temporary impairment of securities still held of $25.7 million in 2006, $16.1 million in 2005 and $16.7 million in 2004. Impairment charges for 2006 include $10.3 million to writedown two equity security positions.
In January 2006, GAFRI completed the sale of its subsidiary, Great American Life Assurance Company of Puerto Rico, for $37.5 million in cash. Results for GAFRI in 2005 included a $3.4 million estimated loss on the sale. Results for 2006 include an additional $463,000 realized loss offsetting a like amount of earnings recorded in 2006 prior to the sale.
AFG's subsidiaries are engaged in a variety of real estate operations including hotels, apartments and office buildings; 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).
Income from real estate operations includes pretax gains of $44.6 million on the sale of New York real estate assets in 2006 and $57.0 million on the sales of coal reserves in 2005. Other income also includes net pretax gains on the sales of other real estate assets of $23.2 million in 2006, $12.0 million in 2005 and $12.7 million in 2004.
$16.5 million. The operating results and gains on the sales of Chatham and Driskill are included in discontinued operations in the Statement of Operations. See Note L - "Discontinued Operations."
Annuity benefits for 2006 increased slightly compared to 2005 as the effect of internal growth and the acquisition of Old Standard Life fixed annuity business were offset by the effect of the fourth quarter 2005 "unlocking" charge discussed below, lower average effective crediting rates and the sale of GAPR.
Annuity and supplemental insurance acquisition expenses include amortization of annuity, supplemental insurance and run-off life business deferred policy acquisition costs ("DPAC") as well as a portion of commissions on sales of insurance products. Annuity and supplemental insurance acquisition expenses also include amortization of the present value of future profits of businesses acquired. The $8.4 million decrease in annuity and supplemental insurance acquisition expenses for 2006 compared to 2005 reflects the effect of the fourth quarter 2005 DPAC write-offs discussed below and the January 2006 sale of GAPR, partially offset by the Ceres and Old Standard Life acquisitions and other growth in the annuity and supplemental insurance businesses.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and run-off life insurance lines of business. Continued spread compression, decreases in the stock market and adverse mortality experience could lead to further write-offs of DPAC in the future.
The following accounting standards are to be implemented by AFG in 2007.
Based on AFG's evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2006. Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2006 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. (the Company) maintained effective internal control over financial reporting as of December 31, 2006, 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.
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, 2006 and 2005, 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, 2006, and our report dated February 27, 2007, expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the Company) as of December 31, 2006 and 2005, 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, 2006. 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of American Financial Group, Inc.'s internal control over financial reporting as of December 31, 2006, based upon criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2007, expressed an unqualified opinion thereon.
Derivatives included in AFG's Balance Sheet are recorded at fair value and consist primarily of (i) the interest component of certain life reinsurance contracts (included in other liabilities), (ii) interest rate swaps (included in debt), and (iii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related call options (included in other investments) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products. Changes in the fair value of derivatives are included in current earnings.
Policy acquisition costs (principally commissions, premium taxes and other marketing and underwriting expenses) related to the production of new business are deferred. For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses,
unamortized acquisition costs and policy maintenance costs exceed the related unearned premiums. A premium deficiency would first be recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency was greater than unamortized acquisition costs, a liability would be accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.
The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of the accounting period on direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
Certain subsidiaries own trusts that issued preferred securities and, in turn, purchased a like amount of subordinated debt from their parent company. Interest and principal payments from the parent fund the respective trust obligations. AFG does not consolidate these trusts because they are "variable interest entities" in which AFG is not considered to be the primary beneficiary. Accordingly, the subordinated debt due to the trusts is included in "long-term debt" in the Balance Sheet and the related interest expense is included in "interest charges on borrowed money" in the Statement of Earnings.
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 (i) deductions of $1.4 million in 2006 and $.6 million in 2005 from net earnings related to dilution of majority-owned subsidiaries and (ii) the following additions to average shares outstanding representing the dilutive effect of stock-based compensation plans: 2006 - 2.5 million shares; 2005 - 1.9 million shares; and 2004 - 1.8 million shares.
Chatham Bars Inn In June 2006, GAFRI sold a resort hotel located on Cape Cod for $166 million. See Note K - "Discontinued Operations."
In May 2004, GAFRI acquired the fixed annuity business of National Health Insurance Company (over 30,000 policies). This transaction increased both annuity benefits accumulated and cash and investments by approximately $750 million.
components were determined based primarily upon similar economic characteristics, products and services.
In 2006, 2005, and 2004, just over 1% of AFG's revenues were derived from the sale of property and casualty insurance in Canada, Mexico and Europe. In 2005 and 2004, just over 2% of AFG's revenues were derived from the sale of life and supplemental health products in Puerto Rico. The Puerto Rico business was sold in January 2006.
(b) Includes a charge of $19.9 million for adjustments related to deferred gains on
(d) Includes a third quarter 2005 charge of $9.5 million related to environmental
Included in deferred policy acquisition costs in AFG's Balance Sheet are $95.0 million and $54.1 million at December 31, 2006 and 2005, respectively, representing the present value of future profits ("PVFP") related to acquisitions by AFG's annuity and supplemental insurance business. The PVFP amounts are net of $70.5 million and $82.5 million of accumulated amortization. The change in PVFP and related accumulated amortization reflects the August 2006 acquisition of Ceres, partially offset by the January 2006 sale of GAPR. Amortization of the PVFP was $9.0 million in 2006, $9.3 million in 2005 and $7.4 million in 2004. During each of the next five years, the PVFP is expected to decrease at a rate of approximately one-eighth of the balance at the beginning of each respective year.
Long-term debt. consisted of the following at December 31 (in millions):
At December 31, 2006, scheduled principal payments on debt for the subsequent five years were as follows: 2007 - $60.8 million, 2008 - $32.2 million, 2009 - $184.4 million, 2010 - $2.9 million and 2011 - $9.1 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.
$500 million. AFG and GAFRI have agreed not to borrow more than $325 million and $200 million, respectively, under the credit facility and AFG has agreed to guarantee amounts borrowed by GAFRI. Amounts borrowed bear interest at rates ranging form 0.5% to 1.25% over LIBOR based on AFG's credit rating. No amounts were borrowed under these agreements at December 31, 2006 or 2005.
To achieve a 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 an additional $2 million to effectively terminate the portion of the interest rate swaps that covered the repurchased debt.
In December 2006, AFG completed a three-for-two common stock split. See "Stock Split" in Note A - "Accounting Policies."
AFG sold 4 million shares of its Common Stock through public offerings in the fourth quarter of 2004 at an average price of $20.37 per share, net of commissions and fees. In addition, American Premier sold 2,042,567 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.
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility over a period equal to the estimated term. AFG began using the SEC's simplified method of calculating expected term with its 2006 grants. The fair value of options granted in 2006, 2005 and 2004 was $6.68 per share, $6.44 per share and $5.95 per share, respectively, based on the following assumptions:
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2006 (in millions):
Cash payments for income taxes, net of refunds, were $213.6 million, $91.9 million and $55.1 million for 2006, 2005 and 2004, respectively.
In the second quarter of 2006, GAFRI sold Chatham Bars Inn, its resort-hotel property located on Cape Cod for $166 million. The results of operations of this investment property and the gain on sale are presented as discontinued operations in the Statement of Earnings. Operating results for a smaller hotel property that was sold in the fourth quarter of 2005 have been reclassified as discontinued operations to conform to the current year's presentation. Balance Sheet amounts prior to the hotel sale have not been reclassified.
A summary of the discontinued hotel operations sold follows (in millions):
The operations of GAPR (sold in 2006) are not reported as discontinued because they were not material to AFG.
Equity in net earnings (losses) of investees includes AFG's share of the losses from a manufacturing business ($2.1 million in 2006, $1.2 million in 2005 and $3.1 million in 2004). In addition, equity in net earnings (losses) of investee for 2005 includes a $3.9 million after tax impairment writedown related to this business.
In 2004, American Premier reached an agreement with two other responsible parties on the allocation of environmental clean-up costs at a former railroad site in Paoli, Pennsylvania. Based on the settlement, American Premier recorded a charge (included in "Other operating and general expenses") of $52 million to increase its liabilities for environmental exposures. Although American Premier has been advised by counsel that it should be able to recover a significant amount of these costs from a financially viable third party, no recovery asset has been recorded for its Paoli Yard costs.
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, 2006 and 2005, respectively, was $518 million and $540 million; related recoverables from reinsurers (net of allowances for doubtful accounts) at those dates were $85 million and $79 million, respectively. The liability for other mass tort reserves at December 31, 2006 and 2005, respectively, was $19 million and $21 million; related recoverables from reinsurers (net of allowances for doubtful accounts) at those dates were $4 million and $3 million, respectively.
Includes $7 million in losses of Transport Insurance Company in 2004
Total rental expense for various leases of office space and equipment was $34 million, $31 million and $35 million for 2006, 2005 and 2004, respectively.
Other operating and general expenses included charges for possible losses on agents' balances, other receivables and other assets in the following amounts: 2006 - $0.4 million; 2005 - $11.1 million; and 2004 - $15.1 million. Losses and loss adjustment expenses included charges for possible losses on reinsurance recoverables of $12.8 million in 2006, $0.4 million in 2005 and $12.7 million in 2004. The aggregate allowance for all such losses amounted to approximately $39 million and $35 million at December 31, 2006 and 2005, respectively.
carrying value and estimated fair value of AFG's financial instruments at
AFG expensed approximately $18 million in 2006 and $20 million in 2005 and $17 million in 2004 for its retirement and employee savings plans.
AFG had an obligation for a line of credit to a company that was 100% owned by AFG's Chairman. In 2004, AFG's Chairman assumed AFG's obligation; AFG no longer has any interest or investment in the company.
On February 22, 2007, AFG announced that it has proposed that GAFRI (an 81%-owned subsidiary) engage in a merger transaction that would increase AFG's ownership of GAFRI's common stock to 100%. Under the proposed merger transaction, GAFRI would acquire for cash all the outstanding shares not currently held by AFG at a price of $23.50 per share for an aggregate amount of approximately $215 million. The proposed transaction is subject to the negotiation of a merger agreement with GAFRI's special committee of independent directors, and would be subject to customary conditions and regulatory approvals. If an agreement is reached, AFG proposes that GAFRI use excess capital plus borrowings from AFG to fund the transaction and anticipates that it would close in the third quarter of 2007.
The information required by the following Items will be included in AFG's definitive Proxy Statement for the 2007 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission within 120 days after the end of Registrant's fiscal year and is incorporated herein by reference.
A. Selected Quarterly Financial Data is included in Note N to
All other schedules for which provisions are made in the applicable