Management's Discussion and Analysis of Financial Condition and Results of Operations ------------------------------------------------
AFG's ratio of earnings to fixed charges on a total enterprise basis was 3.36 for the year ended December 31, 1999 compared to 2.93 in 1995 (pro forma for the Mergers and related transactions).
The National Association of Insurance Commissioners' 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 to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 1999, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements (the lowest capital ratio of any AFG subsidiary was 2.3 times its authorized control level RBC; weighted average of all AFG subsidiaries was 4.8 times).
Sources of Funds AFG, AFC Holding, AFC and American Premier, are organized as holding companies with almost all of their operations being conducted by subsidiaries. These parent corporations, however, have continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends, and taxes. Funds to meet these obligations come primarily from dividend and tax payments from their subsidiaries.
All debentures issued by the parent holding companies and AAG are rated investment grade by three nationally recognized rating agencies. In April 1999, AFG issued $350 million principal amount of 7-1/8% senior debentures due 2009, using the proceeds to retire outstanding holding company public debt and borrowings under AFC's credit line. Under currently effective shelf registration statements, AFG can issue up to an aggregate of $500 million in additional common stock, debt or trust securities. The shelf registrations provide AFG with greater flexibility to access the capital markets from time to time as market and other conditions permit.
IT Initiative From inception of the Year 2000 Project in the early 1990's, AFG estimates that it incurred approximately $79 million in Year 2000 costs, including capitalized costs of $20 million, to successfully ensure its systems function properly in the year 2000 and beyond. Although a significant portion of the costs charged to expense were related primarily to allowing systems to continue to execute properly, the Project also included the upgrading of a significant number of systems and enhanced the knowledge of virtually all existing systems.
In the third quarter of 1999, AFG's newly hired Chief Information Officer initiated an enterprise-wide study of its information technology ("IT") resources, needs and opportunities. AFG expects that the initiative will entail extensive effort and costs and may lead to substantial changes in the area, which should result in significant cost savings, efficiencies and effectiveness in the future. While the costs (most of which will be expensed) will precede any savings to be realized, management expects benefits to greatly exceed the costs incurred, all of which will be funded through available working capital.
The following table provides information about AFG's fixed maturity investments at December 31, 1999 and 1998, that are sensitive to interest rate risk. The table shows principal cash flows (in millions) and related weighted average interest rates by expected maturity date for each of the five subsequent years and for all years thereafter. Callable bonds and notes are included based on call date or maturity date depending upon which date produces the most conservative yield. Mortgage-backed securities ("MBSs") and sinking fund issues are included based on maturity year adjusted for expected payment patterns. Actual cash flows may differ from those expected.
December 31, 1999 December 31, 1998 ----------------- ----------------- Principal Principal Cash Flows Rate Cash Flows Rate ---------- ---- ---------- ---- 2000 $ 618.2 7.83% 1999 $ 849.8 7.97% 2001 622.6 8.69 2000 942.7 7.64 2002 848.4 8.14 2001 954.2 8.32 2003 1,267.6 7.65 2002 1,086.3 7.77 2004 999.2 7.73 2003 1,415.3 7.57 Thereafter 5,871.0 7.50 Thereafter 4,784.1 7.53 --------- --------- Total $10,227.0 7.69% $10,032.4 7.68% ========= ========= Fair Value $ 9,862.2 $10,324.3 ========= =========
Fair First Second Third Fourth Fifth Thereafter Total Value ----- ------ ----- ------ ----- ---------- ------ ------ 1999 $690 $620 $550 $490 $440 $2,730 $5,520 $5,371 1998 660 620 560 500 450 2,660 5,450 5,307
Approximately 90% of the fixed maturities held by AFG were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies at December 31, 1999. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or noninvestment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return.
Individual portfolio securities are sold creating gains or losses as market opportunities exist. Pretax capital gains recognized upon disposition of securities, including investees, during the past five years have been: 1999 - $20 million; 1998 - $16 million; 1997 - $57 million; 1996 - $166 million and 1995 - $84 million. At December 31, 1999, AFG had a net unrealized loss on fixed maturities of $239 million (before income taxes). The net unrealized gain on equity securities was $181 million (before income taxes) at that same date.
General Operating earnings before income taxes were $302 million in 1999, $274 million in 1998 and $380 million in 1997. Results for 1998 include a pretax charge of $214 million for reserve strengthening relating to asbestos and other environmental matters ("A&E") and $159 million of pretax gains on sales of subsidiaries.
Property and Casualty Insurance - Underwriting AFG's property and casualty operations consist of two major business groups: Personal and Specialty.
Special A&E Charge Under the agreement covering the sale of its Commercial lines division in 1998, AFG retained liabilities for certain A&E exposures. Prompted by this retention and as part of the continuing process of monitoring reserves, AFG began a thorough study of its A&E exposures. AFG's study was reviewed by independent actuaries who used state of the art actuarial techniques that have wide acceptance in the industry. The methods used involved sampling and statistical modeling incorporating external databases that supplement the internal information. AFG recorded a fourth quarter charge of $214 million increasing A&E reserves at December 31, 1998, to approximately $866 million (before deducting reinsurance recoverables of $241 million), an amount which, in the opinion of management, makes a reasonable provision for AFG's ultimate liability for A&E claims.
1999 compared to 1998 Investment income decreased 5% from 1998 due primarily to the transfer of investment assets in connection with the sales of the Commercial lines division and Funeral Services division in 1998, partially offset by the effect of the purchases of Worldwide and United Teacher Associates in 1999.
1999 compared to 1998 Other income increased $6.8 million (5%) in 1999 as increased fee income generated by certain insurance operations more than offset a decrease in income from the sale of operating real estate and lease residuals.
Interest on Borrowed Money Changes in interest expense result from fluctuations in market rates as well as changes in borrowings. AFG has generally financed its borrowings on a long-term basis which has resulted in higher current costs. Interest expense increased in both 1999 and 1998 due to higher average indebtedness partially offset by lower average interest rates on AFG's borrowings.
1998 compared to 1997 Other operating and general expenses increased $10.8 million (3%) in 1998 due primarily to inclusion of the operations of Great American Life Assurance Company of Puerto Rico following its acquisition in late 1997 which more than offset the absence of expenses from a noninsurance subsidiary which was sold in the fourth quarter of 1997.
Investee Corporation Equity in net losses of investee corporation represents AFG's proportionate share of the results of Chiquita Brands International.
AFG recorded pretax equity in net losses of Chiquita of $27.4 million, $13.2 million and $5.6 million in 1999, 1998 and 1997, respectively. Chiquita's loss attributable to common shareholders was $75.5 million, $35.5 million and $16.6 million during these same periods.
Cumulative Effect of Accounting Change In the first quarter of 1999, AAG implemented Statement of Position 98-5, "Reporting on the Costs of Start- Up Activities." The SOP requires that costs of start-up activities be expensed as incurred and that unamortized balances of previously deferred costs be expensed and reported as the cumulative effect of a change in accounting principle. Accordingly, AFG expensed previously capitalized start-up costs of $3.8 million (net of minority interest and taxes) in the first quarter of 1999.
Recent Accounting Standards The following accounting standards have been implemented by AFG in 1998 or 1999 or will be implemented in 2001. The implementation of these standards is discussed under various subheadings of Note A to the Financial Statements (segment information is discussed in Note C); effects of each are shown in the relevant Notes. Implementation of Statement of Financial Accounting Standards ("SFAS") No. 133 in the first quarter of 2001 is not expected to have a significant effect on AFG.
Consolidated Statement of Earnings: Years ended December 31, 1999, 1998 and 1997
Consolidated Statement of Cash Flows: Years ended December 31, 1999, 1998 and 1997
In our opinion, the consolidated 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, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. 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.
INDEX TO NOTES -------------- A. Accounting Policies H. Minority Interest B. Acquisitions and Sales of Subsidiaries I. Shareholders' Equity and Investees J. Income Taxes C. Segments of Operations K. Extraordinary Items D. Investments L. Commitments and Contingencies E. Investment in Investee Corporation M. Quarterly Operating Results F. Cost in Excess of Net Assets Acquired N. Insurance G. Long-Term Debt O. Additional Information
Basis of Presentation The consolidated financial statements include the accounts of American Financial Group, Inc. ("AFG") and its subsidiaries. Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
Issuances of Stock by Subsidiaries and Investees Changes in AFG's equity in a subsidiary or an investee caused by issuances of the subsidiary's or investee's stock are accounted for as gains or losses where such issuance is not a part of a broader reorganization.
Benefit Plans AFG provides retirement benefits to qualified employees of participating companies through contributory and noncontributory defined contribution plans contained in AFG's Retirement and Savings Plan. Under the retirement portion of the plan, company contributions are invested primarily in securities of AFG and affiliates. Under the savings portion of the plan, AFG matches a specific portion of employee contributions. Contributions to benefit plans are charged against earnings in the year for which they are declared.
Start-up Costs Prior to 1999, American Annuity Group, Inc. ("AAG"), an 83%-owned subsidiary, deferred certain costs associated with introducing new products and distribution channels and amortized them on a straight-line basis over 5 years. In 1999, AAG implemented Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities." The SOP requires that (i) costs of start-up activities be expensed as incurred and (ii) unamortized balances of previously deferred costs be expensed and reported as the cumulative effect of a change in accounting principle. Accordingly, AFG expensed previously capitalized start- up costs of $3.8 million (net of minority interest and taxes) or $.06 per diluted share, effective January 1, 1999.
Derivatives The Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," during the second quarter of 1998. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including derivative instruments that are embedded in other contracts, and for hedging activities and must be implemented no later than January 1, 2001. SFAS No. 133 requires the recognition of all derivatives (both assets and liabilities) in the balance sheet at fair value. Changes in fair value of derivative instruments are included in current income or as a component of comprehensive income (outside current income) depending on the type of derivative. Implementation of SFAS No. 133 is not expected to have a material effect on AFG's financial position or results of operations.
Earnings Per Share Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share include the following dilutive effects of common stock options: 1999 - .5 million shares; 1998 - 1.0 million shares and 1997 - 1.1 million shares.
United Teacher Associates In October 1999, AAG acquired United Teacher Associates Insurance Company of Austin, Texas ("UTA") for $81 million in cash, pending post-closing adjustments under which AAG may receive as much as several million dollars. UTA provides supplemental health products and retirement annuities, and purchases blocks of insurance policies from other insurers.
Funeral Services division In September 1998, AAG sold its Funeral Services division for approximately $165 million in cash. The division held assets of approximately $1 billion at the sale date. AFG realized a pretax gain of $21.6 million, before $2.7 million of minority interest, on this sale.
Millennium Dynamics, Inc. In 1997, AFG completed the sale of the assets of its software solutions and consulting services subsidiary, Millennium Dynamics, Inc. ("MDI"), to a subsidiary of Peritus Software Services, Inc. for $30 million in cash and 2,175,000 shares of Peritus common stock. AFG recognized a pretax gain of approximately $50 million on the sale.
D. Investments Fixed maturities and other stocks at December 31, consisted of the following (in millions):
The only investment which exceeds 10% of Shareholders' Equity is an equity investment in Provident Financial Group, Inc., having a market value of $231 million and $243 million at December 31, 1999 and 1998, respectively.
Fixed Equity Tax Maturities Securities Effects Total ---------- ---------- ------- ----- ---- Realized ($ 13,092) $ 33,244 ($ 7,053) $ 13,099 Change in Unrealized (641,900) (42,500) 239,500 (444,900)
E. Investment in Investee Corporation Investment in investee corporation reflects AFG's ownership of 24 million shares (36%) of Chiquita common stock. The market value of this investment was $114 million and $229 million at December 31, 1999 and 1998, respectively. Chiquita is a leading international marketer, producer and distributor of quality fresh fruits and vegetables and processed foods.
Current Assets $ 903 $ 840 Noncurrent Assets 1,693 1,669 Current Liabilities 488 531 Noncurrent Liabilities 1,403 1,184 Shareholders' Equity 705 794
F. Cost in Excess of Net Assets Acquired Amortization expense for the excess of cost over net assets of purchased subsidiaries was $14.3 million in 1999, $11.9 million in 1998 and $11.6 million in 1997. At December 31, 1999 and 1998, accumulated amortization amounted to approximately $157 million and $143 million, respectively.
G. Long-Term Debt Long-term debt consisted of the following at December 31, (in thousands):
Holding Companies Subsidiaries Total --------- ------------ ----- 2000 $23,667 $ 3,248 $ 26,915 2001 - 1,430 1,430 2002 74,157 38,265 112,422 2003 - 61,278 61,278 2004 - 14,231 14,231
AFC and AAG each have an unsecured credit agreement with a group of banks under which they can borrow up to $300 million and $200 million, respectively. Borrowings bear interest at floating rates based on prime or Eurodollar rates. Loans mature December 2002 under the AFC credit agreement and from 2000 to 2003 under the AAG credit agreement. At December 31, 1999, the weighted average interest rates on amounts borrowed under the AFC and AAG bank credit lines were 6.56% and 6.76%, respectively.
H. Minority Interest Minority interest in AFG's balance sheet is comprised of the following (in thousands):
AFC Preferred Stock AFC's Preferred Stock is voting, cumulative, and consists of the following:
I. Shareholders' Equity At December 31, 1999, there were 58,419,952 shares of AFG Common Stock outstanding, including 1,365,040 shares held by American Premier for possible distribution to certain creditors and other claimants upon proper claim presentation and settlement pursuant to the 1978 plan of reorganization of American Premier's predecessor, The Penn Central Corporation. Shares being held for distribution are not eligible to vote but otherwise are accounted for as issued and outstanding. AFG is authorized to issue 12.5 million shares of Voting Preferred Stock and 12.5 million shares of Nonvoting Preferred Stock, each without par value.
Stock Options At December 31, 1999, there were 6.9 million shares of AFG Common Stock reserved for issuance under AFG's Stock Option Plan. 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; those granted to nonemployee directors of AFG are fully exercisable upon grant. All options expire ten years after the date of grant. Data for AFG's Stock Option Plan is presented below:
Income taxes at statutory rate $ 75,928 $ 71,221 $107,912 Effect of: Minority interest 7,093 9,438 10,058 Losses utilized (5,250) (6,572) (3,164) Amortization of intangibles 4,686 4,482 3,362 Dividends received deduction (2,783) (2,189) (2,002) Other (4,177) 2,709 (93) -------- -------- -------- Total Provision 75,497 79,089 116,073
For income tax purposes, certain members of the AFC consolidated tax group had the following carryforwards available at December 31, 1999 (in millions):
1999 1998 ---- ---- Deferred tax assets: Net operating loss carryforwards $ 32.6 $ 44.3 Capital loss carryforwards - 23.7 Insurance claims and reserves 236.5 291.2 Other, net 117.6 110.0 ------ ------ 386.7 469.2 Valuation allowance for deferred tax assets (48.9) (88.6) ------ ------ 337.8 380.6 Deferred tax liabilities: Deferred acquisition costs (172.3) (121.3) Investment securities (67.0) (267.9) ------ ------ (239.3) (389.2) ------ ------ Net deferred tax asset (liability) $ 98.5 ($ 8.6) ====== =======
K. Extraordinary Items Extraordinary items represent AFG's proportionate share of gains and losses related to debt retirements by the following companies. Amounts shown are net of minority interest and income taxes (in thousands):
1999 1998 1997 ---- ---- ---- Holding Companies: AFG (parent) $2,295 $ - $ - AFC (parent) (2,993) (77) (5,395) APU (parent) (1,003) (44) (588) Subsidiary: AAG - (649) (1,250) ------ ----- ------
M. Quarterly Operating Results (Unaudited) 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. Historically, Chiquita's operations are significantly stronger in the first and second quarters than in the third and fourth quarters. 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, 1999 (in millions, except per share amounts).
Quarterly earnings per share do not add to year-to-date amounts due to changes in shares outstanding.
1st 2nd 3rd 4th Total Quarter Quarter Quarter Quarter Year ------- ------- ------- ------- ------ 1999 $ 4.4 $7.3 ($ 5.7) $ 14.2 $ 20.2 1998 22.0 8.9 25.4 123.4 179.7
N. Insurance Securities owned by insurance subsidiaries having a carrying value of about $900 million at December 31, 1999, were on deposit as required by regulatory authorities.
Reserves of businesses acquired or sold, net 57 (481) - Reclassification of allowance for uncollectible reinsurance 11 77 - ------ ------ ------
(*) Included primarily in "Other operating and general expenses" in the Statement of Earnings.
Reinsurance In the normal course of business, AFG's insurance subsidiaries assume and cede reinsurance with other insurance companies. The following table shows (in millions) (i) amounts deducted from property and casualty written and earned premiums in connection with reinsurance ceded, (ii) written and earned premiums included in income for reinsurance assumed and (iii) reinsurance recoveries deducted from losses and loss adjustment expenses.
Reinsurance recoveries $ 811 $ 651 $ 296 ====== ====== ======
O. Additional Information Total rental expense for various leases of office space, data processing equipment and railroad rolling stock was $39 million, $41 million and $36 million for 1999, 1998 and 1997, respectively. Sublease rental income related to these leases totaled $2.6 million in 1999, $5.4 million in 1998 and $5.4 million in 1997.
Revenues $ 3,339 $ 4,069 $ 4,026 Net Operating Earnings 325 286 380 Earnings before Extraordinary Items and Accounting Change 161 133 199 Extraordinary Items - Loss on Prepayment of Debt (4) (1) (7) Cumulative Effect of Accounting Change (4) - - Net Income 153 132 192
Liabilities: Annuity benefits accumulated $5,520 $5,371 $ 5,450 $ 5,307 Long-term debt: Holding companies 493 462 415 428 Subsidiaries 240 230 177 176
Financial Instruments with Off-Balance-Sheet Risk On occasion, AFG and its subsidiaries have entered into financial instrument transactions which 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, 1999, AFG and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling up to $54 million.
Benefit Plans AFG expensed approximately $13 million in 1999, $22 million in 1998 and $21 million in 1997 for its retirement and employee savings plans.
Transactions With Affiliates AFG owns a $3.7 million minority interest in a residential homebuilding company. A brother of AFG's Chairman also owns a minority interest. AAG has extended a line of credit to this company under which the homebuilder may borrow up to $8 million at 13% with interest deferred and added to principal. At December 31, 1999 and 1998, $8 million and $6.1 million was due under the credit line, respectively.
Year Ended December 31, ---------------------------- 1999 1998 1997 ---- ---- ---- Income: Dividends from subsidiaries $ 282 $ 282 $ 281 Equity in undistributed earnings of subsidiaries 242,850 209,453 301,385 Investment and other income 27,436 22,367 35,470 -------- -------- -------- 270,568 232,102 337,136
Earnings before income taxes, extraordinary items and accounting change 225,924 204,754 319,610 Provision for income taxes 78,929 79,584 120,127 -------- -------- --------
Investing Activities: Purchases of subsidiaries and other investments (14,894) - (24,872) Sales of investments 13,903 - - -------- -------- -------- (991) - (24,872) -------- -------- --------
Cash and short-term investments at beginning of period 6,777 25,890 43,465 -------- -------- -------- Cash and short-term investments at end of period $ 1,612 $ 6,777 $ 25,890 ======== ======== ========
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES SCHEDULE V - SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS
s/CARL H. LINDNER Chairman of the Board March 28, 2000 Carl H. Lindner of Directors
s/CARL H. LINDNER III Director March 28, 2000 Carl H. Lindner III
Number Exhibit Description - ------ ------------------- 3(a) Amended and Restated Articles of Incorporation, filed as Exhibit 3(a) to AFG's Form 10-K for 1997. (*)
3(b) Code of Regulations, filed as Exhibit 3(b) to AFG's Form 10-K for 1997. (*)
10(g) Deferred Compensation Plan, filed as Exhibit 10 to AFG's Registration Statement on Form S-8 on December 2, 1999 (*)