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 83% of the 164,000 square feet of rentable office space on 17.5 acres of land that it owns in Richfield, Ohio. See Item 1 - Business - “Other Operations” for a discussion of AFG’s other commercial real estate operations.
Fixed charges are computed on a “total enterprise” basis. For purposes of calculating the ratios, “earnings” have been computed by adding to pretax earnings the fixed charges and the noncontrolling interests in earnings of subsidiaries having fixed charges and the undistributed equity in earnings or losses of investees. Fixed charges include interest (including annuity benefits as indicated), amortization of debt premium/discount and expense, preferred dividend and distribution requirements of subsidiaries and a portion of rental expense deemed to be representative of the interest factor. The ratio of earnings to fixed charges excluding annuity benefits was 7.95, 8.86, 7.16, 6.59 and 9.14 for 2014, 2013, 2012, 2011 and 2010, 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.
At December 31, 2014, AFG (parent) held approximately $350 million in cash and securities and had $500 million available under a bank line of credit expiring in December 2016.
Fourth quarter 2014 net earnings attributable to AFG’s shareholders were $127 million ($1.41 per share, diluted) compared to $158 million ($1.73 per share) in the fourth quarter of 2013, reflecting:
higher underwriting profit and net investment income in the property and casualty insurance segment,
higher underwriting profit, including lower special A&E charges, and higher net investment income in the property and casualty insurance segment,
Reserves for future policy benefits related to AFG’s closed block of long-term care insurance 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, 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 and related settlement and maintenance costs as well as unamortized acquisition costs. AFG recorded a loss recognition charge in its long-term care business in the fourth quarter of 2012. As a result of this charge, all remaining unamortized acquisition costs in the long-term care business were written off and policy benefit assumptions were reset to 2012 assumptions, resulting in an increase to the reserve for future policy benefits. These assumptions will not be changed again unless a future loss recognition event occurs. Although no additional loss recognition occurred in 2014 or 2013, adverse changes in any of the current policy benefit assumptions could result in a future loss recognition event and additional charges to earnings.
Net cash used in investing activities was $2.92 billion in 2013 compared to $1.43 billion in 2012, an increase of $1.49 billion. The $1.15 billion increase in net cash flows from annuity policyholders in 2013 as compared to 2012 (discussed below under net cash provided by financing activities) increased the amount of cash available for investment in 2013 compared to 2012. In addition, the increase in net cash used in investing activities reflects the use of cash and cash equivalents held in the property and casualty operations to purchase fixed maturity and equity securities during 2013. Net investment activity in the managed investment entities was a $478 million source of cash in 2013 compared to an $8 million source of cash in 2012.
In April 2014, AFG completed the purchase of Summit Holding Southeast, Inc. and its related companies (“Summit”) from Liberty Mutual Insurance for $259 million using cash on hand at the parent company. In addition, AFG made a capital
In 2012, AFG issued $125 million of 5-3/4% Senior Notes due 2042 and $230 million of 6-3/8% Senior Notes due 2042 and used the proceeds to redeem outstanding higher rate debt. During 2012, AFG repurchased 10.9 million shares of its Common Stock for $415 million. In December 2012, AFG paid a special cash dividend of $0.25 per share of AFG Common Stock totaling approximately $23 million.
National Interstate Corporation (“NATL”), a 51%-owned property and casualty insurance subsidiary, can borrow up to $100 million under its unsecured credit agreement, which expires in November 2017. There was $12 million borrowed under this agreement at December 31, 2014, bearing interest at 1.20% (six-month LIBOR plus 0.875%). The maximum outstanding balance in 2014 was $12 million.
For statutory accounting purposes, equity securities of non-affiliates are generally carried at fair value. At December 31, 2014, AFG’s insurance companies owned publicly traded equity securities with a fair value of $1.65 billion. In addition, GAI’s investment in NATL common stock had a fair value of $304 million and a statutory carrying value of $241 million at
December 31, 2014. 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.
Condensed Parent Only Cash Flows AFG’s parent holding company only condensed cash flows from operating, investing and financing activities are shown below (in millions):
Parent Net Cash Used in Investing Activities Parent holding company investing activities consist of capital contributions to and returns of capital from subsidiaries and, to a much lesser extent, parent company investment activity. Parent holding company net cash used in investing activities was $432 million in 2014 compared to $4 million in 2013 and $284 million in 2012. The $432 million in net cash used in investing activities in 2014 and the $284 million in 2012 are significantly higher than the $4 million in net cash used in investing activities in 2013 due primarily to capital contributions made to subsidiaries to fund the $399 million investment in Summit in 2014 and the redemption of $199 million of AAG Holding senior debentures in 2012.
Parent Net Cash Used in Financing Activities Parent company financing activities consist primarily of repurchases of AFG Common Stock, dividends to shareholders, the issuance and retirement of long-term debt and, to a lesser extent, proceeds from employee stock option exercises. Significant long-term debt and common stock transactions are discussed above. Parent holding company net cash used in financing activities was $171 million in 2014 compared to $180 million in 2013 and $232 million in 2012. The $9 million decrease in net cash used in financing activities in 2014 as compared to 2013 reflects net proceeds of $145 million received in 2014 from the issuance of 6-1/4% Subordinated Debentures due in 2054, partially offset by a $121 million increase in common stock repurchases. The $52 million decrease in net cash used in financing activities in 2013 as compared to 2012 reflects a $345 million decrease in common stock repurchases partially offset by the impact of $229 million in cash provided in 2012 from debt issuances in excess of debt retirements and a $70 million increase in cash dividends paid.
Dollar amounts and time periods are estimates based on historical net payment patterns applied to the gross reserves and do not represent actual contractual obligations. Based on the same assumptions, AFG projects reinsurance recoveries related to these reserves totaling $2.23 billion as follows: Within 1 year - $500 million; 2-3 years - $500 million; 4-5 years - $200 million; and thereafter - $1.03 billion. Actual payments and their timing could differ significantly from these estimates.
AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2014.
AFG’s investment portfolio at December 31, 2014, contained $30.73 billion in “Fixed maturities” and $1.50 billion in “Equity securities” classified as available for sale and carried at fair value with unrealized gains and losses included in a separate component of shareholders’ equity on an after-tax basis. In addition, $266 million in fixed maturities and $195 million in equity securities were classified as trading with changes in unrealized holding gains or losses included in investment income.
Summarized information for AFG’s MBS (including those classified as trading) at December 31, 2014, is shown (dollars in millions) in the table below. Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The majority of the Alt-A securities and substantially all of the subprime securities are backed by fixed-rate mortgages. The average life of the residential and commercial MBS is approximately 5 years and 4 years, respectively.
Summarized information for the unrealized gains and losses recorded in AFG’s Balance Sheet at December 31, 2014, is shown in the following table (dollars in millions). Approximately $450 million of available for sale fixed maturity securities and $90 million of available for sale equity securities had no unrealized gains or losses at December 31, 2014.
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, 2014. 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 “Results of Operations - Consolidated Realized Gains on Securities.”
Each quarterly review includes in-depth analysis of over 400 subdivisions of the business, employing multiple actuarial techniques. For each subdivision, actuaries use informed, professional judgment to adjust these techniques as necessary to respond to specific conditions in the data or within the business.
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 AFG’s 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 approximately $41 million.
In April 2014, AFG acquired Summit Holding Southeast, Inc. and related companies, a leading provider of workers’ compensation solutions in the southeastern United States. The Summit acquisition significantly increased AFG’s volume of workers’ compensation business and improved its geographic diversity. Approximately 24% and 19% of AFG’s workers’ compensation reserves at December 31, 2014 relate to policies written in Florida and California, respectively. Over the past 12 years in both states, there have been numerous revisions to workers’ compensation regulations and operating environments, adding difficulty and uncertainty to the estimation of related liabilities.
AFG recorded favorable prior year reserve development of $15 million in 2014, $11 million in 2013 and $43 million in 2012 related to its other liability - occurrence coverage where both the frequency and severity of claims in excess and umbrella liability coverages were lower than previously projected.
The general state of the economy and the variability of the stock price of the insured can affect the frequency and severity of shareholder class action suits and other situations that trigger coverage under D&O policies. For example, from 2008 to 2010, economic conditions led to higher frequency and severity of claims, particularly in the D&O policies for small account and not-for-profit organizations. Since then, claim frequency has continually decreased from its peak in 2010, offsetting increased claim severity.
AFG recorded favorable prior year reserve development of $18 million in 2014, $41 million in 2013 and $16 million in 2012 on its D&O business as claim severity was less than expected across several prior accident years.
AFG recorded adverse prior year reserve development of $28 million in 2014, $37 million in 2013 and $1 million in 2012 for this line of business as claim severity was significantly higher than expected, particularly from accident years 2010 to 2012.
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 S&P ratings or is secured by “funds withheld” or other collateral.
See Item 1 - Business - “Property and Casualty Insurance Segment - 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” to the financial statements and the gross loss development table under Item 1 - Business - “Property and Casualty Insurance Segment - Loss and Loss Adjustment Expense Reserves.”
segment. These recoverables include $587 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).
Asbestos claims paid in 2013 include payments totaling $106 million associated with the settlement of A.P. Green Industries and another large claim. Substantially all of the settlement amounts had been accrued for in prior years.
An in-depth internal review of AFG’s A&E reserves was completed in the third quarter of 2014 by AFG’s internal A&E claims specialists and actuaries in consultation with specialty outside counsel and an outside consultant. As a result of the review,
As a result of the comprehensive external study completed in the third quarter of 2013, AFG’s property and casualty insurance segment recorded a $54 million pretax special charge to increase its asbestos reserves by $16 million (net of reinsurance) and its environmental reserves by $38 million (net of reinsurance). The increase in the property and casualty segment’s asbestos reserves was driven primarily by slightly higher than expected loss experience, higher defense costs and some increased claim severity. The increase in property and casualty environmental reserves was attributed primarily to a small number of claims where the estimated costs of remediation have increased.
As a result of the in-depth internal review completed in 2012, AFG recorded a $31 million pretax special charge to increase the property and casualty segment’s asbestos reserves by $19 million (net of reinsurance) and its environmental reserves by $12 million (net of reinsurance). The charge relates primarily to an increase in environmental investigative costs and related loss adjustment expenses.
At December 31, 2014, AFG’s loss recognition testing included updated assumptions for claim costs, expenses, reinvestment rates and rate increases. With the assistance of an outside actuarial consulting firm, the historical claim cost assumptions developed in conjunction with the 2012 external actuarial study were refreshed based on AFG’s updated historical experience. Due to the unanticipated decline in interest rates, net reinvestment rates (net of expense and default assumptions) were estimated at 4.52% for 2015 and projected to increase gradually to 6.25% in 2022. After 2022, reinvestment rates were projected to be relatively flat. Rate increase assumptions were updated to reflect higher than previously anticipated actual 2014 rate increases, including the impact of this experience on management’s view of future rate increases. Based on recent experience, management believes that the lapse and mortality assumptions established in connection with the 2012 loss recognition charge continue to be reasonable. As a result of the updated assumptions, AFG has a loss recognition margin (as defined above) of $11 million at December 31, 2014. As a result, no loss recognition charges were recorded in 2014 and the assumptions used to establish reserves for future policy benefits from the 2012 loss recognition charge continue to be used. The following table illustrates the approximate impact of each assumption change on AFG’s run-off long-term care loss recognition margin from December 31, 2013 through December 31, 2014 (in millions):
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 reviews and study were $6 million in 2014, $22 million in 2013 and $2 million in 2012. For a discussion of the $6 million and $22 million charges recorded for those operations in 2014 and 2013, respectively, see “Holding Company, Other and
Unallocated - Results of Operations.” 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 $90 million at December 31, 2014. For a discussion of the uncertainties in determining the ultimate liability, see Note M - “Contingencies” to the financial statements.
Allocate earnings (losses) of CLOs attributable to other debt holders to noncontrolling interests.
Includes $16 million and $35 million in 2014 and 2013, respectively, in net investment income representing the change in fair value of AFG’s CLO investments plus $25 million and $16 million in 2014 and 2013, respectively, in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $23 million and $25 million in 2014 and 2013, respectively, in distributions recorded as interest expense by the CLOs.
Property and Casualty Insurance Segment - Results of Operations Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their financial statements better understand the company’s performance. Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of losses and loss adjustment expenses, and commissions and other underwriting expenses to premiums. A combined ratio under 100% indicates an underwriting profit. The combined ratio does not reflect net investment income, other income, other expenses or federal income taxes. AFG’s property and casualty insurance operations contributed $143 million in pretax earnings in the fourth quarter of 2014 compared to $136 million in the fourth quarter of 2013, an increase of $7 million (5%). The increase in pretax earnings reflects higher underwriting profit across each of AFG’s property and casualty insurance sub-segments and higher net investment income (due primarily to the investment of cash acquired in the April 2014 Summit acquisition), partially offset by lower other income due to income from the sale of real estate in the fourth quarter of 2013.
AFG’s combined ratio has been better than the industry average for 27 of the last 29 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.
Gross written premiums (“GWP”) for AFG’s property and casualty insurance segment were $1.30 billion for the fourth quarter of 2014 compared to $1.07 billion for the fourth quarter of 2013, an increase of $232 million (22%). Detail of AFG’s property and casualty gross written premiums is shown below (dollars in millions):
Reinsurance premiums ceded (“Ceded”) for AFG’s property and casualty insurance segment were 21% of gross written premiums for the fourth quarter of 2014 compared to 23% for the fourth quarter of 2013, a decrease of 2 percentage points. Detail of AFG’s property and casualty reinsurance premiums ceded is shown below (dollars in millions):
Net earned premiums (“NEP”) for AFG’s property and casualty insurance segment were $1.06 billion for the fourth quarter of 2014 compared to $859 million for the fourth quarter of 2013, an increase of $202 million (24%). Detail of AFG’s property and casualty net earned premiums is shown below (dollars in millions):
Specialty casualty Gross written premiums increased $201 million (44%) for the fourth quarter of 2014 compared to the fourth quarter of 2013 reflecting $144 million in premiums generated by Summit, which was acquired in April 2014. Excluding premiums from Summit, gross written premiums increased 12% in the fourth quarter of 2014 compared to the fourth quarter of 2013. Broad-based growth across this group was primarily the result of growth in the workers’ compensation operations and excess and surplus lines businesses. New business opportunities and increased exposures from higher payroll on existing accounts have contributed to the increase in premiums in the workers’ compensation businesses. Organic growth opportunities have contributed to higher premiums in the excess and surplus lines businesses. Average renewal rates were up approximately 1% for this group in the fourth quarter of 2014. Reinsurance premiums ceded as a percentage of gross written premiums declined 5 percentage points for the fourth quarter of 2014 compared to the fourth quarter of 2013 reflecting the impact of the acquisition of Summit, which cedes only about 1% of its premiums.
The Specialty property and casualty insurance operations generated an underwriting profit of $79 million in the fourth quarter of 2014 compared to $75 million in the fourth quarter of 2013, an increase of $4 million (5%). The higher underwriting profit in the fourth quarter of 2014 reflects higher underwriting profits across each of the property and casualty insurance sub-segments.
Specialty financial Underwriting profit for this group was $18 million for the fourth quarter of 2014 compared to $17 million in the fourth quarter of 2013, an increase of $1 million (6%). Higher underwriting profits in the surety and fidelity and financial institutions businesses were partially offset by lower underwriting profitability in the trade credit business.
AFG’s overall loss and LAE ratio was 64.0% for the fourth quarter of 2014 compared to 62.5% for fourth quarter of 2013, an increase of 1.5 percentage points. The components of AFG’s property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
The current accident year loss and LAE ratio for AFG’s Specialty property and casualty insurance operations was 62.8% for both the fourth quarter of 2014 and the fourth quarter of 2013.
Property and transportation The 2.8 percentage point decrease in the loss and LAE ratio for the current year, excluding catastrophe losses is due primarily to higher profitability in the property and inland marine operations.
AFG’s Specialty property and casualty insurance operations recorded net adverse reserve development related to prior accident years of $10 million in the fourth quarter of 2014 compared to net favorable reserve development related to prior accident years of $5 million in the fourth quarter of 2013, a decline of $15 million.
AFG generally seeks to reduce its exposure to catastrophes through individual risk selection, including minimizing coastal and known fault-line exposures, and the purchase of reinsurance. Based on data available at December 31, 2014, AFG’s exposure to a catastrophic earthquake or windstorm that industry models indicate could occur once in every 500 years (a “500-year event”) is expected to be less than 3.5% of AFG’s shareholders’ equity. Catastrophe losses were nominal in both the fourth quarter of 2014 and 2013.
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums increased 1.5 percentage points for the fourth quarter of 2014 compared to the fourth quarter of 2013 reflecting higher profitability-based commissions paid to agents and brokers.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.1 percentage points for the fourth quarter of 2014 compared to the fourth quarter of 2013.
(*) Adjusts the yield on equity securities and tax-exempt bonds to the fully taxable equivalent yield.
The increase in average invested assets and net investment income in the property and casualty segment for the fourth quarter of 2014 as compared to the fourth quarter of 2013 is due primarily to the investment of cash acquired in the Summit acquisition in April 2014 and organic growth in the property and casualty segment. The property and casualty segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 3.54% for the fourth quarter of 2014 compared to 3.94% for the fourth quarter of 2013, a decline of 0.40 percentage points, reflecting the impact of strong investment results in the 2013 quarter and lower yields available in the financial markets.
Amortization of intangibles includes $2 million in the fourth quarter of 2014 related to the Summit acquisition.
The following table details AFG’s earnings before income taxes from its annuity operations for the three months ended December 31, 2014 and 2013 (dollars in millions):
The profitability of a fixed annuity business is largely dependent on the ability of a company to earn income on the assets supporting the business in excess of the amounts credited to policyholder accounts plus expenses incurred (earning a “spread”). Performance measures such as net interest spread and net spread earned are often presented by annuity businesses to help users of their financial statements better understand the company’s performance.
Net investment income for the fourth quarter of 2014 was $285 million compared to $270 million for the fourth quarter of 2013, an increase of $15 million (6%). This increase reflects primarily the growth in AFG’s annuity business, partially offset by the run-off of higher yielding investments. The overall yield earned on investments in AFG’s annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), declined by 0.36 percentage points in the fourth quarter of 2014 compared to the fourth quarter of 2013. This decline in net investment yield reflects (i) the investment of new premium dollars at lower yields as compared to the existing investment portfolio, (ii) the impact of the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets and (iii) the impact of higher non-recurring investment income in the fourth quarter of 2013 compared to the same period in 2014.
Interest credited - fixed for the fourth quarter of 2014 was $127 million compared to $118 million for the fourth quarter of 2013, an increase of $9 million (8%). The impact of growth in the annuity business was partially offset by lower interest crediting rates on new premiums as compared to the crediting rates on policyholder funds surrendered or withdrawn. The average interest rate credited to policyholders, calculated as interest credited divided by average fixed annuity benefits
Excluding those annuities that have guaranteed withdrawal benefits, at December 31, 2014, AFG could reduce the average crediting rate on approximately $18 billion of traditional fixed and fixed-indexed deferred annuities by an additional 0.58% (on a weighted average basis). Annuity policies are subject to Guaranteed Minimum Interest Rates (“GMIRs”) at policy issuance. The table below shows the breakdown of annuity reserves by GMIR. The current interest crediting rates on substantially all of AFG’s annuities with a GMIR of 3% or higher are at their minimum.
AFG’s net interest spread decreased 0.22 percentage points in the fourth quarter of 2014 compared to the same period in 2013 due primarily to the run-off of higher yielding investments. In addition, features included in current annuity product offerings allow AFG to achieve its desired profitability at a lower net interest spread than historical product offerings. As a result of these two items, AFG expects its net interest spread to narrow in the future.
AFG’s net spread earned on fixed annuities decreased 0.27 percentage points in the fourth quarter of 2014 compared to the same period in 2013 due primarily to the 0.22 percentage points decrease in AFG’s net interest spread and the net impact of changes in the fair value of derivatives and related DPAC offset discussed above. These items were partially offset by the impact of growth in AFG’s annuity business on other expenses and other annuity benefits as a percent of fixed annuity benefits accumulated discussed above.
AFG’s annuity operations generated statutory premiums of $971 million in the fourth quarter of 2014 compared to $1.38 billion in the fourth quarter of 2013, a decrease of $410 million (30%). The following table summarizes AFG’s annuity sales (dollars in millions):
Management attributes the 30% decrease in annuity premiums in the fourth quarter of 2014 as compared to the fourth quarter of 2013 to AFG’s disciplined approach to product pricing in a declining interest rate environment and increased levels of competition.
Net investment income (as a % of investments) of 4.85% and 5.21% for the three months ended December 31, 2014 and 2013, respectively, multiplied by the difference between average fixed annuity investments (at amortized cost) and average fixed annuity benefits accumulated in each period.
Run-off Long-Term Care and Life Segment - Results of Operations The following table details AFG’s loss before income taxes from its run-off long-term care and life operations for the three months ended December 31, 2014 and 2013 (dollars in millions):
The $7 million increase in long-term care benefit expense in the fourth quarter of 2014 compared to the fourth quarter of 2013 is due primarily to a $5 million charge related to the commutation of a reinsurance agreement.
AFG expects revenues and expenses related to the long-term care business to generally increase over time as this closed block of business ages. Due to the age and relatively small size of its long-term care business, AFG expects claims volatility from period to period. See “Uncertainties - Run-off Long-term Care Insurance” for details on AFG’s long-term care loss recognition margin, including the estimated impact of changes in key assumptions on the margin.
Holding Company, Other and Unallocated - Results of Operations AFG’s pretax loss outside of its insurance operations totaled $35 million for the fourth quarter of 2014 compared to $46 million for the fourth quarter of 2013, a decrease of $11 million (24%).
The following table details AFG’s loss before income taxes from operations outside of its insurance operations for three months ended December 31, 2014 and 2013 (dollars in millions):
AFG recorded investment income on investments held outside of its insurance operations of $2 million in both the fourth quarter of 2014 and 2013.
AFG’s holding companies and other operations outside of its insurance operations recorded interest expense of $19 million in the fourth quarter of 2014 compared to $17 million in the fourth quarter of 2013, an increase of $2 million (12%). AFG issued $150 million of 6-1/4% Subordinated Debentures in September 2014. The following table details AFG’s long-term debt balances as of December 31, 2014 compared to December 31, 2013 (dollars in millions):
AFG’s holding companies and other operations outside of its insurance operations, recorded other expenses of $29 million in the fourth quarter of 2014 compared to $34 million in the fourth quarter of 2013, a decrease of $5 million (15%). The $5 million decrease reflects lower holding company expenses associated with employee benefit plans that are tied to stock market performance and slightly lower other holding company expenses.
Consolidated Realized Gains on Securities AFG’s consolidated realized gains on securities, which are not allocated to segments, were $8 million in the fourth quarter of 2014 compared to $67 million in the fourth quarter of 2013, a decrease of $59 million (88%). Realized gains (losses) on securities consisted of the following (in millions):
Consolidated Income Taxes AFG’s consolidated provision for income taxes was $65 million for the fourth quarter of 2014 compared to $81 million in the fourth quarter of 2013, a decrease of $16 million (20%). See Note L - “Income Taxes” to the financial statements. The following is a reconciliation of income taxes at the statutory rate of 35% to the provision for income taxes as shown in the Segmented Statement of Earnings (dollars in millions):
AFG’s property and casualty insurance operations contributed $375 million in GAAP pretax earnings in 2013 compared to $322 million in 2012, an increase of $53 million (16%). Property and casualty core pretax earnings were $429 million in 2013 compared to $353 million in 2012, an increase of $76 million (22%). Higher underwriting profit in the Specialty casualty group and Specialty financial group were partially offset by a decline in the underwriting profit in the Property and transportation group during the first half of the year.
The following table details AFG’s GAAP and core earnings before income taxes from its property and casualty operations for the years ended December 31, 2014, 2013 and 2012 (dollars in millions):
AFG reports the underwriting performance of its Specialty insurance business in the following sub-segments: (i) Property and transportation, (ii) Specialty casualty and (iii) Specialty financial.
Reinsurance premiums ceded (“Ceded”) for AFG’s property and casualty insurance segment were 27%, 30% and 32% of gross written premiums for the years ended December 31, 2014, 2013 and 2012, respectively. Detail of AFG’s property and casualty reinsurance premiums ceded is shown below (dollars in millions):
Net written premiums (“NWP”) for AFG’s property and casualty insurance segment were $4.02 billion in 2014 compared to $3.34 billion in 2013, an increase of $679 million (20%). NWP increased $392 million (13%) in 2013 compared to 2012. Detail of AFG’s property and casualty net written premiums is shown below (dollars in millions):
The $672 million (14%) increase in gross written premiums in 2014 compared to 2013 reflects $414 million in premiums from Summit (acquired in April 2014) as well as significant growth in other businesses within the Specialty casualty group.
The $484 million increase in gross written premiums in 2013 compared to 2012 reflects growth across each of the property and casualty sub-segments. Overall average renewal rates increased approximately 4% in 2013.
Gross written premiums increased $121 million in 2013 compared to 2012 due primarily to higher crop premiums and growth in the transportation businesses. Average renewal rates were up approximately 5% in 2013. Reinsurance premiums ceded as a percentage of gross written premiums were 35% in both 2013 and 2012. Higher cessions of multi-peril crop business and higher cost of reinsurance on the property business were offset by higher retention of gross premiums in certain operations and lower reinsurance reinstatement premiums due to the impact of large reinsured losses in 2012 (related to Superstorm Sandy).
Specialty casualty Gross written premiums increased $739 million (41%) in 2014 compared to 2013 reflecting $414 million in premiums from Summit, which was acquired in April 2014. Excluding premiums from Summit, gross written premiums increased 18% in 2014 compared to 2013 as a result of increased premiums in nearly all businesses in this group, particularly in the workers’ compensation, excess and surplus lines and targeted markets operations. New business opportunities and increased exposures from higher payroll on existing accounts have contributed to the increase in premiums in the workers’ compensation businesses. Strong premium growth in the excess and surplus lines and targeted markets operations is the result of broadening opportunities to write business coupled with the benefit from rate increases over multiple quarters. Average renewal rates were up approximately 2% for this group in 2014. Reinsurance premiums ceded as a percentage of gross written premiums declined 6 percentage points in 2014 compared to 2013 reflecting the impact of the acquisition of Summit, which cedes only about 1% of its premiums.
Specialty financial Gross written premiums decreased $17 million (3%) in 2014 compared to 2013. The impact of the October 2013 sale of a service contract business, which ceded all of its premiums under reinsurance contracts, more than offset growth in gross written premiums across most businesses in this group. Average renewal rates for this group decreased about 1 percent in 2014. Reinsurance premiums ceded as a percentage of gross written premiums declined 3 percentage points in 2014 compared to 2013 reflecting the sale of the service contract business, partially offset by higher cessions in the financial institutions business.
The table below details the components of the combined ratio for AFG’s property and casualty segment for 2014, 2013 and 2012 (dollars in millions):
Specialty financial Underwriting profit for this group was $64 million in 2014 compared to $67 million in 2013, a decrease of $3 million (4%). Lower profitability in the trade credit and financial institutions businesses was partially offset by higher profitability in the surety business.
Underwriting profit was $67 million in 2013 compared to $44 million in 2012, an increase of $23 million (52%).The improved results were due primarily to higher underwriting profits in the financial institutions business, primarily from foreclosed and real estate owned property and collateral insurance and the absence of losses from a run-off book of automotive-related business that were included in the results for 2012.
AFG’s overall loss and LAE ratio was 64.3%, 63.7% and 65.8% in 2014, 2013 and 2012, respectively. The components of AFG’s property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
The current accident year loss and LAE ratio for AFG’s Specialty property and casualty insurance operations was 63.5% in 2014 compared to 63.1% in 2013, an increase of 0.4%.
AFG’s Specialty property and casualty insurance operations recorded net favorable reserve development related to prior accident years of $19 million in 2014 compared to $75 million in 2013 and $74 million in 2012, a decrease of $56 million (75%) and an increase of $1 million (1%), respectively.
Specialty casualty Net favorable reserve development of $7 million in 2014 reflects lower than expected claim severity in directors and officers liability insurance, lower than expected claim severity and frequency in excess liability insurance and lower than anticipated claim severity in specialty workers’ compensation business, partially offset by higher than expected claims severity in contractor claims and in a run-off book of casualty business and adverse reserve development at Marketform. Net favorable reserve development of $40 million in 2013 reflects lower than expected claim severity in directors and officers liability insurance and lower than expected claim severity and frequency in excess liability business, partially offset by adverse development from higher than expected claim frequency and severity in products liability claims and higher than expected claim severity in contractor claims. Net favorable reserve development of $18 million in 2012 is due primarily to the release of loss reserves on claims related to the use of Chinese drywall in residential construction as a result of judicial decisions and class action settlements in 2012 that clarified the liability of insured homebuilders. Favorable reserve development in 2012 also reflects lower claim severity in executive liability products partially offset by higher claim severity on losses in a run-off book of U.S.-based program (motel/hotel, restaurants, taverns and recreational) business and adverse reserve development on run-off Italian public hospital medical malpractice liability products written by Marketform.
AFG generally seeks to reduce its exposure to catastrophes through individual risk selection, including minimizing coastal and known fault-line exposures, and the purchase of reinsurance. The $20 million of catastrophe losses in the Property and transportation group in 2014 were primarily from winter storms in the month of January and multiple storms in the midwestern and central United States in the second quarter of 2014. The $27 million in catastrophe losses in the Property and transportation group in 2013 resulted primarily from spring storms in the southeastern United States. The $27 million in catastrophe losses in the Property and transportation group in 2012 resulted primarily from Superstorm Sandy.
AFG’s property and casualty commissions and other underwriting expenses (“U/W Exp”) were $1.17 billion in 2014 compared to $1.02 billion in 2013, an increase of $153 million (15%). AFG’s underwriting expense ratio was 30.2% in 2014 compared to 31.8% in 2013, a decrease of 1.6 percentage points.
AFG’s property and casualty U/W Exp were $1.02 billion in 2013 compared to $887 million in 2012, an increase of $132 million (15%). AFG’s underwriting expense ratio was 31.8% in 2013 compared to 31.1% in 2012, an increase of 0.7 percentage points.
The overall increase of 0.7% in AFG’s expense ratio in 2013 as compared to 2012, as well as the fluctuations in AFG’s sub-segments, reflects higher profitability-based commissions paid to agents and brokers and lower profitability-based commissions received from reinsurers, partially offset by the impact of higher premiums on the ratio.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.1 percentage points in 2013 compared to 2012 reflecting higher profitability-based commissions paid to agents and brokers and lower profitability-based commissions received from reinsurers, partially offset by higher reimbursements for administrative and operating expenses under the Federal crop insurance program and the impact of higher premiums on the ratio.
Net investment income in AFG’s property and casualty operations was $294 million in 2014 compared to $263 million in 2013, an increase of $31 million (12%). Net investment income in AFG’s property and casualty operations was $263 million in 2013 compared to $275 million in 2012, a decrease of $12 million (4%). Net investment income in AFG’s property and casualty operations includes $8 million in 2014, from recording equity in the earnings of limited partnerships and similar investments. Equity in the earnings of these investments has not been material and was included in realized gains (losses) on securities prior to 2014. In recent years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG’s investment portfolio yield. The average invested assets and overall yield earned on investments held by AFG’s property and casualty operations are provided below (dollars in millions):
The property and casualty segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 3.83% in 2013 compared to 4.12% in 2012, a decline of 0.29 percentage points. In addition to the impact of lower yields available in the financial markets, the $188 million increase in average invested assets reflects primarily higher average balances of cash and cash equivalents.
Amortization of intangibles includes $5 million in 2014 related to the Summit acquisition.
Beginning in 2013, AFG’s warranty operations are included in the Specialty financial underwriting results.
AFG’s annuity operations contributed $328 million in GAAP pretax earnings in 2014 compared to $323 million in 2013, an increase of $5 million (2%). AFG’s annuity operations contributed $328 million in core pretax earnings in both 2014 and 2013. While AFG’s average annuity investments (at amortized cost) were 17% higher in 2014 as compared to 2013, the benefit of this growth was offset by the run-off of higher yielding investments, and the impact that fluctuations in interest rates in 2014 and 2013 had on the fair value accounting for fixed-indexed annuities (“FIAs”). AFG’s periodic detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations resulted in an expense reduction of $1 million in 2014 compared to a $2 million charge in 2013.
AFG’s annuity operations contributed $323 million in GAAP pretax earnings in 2013 compared to $256 million in 2012, an increase of $67 million (26%). AFG’s annuity operations contributed $328 million in core pretax earnings in 2013 compared to $256 million in 2012, an increase of $72 million (28%). The increase in both GAAP and core pretax earnings was a result of growth in the annuity business and the positive impact of higher interest rates and strong market performance in 2013 on the fair value accounting for FIAs. Conversely, results for 2012 reflect the negative impact of sharply lower interest rates on the fair value accounting for FIAs. Operating earnings also include a net unlocking charge of $2 million in 2013 compared to $14 million in 2012.
In the second quarter of 2013, AFG recorded a pretax charge of $5 million in its annuity operations to cover expected assessments from state guaranty funds related to the insolvency and liquidation of Executive Life Insurance Company of New York (“ELNY”), an unaffiliated life insurance company. ELNY was placed into rehabilitation by the New York Insurance Department in 1991. In April 2012, ELNY was declared insolvent and ordered into liquidation. AFG’s life insurance subsidiaries are required under the solvency or guaranty laws of most states in which they do business to pay assessments up to certain prescribed limits to fund policyholder losses or liabilities of insolvent insurance companies such as ELNY and started receiving guaranty fund assessments related to ELNY from various states in the second quarter of 2013. AFG believes that all ELNY related guaranty fund assessments have been settled.
The following table details AFG’s GAAP and core earnings before income taxes from its annuity operations for 2014, 2013 and 2012 (dollars in millions):
See “Annuity Unlocking” below for a discussion of the impact that the periodic review of actuarial assumptions had on annuity benefit expense.
Excludes the $5 million pretax non-core charge for ELNY guaranty fund assessments. Including this charge, the net spread earned on fixed annuities was 1.57% in 2013.
Net investment income in 2014 was $1.14 billion compared to $1.03 billion in 2013, an increase of $102 million (10%). This increase primarily reflects the growth in AFG’s annuity business, partially offset by the run-off of higher yielding investments. The overall yield earned on investments in AFG’s annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), declined by 0.32 percentage points in 2014 compared to 2013. This decline in net investment yield reflects the investment of new premium dollars at lower yields as compared to the existing investment portfolio and the impact of the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets.
Net investment income in 2013 was $1.03 billion compared to $976 million in 2012, an increase of $58 million (6%). This increase reflects primarily the growth in AFG’s annuity business. The overall yield earned on investments in AFG’s annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), declined by 0.45 percentage points in 2013 compared to 2012. This decline in net investment yield reflects (i) the investment of new premium dollars in the low interest rate environment and (ii) the impact of the maturity and redemption of higher yielding investments.
AFG’s net interest spread decreased 0.18 percentage points in 2013 compared to 2012 due primarily to the run-off of higher yielding investments, partially offset by lower crediting rates.
Annuity policy charges and other miscellaneous income were $42 million in 2013 compared to $38 million in 2012, an increase of $4 million (11%). The increase reflects $4 million in income from the sale of real estate recorded in 2013.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) were $63 million in 2014, $69 million in 2013 and $61 million in 2012, representing a decrease of $6 million (9%) in 2014 compared to 2013 and an increase of $8 million (13%) in 2013 compared to 2012. In addition to interest credited to policyholders’ accounts and the change in fair value of derivatives related to fixed-indexed annuities, annuity benefits expense also includes the following expenses (in millions, net of guaranteed withdrawal benefit fees):
AFG’s net spread earned on fixed annuities increased 0.12 percentage points in 2013 compared to 2012 as the 0.18 percentage points decrease in AFG’s net interest spread was more than offset by the impact of changes in the fair value of derivatives discussed above.
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, excess benefits expected to be paid on future deaths and annuitizations (“EDAR”) and guaranteed withdrawal benefits. Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati. The following table is a progression of AFG’s annuity benefits accumulated liability for 2014, 2013 and 2012 (in millions):
The 35% increase in annuity premiums in 2013 compared to 2012 reflects continued successful distribution channel expansion, primarily in the financial institutions market, as well as new product offerings. Management also believes that AFG has benefitted from its strong ratings, and that the entire annuity industry has benefitted from the rise in interest rates in 2013, particularly in the financial institutions market.
Excludes the $5 million pretax non-core charge for ELNY guarantee fund assessments in 2013.
Net investment income (as a % of investments) of 5.03% and 5.35% and 5.80% in 2014, 2013 and 2012, respectively, multiplied by the difference between average fixed annuity investments (at amortized cost) and average fixed annuity benefits accumulated in each period.
Medicare Supplement and Critical Illness Segment - Results of Operations AFG’s Medicare supplement and critical illness segment contributed $198 million in GAAP pretax earnings in 2012, which includes a $170 million pretax non-core realized gain on the August 2012 sale of these businesses. See Note B - “Acquisitions and Sales of Businesses” to the financial statements. The following table details AFG’s GAAP and core earnings before income taxes from its Medicare supplement and critical illness business (in millions):
Holding Company, Other and Unallocated - Results of Operations AFG’s net GAAP pretax loss outside of its insurance operations (excluding realized gains) totaled $149 million in 2014 compared to $190 million in 2013, a decrease of $41 million (22%). AFG’s net core pretax loss outside of its insurance operations (excluding realized gains) totaled $143 million in 2014 compared to $168 million in 2013, a decrease of $25 million (15%).
AFG’s net GAAP pretax loss outside of its insurance operations (excluding realized gains) totaled $190 million in 2013 compared to $185 million in 2012, an increase of $5 million (3%). AFG’s net core pretax loss outside of its insurance operations (excluding realized gains) totaled $168 million in 2013 compared to $160 million in 2012, an increase of $8 million (5%).
AFG recorded investment income on investments held outside of its insurance operations of $5 million, $8 million and $5 million in 2014, 2013 and 2012, respectively.
AFG’s holding companies and other operations outside of its insurance operations recorded interest expense of $69 million in 2014 compared to $68 million in 2013, an increase of $1 million (1%). AFG issued $150 million of 6-1/4% Subordinated Debentures in late September 2014.
AFG’s holding companies and other operations outside of its insurance operations recorded interest expense of $68 million in 2013 compared to $71 million in 2012, a decrease of $3 million (4%). In 2012, AFG issued new Senior Notes and used the proceeds to redeem higher rate debt.
As a result of the in-depth internal reviews and comprehensive external study of A&E exposures discussed under “Uncertainties - Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG’s holding companies and other operations outside of its insurance operations recorded non-core special charges of $6 million, $22 million and $2 million in 2014, 2013 and 2012, respectively, to increase liabilities related to the A&E exposures of AFG’s former railroad and manufacturing operations. The 2014 and 2013 charges related to slightly higher estimated operation and maintenance costs at sites where remediation is underway, coupled with higher estimated cleanup costs at a limited number of sites. In 2012, these operations also recorded a $15 million non-core charge resulting from an adverse judgment in a long-standing labor contract dispute related to AFG’s former railroad operations and an $8 million non-core loss on the retirement of debt.
Realized gains on disposals include gains on sales of shares of Verisk Analytics, Inc. of $49 million and $93 million in 2013 and 2012, respectively.
See Note A - “Accounting Policies - Managed Investment Entities” to the financial statements for a discussion of a recent accounting standard update that will impact AFG’s accounting for its managed CLOs.
AFG’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including AFG’s Co-Chief Executive Officers and Chief Financial Officer, AFG conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2014, based on the criteria set forth in “Internal Control - Integrated Framework” issued in 2013 by the Committee of Sponsoring Organizations of the Treadway Commission.
In conducting AFG’s evaluation of the effectiveness of its internal control over financial reporting, AFG has not included Summit Holding Southeast, Inc., which was acquired in 2014. This acquisition constituted less than 4% of total assets as of December 31, 2014 and less than 8% of total revenues and net earnings for the year then ended. Summit Holding Southeast, Inc.’s operations will be included in AFG’s assessment as of December 31, 2015. Refer to Note B - “Acquisitions and Sales of Businesses” to the consolidated financial statements for further discussion of this acquisition.
We have audited American Financial Group, Inc. and subsidiaries’ (the Company’s) internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Summit Holding Southeast, Inc., which is included in the 2014 consolidated financial statements of American Financial Group, Inc. and subsidiaries and constituted less than 4% of total assets as of December 31, 2014 and less than 8% of total revenues and net earnings for the year then ended. Our audit of internal control over financial reporting of American Financial Group, Inc. and subsidiaries also did not include an evaluation of the internal control over financial reporting of Summit Holding Southeast, Inc.
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. and subsidiaries as of December 31, 2014 and 2013, 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, 2014, and our report dated February 26, 2015, 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, 2014 and 2013, 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, 2014. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Financial Group, Inc. and subsidiaries at December 31, 2014 and 2013 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
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, 2014, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 26, 2015 expressed an unqualified opinion thereon.
To qualify for hedge accounting, at the inception of a derivative contract, AFG formally documents the relationship between the terms of the hedge and the hedged items and its risk management objective. This documentation includes defining how hedge effectiveness and ineffectiveness will be measured on a retrospective and prospective basis. Changes in the fair value of derivatives that are designated and qualify as highly effective cash flow hedges are recorded in AOCI and are reclassified into earnings when the variability of the cash flows from the hedged items impact earnings. Any hedge ineffectiveness is immediately recorded in current period earnings. When the change in the fair value of a qualifying cash flow hedge is included in earnings, it is included in the same line item in the Consolidated Statement of Earnings as the cash flows from the hedged item. Qualifying highly effective cash flow hedges include interest rate swaps, which are used to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities.
adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains (losses) on securities.
AFG manages, and has investments in, collateralized loan obligations (“CLOs”) that are VIEs (see Note H - “Managed Investment Entities”). Both the management fees (payment of which is subordinate to other obligations of the CLOs) and the investments in the CLOs are considered variable interests. AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) it has exposure to CLO losses (through its investments in the CLO debt tranches) and the right to receive benefits (through its subordinated management fees and returns on its investments), both of which could potentially be significant to the CLOs.
Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG’s Balance Sheet (at fair value). AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The excess of fair value of the CLOs’ assets over the fair value of the liabilities is recorded in AFG’s Balance Sheet as appropriated retained earnings - managed investment entities, representing amounts that ultimately will inure to the CLO debt holders.
At December 31, 2014, assets and liabilities of managed investment entities included $17 million in assets and $12 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 the second quarter of 2015. Upon closing, all warehoused assets are expected to be transferred to the new CLO and the liabilities will be repaid.
Unearned Revenue Certain upfront policy charges on annuities are deferred as unearned revenue (included in other liabilities) and recognized in net earnings using the same assumptions and estimated gross profits used to amortize DPAC.
AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: 2014 - 1.0 million, 2013 - 1.1 million and 2012 - 1.8 million. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2014, 2013 and 2012 periods.
Acquisition of Summit Holding Southeast, Inc. On April 1, 2014, AFG acquired Summit Holding Southeast, Inc. and its related companies (“Summit”), from Liberty Mutual Insurance for $259 million using cash on hand at the parent company. Immediately following the acquisition, AFG made a capital contribution of $140 million, bringing its total capital investment in the Summit business to $399 million. Summit is based in Lakeland, Florida and is a leading provider of specialty workers’ compensation solutions in the southeastern United States with $539 million in net written premiums in 2014. Summit continues to operate under the Summit brand as a member of AFG’s Great American Insurance Group. Summit is included in the Specialty casualty sub-segment and generated $410 million in net earned premiums subsequent to AFG’s acquisition.
AFG believes that the agents’ balances and other acquired receivables are collectible. The intangible assets acquired include $1 million in indefinite lived intangible assets related to state insurance licenses and $46 million in finite lived intangibles, primarily related to agency relationships. The finite lived intangibles are being amortized over an average expected life of 7 years. The fair value of the acquired liability for unpaid losses and loss adjustment expenses and related recoverables from reinsurers was estimated by discounting actuarial projected future net cash flows using the U.S. Treasury yield curve (with an adjustment for the illiquidity of insurance reserves) and then adding a risk adjustment to reflect the net present value of the profit that a market participant would require in return for the assumption of the risk associated with the reserves. The fair value of Summit’s agency relationship was estimated using a multi-period excess earnings method, which is a form of the income approach. The acquisition resulted in the recognition of $16 million in non-deductible goodwill based on the excess of the purchase price over the fair value of the net assets acquired. The goodwill represents the fair value of acquired intangible assets that do not qualify for separate recognition, including the value of Summit’s assembled workforce.
Sale of Medicare Supplement and Critical Illness Segment In August 2012, AFG completed the sale of its Medicare supplement and critical illness businesses, which included Loyal American Life Insurance Company and four other insurance companies, to Cigna Corporation for $326 million in cash resulting in a pretax gain of $170 million (including post-closing adjustments). Since the transaction includes the ongoing cessions of certain business to Cigna, the operations being sold are not reported as discontinued operations.
Total 2012 revenues, costs and expenses, and earnings before income taxes for the Medicare supplement and critical illness segment through the sale date were $212 million, $184 million and $28 million, respectively.
During 2012, AFG acquired the outstanding 28% of Marketform, its London-based Lloyd’s property and casualty insurance operation, that it did not already own for $17 million and sold a small annuity company for $7 million.
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
Includes special charges to increase asbestos and environmental (“A&E”) reserves of $24 million, $54 million and $31 million in 2014, 2013 and 2012, respectively.
Includes a loss recognition charge of $153 million in the fourth quarter of 2012.
Includes holding company expenses, special charges to increase A&E reserves ($6 million in 2014, $22 million in 2013 and $2 million in 2012) and losses of managed investment entities attributable to noncontrolling interests ($51 million in 2014, $26 million in 2013 and $98 million in 2012). 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.
The transfers from Level 2 to Level 1 are due to increases in trade frequency, resulting in trade data sufficient to warrant classification in Level 1. The transfers from Level 1 to Level 2 are due to decreases in trade frequency, resulting in lack of available trade data sufficient to warrant classification in Level 1. Approximately 3.5% of the total assets carried at fair value on December 31, 2014, were Level 3 assets. Approximately 79% ($1.07 billion) of the Level 3 assets were priced using non-binding broker quotes, for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AFG. Since internally developed Level 3 asset fair values represent less than 1% of the total assets measured at fair value and less than 5% of AFG’s shareholders’ equity, changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.
The fair values of the liabilities of managed investment entities were determined using primarily non-binding broker quotes, which were reviewed by AFG’s investment professionals. AFG’s investment professionals are familiar with the cash flow models used by the brokers to determine the fair value of these liabilities and review the broker quotes based on their knowledge of the CLO market and the market for the underlying assets. Their review includes consideration of expected reinvestment, default and recovery rates on the assets supporting the CLO liabilities, as well as surveying general CLO liability fair values and analysis provided by third parties.
Changes in balances of Level 3 financial assets and liabilities carried at fair value during 2014, 2013 and 2012 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.
Total realized/unrealized gains (losses) included in net income for the embedded derivatives reflects gains related to the unlocking of actuarial assumptions of $2 million in 2013.
Total realized/unrealized gains (losses) included in net income includes losses of $125 million related to liabilities outstanding as of December 31, 2012. See Note H - “Managed Investment Entities.”
Total realized/unrealized gains (losses) included in net income for the embedded derivatives reflects gains related to the unlocking of actuarial assumptions of $36 million in 2012.
AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. For 2014, AFG recorded less than $1 million in other-than-temporary impairment charges related to its residential MBS.
AFG recorded less than $1 million in other-than-temporary charges on preferred stocks during 2014. At December 31, 2014, the gross unrealized losses on preferred stocks of $5 million relate to 19 securities. All of the preferred stocks that have been in an unrealized loss position for 12 months or more (8 securities) have investment grade ratings.
A progression of the credit portion of other-than-temporary impairments on fixed maturity securities for which the non-credit portion of an impairment has been recognized in other comprehensive income is shown below (in millions):
Equity in the earnings of partnerships has not been material and was included in realized gains (losses) on securities prior to 2014.
Warrants to purchase shares of publicly traded companies, which represent a small component of AFG’s overall investment portfolio, are considered to be derivatives that must be marked to market through earnings.
The following table summarizes the gain (loss) included in the Statement of Earnings for changes in the fair value of derivatives that do not qualify for hedge accounting for 2014, 2013 and 2012 (in millions):
AFG’s maximum exposure to economic loss on its CLOs is limited to its investment in the CLOs, which had an aggregate fair value of $289 million (including $92 million invested in the most subordinate debt tranches) at December 31, 2014, and $271 million at December 31, 2013.
Included in Earnings before income taxes in AFG’s Statement of Earnings.
The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $83 million and $15 million at December 31, 2014 and 2013. The aggregate unpaid principal balance of the CLOs’ debt exceeded its fair value by $131 million and $109 million at those dates. The CLO assets include $2 million and $1 million in loans at December 31, 2014 and 2013, respectively, for which the CLOs are not accruing interest because the loans are in default (aggregate unpaid principal balance of $6 million at both of those dates).
Changes in the carrying value of goodwill during 2012, 2013 and 2014, by reporting segment, are presented in the following table (in millions):
In the second quarter of 2014, goodwill increased by $16 million due to the purchase of Summit as discussed in Note B - “Acquisitions and Sales of Businesses.” In the third quarter of 2012, goodwill decreased $1 million due to the sale of a small annuity subsidiary.
At December 31, 2014, scheduled principal payments on debt for the subsequent five years and thereafter were as follows: 2015 - $14 million; 2016 - $45 million; 2017 - $12 million; 2018 - none; 2019 - $350 million and thereafter - $640 million.
AFG can borrow up to $500 million under its revolving credit facility which expires in December 2016. Amounts borrowed under this agreement bear interest at rates ranging from 1.00% to 1.875% (currently 1.375%) over LIBOR based on AFG’s credit rating. No amounts were borrowed under this facility at December 31, 2014 or December 31, 2013.
In September 2014, AFG issued $150 million in 6-1/4% Subordinated Debentures due 2054. The net proceeds of the offering will be used for general corporate purposes, which may include repurchases of AFG’s outstanding Common Stock or the redemption of all or a portion of AFG’s $132 million outstanding aggregate principal amount of 7% Senior Notes due September 2050, which become redeemable (at par) at AFG’s option beginning on September 30, 2015.
In August 2013, AAG Holding redeemed its Variable Rate Subordinated Debentures at par value. In September 2013, an AFG subsidiary paid off its remaining secured borrowing balance at maturity.
Cash interest payments on long-term debt were $72 million in 2014, $71 million in 2013 and $75 million in 2012.
At December 31, 2014, there were 10.2 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.
AFG uses the Black-Scholes option pricing model to calculate the fair value of its option grants. The expected dividend yield is based on AFG’s current dividend rate. To determine expected volatility, AFG considers its daily historical volatility as well as implied volatility on traded options. The expected term was estimated based on historical exercise patterns and post vesting cancellations. The risk-free rate for periods associated with the expected term is based upon the U.S. Treasury yield curve in effect on the grant date.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries for 2014, 2013 and 2012 was $25 million, $36 million and $26 million, respectively. Related tax benefits totaled $8 million in 2014, $12 million in 2013 and $8 million in 2012. At December 31, 2014, there was $30 million and $11 million of unrecognized compensation expense related to nonvested stock options and restricted stock awards, respectively. These amounts are expected to be recognized over a weighted average of 3.2 and 2.3 years, respectively.
The progression of the components of accumulated other comprehensive income follows (in millions):
A decision in favor of AFG from litigation with the IRS regarding the calculation of tax reserves for certain annuity liabilities became final in August 2012. As a result, during the third quarter of 2012, AFG recorded net earnings of approximately $28 million, which included the expected refund of $17 million of tax and interest paid to the IRS in 2005 and 2006 as well as a decrease in the liability for uncertain tax positions. In December 2012, AFG reached an agreement with the IRS to close subsequent years held open by the tax case. As a result, AFG decreased its tax liabilities by approximately $39 million in the fourth quarter of 2012.
AFG’s 2012 - 2014 tax years remain subject to examination by the IRS.
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2014 (in millions):
The increase in the deferred tax assets related to insurance claims and reserves reflects growth in the annuity business, the April 2014 acquisition of Summit and the impact of the increase in unrealized gains on fixed maturity securities.
The changes in the deferred tax liabilities related to investment securities and deferred policy acquisition costs at year end 2014 compared to 2013 are due primarily to the increase in unrealized gains on fixed maturity securities.
AFG increased its liability for uncertain tax positions by $1 million in 2013 and $3 million in 2012, exclusive of interest, for the uncertainty as to the timing of tax return inclusion of income related to certain securities. During 2012, AFG also increased its liability for uncertain tax positions by $2 million related to the deductibility of certain financing expenses.
The resolution of the tax case and closure of subsequent tax years during 2012 (discussed above) also reduced AFG’s liability for uncertain tax positions by $36 million and the related liability for interest by $14 million. Additionally, the IRS issued new guidance during the third quarter of 2012 that brought certainty to the timing of investment deductions, which caused AFG to reduce its liability for uncertain tax positions by $10 million. Because this was solely a timing issue, the reduction in AFG’s liability for uncertain tax positions for this item was offset by an increase in AFG’s deferred tax liability with no overall impact on income tax expense.
Cash payments for income taxes, net of refunds, were $347 million, $204 million and $277 million for 2014, 2013 and 2012, respectively.
AFG completed an in-depth internal review of its asbestos and environmental (“A&E”) exposures in the third quarter of 2014. The study resulted in A&E charges of $24 million for the property and casualty group and $6 million for the former railroad and manufacturing operations. In the third quarter of 2013, AFG completed a comprehensive study of its A&E exposures with the assistance of specialty actuarial, engineering and consulting firms and outside counsel. The study resulted in A&E charges of $54 million for the property and casualty group and $22 million for the former railroad and manufacturing operations. In the third quarter of 2012, AFG completed an in-depth internal review of its A&E exposures, which resulted in A&E charges of $31 million for the property and casualty group and $2 million for the former railroad and manufacturing operations.
At December 31, 2014, American Premier and its subsidiaries had liabilities for environmental and personal injury claims and other contingencies aggregating $80 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, 2014 (in millions, except per share amounts). Quarterly earnings per share do not add to year-to-date amounts due to changes in shares outstanding.
(*) Reflects the acquisition of Summit in April 2014 (see Note B - “Acquisitions and Sales of Businesses”).
Favorable development in 2013 was due primarily to lower than expected severity in directors and officers liability insurance and lower than expected claim severity and frequency in the excess liability business (both within the Specialty casualty sub-segment) lower than expected frequency and severity in the foreign credit and financial institutions businesses (within the Specialty financial sub-segment) and favorable reserve development associated with AFG’s internal reinsurance program, partially offset by the $54 million special charge to increase asbestos and environmental reserves.
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. No additional loss recognition charges were recorded in 2014 or 2013. At December 31, 2014, AFG’s long-term care insurance reserves were $807 million, net of reinsurance recoverables and excluding the impact of unrealized gains on securities.
FHLB Funding Agreements Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions. Members are required to purchase stock in the FHLB in addition to maintaining collateral deposits that back any funds advanced. GALIC’s $34 million investment in FHLB capital stock at December 31, 2014, is included in other investments at cost. Membership in the FHLB provides the annuity operations with a substantial additional source of liquidity. These advances further the FHLB’s mission of improving access to housing by increasing liquidity in the residential mortgage-backed securities market. In the second quarter of 2013, the FHLB advanced GALIC $200 million, (included in annuity benefits accumulated) increasing the total amount advanced to $440 million at both December 31, 2013 and December 31, 2014. Interest rates under the various funding agreements on these advances range from 0.02% to 0.23% over LIBOR (average rate of 0.32% at December 31, 2014). While these advances must be repaid between 2016 and 2018, GALIC has the option to prepay all or a portion of the advances. The advances on these agreements are collateralized by mortgage-backed securities with a fair value of $544 million (included in available for sale fixed maturity securities) at December 31, 2014. Interest credited on the funding agreements, which is included in annuity benefits, was $1 million in 2014 and 2013 and less than $1 million in 2012.
Payments of dividends by AFG’s insurance companies are subject to various state laws that limit the amount of dividends that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 2015 from its insurance subsidiaries without seeking regulatory clearance is $673 million. Additional amounts of dividends require regulatory approval.
AFG paid common stock dividends to shareholders totaling $169 million, $161 million and $91 million in 2014, 2013 and 2012, respectively. Currently, there are no regulatory restrictions on AFG’s retained earnings or net income that materially impact its ability to pay dividends. Based on shareholders’ equity at December 31, 2014, AFG could pay dividends in excess of $1 billion without violating its most restrictive debt covenant. However, the payment of future dividends will be at the discretion of AFG’s Board of Directors and will be dependent on many factors including AFG’s financial condition and results of operations, the capital requirements of its insurance subsidiaries, and rating agency commitments.
AFG has reinsured approximately $12.70 billion of its $16.71 billion in face amount of life insurance at December 31, 2014 compared to $13.43 billion of its $17.98 billion in face amount of life insurance at December 31, 2013. Life written premiums ceded were $41 million, $44 million and $42 million for 2014, 2013 and 2012, respectively.
AFG’s aggregate allowance for uncollectible reinsurance recoverables was $25 million and $27 million at December 31, 2014 and 2013, respectively. AFG reviews the allowance quarterly and adjusts it as necessary to reflect changes in estimates of uncollectible balances. In 2014, 2013 and 2012, AFG recorded charges against the allowance of $4 million, $1 million and less than $1 million, respectively (included in losses and loss adjustment expenses). In 2014, the allowance was reduced by reinsurance recoverable write-offs of $6 million.
Financial Instruments - Unfunded Commitments 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, 2014, AFG and its subsidiaries had commitments to fund credit facilities and contribute capital to limited partnerships and limited liability corporations of approximately $370 million.
The following financial information from American Financial Group’s Form 10-K for the year ended December 31, 2014, formatted in XBRL (Extensible Business Reporting Language):