AFG reported net earnings attributable to shareholders of $479 million ($4.33 per share diluted) in 2010 compared to $519 million ($4.45 per share diluted) in 2009. Improved operating results in the annuity and supplemental insurance group and higher realized gains were more than offset by lower underwriting profit and lower investment income in the property and casualty operations.
Ratios AFG’s debt to total capital ratio on a consolidated basis is shown below (dollars in millions). Management intends to maintain the ratio of debt to capital at or below 25% and intends to maintain the capital of its significant insurance subsidiaries at or above levels currently indicated by rating agencies as appropriate for the current ratings.
AFG’s ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.41 for the year ended December 31, 2010. Excluding annuity benefits, this ratio was 9.09 for 2010. Although the ratio excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
In August 2010, AFG replaced its bank credit facility with a three-year, $500 million revolving credit line. There were no borrowings under this agreement, or any other parent company short-term borrowing arrangements, during 2010. In September 2010, AFG issued $132 million of 7% Senior Notes due 2050.
Under tax allocation agreements with AFG, its 80%-owned U.S. subsidiaries generally pay taxes to (or recover taxes from) AFG based on each subsidiary’s contribution to amounts due under AFG’s consolidated tax return.
Subsidiary Liquidity Great American Life Insurance Company (“GALIC”), a wholly-owned annuity and supplemental insurance subsidiary, became a member of the Federal Home Loan Bank of Cincinnati (“FHLB”) in 2009. The FHLB makes loans 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 borrowed. GALIC’s $15 million investment in FHLB capital stock at December 31, 2010, is included in other investments at cost. Membership in the FHLB provides the annuity and supplemental insurance operations with a substantial additional source of liquidity. No funds have been borrowed from the FHLB.
The liquidity requirements of AFG’s insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have generally provided more than sufficient funds to meet these requirements without requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
In the annuity business, where profitability is largely dependent on earning a “spread” between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to guaranteed minimums. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG’s annuity products.
Reserve projections include anticipated cash benefit payments only. Projections do not include any impact for future earnings or additional premiums.
Includes a 15-year lease for new office space with rentals, including estimated operating costs, averaging approximately $17 million per year beginning in 2011.
AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2010.
Fixed income investment funds are generally invested in securities with intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions. At December 31, 2010, the average life of AFG’s fixed maturities was about six years.
Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG’s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. Prices obtained from a broker or pricing service are adjusted only in cases where they are deemed not to be representative of an appropriate exit price (fewer than 1% of the securities).
AFG’s MBS are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates.
Summarized information for the unrealized gains and losses recorded in AFG’s Balance Sheet at December 31, 2010, is shown in the following table (dollars in millions). Approximately $282 million of available for sale “Fixed maturities” and $42 million of “Equity securities” had no unrealized gains or losses at December 31, 2010.
The following table summarizes (dollars in millions) the unrealized loss for all securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
historical operating, balance sheet and cash flow data contained in issuer SEC filings and news releases,
the continuity of dividend payments, maintenance of investment grade ratings and hybrid nature of certain investments,
Property and Casualty Insurance Reserves Estimating the liability for unpaid losses and loss adjustment expenses (“LAE”) is inherently judgmental and is influenced by factors that are subject to significant variation. Determining the liability is a complex process incorporating input from many areas of the company including actuarial, underwriting, pricing, claims and operations management.
While current factors and reasonably likely changes in variable factors are considered in estimating the liability for unpaid losses, there is no method or system that can eliminate the risk of actual ultimate results differing from such estimates. As shown in footnote (a) to the reserve development table (loss triangle) on page 8, the original estimates of AFG’s liability for losses and loss adjustment expenses, net of reinsurance, over the past 10 years have developed through December 31, 2010, to be deficient (for four years) by as much as 20.2% and redundant (for six years) by as much as 14.5% (excluding the effect of special charges for asbestos, environmental and other mass tort exposures). This development illustrates the historical impact caused by variability in factors considered in estimating insurance reserves.
This long-tail line of business provides coverage to employees who may be injured in the course of employment. Some of the important variables affecting estimation of loss reserves for workers’ compensation include:
AFG’s workers’ compensation business is written primarily in California. Significant reforms passed by the California state legislature in 2003 and in 2004 reduced employer premiums and set treatment standards for injured workers. AFG recorded favorable prior year loss development of $11 million in 2010, $20 million in 2009 and $32 million in 2008 due primarily to the impact of the legislation on claim costs being more favorable than previously anticipated. As claims incurred in 2003 through 2007 are now reaching a higher percentage of settlement and maturity, management is able to estimate the ultimate costs of these claims with more precision.
Management assumes now that the standard actuarial techniques adequately reflect the impact of the reforms and recent judicial decisions. Several methods (including development methods and those based on claim count and severity) are weighted together to produce indications of reserve need. Management continues to review the frequency, severity and loss and LAE ratios implied by the indications from the standard tests and considers the uncertainties of future costs in determining the appropriate reserve level.
AFG recorded favorable prior year loss development of $40 million in 2010, $26 million in 2009 and $29 million in 2008 on its directors’ and officers’ liability business as claim severity was significantly less than expected. The legal professional liability business, which is in run-off, had favorable development of $18 million in 2010 and $14 million in 2009 after several years of modest adverse development; as this run-off liability has matured, the claim severity trends have stabilized and the frequency is also less than expected.
While management applies the actuarial methods mentioned above, more judgment is involved in arriving at the final reserve to be held. The selection of methods vary by subdivision of the data within this line. Some businesses within this line use the Paid Development method while others use the Case Incurred Development method and the Bornhuetter-Ferguson method.
AFG recorded favorable prior year loss development of $26 million in 2010, $6 million in 2009 and $8 million in 2008 for this line of business as claim severity was lower than in prior assumptions.
AFG recorded favorable prior year loss development of $13 million in 2010, $11 million in 2009 and $6 million in 2008 in its Specialty Human Services division that specializes in products for non-profit organizations. Claim severity has been less than anticipated in prior estimates.
The following table illustrates the effect that purchasing reinsurance has had on AFG’s combined ratio over the last three years.
Approximately 65% of AFG’s net asbestos reserves relate to policies written directly by AFG subsidiaries. Claims from these policies generally are product oriented claims with only a limited amount of non-product exposures, and are dominated by small to mid-sized commercial entities that are mostly regional policyholders with few national target defendants. The remainder is assumed reinsurance business that includes exposures for the periods 1954 to 1983. The asbestos and environmental assumed claims are ceded by various insurance companies under reinsurance treaties. A majority of the individual assumed claims have exposures of less than $100,000 to AFG. Asbestos losses assumed include some of the industry known manufacturers, distributors and installers. Pollution losses include industry known insured names and sites.
Establishing reserves for A&E claims relating to policies and participations in reinsurance treaties and former operations is subject to uncertainties that are significantly greater than those presented by other types of claims. For this group of claims, traditional actuarial techniques that rely on historical loss development trends cannot be used and a meaningful range of loss cannot be estimated. Case reserves and expense reserves are established by the claims department as specific policies are identified. In addition to the case reserves established for known claims, management establishes additional reserves for claims not yet known or reported and for possible development on known claims. These additional reserves are management’s best estimate based on periodic comprehensive studies and internal reviews adjusted for payments and identifiable changes, supplemented by management’s review of industry information about such claims, with due consideration to individual claim situations.
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, how 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 $16 million.
During the second quarter of 2010, AFG completed an in-depth internal review of its asbestos and environmental exposures relating to the run-off operations of its property and casualty group and exposures related to former railroad and manufacturing operations and sites. The review relied on a comprehensive exposure analysis by AFG’s internal A&E claims specialists and actuaries in consultation with external actuaries and outside specialty counsel. It considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development. During the course of the internal review, there were no newly identified emerging trends or issues that management believes significantly impact the overall adequacy of AFG’s A&E reserves. During the second quarter of 2009, AFG completed a comprehensive study of its A&E exposures with the assistance of outside actuarial and engineering firms and specialty outside counsel. See Management’s Discussion and Analysis - “Results of Operations - Asbestos and Environmental Reserve Charges” for the amount of A&E reserve strengthening recorded in 2010, 2009 and 2008.
The tax effects of reconciling items are shown below (in millions):
In addition, realized gains (losses) are shown net of noncontrolling interests of ($6 million) in 2010, ($4 million) in 2009 and $10 million in 2008.
Net earnings attributable to shareholders increased in 2009 compared to 2008 due primarily to after-tax net realized gains of $26 million in 2009 compared to after-tax net realized losses of $270 million in 2008. Core net operating earnings increased in 2009 due primarily to improved underwriting profits in the specialty property and casualty operations and higher investment income.
Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. A combined ratio under 100% indicates an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.
AFG’s combined ratio has been better than the industry average for twenty-three of the last twenty-five years and excluding AFG’s special A&E charges, for all twenty-five 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 decreased 5% in 2010 compared to 2009 due primarily to competitive pressures and lower spring agricultural commodity prices. Premiums resulting from National Interstate’s third quarter acquisition of Vanliner, premium growth from Marketform and higher fall agricultural commodity prices partially offset these declines. The increase in net written premiums in 2010 compared to 2009 is a result of decreased cessions under the crop reinsurance agreement, partially offset by the decline in premiums resulting from a reinsurance transaction in the Specialty financial group. Excluding crop operations, gross and net written premiums decreased 2% and 5%, respectively, in 2010 compared to 2009. Average renewal rates in the Specialty insurance operations during 2010 were flat compared to the prior year.
The Specialty insurance operations generated an underwriting profit of $424 million in 2009, $60 million higher than in 2008. The 2009 combined ratio improved 4.9 points from 2008 primarily as a result of higher crop underwriting profits and lower catastrophe losses, partially offset by lower favorable development. Specialty insurance results for 2009 include 8.5 points of favorable reserve development compared to 8.7 points in 2008 and .7 points of catastrophe losses compared to 2.1 points in 2008.
Property and transportation gross written premiums for 2010 declined from 2009 primarily as a result of lower spring commodity prices that had the effect of lowering AFG’s crop premium volume. These declines were partially offset by additional premiums from the Vanliner acquisition in July 2010. AFG returned to historical levels of 50% cessions under its crop reinsurance agreement in 2010, contributing to a substantial increase in this group’s net written premiums. Excluding crop, this group’s net written premiums for 2010 increased 9% from 2009, primarily as a result of the Vanliner acquisition. This group reported an underwriting profit of $140 million in 2010, $96 million lower than in 2009 due primarily to lower favorable reserve development and higher catastrophe losses. While favorable crop yields contributed to strong results in the crop operations, the results were lower than in 2009. Results for 2010 include $27 million (2.3 points) of favorable reserve development compared to $52 million (5.7 points) in 2009. Catastrophe losses for this group were $39 million (3.3 points) in 2010 compared to minimal catastrophe losses in 2009.
Gross and net written premiums decreased significantly in 2009 compared to 2008 as a result of lower spring commodity prices on crop operations, planned volume reductions in the inland marine operations and soft market conditions in the property and inland marine and transportation operations. Increased cessions under a crop reinsurance treaty also reduced net written premiums in 2009. Excluding crop, net written premiums for this group decreased 11% in 2009 when compared to the 2008 period. This group reported 2009 underwriting profits of $236 million, a 51% improvement over the 2008 period. The combined ratio improved 13.8 points to 74.1%. Favorable crop yields and relatively stable commodity prices resulted in record profitability for the crop operations and contributed in large measure to these results. The other property and transportation businesses reported strong underwriting profits notwithstanding soft market conditions. Results for 2009 include $52 million (5.7 points) of favorable reserve development compared to $65 million (5.0 points) in 2008. Catastrophe losses for this group were $7 million in 2009 compared to $50 million in 2008.
Specialty casualty gross and net written premiums decreased in 2010 compared to 2009 due primarily to competitive market conditions in the excess and surplus markets and California workers’ compensation businesses, as well as volume reductions resulting from decreased demand for general liability coverages in the homebuilders’ market. Growth in gross written premiums in the Marketform and environmental operations partially offset these declines. Increased retentions in the executive liability operations helped to offset decreases in net written premiums. This group reported an underwriting profit of $47 million in 2010, $16 million lower than in 2009. The decrease was primarily due to lower underwriting profits in the California workers’ compensation business and the general liability operations (primarily those that serve the homebuilders’ industry). These decreases were partially offset by improved results in the executive liability and excess and surplus operations. Underwriting results for 2010 and 2009 include $55 million and $56 million, respectively, in adverse reserve development related to Marketform, primarily its run-off Italian public hospital medical malpractice business. Included in AFG’s liability for unpaid losses and loss adjustment expenses at December 31, 2010 are reserves of $126 million related to this business.
Specialty financial gross written premiums decreased in 2010 compared to 2009, reflecting the decision to exit certain automotive lines of business in 2009. During the third quarter of 2010, AFG ceded the unearned premium related to these businesses in a reinsurance transaction, which resulted in a reduction of approximately $100 million in net written premiums. Specialty financial underwriting profit was $112 million in 2010 compared to $134 million in 2009. The lower underwriting profit in 2010 reflects $51 million less of favorable prior year reserve development in the run-off residual value insurance (“RVI”) operations than was recorded in 2009. Other businesses in this group reported strong underwriting profits.
Loss development As shown in Note O - “Insurance - Property and Casualty Insurance Reserves,” AFG’s property and casualty operations recorded favorable loss development of $158 million in 2010, $198 million in 2009 and $242 million in 2008 related to prior accident years. Major areas of favorable (adverse) development were as follows (in millions):
The favorable reserve development in the Property and transportation group in 2010 is due primarily to lower than expected loss frequency in crop products and lower severity in auto liability products. The favorable reserve development in the Property and transportation group in 2009 and 2008 reflects lower than expected loss frequency in crop and ocean marine products and lower severity in farm and crop losses.
Favorable reserve development in Specialty financial in 2010 and 2009 related to lower than expected frequency and severity in the run-off RVI operations due to favorable trends in used car sale prices. Lower loss severity in AFG’s surety, fidelity and crime products contributed to favorable development in all three years.
“Bank Annuities - Direct” represent premiums generated by financial institutions appointed and serviced directly by AFG. “Bank Annuities - Indirect” represent premiums generated through banks by independent agents or brokers.
Investment Income The $9 million decrease in investment income in 2010 compared to 2009 reflects lower yields on fixed maturity investments partially offset by higher average invested assets. Investment income increased $77 million for 2009 compared to 2008 due primarily to higher yields on certain fixed maturity investments. Investment income includes $66 million in 2010, $130 million in 2009 and $77 million in 2008 of interest income earned on interest-only and similar MBS, primarily non-agency interest-only securities with interest rates that float inversely with short-term rates. These MBS, the majority of which were purchased in late 2007 and early 2008, had a carrying value of $101 million at December 31, 2010. These securities have benefited from slow prepayments and low short-term interest rates, which are reflective of the weak housing market and general economic conditions over the past three years.
Other Income The $32 million decrease in other income in 2010 compared to 2009 reflects a decline in income from AFG’s warranty business and lower fee income in certain other businesses, partially offset by $16 million in income recorded during the third quarter of 2010 from the sale of real estate and the termination of leases by a tenant. The $68 million decrease in other income for 2009 compared to 2008 reflects a $25 million decline in income from AFG’s warranty business, lower income from real estate operations and lower fee income in certain other businesses.
Annuity and Supplemental Insurance Acquisition Expenses Annuity and supplemental insurance acquisition expenses include amortization of annuity, supplemental insurance and life business deferred policy acquisition costs (“DPAC”) as well as a portion of commissions on sales of insurance products. Annuity and supplemental insurance acquisition expenses also include amortization of the present value of future profits of businesses acquired (“PVFP”).
As a result of the 2010 review of actual results and future assumptions discussed above in “Annuity Benefits,” AFG recorded a $28 million write-off of DPAC due primarily to the impact of changes in assumptions related to future investment yields and annuitization and death benefits partially offset by the impact of lower expected expenses and crediting rates in the fixed annuity business. As a result of the 2009 review, AFG recorded an $8 million write-off of DPAC due primarily to the impact of changes in assumptions related to future investment yields on the fixed annuity business. Excluding these charges, insurance acquisition expenses increased $24 million in 2010 compared to 2009 reflecting additional amortization due to growth in the annuity business. As a result of the 2008 review, AFG recorded a $15 million reduction in annuity and supplemental insurance acquisition expenses due primarily to changes in assumptions related to investment yields. This reduction was partially offset by $10 million in DPAC write-offs due to the impact of poor stock market performance on the variable annuity business.
The vast majority of this group’s DPAC asset relates to its annuity and life insurance lines of business. Unanticipated spread compression, decreases in the stock market, adverse mortality experience, and higher than expected lapse rates could lead to further write-offs of DPAC or PVFP in the future.
Other Operating and General Expenses The $85 million decrease in 2010 compared to 2009 reflects the 2009 sale of a small subsidiary, lower expenses in AFG’s warranty business due to the run-off of certain products, and lower expenses in the annuity and supplemental insurance operations.
New accounting standards implemented in 2010, are discussed in Note A - “Accounting Policies” under the following subheadings.
In October 2010, the FASB issued Accounting Standards Update 2010-26 to address diversity in practice regarding which costs related to issuing or renewing insurance contracts qualify for deferral. To qualify for deferral, the guidance specifies that a cost must be directly related to the successful acquisition of an insurance contract. The guidance is effective for periods ending after December 31, 2011, with retrospective application permitted, but not required. AFG expects that this guidance will result in fewer acquisition costs being capitalized and is currently assessing the method and impact of adoption.
In November 2008, the Securities and Exchange Commission (“SEC”) issued a proposed roadmap regarding the use of International Financial Reporting Standards (“IFRS”) by U.S. issuers of financial statements. Under the proposed roadmap, AFG would be required to prepare its financial statements in accordance with IFRS instead of U.S. GAAP beginning in 2014. IFRS is a comprehensive series of accounting standards published by the International Accounting Standards Board (“IASB”). While U.S. GAAP and IFRS have converged in many areas, the IASB is currently considering methodologies for valuing insurance contract liabilities that may be significantly different from the methodologies currently required by GAAP. AFG is currently assessing the impact that the adoption of IFRS would have on its financial statements and will continue to monitor the development of the potential implementation of IFRS.
Based on AFG’s evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2010. The attestation report of AFG’s independent registered public accounting firm on AFG’s internal control over financial reporting as of December 31, 2010, is set forth below.
We have audited American Financial Group, Inc. and subsidiaries’ (the Company’s) internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (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.
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of earnings, changes in equity and cash flows for each of the three years in the period ended December 31, 2010. 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, 2010 and 2009, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, 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.
As discussed in Note A to the consolidated financial statements, in connection with implementing new accounting standards, the Company changed its methods of accounting for certain variable interest entities in 2010 and for noncontrolling interests and other-than-temporary impairments of investments in fixed maturity securities in 2009.
As a result of a new accounting standard adopted on January 1, 2009, noncontrolling interests in subsidiaries (formerly referred to as minority interest) is reported in the Balance Sheet as a separate component of equity and in the Statement of Earnings as an adjustment to net income in deriving net earnings attributable to AFG’s shareholders.
The preparation of the financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
Fair Value Measurements Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. Except for the acquisition discussed in Note B - “Acquisitions” and the impairment of goodwill discussed in Note I - “Goodwill and Other Intangibles,” AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in 2010.
In 2009, AFG adopted new accounting guidance relating to the recognition and presentation of other-than-temporary impairments. Under the guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then an entity may separate other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit-related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are required to be shown in the Statement of Earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is required to reduce the amortized cost of that security to fair value. AFG adopted this guidance effective January 1, 2009, and recorded a cumulative effect adjustment of $17 million to reclassify the non-credit component of previously recognized impairments from retained earnings to accumulated other comprehensive income (loss). Additional disclosures required by this guidance are contained in Note E - “Investments.”
Goodwill Goodwill represents the excess of cost of subsidiaries over AFG’s equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually.
Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaries retain the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. 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. AFG 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. The securities related to these transactions are classified as “trading.” The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of the related trading portfolios.
Deferred Policy Acquisition Costs (“DPAC”) Policy acquisition costs (principally commissions, premium taxes and other marketing and underwriting expenses) related to the production of new business are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses.
For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses, unamortized acquisition costs and policy maintenance costs exceed the related unearned premiums. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.
DPAC includes the present value of future profits on business in force of annuity and supplemental insurance companies acquired (“PVFP”). PVFP represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. PVFP is amortized with interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
Managed Investment Entities In 2009, the Financial Accounting Standards Board issued a new standard changing how a company determines if it is the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”). This determination is based primarily on a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance and the obligation to absorb losses of, or receive benefits from, the entity that could potentially be significant to the VIE.
AFG manages, and has minor investments in, six collateralized loan obligations (“CLOs”) that are VIEs. As further described in Note H, these entities issued securities in various tranches and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. Both the management fees (payment of which are subordinate to other obligations of the CLOs) and the investments in the CLOs are considered variable interests. Based on the new accounting guidance, 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 subordinated 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. Accordingly, AFG began consolidating these entities on January 1, 2010.
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 net gain or loss from accounting for the CLO assets and liabilities at fair value subsequent to January 1, 2010, is separately presented in AFG’s Statement of Earnings. CLO earnings attributable to AFG’s shareholders represent the change in fair value of AFG’s investments in the CLOs and management fees earned. As further detailed in Note H - “Managed Investment Entities,” all other CLO earnings (losses) are not attributable to AFG’s shareholders and will ultimately inure to the benefit of the other CLO debt holders. As a result, such CLO earnings (losses) are included in net earnings (loss) attributable to noncontrolling interests in AFG’s Statement of Earnings and in appropriated retained earnings - managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2022), it is expected that losses attributable to noncontrolling interests will reduce appropriated retained earnings towards zero as the fair values of the assets and liabilities converge and the CLO assets are used to pay the CLO debt.
Annuity Benefits Accumulated Annuity receipts and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for surrender charges are credited to other income.
Life, Accident and Health Reserves Liabilities for future policy benefits under traditional life, accident and health policies are computed using the net level premium method. Computations are based on the original projections of investment yields, mortality, morbidity and surrenders and include provisions for unfavorable deviations. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.
Income Taxes Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized.
Stock-Based Compensation All share-based grants are recognized as compensation expense on a straight-line basis over their vesting periods based on their calculated “fair value” at the date of grant. AFG uses the Black-Scholes pricing model to measure the fair value of employee stock options. See Note K -“Shareholders’ Equity” for further information on stock options.
Benefit Plans AFG provides retirement benefits to qualified employees of participating companies through the AFG 401(k) Retirement and Savings Plan, a defined contribution plan. AFG makes all contributions to the retirement fund portion of the plan and matches a percentage of employee contributions to the savings fund. Company contributions are expensed in the year for which they are declared. 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.
Earnings Per Share Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding during the period. The calculation of diluted earnings per share includes the following adjustments to weighted average common shares related to stock-based compensation plans: 2010 - 1.3 million, 2009 - 1.1 million and 2008 - 1.7 million. Weighted average common shares in 2008 also includes an adjustment of .6 million related to convertible notes.
AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: 2010 - 3.5 million, 2009 - 5.7 million and 2008 - 4.4 million. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were less than $1 million in the 2010, 2009 and 2008 periods.
Marketform Group In January 2008, AFG paid $75 million in cash (including transaction costs) to acquire approximately 67% of Marketform Group Limited, an agency that focuses on medical malpractice and other specialty property and casualty insurance products outside of the United States using a Lloyd’s platform (Syndicate 2468). Approximately $36 million of the acquisition cost was recorded as an intangible asset for the present value of future profits from the acquired business and is being amortized over the estimated retention period of seven years.
Strategic Comp Holdings AFG acquired Strategic Comp Holdings, LLC in January 2008 for $37 million in cash. Additional contingent consideration could be due after seven years based on achieving certain operating milestones. Strategic Comp, headquartered in Louisiana, is a provider of workers’ compensation programs for mid-size to large commercial accounts. The entire purchase price was recorded as intangible renewal rights and is being amortized over the estimated retention period of seven years.
AFG manages its business as three segments: (i) property and casualty insurance, (ii) annuity and supplemental insurance and (iii) other, which includes holding company assets and costs and assets and operations of the managed investment entities.
The following tables (in millions) show AFG’s assets, revenues and operating earnings before income taxes by significant business segment and sub-segment.
Level 3 - Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable. The unobservable inputs may include management’s own assumptions about the assumptions market participants would use based on the best information available in the circumstances. AFG’s Level 3 is comprised of financial instruments, including liabilities of managed investment entities, whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, observable market information.
Variable annuity liabilities equal the fair value of variable annuity assets.
Changes in balances of Level 3 financial assets and liabilities during 2010, 2009 and 2008 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.
Fair Value of Financial Instruments The following table presents (in millions) the carrying value and estimated fair value of AFG’s financial instruments at December 31.
The non-credit related portion of other-than-temporary impairment charges are included in other comprehensive income (loss). Such charges taken for securities still owned at December 31, 2010 and 2009, respectively, were $258 million and $284 million for residential MBS, $1 million and $3 million for commercial MBS and $1 million and $4 million for corporate bonds.
The following tables show gross unrealized losses (in millions) on fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2010 and 2009.
At December 31, 2010, the gross unrealized losses on fixed maturities of $216 million relate to approximately 1,150 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 58% of the gross unrealized loss and 82% of the fair value.
The table below sets forth the scheduled maturities of available for sale fixed maturities as of December 31, 2010 (in millions). Securities with sinking funds and other securities that pay down principal over time are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers. MBS had an average life of approximately four years at December 31, 2010.
AFG has entered into $800 million notional amount of pay-fixed interest rate swaptions (options to enter into pay-fixed/receive floating interest rate swaps at future dates expiring between 2012 and 2015) to mitigate interest rate risk in its annuity operations. AFG paid $21 million to purchase these swaptions, which represents its maximum potential economic loss over the life of the contracts.
AFG’s indexed annuities, which represented 27% of annuity benefits accumulated at December 31, 2010, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG’s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be generally offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives.
During 2010, 2009 and 2008, AFG capitalized $33 million, $32 million and $53 million, respectively, relating to sales inducements offered to annuity policyholders. Amortization of sales inducements was $36 million, $20 million and $10 million in these periods, respectively.
AFG is the investment manager and has investments ranging from 7.5% to 24.4% of the most subordinate debt tranche of six collateralized loan obligation entities or “CLOs,” which are considered variable interest entities. Upon formation between 2004 and 2007, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG’s investments in these entities receive residual income from the CLOs only after the CLOs pay operating expenses (including management fees to AFG), interest on and returns of capital to senior levels of debt securities. There are no contractual requirements for AFG to provide additional funding for these entities. AFG has not provided and does not intend to provide any financial support to these entities.
In analyzing expected cash flows related to these entities, AFG determined that it will not receive a majority of the residual returns nor absorb a majority of the entities’ expected losses. Accordingly, AFG was not required to consolidate these variable interest entities prior to 2010. Beginning in 2010, accounting standards for determining the primary beneficiary of a variable interest entity changed from the above quantitative assessment to a qualitative assessment as outlined in Note A - “Accounting Policies, Managed Investment Entities.” Under the new guidance, AFG determined that it is the primary beneficiary of the CLOs it manages and began consolidating the CLOs on January 1, 2010.
The revenues and expenses of the CLOs are separately identified in AFG’s Statement of Earnings, after elimination of $15 million in management fees and $17 million in income attributable to shareholders of AFG in 2010, as measured by the change in the fair value of AFG’s investments in the CLOs. AFG’s operating earnings before income taxes for 2010 includes $64 million in CLO losses attributable to noncontrolling interests.
Changes in the carrying value of goodwill during 2009 and 2010, by reporting segment, are presented in the following table (in millions):
Included in other assets in AFG’s Balance Sheet is $49 million at December 31, 2010 and $60 million at December 31, 2009 in amortizable intangible assets related to property and casualty insurance acquisitions, primarily the 2008 acquisitions of Marketform and Strategic Comp. These amounts are net of accumulated amortization of $35 million and $23 million, respectively. Amortization of these intangibles was $12 million in 2010, $22 million in 2009 and $24 million in 2008. Future amortization of intangibles (weighted average amortization period of 4 years) is estimated to be $12 million in each of 2011, 2012, 2013 and 2014, and less than $1 million per year thereafter. Other assets also include $8 million in non-amortizable intangible assets related to insurance licenses acquired in the acquisition of Vanliner in 2010.
At December 31, 2010, scheduled principal payments on debt for the subsequent five years were as follows: 2011 - $20 million, 2012 - $32 million, 2013 - $20 million, 2014 - $2 million and 2015 - $14 million.
In September 2010, AFG issued $132 million of 7% Senior Notes due 2050. In April 2009, AFG paid $136 million to redeem its outstanding 7-1/8% Senior Debentures at maturity. In June 2009, AFG issued $350 million of 9-7/8% Senior Notes due 2019 and used the proceeds to repay borrowings under the bank credit facility.
In 2009, AFG subsidiaries borrowed a total of $59 million at interest rates ranging from 3.8% to 4.25% over LIBOR (weighted average interest rate of 4.3% at December 31, 2010). The loans require principal payments over the next three years.
Cash interest payments on long-term debt were $68 million in 2010, $64 million in 2009 and $58 million in 2008. Interest expense in the Statement of Earnings includes interest credited on funds held by AFG’s insurance subsidiaries under reinsurance contracts and other similar agreements as follows: 2010 - $10 million, 2009 - $7 million; and 2008 - $8 million.
At December 31, 2010, there were 14.7 million shares of AFG Common Stock reserved for issuance under AFG’s stock incentive plans. Options are granted with an exercise price equal to the market price of AFG Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant; those granted to non-employee directors of AFG are fully exercisable upon grant. Options expire ten years after the date of grant. Data for stock options issued under AFG’s stock incentive plans is presented below:
AFG uses the Black-Scholes option pricing model to calculate the “fair value” of its option grants. Expected volatility is based on historical volatility over a period equal to the estimated term. The expected term was estimated based on historical exercise patterns and post vesting cancellations. The weighted average fair value of options granted during 2010, 2009 and 2008 was $8.90 per share, $5.85 per share and $7.93 per share, respectively, based on the following assumptions:
AFG issued 141,264 shares of Common Stock (fair value of $24.83 per share) in the first quarter of 2010 under the Annual Co-CEO Equity Bonus Plan.
Total earnings before income taxes include income (losses) subject to tax in foreign jurisdictions of ($12 million) in 2010, ($71 million) in 2009 and $26 million in 2008.
AFG’s 2010, 2009 and 2008 tax years remain subject to examination by the IRS. In addition, AFG has several tax years for which there are ongoing disputes. AFG filed a suit for refund in the U.S. District Court in Southern Ohio as a result of its dispute with the IRS regarding the calculation of tax reserves for certain annuity reserves pursuant to Actuarial Guideline 33. Oral arguments on joint motions for summary judgment were presented in June 2009. In March 2010, the Court issued an Order denying both motions. In June 2010, the Court issued a final judgment in favor of AFG. The IRS has appealed the decision. Ultimate resolution may require revised tax calculations for the years 1996-2005, possibly requiring a revised application of tax attribute carryovers or carrybacks, both capital and ordinary, to the affected years, and is contingent upon formal review and acceptance by the IRS. Resolution of the case could result in a decrease in the liability for unrecognized tax benefits by up to $36 million and a decrease in related accrued interest of $12 million. These amounts do not include tax and interest paid to the IRS in 2005 and 2006, for which the suit was filed, totaling $17 million.
Cash payments for income taxes, net of refunds, were $196 million, $190 million and $199 million for 2010, 2009 and 2008, respectively.
While management believes AFG has recorded adequate reserves for the items discussed in this note, the outcome is uncertain and could result in liabilities that may vary from amounts AFG has currently recorded. Such amounts could have a material effect on AFG’s future results of operations and financial condition.
The operations of certain AFG 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. The profitability of AFG’s crop insurance business is primarily recognized during the second half of the year as crop prices and yields are determined. Quarterly results necessarily rely heavily on estimates. These estimates and certain other factors, such as the 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, 2010 (in millions, except per share amounts). Quarterly earnings per share do not add to year-to-date amounts due to changes in shares outstanding.
Pretax realized gains (losses) on securities (including other-than-temporary impairments) and favorable (unfavorable) prior year development of AFG’s liability for losses and loss adjustment expenses (“LAE”) were as follows (in millions):
Results for 2010 include pretax catastrophe losses of $34 million in the second quarter, primarily from hailstorms in Oklahoma. Results for the third quarter of 2010 include a pretax gain of $26 million from the sale of a portion of AFG’s investment in Verisk Analytics, Inc. and $39 million in adverse reserve development related to Marketform, primarily its run-off Italian public hospital medical malpractice business.
Securities owned by U.S.-based insurance subsidiaries having a carrying value of approximately $1.2 billion at December 31, 2010, were on deposit as required by regulatory authorities. At December 31, 2010, AFG and its subsidiaries had $144 million in undrawn letters of credit ($43 million of which was collateralized) supporting the underwriting capacity of its U.K.-based Lloyd’s insurer.
Property and Casualty Insurance Reserves The liability for losses and LAE for long-term scheduled payments under certain workers’ compensation insurance has been discounted at 6%, an approximation of long-term investment yields. As a result, the total liability for losses and loss adjustment expenses at December 31, 2010, has been reduced by $32 million.
Variable Annuities At December 31, 2010, the aggregate guaranteed minimum death benefit value (assuming every variable annuity policyholder died on that date) on AFG’s variable annuity policies exceeded the fair value of the underlying variable annuities by $52 million, compared to $85 million at December 31, 2009. Death benefits paid in excess of the variable annuity account balances were less than $1 million in each of the last three years.
Financial Instruments with Off-Balance-Sheet Risk On occasion, AFG and its subsidiaries have entered into financial instrument transactions that may present off-balance-sheet risks of both a credit and market risk nature. These transactions include commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. At December 31, 2010, AFG and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling up to $26 million.
Grossed up for prepaid reinsurance premiums of $422 and $381 at December 31, 2010 and 2009, respectively.
2010 Annual Co-CEO Equity Bonus Plan, filed as Exhibit 10(c) to AFG’s Form 10-K for 2009.
Amendment to Credit Agreement dated March 29, 2006, among American Financial Group, Inc., AAG Holding Company, Inc., each as borrowers, and several lenders, filed as Exhibit 10(i) to AFG’s Form 10-K for 2007.
Credit Agreement dated August 2, 2010, among American Financial Group, Inc., Bank of America, N.A., as Administrative Agent, and several lenders, filed as Exhibit 99.2 to AFG’s Form 8-K filed on August 3, 2010.
The following financial information from American Financial Group’s Form 10-K for the year ended December 31, 2010, formatted in XBRL (Extensible Business Reporting Language):