Subsidiaries of AFG own several buildings in downtown Cincinnati. AFG and its affiliates occupy approximately 40% of the aggregate 690,000 square feet of commercial and office space in these buildings.
AFG and its insurance subsidiaries lease the majority of their office and storage facilities in numerous cities throughout the United States, including the Company’s home offices in Cincinnati. National Interstate occupies approximately 90% of the 177,000 square feet of office space on 17.5 acres of land that it owns in Richfield, Ohio. See Item 1 - “Business”-“Other Operations” for a discussion of AFG’s other commercial real estate operations.
The ratio of earnings to fixed charges excluding annuity benefits was 7.16, 6.59, 9.14, 11.03 and 4.51 for 2012, 2011, 2010, 2009 and 2008, respectively. Although the ratio of earnings to fixed charges excluding annuity benefits 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.
As discussed in Note A - “Accounting Policies - Accounting Standards Adopted in 2012,” certain historical amounts presented herein have been retrospectively adjusted to reflect the adoption of new accounting guidance related to deferred policy acquisition costs (“DPAC”).
the establishment of insurance reserves, especially asbestos and environmental-related reserves and reserves for AFG’s closed block of long-term care insurance,
AFG’s ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.98 for the year ended December 31, 2012. Excluding annuity benefits, this ratio was 7.16. Although the ratio excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
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.
In the annuity business, where profitability is largely dependent on earning a “spread” between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG’s annuity products. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to contractually guaranteed minimum interest rates (“GMIRs”). AFG began selling policies with GMIRs below 2% in 2003; almost all new business since late 2010 has been issued with a 1% GMIR. At December 31, 2012, the average crediting rate on AFG’s annuities was approximately 2.74%, while the average GMIR was approximately 2.23%. As of that date, AFG could reduce the average crediting rate of its $14 billion of traditional and fixed-indexed deferred annuities without guaranteed withdrawal benefits by approximately 42 basis points (on a weighted average basis).
For statutory accounting purposes, equity securities of non-affiliates are generally carried at fair value. At December 31, 2012, AFG’s insurance companies owned publicly traded equity securities with a fair value of $902 million. In addition, GAI’s investment in NATL common stock had a fair value of $294 million and a statutory carrying value of $233 million at December 31, 2012. 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.
AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2012.
AFG’s investment portfolio at December 31, 2012, contained $24.1 billion in “Fixed maturities” classified as available for sale and $939 million in “Equity securities,” all carried at fair value with unrealized gains and losses included in a separate component of shareholders’ equity on an after-tax basis. In addition, $321 million in fixed maturities were classified as trading with changes in unrealized holding gains or losses included in investment income.
Fixed income investment funds are generally invested in securities with intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions. At December 31, 2012, the average life of AFG’s fixed maturities was about six years.
Fair values for AFG’s portfolio are determined by AFG’s internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on closing prices obtained from the pricing services. For mortgage-backed securities (“MBS”), which comprise approximately 30% of AFG’s fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the remainder of AFG’s fixed maturity portfolio, approximately 90% are priced using pricing services and the balance is priced primarily by using non-binding broker quotes. When prices obtained for the same security vary, AFG’s internal investment professionals select the price they believe is most indicative of an exit price.
In general, the fair value of AFG’s fixed maturity investments is inversely correlated to changes in interest rates. The following table demonstrates the sensitivity of such fair values to reasonably likely changes in interest rates by illustrating the estimated effect on AFG’s fixed maturity portfolio that an immediate increase of 100 basis points in the interest rate yield curve would have at December 31, 2012 (dollars in millions). Increases or decreases from the 100 basis points illustrated would be approximately proportional.
The National Association of Insurance Commissioners (“NAIC”) assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC retained a third-party investment management firm to assist in the determination of appropriate NAIC designations for mortgage-backed securities based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At December 31, 2012, 97% (based on statutory carrying value of $6.4 billion) of AFG’s MBS securities had an NAIC designation of 1 or 2.
Based on its analysis of the factors listed above, management believes AFG will recover its cost basis in the securities with unrealized losses and that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, 2012. Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers’ creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG’s ability or intent change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG’s investment portfolio could have a significant adverse effect on AFG’s liquidity. For information on AFG’s realized gains (losses) on securities, including charges for “other-than-temporary” impairment, see Management’s Discussion and Analysis - “Results of Operations - Realized Gains (Losses) on Securities.”
Property and Casualty Insurance Reserves Estimating the liability for unpaid losses and loss adjustment expenses (“LAE”) is inherently judgmental and is influenced by factors that are subject to significant variation. Determining the liability is a complex process incorporating input from many areas of the Company including actuarial, underwriting, pricing, claims and operations management.
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.
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 that can eliminate the risk of actual ultimate results differing from such estimates. As shown in footnote (a) to the reserve development table (loss triangle) on page 8, the original estimates of AFG’s liability for losses and loss adjustment expenses, net of reinsurance and excluding the effect of special charges for asbestos and
environmental exposures, over the past 10 years have developed through December 31, 2012, to be deficient (for two years) by as much as 15.7% and redundant (for eight years) by as much as 17.7%. This development illustrates the historical impact caused by variability in factors considered in estimating insurance reserves.
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, 2012, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
Approximately 43% of AFG's workers compensation business is currently written in California. Over the last 10 years, there have been numerous reforms, revisions and interpretations of regulations. Reforms in 2003 and 2004 tended to reduce costs and benefits. During the economic downturn, these trends were reversed and costs began to increase, causing results to differ from expectations. In recent years, AFG has experienced an improved pricing environment leading to the expectation of improved results for this business. At this time, there is uncertainty around the impact of the recently passed California Senate Bill 863, which is intended to increase benefits to injured workers while promoting cost-saving efficiencies. Such frequent, significant changes in the operating environment make it difficult to appropriately price these insurance policies and estimate related liabilities.
AFG’s legal professional liability business has been in run-off since 2008 with only 65 claims remaining open at December 31, 2012. These claims are expected to settle within the existing reserves. AFG recorded favorable reserve development of less than $1 million in 2012 compared to $17 million in 2011 and $18 million in 2010 on the run-off legal and professional liability business.
favorable development in coverage for non-profit organizations of $6 million in 2012, $6 million in 2011 and $13 million in 2010 as claim severity was less than anticipated.
Recoverables from Reinsurers and Availability of Reinsurance AFG is subject to credit risk with respect to its reinsurers, as reinsurance contracts do not relieve AFG of its liability to policyholders. To mitigate this risk, substantially all reinsurance is ceded to companies with investment grade or better S&P ratings or is secured by “funds withheld” or other collateral.
See Item 1 - “Business” - “Property and Casualty Insurance Operations - Reinsurance” for more information on AFG’s reinsurance programs. For additional information on the effect of reinsurance on AFG’s historical results of operations see Note O - “Insurance - Reinsurance” and the gross loss development table under Item 1 - “Business” - “Property and Casualty Insurance Operations - Loss and Loss Adjustment Expense Reserves.”
Outside of its property and casualty operations, AFG has reinsurance recoverables totaling $976 million, including $614 million from Hannover Life Reassurance Company of America (rated A+ by A.M. Best) and $203 million from Loyal American Life Insurance Company, a subsidiary of Cigna (rated A- by A.M. Best). This reinsurance is related primarily to the reinsurance of
There is a growing interest at the state 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 piecemeal state-by-state solutions.
AFG has conducted comprehensive studies of its asbestos and environmental reserves with the aid of outside actuarial and engineering firms and specialty outside counsel every two years with an in-depth internal review during the intervening years.
Reserves for future policy benefits under long-term care policies are established (and related acquisition costs are amortized) over the life of the policies based on policy benefit assumptions as of the date of issuance, including investment yields, mortality, morbidity, persistency and expenses. Once these assumptions are established for a given policy or group of policies, they are not changed over the life of the policy unless a loss recognition event (premium deficiency) occurs. Loss recognition occurs when, based on current expectations as of the measurement date, the existing contract liabilities plus the present value of future premiums (including reasonably expected rate increases), are not expected to cover the present value of future claims payments, related settlement and maintenance costs, and unamortized acquisition costs.
Although management believes that its loss recognition assumptions at December 31, 2012, are reasonable, actual results will depend on how well future experience conforms to these assumptions, including the level and type of claim activity, persistency, expected rate increase approvals, and reinvestment rates. The relationship among these assumptions is complex, with deviations in one assumption often influencing the outcome of others. External factors, including, but not limited to changes in the regulatory and judicial environment, along with medical advancements and innovation in long-term care delivery systems, could have a material impact on the ultimate performance of this closed block of business. In addition, the loss recognition charge does not include any margin for adverse deviation in the reserve assumptions (in accordance with accounting guidance), therefore even a small adverse change in one of the key assumptions could result in a future loss recognition charge unless offset by a favorable change in another assumption.
The following table (in millions) illustrates the impact on net earnings of adverse changes in key loss recognition assumptions. The result of each assumption change represents the increase in the 2012 loss recognition charge that would have resulted from using the more adverse assumption. Each item reflects a change to a single assumption without changes to other assumptions.
Contingencies related to Subsidiaries’ Former Operations The A&E studies and reviews discussed above encompassed reserves for various environmental and occupational injury and disease claims and other contingencies arising out of the railroad operations disposed of by American Premier’s predecessor and certain manufacturing operations disposed of by American Premier and its subsidiaries and by Great American Financial Resources, Inc. Charges resulting from the A&E studies and review were less than $10 million in 2012, 2011 and 2010. In the third quarter of 2012, AFG recorded a pretax charge of $15 million for an adverse judgment received in a long-standing labor dispute involving American Premier’s former railroad employees, the likelihood of which was previously considered to be remote. Liabilities for claims and contingencies arising from these former railroad and manufacturing operations totaled $102 million at December 31, 2012. For a discussion of the uncertainties in determining the ultimate liability, see Note M - “Contingencies” to the financial statements.
Accounting standards require AFG to consolidate its investments in collateralized loan obligation (“CLO”) entities that it manages and owns an interest in (in the form of debt). See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities.” The effect of consolidating these entities is shown in the tables below (in millions). The “Before CLO Consolidation” columns include AFG’s investment and earnings in the CLOs on an unconsolidated basis.
Includes $31 million and $6 million in 2012 and 2011, respectively, in investment income representing the change in fair value of AFG’s CLO investments plus $18 million and $19 million in 2012 and 2011, respectively, in CLO management fees earned.
In addition, realized gains (losses) are shown net of noncontrolling interests of ($2 million) in 2012, ($1 million) in 2011 and ($6 million) in 2010.
Net earnings attributable to shareholders increased in 2012 compared to 2011 due primarily to a $114 million after-tax gain on the sale of AFG’s Medicare supplement and critical illness businesses, higher realized gains on securities and tax benefits of $67 million related to the favorable resolution of certain tax litigation and settlement of open tax years, partially offset by an after tax charge of $99 million to write off deferred acquisition costs and strengthen reserves in the closed block of long-term care insurance. Core net operating earnings decreased in 2012 compared to 2011 as higher earnings in the annuity operations were more than offset by lower underwriting profits and lower investment income in the Specialty property and casualty insurance operations.
Net earnings attributable to shareholders and core net operating earnings decreased in 2011 compared to 2010 due primarily to lower underwriting profit and lower investment income in the property and casualty insurance operations partially offset by increased earnings in the annuity insurance operations. Net earnings attributable to shareholders were also impacted by a second quarter 2011 special A&E charge and a fourth quarter 2011 charge for a valuation allowance against deferred tax assets.
AFG’s combined ratio has been better than the industry average for 25 of the last 27 years. Management believes that AFG’s insurance operations have performed better than the industry as a result of its specialty niche focus, product line diversification, stringent underwriting discipline and alignment of compensation incentives.
Premiums and combined ratios for AFG’s property and casualty insurance operations were as follows (dollars in millions):
The Specialty insurance operations generated an underwriting profit of $131 million in 2012, $100 million lower than in 2011. The decline in 2012 was due primarily to lower profitability in the crop insurance business as a result of the Midwest drought
Gross and net written premiums increased in 2011 compared to 2010 due primarily to higher premiums in the Property and transportation segment, particularly the crop and transportation businesses. In addition, higher net written premiums in 2011 reflect the impact of a third quarter 2010 reinsurance transaction in the Specialty financial group.
Property and transportation Gross and net written premiums for 2012 were impacted by lower spring agricultural commodity prices for corn and soybeans, which had the effect of reducing crop insurance premiums. The decrease in net written premiums was more than offset by growth in the transportation businesses. The Property and transportation group reported an underwriting profit of $19 million, $94 million lower than in 2011, due primarily to the effects of the Midwest drought on the crop operations and losses from Superstorm Sandy. Catastrophe losses for the Property and transportation group were $40 million (2.8 points) in 2012 compared to $32 million (2.3 points) in 2011. Average renewal rates were up approximately 3% for the year in this group.
Specialty casualty Gross and net written premiums for 2012 were higher than in 2011 as a result of business opportunities in the excess and surplus operations, growth in the workers’ compensation and agency captive insurance businesses and market hardening in many of the other Specialty casualty operations. This group reported an underwriting profit of $53 million in 2012, compared to $35 million in 2011. Improved 2012 accident year results in several operations and increased favorable reserve development in the general liability lines were partially offset by lower favorable reserve development in the executive liability and excess and surplus businesses. Results for 2012 include $18 million (1.9 points) of favorable reserve development compared to $71 million (8.2 points) in 2011. Average renewal rates were up approximately 4% for this group in 2012.
Specialty financial Gross written premiums for 2012 were up when compared to 2011 due to higher premiums in the financial institutions business, as well as growth in a service contract business. All of the premiums in the service contract business were ceded under reinsurance agreements. This group reported an underwriting profit of $44 million in 2012 compared to $65 million in 2011. Lower profitability in the financial institutions, surety and foreign credit businesses contributed to these results. Average renewal rates for this group were flat in 2012.
Net written premiums in 2011 were higher when compared to 2010 due primarily to the impact of a third quarter 2010 reinsurance transaction that involved the sale of unearned premiums related to the automotive lines of business. This group reported an underwriting profit of $65 million in 2011, $58 million lower than in 2010. Lower favorable reserve development, primarily in the run-off automobile residual value insurance (“RVI”) business, contributed to this decline.
Operating earnings before income taxes (excluding realized gains (losses)) of the annuity operations increased $29 million (18%) to $188 million in 2011 due primarily to AFG's ability to maintain spreads on a larger base of invested assets and the impact of a $25 million unlocking charge in 2010, partially offset by the impact of a decrease in the stock market performance on the variable annuity business and the impact of lower interest rates on the indexed annuity business.
Annuity premiums in 2012 were down slightly compared to 2011 and reflect actions taken by AFG in response to the significant drop in interest rates that began in the second quarter of 2012. These actions included reductions in interest rates credited to policyholders and in commissions paid to agents. Management believes that fixed-indexed annuities continued to sell well in both the individual and bank markets due to their market participation and other features. Conversely, management believes that traditional fixed annuity sales decreased due to low absolute crediting rates in the market, and that this decrease is consistent with industry experience. In addition, AFG was impacted by aggressive participants and new entrants in certain of its markets.
The increase in annuity premiums in 2011 compared to 2010 reflects primarily: (i) the introduction of new fixed-indexed annuity products and guaranteed withdrawal and death benefits features, (ii) AFG’s focus on independent broker dealers, (iii) successful recruiting of registered representatives and registered investment advisors, and (iv) the addition of two relatively large banks in 2010 and 2011.
The Medicare supplement and critical illness operations contributed pretax operating earnings (excluding realized gains (losses)) of $28 million through the date these operations were sold in August 2012, compared to $34 million and $31 million for the full year of 2011 and 2010, respectively.
Medicare supplement and critical illness premium amounts include only premiums received prior to August 31, 2012, the effective date of the sale of these businesses. See Note B - “Acquisitions and Sales of Subsidiaries.”
Realized gains on disposals include gains on sales of shares of Verisk Analytics, Inc. of $93 million in 2012, $76 million in 2011 and $26 million in 2010.
The change in fair value of derivatives includes net gains of $5 million in 2012, net losses of less than $1 million in 2011 and net gains of $50 million in 2010 from the mark-to-market of MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. See Note F - “Derivatives.”
Other Income Other income increased $8 million in 2012 compared to 2011 due primarily to fees charged to policyholders associated with increased sales of fixed-indexed annuities with guaranteed withdrawal benefits. The $19 million decrease in other income in 2011 compared to 2010 reflects $16 million in income recorded in the third quarter of 2010 from the sale of real estate and the termination of leases by a tenant.
Although the table above includes the impact of assumption changes in both the fixed and variable annuity businesses, the vast majority of the net charge in each period relates to the fixed (including fixed-indexed) annuity business. The 2012 net charge was due primarily to the impact of changes in assumptions related to future investment yields partially offset by changes in assumptions related to crediting rates, surrenders and annuitization and death benefits. Reinvestment rates used to project future investment yields are based primarily on 10-year corporate bond yields. For the 2012 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 3.50% in 2013, grading up ratably to an ultimate net reinvestment rate of 5.27% in 2022 and beyond. These rates are approximately 100 basis points lower than the 2011 reinvestment rate assumptions. The 2010 net charge was due primarily to the impact of changes in assumptions related to future investment yields, surrenders and annuitization and death benefits offset by the impact of lower expected expenses and crediting rates.
Annuity Benefits Annuity benefits reflect amounts accrued on annuity policyholders’ funds accumulated. On deferred annuities (annuities in the accumulation phase), interest is generally credited 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), additional reserves are accrued for persistency and premium bonuses and excess benefits expected to be paid for future deaths and annuitizations. Changes in investment yields, crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect these additional reserves and could result in charges (or credits) to earnings in the period the projections are modified.
Excluding the impact of the unlocking of actuarial assumptions discussed above under “Annuity Unlockings”, annuity benefits increased $27 million in 2012 compared to 2011 and $73 million in 2011 compared to 2010 reflecting growth in the annuity business partially offset by lower average crediting rates. The impact of changes in interest rates and stock market performance on the fair value of derivatives related to the fixed-indexed annuity business also impacted the 2012, 2011 and 2010 results.
The $153 million loss recognition charge recorded in the fourth quarter of 2012 for AFG’s closed block of long-term care insurance discussed under “Uncertainties - Run-off Long-term Care Insurance” includes a $79 million write-off of DPAC and PVFP.
See “Annuity Unlockings” above for a discussion of the impact that the periodic review of actuarial assumptions had on annuity and supplemental insurance acquisition expenses.
The vast majority of this group’s DPAC asset relates to its annuity business. Unanticipated spread compression, decreases in the stock market, adverse mortality experience, and higher than expected lapse rates could lead to write-offs of DPAC or PVFP in the future.
Interest Charges on Borrowed Money Interest expense increased $7 million (9%) in 2011 compared to 2010 reflecting AFG’s issuance of $132 million of 7% Senior Notes in September 2010.
Other Operating and General Expenses The $28 million (7%) increase in other operating and general expenses for 2012 compared to 2011 reflects the impact of a $15 million adverse judgment in a long-standing labor contract dispute related to AFG’s former railroad operations, the likelihood of which was previously considered to be remote, an $8 million loss on the retirement of debt, and a $2 million special charge to increase liabilities related to A&E exposures of AFG’s former railroad and manufacturing operations. Other operating and general expenses for 2011 include a $9 million special charge to increase A&E liabilities which was more than offset by the impact of a $10 million recovery on a prior property and casualty extracontractual obligation claim.
Consolidated Statement of Earnings for the years ended December 31, 2012, 2011 and 2010
Consolidated Statement of Cash Flows for the years ended December 31, 2012, 2011 and 2010
“Selected Quarterly Financial Data” has been included in Note N to the Consolidated Financial Statements.
Based on AFG’s evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2012. The attestation report of AFG’s independent registered public accounting firm on AFG’s internal control over financial reporting as of December 31, 2012, is set forth below.
In our opinion, American Financial Group, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of earnings, comprehensive income, changes in equity and cash flows for each of the three years in the period ended December 31, 2012. 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.
As discussed in Note A to the consolidated financial statements, in connection with implementing a new accounting standard in 2012, the Company retrospectively changed its method of accounting for costs associated with issuing or renewing insurance contracts.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Financial Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2013, expressed an unqualified opinion thereon.
Basis of Presentation The consolidated financial statements include the accounts of American Financial Group, Inc. (“AFG”) and its subsidiaries. Certain reclassifications have been made to prior years to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to December 31, 2012, and prior to the filing of this Form 10-K, have been evaluated for potential recognition or disclosure herein.
Accounting Standards Adopted in 2012 Effective January 1, 2012, AFG retrospectively adopted Accounting Standards Update (“ASU”) 2010-26 that addresses which costs related to issuing or renewing insurance contracts qualify for deferral. To qualify for deferral, the guidance specifies that a cost must be directly related to the successful acquisition of an insurance contract. The financial statements and related disclosures for prior periods have been adjusted to reflect the adoption of the new standard.
Effective January 1, 2012, AFG retrospectively adopted ASU 2011-05, which eliminates the option to report other comprehensive income in the Statement of Changes in Equity. As permitted by the standard, comprehensive income is presented herein in a separate statement immediately following the Statement of Earnings. This new presentation does not change the measurement of net earnings, other comprehensive income or earnings per share, and accordingly, had no impact on AFG’s results of operations or financial position.
Effective January 1, 2012, AFG prospectively adopted ASU 2011-04, which clarifies the application of existing fair value measurement and amends certain disclosure requirements. Disclosures required by the guidance are included in Note D. The impact of adoption was not material to AFG’s results of operations or financial position.
Fair Value Measurements Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in 2012 or 2011.
New accounting guidance adopted by AFG on January 1, 2010, requires additional disclosures about transfers between levels in the hierarchy of fair value measurements. The guidance also clarifies existing disclosure requirements related to the level of disaggregation presented and inputs used in determining fair values. Additional detail relating to the roll-forward of Level 3 fair values was required beginning in 2011.
Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities (“MBS”) 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.
Goodwill Goodwill represents the excess of cost of subsidiaries over AFG’s equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually. Under guidance adopted in 2011, an entity is not required to complete the quantitative annual goodwill impairment test on a reporting unit if the entity elects to perform a qualitative analysis and determines that it is more likely than not that the reporting unit’s fair value exceeds its carrying amount. The adoption of this guidance did not impact AFG’s results of operations or financial position.
A subsidiary cedes life insurance policies to a third party on a funds withheld basis whereby the subsidiary retains the assets (securities) associated with the reinsurance contract. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. This reinsurance contract is considered to contain an embedded derivative (that must be adjusted to fair value) because the yield on the payable is based on a specific block of the ceding company’s assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolio of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to this contract are classified as “trading.” The adjustment to the fair value of the embedded derivative offsets the investment income recorded on the adjustment to the fair value of the related trading portfolio.
DPAC and certain other balance sheet amounts related to annuity, long-term care and life businesses are also adjusted, net of tax, for the change in expense that would have been recorded if the unrealized gains (losses) from securities had actually been realized. These adjustments are included in unrealized gains (losses) on marketable securities, a component of accumulated other comprehensive income in AFG’s Balance Sheet.
At December 31, 2012, assets and liabilities of managed investment entities include $107 million in assets and $87 million in liabilities of a temporary warehousing entity that was established in connection with the formation of a new CLO that is expected to close in March 2013. Upon closing, all warehoused assets are expected to be transferred to the new CLO and the liabilities will be repaid.
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in
which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
In addition, reserves for traditional life and long-term care policies are subject to adjustment for loss recognition charges that would have been recorded if the unrealized gains from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of accumulated other comprehensive income in AFG’s Balance Sheet.
Noncontrolling Interests For Balance Sheet purposes, noncontrolling interests represents the interests of shareholders other than AFG in consolidated entities. In the Statement of Earnings, net earnings and losses attributable to noncontrolling interests represents such shareholders’ interest in the earnings and losses of those entities.
In December 2012, AFG disaggregated its annuity and supplemental operations into three reporting segments - annuity, run-off long-term care and life, and Medicare supplement and critical illness. The segment reporting changes reflect the Company’s revised, more granular view of these businesses following the sale of the Medicare supplement and critical illness business in the third quarter of 2012 and significant loss recognition charge in the long-term care business in the fourth quarter of 2012. This change will give management and investors greater insight into the results of operations and financial position of each of these businesses. The changes in AFG’s internal financial reporting related to this disaggregation took effect on December 31, 2012, and resulted in these reporting segment changes. Prior period amounts have been restated to conform to the new presentation.
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily
Includes holding company expenses, a second quarter 2011 special charge of $9 million to increase asbestos and environmental reserves and $98 million, $24 million and $64 million in losses of managed investment entities attributable to noncontrolling interests for the years ended December 31, 2012, 2011 and 2010, respectively. Holding company expenses in 2012 also include an $8 million loss on retirement of debt and a $15 million charge for a labor matter related to AFG’s former railroad operations.
AFG’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. AFG’s internal investment professionals are a group of approximately 20 analysts whose primary responsibility is to manage AFG’s investment portfolio. These professionals monitor individual investments as well as overall industries and are active in the financial markets on a daily basis. The group is led by AFG’s chief investment officer, who reports directly to one of AFG’s Co-CEOs. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG’s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. In addition, the Company communicates directly with the pricing service regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities.
The range of adjustments for insurance subsidiary’s credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AFG’s individual fixed-indexed annuity products with an expected range of 5% to 12% in the majority of future calendar years (4% - 20% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flows assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.
Total realized/unrealized loss included in net income includes losses of $213 million related to liabilities outstanding as of December 31, 2010. See Note H - “Managed Investment Entities.”
The table below sets forth the scheduled maturities of available for sale fixed maturities as of December 31, 2012 (in millions). Asset-backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. MBS had an average life of approximately 4 years at December 31, 2012.
There were no investments in individual issuers that exceeded 10% of Shareholders’ Equity at December 31, 2012 or 2011.
Net Unrealized Gain on Marketable Securities In addition to adjusting equity securities and fixed maturity securities classified as “available for sale” to fair value, GAAP requires that deferred policy acquisition costs and certain other balance sheet amounts related to annuity, long-term care and life businesses be adjusted to the extent that unrealized gains and losses from securities would result in adjustments to those balances had the unrealized gains or losses actually been realized. The following table shows (in millions) the components of the net unrealized gain on securities that is included in Accumulated Other Comprehensive Income in AFG’s Balance Sheet.
Primarily adjustments to deferred policy acquisition costs and reserves related to annuities and long-term care business.
Realized gains (losses) on securities include net gains of $5 million in 2012 compared to net losses of less than $1 million in 2011 and net gains of $50 million in 2010 from the mark-to-market of certain MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. Gross realized gains and losses (excluding impairment writedowns and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
The following table summarizes the gain (loss) included in the Statement of Earnings for changes in the fair value of these derivatives for 2012, 2011 and 2010 (in millions):
AFG is the investment manager and its subsidiaries have investments ranging from 7.5% to 51.2% of the most subordinate debt tranche of nine collateralized loan obligation entities or “CLOs,” which are considered variable interest entities. AFG’s subsidiaries also own portions of the senior debt tranches of certain of these CLOs. Upon formation between 2004 and 2012, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG’s investments in the subordinate debt tranches of these entities receive residual income from the CLOs only after the CLOs pay operating expenses (including management fees to AFG), interest on and returns of capital to senior levels of debt securities. There are no contractual requirements for AFG to provide additional funding for these entities. AFG has not provided and does not intend to provide any financial support to these entities.
In February 2012, one of the AFG CLOs was substantially liquidated at the instruction of the holder of the majority of the most subordinate debt tranche, as permitted by the CLO indentures. In 2012, AFG formed two new CLOs, which issued an aggregate face amount of $860 million of liabilities (including $74 million face amount purchased by subsidiaries of AFG). In 2012, AFG subsidiaries also purchased $74 million face amount of senior debt tranches of existing CLOs for $69 million.
Included in Operating earnings before income taxes in AFG’s Statement of Earnings.
Changes in the carrying value of goodwill during 2010, 2011 and 2012, by reporting segment, are presented in the following table (in millions):
The carrying value of long-term debt consisted of the following at December 31 (in millions):
At December 31, 2012, scheduled principal payments on debt for the subsequent five years were as follows: 2013 - $20 million; 2014 - $2 million; 2015 - $14 million; 2016 - $45 million and 2017 - $12 million.
As shown below at December 31 (in millions), the majority of AFG’s long-term debt is unsecured obligations of the holding company and its subsidiaries:
In November 2012, National Interstate replaced its $50 million bank credit facility with a new five-year, $100 million unsecured credit agreement. At December 31, 2012, there was $12 million outstanding under this agreement, bearing interest at a rate equal to three-month LIBOR plus 0.875% (1.186% at December 31, 2012).
In June 2012, AFG issued $230 million in 6-3/8% Senior Notes due 2042 and used the proceeds to redeem the outstanding AAG Holding Company 7-1/2% and 7-1/4% Senior Debentures at par value in July 2012. In August 2012, AFG issued $125 million in 5-3/4% Senior Notes due 2042 and used the proceeds to redeem the outstanding AFG 7-1/8% Senior Debentures at par value in September 2012.
Cash interest payments on long-term debt were $75 million in 2012, $74 million in 2011 and $68 million in 2010. 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: $9 million in 2012 and $10 million in 2011 and 2010.
At December 31, 2012, there were 13.7 million shares of AFG Common Stock reserved for issuance under AFG’s stock incentive plans. Options are granted with an exercise price equal to the market price of AFG Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant and expire ten years after the date of grant.
The total intrinsic value of options exercised during 2012, 2011 and 2010 was $25 million, $23 million and $19 million, respectively. During 2012, 2011 and 2010, AFG received $40 million, $33 million and $27 million, respectively, in cash from the exercise of stock options. The total tax benefit related to the exercises was $8 million, $7 million and $6 million, respectively.
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 expected term. The expected term was estimated based on historical exercise patterns and post vesting cancellations. The weighted average fair value of options granted during 2012, 2011 and 2010 was$13.02 per share, $12.49 per share and $8.90 per share, respectively, based on the following assumptions:
Includes net unrealized gains of $33 million at December 31, 2012 compared to net unrealized losses of $16 million and $11 million at December 31, 2011 and 2010, respectively, related to securities for which only the credit portion of an other-than-temporary impairment has been recorded in earnings.
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2012 (in millions):
The changes in the deferred tax liabilities related to investment securities and deferred policy acquisition costs at year end 2012 compared to 2011 are due primarily to the increase in unrealized gains on fixed maturity securities. The decline in the deferred tax liability related to deferred policy acquisition costs also reflects the fourth quarter 2012 write-off of DPAC in AFG’s closed block of long-term care insurance.
AFG increased its liability for uncertain tax positions by $3 million in 2012, $7 million in 2011 and $16 million in 2010, exclusive of interest, to reflect uncertainty as to the timing of tax return inclusion of income related to certain securities. Because the ultimate recognition of income with respect to these securities is highly certain, any adjustments to this liability will result in offsetting adjustments to AFG’s deferred tax liability. Accordingly, the ultimate resolution of this item will not impact AFG’s annual effective tax rate but could accelerate the payment of taxes. During 2012, AFG also increased its liability for uncertain tax positions by $2 million related to the deductibility of certain financing expenses.
A progression of the liability for uncertain tax positions, excluding interest and penalties, follows (in millions):
The total unrecognized tax benefits and related interest that, if recognized, would impact the effective tax rate is $3 million at December 31, 2012. AFG’s provision for income taxes included a benefit of $14 million in 2012 and expense of $3 million in 2011 and $2 million in 2010 of interest (net of federal benefit or expense). AFG’s liability for interest related to unrecognized tax benefits was $1 million at December 31, 2012 and $15 million at December 31, 2011 (net of federal benefit); no penalties were accrued at those dates.
Cash payments for income taxes, net of refunds, were $277 million, $157 million and $196 million for 2012, 2011 and 2010, respectively.
At December 31, 2012, American Premier and its subsidiaries had liabilities for environmental and personal injury claims and other contingencies aggregating $93 million. The environmental claims consist of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs related to certain sites formerly owned or operated by the railroad and manufacturing operations. Remediation costs are difficult to estimate for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. The personal injury claims and other contingencies include pending and expected claims, primarily by former employees of PCTC, for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the workplace and other labor disputes.
The following are quarterly results of consolidated operations for the two years ended December 31, 2012 (in millions, except per share amounts). Quarterly earnings per share do not add to year-to-date amounts due to changes in shares outstanding.
Pretax realized gains (losses) on subsidiaries and securities (including other-than-temporary impairments) and favorable (unfavorable) prior year development of AFG’s liability for losses and loss adjustment expenses (“LAE”) were as follows (in millions):
Realized gains and losses (in the table above) for the third quarter of 2012 include a pretax gain of $155 million on the sale of AFG’s Medicare supplement and critical illness businesses. Unfavorable prior year development (in the table above) for the third quarter of 2012 includes pretax special charges of $31 million to strengthen property and casualty insurance reserves for
Unfavorable prior year development for the second quarter of 2011 includes pretax special charges of $50 million to strengthen property and casualty insurance asbestos and environmental reserves. Results for the second quarter of 2011 also include pretax special charges of $9 million to strengthen reserves for asbestos and environmental exposures related to AFG’s railroad and manufacturing operations, pretax catastrophe losses of $23 million primarily from tornadoes and pretax realized gains of $33 million from the sales of a portion of AFG’s investment in Verisk Analytics, Inc. (“Verisk”). The 2011 fourth quarter includes a $34 million special charge for a valuation allowance against deferred tax assets and $40 million of pretax realized gains on sales of Verisk.
Property and Casualty Insurance Reserves The liability for losses and LAE for long-term scheduled payments under certain workers’ compensation insurance has been discounted at 4.5%, an approximation of long-term investment yields. As a result, the total liability for losses and loss adjustment expenses at December 31, 2012, has been reduced by $22 million.
Favorable development in 2012 was due primarily to lower than expected frequency and severity in the homebuilders’ general liability business within the Specialty casualty sub-segment and lower than expected frequency in the crop business within the Property and transportation sub-segment, partially offset by higher frequency and severity in a block of program business in the Specialty casualty sub-segment and the $31 million special charge to increase asbestos and environmental reserves. Favorable development in 2011 was due primarily to lower than expected severity in certain businesses within the Specialty casualty sub-segment and lower than expected frequency in crop business within the Property and transportation sub-segment, partially offset by the $50 million special charge to increase asbestos and environmental reserves. Favorable development in 2010 was primarily in the Specialty casualty and Specialty financial sub-segments.
In 2012, AFG recorded a $153 million pretax loss recognition charge to write off deferred policy acquisition costs and strengthen reserves on its closed block of long-term care insurance, due primarily to the impact of changes in assumptions related to future investment yields resulting from the continued low interest rate environment, as well as changes in claims, expenses and persistency assumptions. At December 31, 2012, AFG’s long-term care insurance reserves were $755 million, net of reinsurance recoverables.
(*) Included primarily in “Other operating and general expenses” in the Statement of Earnings.
Reinsurance In the normal course of business, AFG’s insurance subsidiaries cede reinsurance to other companies to diversify risk and limit maximum loss arising from large claims. To the extent that any reinsuring companies are unable to meet obligations under agreements covering reinsurance ceded, AFG’s insurance subsidiaries would remain liable. The following table shows (in millions) (i) amounts deducted from property and casualty written and earned premiums in connection with reinsurance ceded, (ii) written and earned premiums included in income for reinsurance assumed and (iii) reinsurance recoveries, which represent ceded losses and loss adjustment expenses.
AFG has reinsured approximately $14 billion in face amount of life insurance at December 31, 2012 and $16 billion at December 31, 2011. Life written premiums ceded were $42 million, $44 million and $49 million for 2012, 2011 and 2010, respectively.
Variable Annuities At December 31, 2012, the aggregate guaranteed minimum death benefit value (assuming every variable annuity policyholder died on that date) on AFG’s variable annuity policies exceeded the fair value of the underlying variable annuities by $40 million, compared to $63 million at December 31, 2011. Death benefits paid in excess of the variable annuity account balances were less than $1 million in each of the last three years.
Operating Leases Total rental expense for various leases of office space and equipment was $51 million in 2012, $54 million in 2011 and $42 million in 2010. 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, 2012, were as follows: 2013 - $54 million; 2014 - $52 million; 2015 - $44 million; 2016 - $38 million; 2017 - $31 million; and $185 million thereafter.
Financial Instruments with Off-Balance-Sheet Risk On occasion, AFG and its subsidiaries have entered into financial instrument transactions that may present off-balance-sheet risks of both a credit and market risk nature. These transactions include commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. At December 31, 2012, AFG and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling up to $75 million.
The information required by the following Items will be included in AFG’s definitive Proxy Statement for the 2013 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission within 120 days after the end of the Registrant’s fiscal year and is incorporated herein by reference.
Grossed up for reinsurance recoverables of $2,716 and $2,238 at December 31, 2012 and 2011, respectively.