At December 31, 2005, AFG (parent) had over $160 million in cash and securities and no amounts borrowed under its bank line of credit.
Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions could change and thus impact amounts reported in the future. The areas where management believes the degree of judgment required to determine amounts recorded in the financial statements make accounting policies critical are as follows:
See "Liquidity and Capital Resources - Uncertainties" for a discussion of insurance reserves and contingencies related to American Premier's former operations and "Liquidity and Capital Resources - Investments" for a discussion of impairments on investments. Deferred policy acquisition costs ("DPAC") and certain liabilities related to annuities and universal life insurance products are amortized in relation to the present value of expected gross profits on the policies. Assumptions considered in determining expected gross profits involve significant judgment and include management's estimates of assumed interest rates and investment spreads, surrenders, annuitizations, renewal premiums and mortality. Should actual experience require management to change its assumptions regarding the emergence of future revenues and profits (commonly referred to as "unlocking"), a charge or credit would be recorded to adjust DPAC or annuity liabilities to the levels they would have been if the new assumptions had been used from the inception date of each policy.
AFG's debt to total capital ratio on a consolidated basis is shown below (dollars in millions). Management expects that continued earnings and debt repurchases will reduce this ratio below 25% during 2006.
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.82 for the year ended December 31, 2005 (2.25 excluding the A&E and other mass tort charges). Excluding annuity benefits, this ratio was 4.81 for 2005 (6.83 excluding the A&E and other mass tort charges). Although the ratio excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
The NAIC's model law for risk based capital ("RBC") applies to both life and property and casualty companies. RBC formulas determine the amount of capital that an insurance company needs so that it has an acceptable expectation of not becoming financially impaired. At December 31, 2005, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements. The lowest capital ratio of any operating AFG subsidiary was over 3-1/2 times its authorized control level RBC.
Management believes AFG has sufficient resources to meet its liquidity requirements. If funds generated from operations, including dividends and tax payments from subsidiaries, are insufficient to meet fixed charges in any period, AFG would be required to utilize parent company cash and marketable securities ($163 million at December 31, 2005) or to generate cash through borrowings, sales of other assets, or similar transactions.
During 2005, AFG repurchased $15.6 million of its 7-1/8% Debentures due 2007 and $71.2 million of its 7-1/8% Debentures due 2009 for $92.6 million in cash. Through February 2006, AFG repurchased an additional $22.1 million of its 7-1/8% Debentures due 2009 for $23.5 million in cash.
In 2004, AFG raised approximately $193 million through the issuance of common stock and 30-year Senior Debentures. The proceeds were used to retire trust preferred securities with a higher effective interest rate and for investment purposes. In addition, American Premier, sold an additional 1.3 million previously issued and outstanding AFG common shares. These shares were held for the benefit of certain unsecured creditors of American Premier's predecessor, The Penn Central Transportation Company. Proceeds from that sale ($41.5 million) were placed in escrow and used to pay American Premier's environmental claims related to its former railroad operations.
Under tax allocation agreements with AFG, its 80%-owned U.S. subsidiaries generally compute tax provisions as if filing separate returns based on book taxable income computed in accordance with generally accepted accounting principles. Under tax allocation agreements in effect through 2005, the resulting provision (or credit) was currently payable to (or receivable from) AFG. Under a new agreement that became effective in 2006, subsidiaries will generally pay or recover taxes on a separate company tax return basis.
In January 2005, NATL, a majority-owned subsidiary that specializes in property and casualty insurance for the passenger transportation industry, issued 3,350,000 shares of its common stock in an initial public offering. A portion of the $40.4 million of net proceeds from this offering were used to repay NATL's $15 million promissory note to another AFG subsidiary. The remainder was used for other general corporate purposes. After the offering, AFG owns approximately 54% of NATL.
In GAFRI's annuity business, where profitability is largely dependent on earning a "spread" between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on GAFRI's annuity products. With declining rates, GAFRI receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums.
4-5 years - $300 million; and thereafter - $343 million. Actual
As discussed in Note B to the financial statements, AFG will pay additional amounts for its Farmers Crop acquisition based on customer retention. Payments are not expected to exceed $30 million over the next three years. AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2005.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at December 31, 2005, is shown in the following table (dollars in millions). Approximately $105 million of available for sale "Fixed maturities" had no unrealized gains or losses at December 31, 2005.
Although AFG had the ability to continue holding these investments, its intent to hold them changed due primarily to deterioration in the issuers' creditworthiness or decisions to lessen credit exposure to a particular issuer or industry. Intent to hold may also change due to asset/liability management decisions, market movements and changes in views about appropriate asset allocation.
Estimating the liability for unpaid losses and LAE is inherently judgmental and is influenced by factors that are subject to significant variation. Through the use of analytical reserve development techniques, management considers items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, general economic trends and the legal environment.
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 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, over the past 10 years have developed through December 31, 2005, to be deficient (for eight years) by as much as 15.7% and redundant (for two years) by as much as 1.4% (excluding the effect of special charges for asbestos, environmental and other mass tort exposures). The average of such redundancies and deficiencies has been slightly (less than 5%) deficient. Management believes this development illustrates the variability in factors considered in estimating its insurance reserves.
The level of detail in which data is analyzed varies among the different lines of business. Data is generally analyzed by major product or by coverage within product, using countrywide data; however, in some situations, data may be reviewed by state for a few large volume states. Appropriate segmentation of the data is determined based on data volume, data credibility, mix of business, and other actuarial considerations. Overall, Company actuaries review over 500 identified line components. Point estimates are selected based on test indications and judgment.
An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. To estimate the sensitivity of recorded reserves to an unexpected change in the trends, 1% was added to the trend that is embedded in the factors used to determine the
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 that trigger coverage under directors' and officers' liability policies. This has caused some adverse development in the past and is judgmentally considered in reserving for this line of business.
While management believes that AFG's reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims, the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, whether claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims. A 1% variation in loss cost trends, caused by any of the factors previously described, would change net income by approximately $24 million.
From time to time, AFG has engaged independent firms to work closely with its claims staff to study the A&E reserves of its insurance company subsidiaries. The most recent study was completed in the third quarter of 2005 and resulted in AFG recording a pretax charge of $169 million to increase its A&E reserves. Absent legislative reforms, which may alter the need for an independent review, management expects to conduct another routine study in 2007. For a discussion of the A&E reserve strengthening, see Management's Discussion and Analysis - "Results of Operations - Asbestos and Environmental Reserve Charge."
5.25% interest), all of which was covered by reserves established prior to 2003, and anticipated reinsurance recoverables for this matter. The agreement allows up to 10% of the settlement to be paid in AFG Common Stock. The settlement has received the approval of the bankruptcy court supervising the reorganization of A.P. Green. It remains subject to the confirmation by the bankruptcy court of a plan of reorganization that includes an injunction prohibiting the assertion against Great American of any present or future asbestos personal injury claims under policies issued to A.P. Green and related companies. No assurance can be made that a plan of reorganization will be confirmed; no payments are required until completion of the process. The bankruptcy court has scheduled hearings on the confirmation of the plan of reorganization beginning June 5, 2006.
The following table shows AFG's net earnings and diluted earnings per share as stated in the Statement of Earnings as well as the after-tax effect of other items included in these GAAP measures that are listed below to assist investors in analyzing their impact on the trend in operating results (in millions, except per share amounts):
Excluding the effects of items shown in the table above, net earnings increased in 2005 and 2004 due primarily to improved property and casualty underwriting results and higher operating earnings in the annuity and supplemental insurance operations.
Over the last several years, AFG has been realigning its property and casualty business mix and focusing on rate adequacy in order to improve its operating profitability. Management has continued to direct capital in order to take advantage of certain specialty market opportunities. Management believes these actions have been successful and that the current mix of specialty businesses positions the Company for solid growth and continuing improved profitability in the foreseeable future.
2003 and the direct auto business through its sale at the end of April 2003.
(b) Includes 3.8 points in 2005 and 4.7 points in 2004 for the effect of
residual value business. Includes 1.9 points in 2005 and 0.9 points in 2004
Gross written premiums for the specialty business were about the same as in 2004, while net written premiums were 10% higher, reflecting the effect of increased premium retention in certain Property and Transportation businesses. While certain operations experienced solid volume growth, overall premium levels for the Specialty insurance operations continued to be impacted by the moderating rate environment. Overall average rates for 2005 were about the same as 2004.
Gross written premiums of the Specialty business increased 12% for 2004 compared to 2003 reflecting volume growth in crop, California workers' compensation, collateral protection and other profitable product lines and the impact of continuing rate increases. Specialty rate increases averaged approximately 6% during 2004. The 20% increase in net written premiums during 2004 also reflects a decrease in reinsurance ceded.
These businesses reported an underwriting profit of $123 million for 2004, including $37 million (1.8 points) for the effect of hurricane losses. Overall, the combined ratio for 2004 improved 1.9 points compared to 2003.
Property and transportation gross written premiums were slightly higher than in 2004 as new premiums resulting from the recent acquisition of Farmers Crop Insurance Alliance and solid volume growth in the transportation, inland marine and equine businesses more than offset the effect of lower commodity prices earlier in the year which were used to establish crop insurance coverages and lower volume resulting from competitive pricing within the excess property insurance operations. Net written premiums increased 33% from 2004 reflecting a reduction in reinsurance ceded, principally in the crop insurance and inland marine operations. This group reported a combined ratio of 83.0%, 2.3 points higher than in 2004. While the crop insurance operations achieved strong profitability in 2005, the results were lower than the record profitability recorded in 2004. The transportation, marine and other agricultural operations also generated strong underwriting profits in 2005.
Specialty casualty gross written premiums decreased 3% in 2005 while net written premiums remained about the same, reflecting lower volume resulting from stronger competition in many of the commercial casualty markets. This group generated an underwriting profit of $63.4 million for 2005 with its combined ratio improving 8.5 points to 91.3%. This significant improvement is the result of a substantial decrease in unfavorable development in the executive liability operations along with strong underwriting profits from the excess and surplus lines and from coverage for not-for-profit businesses.
Specialty financial gross written premiums grew 5% in 2005 compared to 2004 as a result of volume growth in the profitable fidelity and crime and several other lender services lines. Net written premiums decreased 3% in 2005 from 2004 reflecting the effect of the commutation of a reinsurance agreement in 2004 coupled with an increase in premiums ceded in 2005. This group's combined ratio for 2005 was 121.3% and included 12.4 points for the residual value charge and 1.9 points for hurricane losses. Losses from the residual value business were partially offset by strong profitability in the fidelity and crime and financial institutions operations.
Gross written premiums increased 18% for 2004 due to substantial volume growth in collateral protection products for financial institutions. The 31% increase in net written premiums also reflects a decrease in reinsurance ceded, including the impact of premiums returned in connection with the commutation of a reinsurance agreement. The impact of the commutation increased the 2004 combined ratio by about 4.1 points, driving it slightly higher than 2003.
gross and net written premiums for 2005 were about the same as 2004 as volume growth was offset by lower rates. The combined ratio for 2005 improved 19.5 points from 2004 reflecting the benefit of the improving claims environment resulting from the workers' compensation reforms enacted in California. The 2005 underwriting results included favorable prior year reserve development of $24.4 million, or 7.0 points. Rate decreases in California, which are responsive to the improving claims environment, averaged about 16% in 2005.
This study reviewed open and closed A&E claims at June 30, 2005. With respect to asbestos, it considered both direct insurance and assumed reinsurance, products and non-products exposure, paid claims history, the pattern of new claims, settlements and projected development. As has been reported by others, the asbestos legal climate remains very difficult to predict. While some progress has been made in state asbestos tort reform, that progress has been somewhat offset by increased claims costs, increased defense costs, the assertion of non-products theories and an increasing number of claims against small to mid-sized insureds.
While tort reform is helping in some jurisdictions, the legal climate in many jurisdictions continues to deteriorate, with larger verdict values being experienced. Expanding coverage interpretations by some courts also has led to increased exposure to some policies in certain jurisdictions.
With respect to the environmental claims, the study considered both direct insurance and assumed reinsurance, projected exposure at both National Priorities List ("NPL") sites and non-NPL sites, historic payment patterns, patterns of new claims, settlements and projected development. The increase in environmental reserves is primarily due to an increase in clean up costs at certain sites above prior expectations and a recent unexpected increase in the number of new claims that have been reported to the Company. In addition, projected development on a few claims exceeded estimates in the previous 2001 study.
The arbitration settlement represents a charge in 2003 for an unfavorable decision resulting from Great American's share of a 1995 property fire and business interruption claim. Great American was a 9.5% participant with a number of other companies in the insurance pool that insured the loss during the 1995 coverage year.
In July 2004, AFG received common and preferred shares equivalent to 8.1 million common shares of National City Corporation in exchange for its ownership interest in Provident Financial Group and realized a $214.3 million pretax gain on the transaction.
In January 2006, GAFRI completed the previously announced sale of its subsidiary, Great American Life Assurance Company of Puerto Rico, for $37.5 million in cash. Results for GAFRI in 2005 included a $3.4 million estimated loss on the sale.
The increase in income from real estate operations reflects $73.6 million in pretax gains on the sales of coal reserves and a hotel, and to a lesser extent, acquisition of new properties. Other income also includes net pretax gains on the sale of other real estate assets of $12.0 million in 2005, $12.7 million in 2004 and $10.3 million in 2003.
In the fourth quarter of 2005, GAFRI conducted its annual review of the actual results and future assumptions underlying its annuity operations, including assumptions related to future interest rates and persistency. Primarily as a result of the continuing low interest rate environment, GAFRI adjusted or "unlocked" the actuarial assumptions related to its annuity business in force and recorded a pretax charge of approximately $11.6 million to insurance liabilities related to that business. In 2004, these liabilities were increased by approximately $5 million due to trends in actual experience. Management believes that significant changes in projected investment yields could result in charges (or credits) to earnings in the period the projections are modified.
The increase in annuity benefits in 2004 compared to 2003 also reflects the acquisition of the block of National Health Insurance Company business.
As part of the 2005 annual review of actual results and future assumptions discussed above under "Annuity Benefits," GAFRI recorded net charges of $4.2 million to annuity and supplemental insurance acquisition expenses primarily related to spread narrowing partially offset by the expected improved future persistency related to GAFRI's annuities, due to the impact of the current interest rate environment. Also in 2005, GAFRI recorded a $13.6 million write-off of DPAC due to an unexpected increase in mortality in GAFRI's run-off life operations. Annuity and supplemental insurance acquisition expenses for 2004 were reduced by $5.1 million related to favorable trends in actual experience. In 2003, these expenses included net charges of $15.2 million related to spread narrowing.
The vast majority of GAFRI's DPAC asset relates to its fixed annuity, variable annuity and run-off life insurance lines of business. Continued spread compression, decreases in the stock market and adverse mortality could lead to further write-offs of DPAC in the future.
Interest expense for 2005 increased $1.3 million compared to 2004 due primarily to a higher effective interest rate on GAFRI's interest rate swap. See Note A - "Accounting Policies - Derivatives" to the Financial Statements for a discussion of GAFRI's interest rate swap.
Other operating and general expenses for 2005 include a $9.5 million pretax charge to increase reserves related to environmental liabilities at GAFRI's former manufacturing operations and $8.0 million in losses on debt retirements. In 2004, other operating and general expenses include a $52 million charge based on American Premier's settlement of litigation related to environmental clean-up costs at a former railroad site, a $4 million goodwill write-off in the annuity and supplemental insurance operations and $2.2 million in losses on debt retirements. Excluding these items, other operating and general expenses were about the same in 2005 compared to 2004.
The 2003 provision for income taxes includes a benefit of $136 million related to the AFG/AFC merger for the effect of the elimination of deferred tax liabilities associated with AFC's holding of AFG stock and reflects $5.5 million in tax benefits related to AFG's basis in Infinity stock. See Note L to the Financial Statements for more information on the effects of the AFG/AFC merger and an analysis of items affecting AFG's effective tax rate.
AFG's proportionate share ($12.2 million) of Infinity's earnings is included in equity in net earnings (losses) of investees for the period between the initial sale of 61% of Infinity in February 2003 and AFG's sale of its remaining shares in December 2003.
In July 2004, AFG recorded a $3.8 million after-tax charge resulting from implementation of EITF 03-16, "Accounting for Investments in Limited Liability Companies." This charge reflects the cumulative effect of changing from the cost method to the equity method of accounting for AFG's investment in a limited liability company. This charge reduced AFG's investment in this entity to zero.
Effective December 31, 2003, AFG implemented Financial Accounting Standards Board ("FASB") Interpretation No.46 ("FIN 46"), "Consolidation of Variable Interest Entities." This interpretation sets forth the requirements for determining the status of entities that do not share economic risk and reward through typical equity ownership, but rather through contractual relationships that distribute economic risks and rewards among various parties. Once an entity is determined to be a variable interest entity, it is required to be consolidated by the primary beneficiary, which is deemed to be the party that is exposed to a majority of the expected losses, or benefits from a majority of the expected residual returns, or both.
See Note A to the Financial Statements - "Accounting Policies" - "Managed Investment Entity" and "Payable to Subsidiary Trusts." The cumulative effect of implementing FIN 46 was an increase in income of $6.3 million.
The implementation of SFAS No. 123(R) is discussed under "Stock-Based Compensation" in Note A to the Financial Statements. SFAS No. 154 requires that voluntary changes in accounting principles and corrections of errors be reported by retroactively restating prior periods' financial statements unless it is impractical to do so. The standard is effective for fiscal years beginning after December 15, 2005. SOP 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts," provides guidance on accounting for deferred policy acquisition costs on certain internal replacements of insurance and investment contracts. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. The SOP is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. AFG is currently assessing the impact of implementing this standard.
AFG's management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including AFG's principal executive officers and principal financial officer, AFG conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2005, based on the criteria set forth in "Internal Control - Integrated Framework" issued 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 excluded the 2005 acquisition of the multi-peril crop and crop hail business of Farmers Alliance Mutual Insurance Company. This acquisition constituted less than 1% of total assets as of December 31, 2005 and less than 1% of total revenues and net earnings for the year then ended. Refer to Note B to the consolidated financial statements for further discussion of this acquisition.
Based on AFG's evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2005. Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2005 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report, which is set forth below.
We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that American Financial Group, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). American Financial Group, Inc.'s management is responsible for maintaining effective internal control over financial reporting and for its assessment about the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
As indicated in the accompanying Management's Report on Internal Control Over Financial Reporting, management's assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of the multi-peril crop and crop hail business of Farmers Alliance Mutual Insurance Company, which is included in the 2005 consolidated financial statements of American Financial Group, Inc. and constituted less than 1% of total assets as of December 31, 2005, and less than 1% of total revenues and net earnings for the year then ended. Management did not assess the effectiveness of internal control over financial reporting at this entity because the Company acquired this entity during 2005. Our audit of internal control over financial reporting of American Financial Group, Inc. also did not include an evaluation of the internal control over financial reporting of this acquired entity.
We have audited the accompanying consolidated balance sheet of American Financial Group, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of earnings, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 2005. 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, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, 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), the effectiveness of American Financial Group, Inc.'s internal control over financial reporting as of December 31, 2005, based upon criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2006, expressed an unqualified opinion thereon.
Derivatives included in AFG's Balance Sheet consist primarily of (i) the interest component of certain life reinsurance contracts (included in other liabilities), (ii) interest rate swaps (included in debt), and (iii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related call options (included in other investments) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products. Changes in the fair value of derivatives are included in current earnings.
Subsidiaries of AFG's 82%-owned subsidiary, Great American Financial Resources, Inc. ("GAFRI"), cede life insurance policies to a third party on a funds withheld basis where GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. Effective October 1, 2003, GAFRI implemented Statement of Financial Accounting Standards ("SFAS") No. 133 Implementation Issue B36 ("B36"). Under B36, these reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. As permitted under B36, GAFRI reclassified the securities related to these transactions from "available for sale" to "trading." The $16.1 million cumulative effect of adjusting to fair value the derivatives embedded in the payables at October 1, 2003, was offset by
Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which GAFRI earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.
Under FIN 46, AFG deconsolidated wholly-owned subsidiary trusts (formed prior to 2003) because they are "variable interest entities" in which AFG is not considered to be the primary beneficiary. These subsidiary trusts were formed to issue preferred securities and, in turn, purchase a like amount of subordinated debt from their parent company which provides interest and principal payments to fund the respective trust obligations. Accordingly, the subordinated debt due to the trusts is shown as a liability in the Balance Sheet, and beginning in 2004, the related interest expense is shown in the Statement of Earnings as "interest on subsidiary trust obligations." Prior to 2004, this interest was included in the Statement of Earnings as "minority interest expense, net of tax." Implementation of FIN 46 with respect to the preferred securities had no effect on earnings.
The following table illustrates the effect on net earnings (in thousands) and earnings per share had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the method prescribed by SFAS No. 123. See Note K - "Shareholders' Equity" for further information on stock options.
For SFAS No. 123 purposes, the "fair value" of $9.66 per option granted in 2005, $8.92 in 2004 and $5.62 in 2003 was calculated using the Black-Scholes option pricing model and the following assumptions: expected dividend yield of 2%; expected volatility of 28% for 2005, 29% for 2004 and 30% for 2003; risk-free interest rate of 4.3% for 2005, 3.7% for 2004 and 3.6% for 2003; and expected option life of 8.4 years in 2005, 7.5 years in 2004 and 7.4 years in 2003. There is no single reliable method to determine the actual value of options at grant date. Accordingly, actual value of the option grants may be higher or lower than the SFAS No. 123 "fair value".
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment." SFAS No. 123(R) revises SFAS No. 123 and eliminates the use of the intrinsic value method prescribed by APB 25. Under SFAS No. 123(R), companies must recognize compensation expense for all new share-based awards (including employee stock options), and the nonvested portions of prior awards, based on their fair value at the date of grant. AFG will implement the new standard as of January 1, 2006, on a modified prospective basis. After that date, all share-based grants will be recognized as compensation expense over the vesting period. AFG intends to use the Black-Scholes pricing model to measure the fair value of employee stock options. Had AFG adopted SFAS No. 123(R) in prior periods, the impact on net earnings and earnings per share would have been similar to the pro forma amounts discussed above.
AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period the employees earn such benefits.
In the fourth quarter of 2005, GAFRI reached an agreement to sell its subsidiary, Great American Life Assurance Company of Puerto Rico ("GAPR"), for $37.5 million in cash and recorded an estimated $3.4 million pretax loss. The sale was completed in January 2006.
In 2003, AFG sold Fidelity Excess and Surplus Insurance Company, an inactive subsidiary, for $28.9 million, realizing a pretax gain of $4.3 million. AFG retained all liability for Fidelity's business related to the period AFG owned the company.
In 2003, AFG sold two of its subsidiaries that market automobile insurance directly to customers for $32.2 million, realizing a pretax gain of $3.4 million on the sale. The transaction included the transfer of the right of Great American Insurance Company ("GAI"), an AFG subsidiary, to renew certain of its personal automobile insurance business written on a direct basis in selected markets.
In public offerings in 2003, AFG sold all the shares of Infinity Property and Casualty Corporation ("Infinity", its personal automobile insurance business) for a total of $400 million, realizing a net pretax gain of $17.1 million.
AFG's businesses operate throughout the United States. In 2005, 2004, and 2003, just over 2% of AFG's revenues were derived from the sale of life and supplemental health products in Puerto Rico; just over 1% of its revenues were derived from the sale of property and casualty insurance in Mexico, Canada and Europe.
(b) Revenues include sales of products and services as well as other income earned by
(c) Includes 2003 earned premiums of $163.6 million related to the personal and direct
(d) Includes a charge of $19.9 million for adjustments related to deferred gains on
(e) Includes a third quarter 2005 charge of $179.3 million to increase asbestos,
arbitration decision relating to a 1995 property claim from a discontinued business.
The following tables show gross unrealized losses on fixed maturities and other stocks by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2005 and 2004.
The table below sets forth the scheduled maturities of fixed maturities as of December 31, 2005. 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. Mortgage-backed securities had an average life of approximately
Gross gains and losses (excluding impairment writedowns) on available for sale fixed maturity investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
Long-term debt consisted of the following at December 31 (in thousands):
7-1/8% Debentures due 2009 for $23.5 million in cash and GAFRI repurchased $51.5 million of its 6-7/8% Notes for $53.4 million in cash.
7-1/4% senior debentures due 2034. Proceeds from both offerings were used to redeem at face value a portion of the outstanding trust preferred securities.
In 2004, AFG and GAFRI replaced their existing credit agreements with revolving credit facilities under which they can borrow up to $300 million and $165 million, respectively. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on the respective borrower's credit ratings. AFG's credit agreement will expire in November 2008 or in September 2007 if AFG has not retired or refinanced its 7-1/8% Debentures due in 2007. GAFRI's bank line will expire in 2008.
NATL and GAFRI effectively provide unconditional guarantees of their respective trusts' obligations. In the fourth quarter of 2005, GAFRI repurchased $20.8 million of its 8-7/8% preferred securities for $22.6 million in cash. In the first quarter of 2004, GAFRI repurchased $27.2 million of its 8-7/8% preferred securities for $28.5 million in cash. The AFG 9-1/8% trust preferred securities and the GAFRI 9-1/4% trust preferred securities were redeemed at face value in the first quarter of 2004.
AFG sold 2,679,000 shares of its Common Stock through public offerings in the fourth quarter of 2004 at an average price of $30.56 per share, net of commissions and fees. In addition, American Premier sold 1,361,711 previously issued and outstanding AFG common shares that it was holding for the benefit of certain creditors and other claimants pursuant to the 1978 plan of reorganization of its predecessor, The Penn Central Transportation Company. The $41.5 million in proceeds were placed in escrow to be used to settle such claims. In November 2003, in conjunction with the AFG/AFC merger, AFG issued 3.3 million shares of Common Stock in exchange for all of the outstanding shares of AFC Series J preferred stock.
The following is a reconciliation of income taxes at the statutory rate of 35% and income taxes as shown in the Statement of Earnings (in thousands):
The AFG/AFC merger in November 2003 resulted in the elimination of $170 million in deferred tax liabilities associated with AFC's holding of AFG stock. From 1980 through March 1995, AFC accounted for its investment in AFG's predecessor using the equity method of accounting. During this period, as AFC's book basis
The gross deferred tax asset has been reduced by a valuation allowance related to a portion of AFG's net operating loss carryforwards ("NOL") that is subject to the separate return limitation year ("SRLY") tax rules. A SRLY NOL can be used only by the entity that created it and only in years that both the entity and the consolidated group have taxable income. The likelihood of realizing this asset will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period in the developments on which they are based become known.
The American Jobs Creation Act of 2004 provides a special one-time dividends received deduction on the repatriation of certain foreign earnings. AFG subsidiaries paid $91.5 million in dividends that qualified for this special tax treatment during 2005. Since deferred taxes had previously been accrued on most of these earnings, only $846,000 in additional income tax was recognized on the earnings remitted.
Equity in net earnings (losses) of investees includes AFG's share of the losses from a manufacturing business ($1.2 million in 2005, $3.2 million in 2004 and $3.1 million in 2003). In addition, equity in net earnings (losses) of investee for 2005 includes a $3.9 million after tax impairment writedown related to this business. From the date of the initial sale of 61% of Infinity in February 2003 through the date of the sale of its remaining interest in Infinity in December 2003, AFG accounted for its ownership interest in Infinity as an investee using the equity method. Equity in Infinity's net earnings during this period was $12.2 million.
Loss accruals (included in other liabilities) have been recorded 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, Penn Central Transportation Company ("PCTC"), prior to its bankruptcy reorganization in 1978 and certain manufacturing operations disposed of by American Premier.
In November 2004, American Premier reached an agreement with two other responsible parties on the allocation of environmental clean-up costs at a former railroad site in Paoli, Pennsylvania. Based on the settlement, American Premier recorded a charge (included in "Other operating and general expenses") of $52 million to increase its liabilities for environmental exposures. Although American Premier has been advised by counsel that it should be able to recover a significant amount of these costs from a financially viable third party, no recovery asset has been recorded for its Paoli Yard costs.
At December 31, 2005, American Premier had liabilities for environmental and personal injury claims aggregating $89.3 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 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.
While management believes AFG has recorded adequate reserves for the items discussed in this note, the outcome is uncertain and could result in liabilities exceeding amounts AFG has currently recorded. Additional amounts could have a material adverse effect on AFG's future results of operations and financial condition.
The operations of certain of AFG's business segments are seasonal in nature. While insurance premiums are recognized on a relatively level basis, claim losses related to adverse weather (snow, hail, hurricanes, tornadoes, etc.) may be seasonal. Quarterly results necessarily rely heavily on estimates. These estimates and certain other factors, such as the nature of investees' operations and discretionary sales of assets, cause the quarterly results not to be necessarily indicative of results for longer periods of time.
The following are quarterly results of consolidated operations for the two years ended December 31, 2005 (in millions, except per share amounts).
Results for the fourth quarter of 2005 include pretax charges of (i) $45.0 million associated with the residual value business, (ii) $29.4 million to deferred acquisition costs and insurance liabilities related to the annuity and run-off life operations, (iii) $18.3 million for adjustments to deferred gains on retroactive reinsurance, and (iv) $12.6 million in hurricane losses. These items were partially offset by pretax gains of $42.6 million from the sales of Ohio and Pennsylvania coal properties and a Texas hotel.
Results for the third quarter of 2005 include a $179.3 million pretax charge to strengthen asbestos, environmental and other mass tort insurance reserves, $40 million in pretax losses related to hurricanes and a $30.9 million pretax gain on the sale of Illinois coal reserves.
The liability for losses and loss adjustment expenses for long-term scheduled payments under certain workers' compensation insurance has been discounted at about 7%, an approximation of long-term investment yields. As a result, the total liability for losses and loss adjustment expenses at December 31, 2005, has been reduced by $34 million.
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, 2005, AFG and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling up to $28 million.
In connection with the sale of the remaining shares of Infinity in December 2003, AFG paid Infinity $13.5 million to commute a prior indemnification and cost reimbursement obligation. AFG purchased at fair value $4.7 million in marketable securities from Infinity during 2003. During 2003, Infinity paid AFG $9.0 million for rent, information technology, investment, accounting, legal, actuarial and other services. In 2003, Infinity repaid a $55 million note due to AFG plus $2.5 million in interest.
The information required by the following Items will be included in AFG's definitive Proxy Statement for the 2006 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission within 120 days after the end of Registrant's fiscal year and is incorporated herein by reference.