AFG’s insurance subsidiaries lease the majority of their office and storage facilities in numerous cities throughout the United States, including Great American’s and GAFRI’s home offices in Cincinnati. In 2011, AFG consolidated operations from several leased and owned locations in downtown Cincinnati into a new office tower in that city subject to a 15-year lease. National Interstate occupies approximately 90% of the 177,000 square feet of office space on 17.5 acres of land that it owns in Richfield, Ohio. See Item 1 - “Business” - “Other Operations” for a discussion of AFG’s other commercial real estate operations.
Fixed charges are computed on a “total enterprise” basis. For purposes of calculating the ratios, “earnings” have been computed by adding to pretax earnings the fixed charges and the noncontrolling interests in earnings of subsidiaries having fixed charges and the undistributed equity in losses of investees. Fixed charges include interest (including annuity benefits as indicated), amortization of debt premium/discount and expense, preferred dividend and distribution requirements of subsidiaries and a portion of rental expense deemed to be representative of the interest factor.
The ratio of earnings to fixed charges excluding annuity benefits was 6.61, 9.09, 11.06, 4.75 and 8.49 for 2011, 2010, 2009, 2008 and 2007, respectively. Although the ratio of earnings to fixed charges excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, some investors and lenders may not consider interest credited to annuity policyholders’ accounts a borrowing cost for an insurance company, and accordingly, believe this ratio is meaningful.
At December 31, 2011, AFG (parent) held approximately $456 million in cash and securities and had $500 million available under a bank line of credit expiring in August 2013.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance, focusing on specialized commercial products for businesses and in the sale of traditional fixed and indexed annuities and a variety of supplemental insurance products such as Medicare supplement.
The property and casualty business is cyclical in nature with periods of high competition resulting in low premium rates, sometimes referred to as a “soft market” or “downcycle” followed by periods of reduced competition and higher premium rates, referred to as a “hard market” or “upcycle.” For the past several years, AFG’s property and casualty insurance operations have experienced soft market conditions.
AFG reported net earnings attributable to shareholders of $343 million ($3.33 per share diluted) in 2011 compared to $479 million ($4.33 per share diluted) in 2010.
AFG’s ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.95 for the year ended December 31, 2011. Excluding annuity benefits, this ratio was 6.61 for 2011. Although the ratio excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
The 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, 2011, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements.
Subsidiary Liquidity Great American Life Insurance Company (“GALIC”), a wholly-owned annuity and supplemental insurance subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions, which provides the annuity and supplemental insurance operations with a substantial additional source of liquidity. In the fourth quarter of 2011, the FHLB advanced GALIC $240 million at interest rates ranging from .02% to .03% over LIBOR (average rate of .31% at December 31, 2011). These advances must be repaid within 5 to 7 years, but GALIC has the option to prepay all or a portion of the advances on a monthly basis. GALIC has invested the proceeds from the advances in fixed maturity securities for the purpose of earning a spread over the interest payments due to the FHLB.
National Interstate Corporation (“NATL”), a 52%-owned property and casualty insurance subsidiary, can borrow up to $75 million, subject to certain conditions, under an unsecured credit agreement expiring in December 2012. Amounts borrowed bear interest at rates ranging from .45% to .9% (currently .65%) over LIBOR based on NATL’s credit rating. There was $22 million outstanding under this agreement at December 31, 2011. The maximum outstanding balance under this agreement during 2011 was $22 million.
In the annuity business, where profitability is largely dependent on earning a “spread” between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG’s annuity products.
With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to contractually guaranteed minimum interest rates (“GMIRs”). AFG began selling new policies with GMIRs below 2% in 2003; almost all new business since late 2010 has been issued with a 1% GMIR. At December 31, 2011, the average crediting rate on AFG’s annuities was approximately 3.1%, while the average GMIR was approximately 2.5%. This margin provides AFG the flexibility to lower its crediting rates by up to 60 basis points on average in the future should market interest rates continue to remain low for a long period of time.
For statutory accounting purposes, equity securities of non-affiliates are generally carried at fair value. At December 31, 2011, AFG’s insurance companies owned publicly traded equity securities with a fair value of $895 million. In addition, GAI’s investment in NATL common stock had a fair value of $252 million and a statutory carrying value of $199 million at December 31, 2011. Decreases in market prices could adversely affect the insurance group’s capital, potentially impacting the amount of dividends available or necessitating a capital contribution. Conversely, increases in market prices could have a favorable impact on the group’s dividend-paying capability.
Dollar amounts and time periods are estimates based on historical net payment patterns applied to the gross reserves and do not represent actual contractual obligations. Based on the same assumptions, AFG projects reinsurance recoveries related to these reserves totaling $2.2 billion as follows: Within 1 year - $600 million; 2-3 years - $600 million; 4-5 years - $400 million; and thereafter - $638 million. Actual payments and their timing could differ significantly from these estimates.
AFG’s $74 million liability for unrecognized tax benefits (including $15 million in interest) as of December 31, 2011, is not included because the period of payment cannot be reliably estimated.
AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2011.
Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG’s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. In addition, the Company communicates directly with the pricing service regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities. 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).
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. Although interest rates have been low for the last few years, a weak housing market and uncertain economic conditions have led to tighter lending standards, which have resulted in fewer buyers being able to refinance the mortgages underlying much of AFG’s non-agency RMBS portfolio.
The National Association of Insurance Commissioners (“NAIC”) assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC retained a third-party investment management firm to assist in the determination of appropriate NAIC designations for mortgage-backed securities based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At December 31, 2011, 97% (based on statutory carrying value of $6.5 billion) of AFG’s MBS securities had an NAIC designation of 1 or 2.
Summarized information for the unrealized gains and losses recorded in AFG’s Balance Sheet at December 31, 2011, is shown in the following table (dollars in millions). Approximately $133 million of available for sale “Fixed maturities” and $36 million of “Equity securities” had no unrealized gains or losses at December 31, 2011.
The table below sets forth the scheduled maturities of AFG’s available for sale fixed maturity securities at December 31, 2011, based on their fair values. 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.
When a decline in the value of a specific investment is considered to be “other-than-temporary,” a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced by the amount of the charge. The determination of whether unrealized losses are “other-than-temporary” requires judgment based on subjective as well as objective factors. Factors considered and resources used by management include:
Based on its analysis of the factors listed above, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, 2011. Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers’ creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG’s ability or intent change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG’s investment portfolio could have a significant adverse effect on AFG’s liquidity. For information on AFG’s realized gains (losses) on securities, including charges for “other-than-temporary” impairment, see Management’s Discussion and Analysis - “Results of Operations - Realized Gains (Losses) on Securities.”
The following table shows (in millions) the breakdown of AFG’s property and casualty reserves between case reserves, IBNR reserves and LAE reserves (estimated amounts required to adjust, record and settle claims, other than the claim payments themselves).
AFG recorded favorable development of $50 million in 2011, $108 million in 2010 and $55 million in 2009 related to its other liability-occurrence coverage where both the frequency and severity of claims were lower than previously projected.
Uncertainty has emerged regarding AFG’s potential exposure for claims arising from the use of Chinese drywall. The potential exposure arises from insured policyholders who may have been associated with the installation of Chinese drywall in residential construction. AFG continues to monitor judicial decisions and settlements in this evolving area and is evaluating the possible implications of recent events on its potential exposure. While the ultimate liability is uncertain, management believes that AFG’s reserves for claims arising from the use of Chinese drywall are adequate.
Approximately one-half of AFG’s workers’ compensation business is currently written in California. Major reforms passed by the California state legislature in 2003 and in 2004 reduced employer premiums and set treatment standards for injured workers in that state. AFG’s subsidiary that writes workers’ compensation business in California recorded favorable prior year loss development of $5 million in 2011, $11 million in 2010 and $20 million in 2009 due primarily to the business written in California prior to 2008.
For several years after the reforms, the impact on claim settlements was more favorable than originally anticipated for claims incurred in 2003 to 2007, resulting in favorable development through 2011. However, this trend has subsided and the favorable development has flattened for more recent years. In both California and countrywide, economic conditions over the last couple years have led to longer duration of claims resulting in higher claim severity.
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. Recent economic conditions have led to increased claims for small account business and not-for-profit organizations.
AFG recorded favorable prior year loss development of $66 million in 2011, $40 million in 2010 and $26 million in 2009 on its directors’ and officers’ liability business as claim severity was significantly less than expected for claims incurred prior to 2010. Claims incurred in 2010 have developed adversely as economic conditions have driven severity higher than originally anticipated. The legal professional liability business, which has been in run-off since 2008, had favorable development of $17 million in 2011, $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.
AFG recorded favorable prior year loss development of $8 million in 2011, $26 million in 2010 and $6 million in 2009 for this line of business as claim severity was lower than in prior assumptions.
A slow moving judicial system including varying approaches to medical malpractice claims among courts in different regions of Italy
Marketform recorded adverse prior year reserve development of $44 million in 2011, $55 million in 2010 and $56 million in 2009 related primarily to its Italian public hospital medical malpractice business, which it ceased writing in 2008. The development resulted from significant issues related to third party administration of claims and a challenging legal environment in Italy. Management believes that current reserves, which represent its best estimate of future liabilities, are adequate. Nonetheless, it concluded that sufficient uncertainty exists with respect to Italian public hospital medical malpractice reserves to leave open the 2007 year of account, in accordance with Lloyd’s provisions until a larger percentage of claims have been paid and the ultimate liabilities can be estimated with greater certainty. Included in AFG’s liability for unpaid losses and loss adjustment expenses at December 31, 2011, are reserves of $126 million related to this business.
See Item 1 - “Business” - “Property and Casualty Operations - Reinsurance” for more information on AFG’s reinsurance programs. For additional information on the effect of reinsurance on AFG’s historical results of operations see Note O - “Insurance - Reinsurance” and the gross loss development table under Item 1 - “Business” - “Property and Casualty Operations - Loss and Loss Adjustment Expense Reserves.”
Approximately 59% 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.
Emerging trends, such as those named below, could impact AFG’s reserves and payments:
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 $17 million.
The survival ratio is a measure often used by industry analysts to compare A&E reserves strength among companies. This ratio is typically calculated by dividing reserves for A&E exposures by the three year average of paid losses, and therefore measures the number of years that it would take to pay off current reserves based on recent average payments. Because this ratio can be significantly impacted by a number of factors such as loss payout variability, caution should be exercised in attempting to determine reserve adequacy based simply on the survival ratio. At December 31, 2011, AFG’s three year survival ratios were 17.4 times paid losses for the asbestos reserves and 11.0 times paid losses for the total A&E reserves. Excluding amounts associated with the settlements of asbestos-related coverage litigation for A.P. Green Industries (see Item 3 - “Legal Proceedings”) and another large claim, AFG’s three year survival ratios were 10.9 and 7.6 times paid losses for the asbestos reserves and total A&E reserves, respectively. Data published by Conning Research & Consulting in June 2012 indicate that industry survival ratios were 8.5 for asbestos reserves and 7.8 for total A&E reserves at December 31, 2010.
asbestos exposures were increased to reflect higher frequency and severity of mesothelioma and other cancer claims as well as increased defense costs on many of these claims. These trends were partially offset by a decline in the number of claims without serious injury and fewer new claims that required payment being reported to AFG. The increase in the property and casualty group’s environmental reserves was attributed primarily to a small number of increases on specific environmental claims at several sites. During the second quarter of 2010, an in-depth internal review of AFG’s A&E exposures was completed by AFG’s internal A&E claims specialists and actuaries in consultation with external actuaries and specialty outside counsel. 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. The 2010 in-depth internal review and the 2009 comprehensive study resulted in only minor adjustments to the A&E reserves. See Management’s Discussion and Analysis - “Results of Operations - Asbestos and Environmental Reserve Charges” for the amount of A&E reserve strengthening recorded in 2011, 2010 and 2009.
Supplemental Insurance Reserves - Long-term Care AFG, as well as other companies selling long-term care products have relatively limited claims, lapse, and mortality experience over extended periods, making it difficult to predict future claims. Long-term care claims tend to be much higher in dollar amount and longer in duration than other health care products such as Medicare supplement. In addition, long-term care claims are incurred much later in the life of a policy than most other supplemental health products. These factors make it difficult to appropriately price this product and were instrumental in AFG’s decision to stop writing new policies beginning in January 2010. AFG’s long-term care products have level premiums and are guaranteed renewable. Premium rates can potentially be increased in reaction to adverse experience. However, any rate increases would require regulatory approval.
Reserves for future policy benefits under long-term care policies are established (and related acquisition costs are amortized) over the life of the policies based on policy benefit assumptions as of the date of issuance, including investment yields, mortality, morbidity, persistency, and expenses. Once these assumptions are established for a given policy or group of policies, they are not changed over the life of the policy unless a loss recognition event (premium deficiency) occurs. Loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums, including reasonably expected rate increases, are not expected to cover the present value of future claims payments and related settlement and maintenance costs as well as unamortized acquisition costs. Based on loss recognition testing at December 31, 2011, AFG’s long-term care reserves plus the present value of future premiums exceeded claims costs and unamortized acquisition expenses by approximately $25 million. Adverse changes in any of the reserve assumptions in future periods could result in loss recognition for AFG’s long-term care business. For example, a 1% change in claims costs or a 0.1% change in investment yields in all future periods, excluding their effect on the Company’s ability to achieve future rate increases, would each impact the December 31, 2011, “excess” described above by approximately $10 million. Once the “excess” is reduced to zero, the impact of adverse changes in assumptions is recorded as a charge to earnings as either a reduction in unamortized acquisition costs or an increase to contract reserves, net of any reinsurance recoverable.
Beginning in 2010, accounting standards require AFG to consolidate its investments in collateralized loan obligation (“CLO”) entities that it manages and owns an interest in (in the form of debt). See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities.” The effect of consolidating these entities is shown in the tables below (in millions). The “Before CLO Consolidation” columns include AFG’s investment and earnings in the CLOs on an unconsolidated basis.
Includes $6 million and $17 million in 2011 and 2010, respectively, in investment income representing the change in fair value of AFG’s CLO investments plus $19 million and $15 million in 2011 and 2010, respectively, in CLO management fees earned.
In addition, realized gains are shown net of noncontrolling interests of ($1 million) in 2011, ($6 million) in 2010 and ($4 million) in 2009.
The valuation allowance is net of $6 million in noncontrolling interest.
Net earnings attributable to shareholders and core net operating earnings decreased in 2010 compared to 2009 due primarily to lower underwriting profit and lower investment income in the property and casualty insurance operations, partially offset by improved results in the annuity and supplemental insurance operations. Net earnings attributable to shareholders also benefited from higher realized gains in 2010 than in 2009.
AFG’s combined ratio has been better than the industry average for twenty-four of the last twenty-six 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.
The Specialty insurance operations generated an underwriting profit of $308 million in 2010, $116 million lower than in 2009. In addition to soft market conditions, the reduced profit in 2010 compared to 2009 reflects a $35 million decrease in favorable prior year reserve development and a $31 million increase in catastrophe losses. Results for 2010 include 6.7 points of favorable reserve development compared to 8.5 points in 2009 and 1.9 points of catastrophe losses compared to .7 points in 2009.
Property and transportation gross and net written premiums increased in 2011 when compared to 2010 as a result of higher crop premiums resulting from higher spring agricultural commodity prices as well as additional premiums related to National Interstate’s acquisition of Vanliner in July 2010. This group reported an underwriting profit of $113 million, $27 million lower than in 2010. Lower underwriting profits in the crop, property and inland marine and transportation businesses were partially offset by lower catastrophe losses. Catastrophe losses for this group were $32 million (2.3 points) in 2011 compared to $39 million (3.3 points) in 2010.
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. AFG returned to historical levels of 50% cessions under its crop reinsurance agreement in 2010, compared to 90% in 2009, 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. Results for 2010 include 2.3 points of favorable reserve development compared to 5.7 points in 2009 and 3.3 points of catastrophe losses in 2010 compared to minimal catastrophe losses in 2009.
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.
Specialty financial net written premiums in 2011 were higher when compared to 2010 due primarily to the impact of a third quarter 2010 reinsurance transaction that involved the sale of unearned premiums related to the automotive lines of business. This group reported an underwriting profit of $61 million in 2011, $51 million lower than in 2010. Lower favorable reserve development, primarily in the run-off automobile residual value insurance (“RVI”) business, contributed to this decline.
Asbestos and Environmental Reserve Charges As previously discussed under “Uncertainties - Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG has established property and casualty insurance reserves for claims related to environmental exposures and asbestos claims. AFG also has recorded liabilities for various environmental and occupational injury and disease claims arising out of former railroad and manufacturing operations. Total charges recorded to increase reserves (net of reinsurance recoverable) for A&E exposures of AFG’s property and casualty group (included in loss and loss adjustment expenses) and its former railroad and manufacturing operations (included in other operating and general expenses) were as follows (in millions):
Favorable reserve development in the Property and transportation group in 2011, 2010 and 2009 reflects lower than expected loss frequency in crop products. The favorable reserve development in this group also reflects lower severity in auto liability products in 2010 and lower than expected loss frequency in ocean marine products and lower severity in farm and crop losses in 2009.
Statutory Annuity Premiums The following table summarizes AFG’s annuity sales (statutory, in millions).
The increase in annuity premiums in 2011 and 2010 is attributable to increased sales of indexed annuities in the non-403(b) single premium market and higher sales through banks.
Increased sales of indexed annuities reflects the industry trend towards indexed annuities and away from traditional fixed annuities, as well as AFG’s introduction of new indexed products and features. The increase in “Bank Annuities” premiums in 2011 reflects the addition of several new banks.
Life, Accident and Health Premiums and Benefits The following table summarizes AFG’s life, accident and health premiums and benefits as shown in the Consolidated Statement of Earnings (in millions):
Investment Income Over the past couple of years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG’s investment portfolio yield. The $50 million increase in investment income in 2011 compared to 2010 reflects higher average invested assets, primarily related to growth in the annuity business, partially offset by lower yields on fixed maturity investments. 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 includes $27 million in 2011, $66 million in 2010 and $130 million in 2009 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.
Realized gains on disposals include gains of approximately $76 million in 2011, $26 million in 2010 and $76 million in 2009 on sales of shares of Verisk Analytics, Inc.
Approximately $57 million, $79 million and $221 million of the impairment charges in 2011, 2010 and 2009, respectively, related to fixed maturity investments, primarily corporate bonds and MBS.
Realized Losses on Subsidiaries In the third quarter of 2010, AFG recorded an impairment charge of $22 million resulting from management’s decision to de-emphasize the sale of supplemental health insurance products through career agents, including the sale of a marketing subsidiary. Partially offsetting this loss was National Interstate’s $7 million gain on the acquisition of Vanliner in 2010. See Note I - “Goodwill and Other Intangibles” and Note B - “Acquisition.”
In the fourth quarters of 2011, 2010 and 2009, AFG conducted its detailed review of actual results and future assumptions underlying its annuity operations. As a result of the reviews, AFG recorded expense reductions of $10 million in 2011 and $3 million in 2010 and a charge of $5 million in 2009 to annuity benefits related to changes in these assumptions. Excluding these items, annuity benefits increased $73 million in 2011 compared to 2010 and $17 million in 2010 compared to 2009 reflecting growth in the annuity business partially offset by lower average crediting rates. The impact of changes in interest rates and stock market performance on the fair value of derivatives related to the indexed annuity business also impacted the 2011 and 2010 results.
As a result of the 2011 and 2010 reviews of actual results and future assumptions discussed above in “Annuity Benefits,” AFG recorded write-offs of DPAC of $10 million in 2011 and $28 million in 2010 due primarily to the impact of changes in assumptions related to future investment yields, surrenders 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 remained unchanged in 2011 compared to 2010 and increased $24 million in 2010 compared to 2009 reflecting additional amortization due to growth in the annuity business.
Interest Charges on Borrowed Money Interest expense increased $7 million (9%) in 2011 compared to 2010 and $11 million (16%) in 2010 compared to 2009 reflecting AFG’s issuance of $132 million of 7% Senior Notes in September 2010.
Income Taxes See Note L - “Income Taxes” to the financial statements for an analysis of items affecting AFG’s effective tax rate.
Marketform’s losses reflect adverse reserve development in its run-off Italian public hospital medical malpractice business. As discussed in Notes A and H to the financial statements, the losses of Managed Investment Entities in 2011 and 2010 represent CLO losses that ultimately inure to holders of CLO debt other than AFG.
See Note A - Recent Accounting Standards for a discussion of new accounting standards to be adopted by AFG in 2012.
AFG’s management, with participation of its Co-Chief Executive Officers and its principal financial officer, has evaluated AFG’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG’s Co-CEOs and principal financial officer concluded that these controls and procedures are effective. There have been no changes in AFG’s internal control over financial reporting during the fourth fiscal quarter of 2011 that materially affected, or are reasonably likely to materially affect, AFG’s internal control over financial reporting. There have been no significant changes in AFG’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
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, 2011, based on the criteria set forth in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.
In our opinion, American Financial Group, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Financial Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2012, expressed an unqualified opinion thereon.
Basis of Presentation The consolidated financial statements include the accounts of American Financial Group, Inc. (“AFG”) and its subsidiaries. Certain reclassifications have been made to prior years to conform to the current year’s presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to December 31, 2011, and prior to the filing of this Form 10-K, have been evaluated for potential recognition or disclosure herein.
In May 2011, the FASB issued ASU 2011-04 which clarifies the application of existing fair value measurement and amends certain disclosure requirements. The guidance is to be applied prospectively for reporting periods beginning after December 15, 2011. Early adoption is not permitted. The impact of adoption is not expected to be material to AFG’s results of operations or financial position.
In June 2011, the FASB issued ASU 2011-05, which eliminates the option to report other comprehensive income in the statement of changes in equity. Instead, the guidance requires that all other comprehensive income (non-owner changes in shareholders’ equity) be presented either in a single continuous statement of comprehensive income, which would contain net income and other comprehensive income sections and replace the statement of earnings, or in a separate statement of other comprehensive income immediately following the statement of earnings. AFG intends to present other comprehensive income in a separate statement. The guidance is effective January 1, 2012, with retrospective application required. The guidance relates solely to the presentation of other comprehensive income and therefore does not change the measurement of net income, other comprehensive income or earnings per share. Accordingly, the adoption of this guidance will have no impact on AFG’s results of operations or financial position.
New accounting guidance adopted by AFG on January 1, 2010, requires additional disclosures about transfers between levels in the hierarchy of fair value measurements. The guidance also clarifies existing disclosure requirements related to the level of disaggregation presented and inputs used in determining fair values. Additional detail relating to the roll-forward of Level 3 fair values was required in 2011.
Investments Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income (loss) in AFG’s Balance Sheet. Fixed maturity and equity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.
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 the other-than-temporary impairment is separated 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 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 recorded 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.”
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. As discussed above under “Recent Accounting Standards,” AFG’s current accounting for DPAC will change effective in 2012 and amounts included herein will be adjusted retrospectively.
DPAC related to annuities is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and variable annuity policy charges, less death and annuitization benefits in excess of account balances and estimated future policy administration expenses. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains (losses).
DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of accumulated other comprehensive income in AFG’s Balance Sheet.
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. 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.
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liability for EDAR is accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and variable annuity policy charges, and unearned revenues once they are recognized as income.
Statement of Cash Flows For cash flow purposes, “investing activities” are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. “Financing activities” include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, benefits and withdrawals are also reflected as financing activities. All other activities are considered “operating.” Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.
Vanliner Group, Inc. (“Vanliner”) In July 2010, National Interstate (“NATL”), a 52%-owned subsidiary of AFG, completed the acquisition of Vanliner, a market leader in providing insurance for the moving and storage industry for $114 million (including post-closing adjustments). The initial purchase price (funded primarily with cash on hand) was based on Vanliner’s estimated tangible book value at the date of closing and is subject to certain adjustments, including a four and one-half year balance sheet guarantee whereby both favorable and unfavorable developments related to the closing balance sheet inure to the seller, UniGroup, Inc. In accordance with accounting guidance, all assets acquired and liabilities assumed were recognized at their fair values as of the acquisition date. The purchase price allocation based on these fair values resulted in a gain on purchase of $7 million (included in realized gains on subsidiaries). Vanliner’s premiums associated with policies in force as of December 31, 2011 totaled approximately $93 million. Pro forma results of operations for AFG assuming the acquisition of Vanliner had taken place at the beginning of 2010 would not differ significantly from actual reported results.
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 the assets and operations of the managed investment entities.
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily excess and surplus, general liability, executive liability, umbrella and excess liability, customized programs for small to mid-sized businesses and California workers’ compensation, and (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions (including collateral and mortgage protection insurance), surety and fidelity products and trade credit insurance. AFG’s annuity and supplemental insurance business markets traditional fixed and indexed annuities and a variety of supplemental insurance products such as Medicare supplement.
Sales of property and casualty insurance outside of the United States represented 5% of AFG’s revenues in 2011, and 4% in both 2010 and 2009.
Includes holding company expenses, a second quarter 2011 special charge of $9 million to increase asbestos and environmental reserves and $24 million and $64 million in losses of managed investment entities attributable to noncontrolling interests for the years ended December 31, 2011 and 2010, respectively.
During 2011 and 2010, there were no significant transfers between Level 1 and Level 2. Approximately 4% of the total assets measured at fair value on December 31, 2011, were Level 3 assets. Approximately 95% of these assets were priced using non-binding broker quotes. The fair values of the liabilities of managed investment entities were determined using non-binding broker quotes, which were reviewed by AFG’s investment professionals.
Changes in balances of Level 3 financial assets and liabilities during 2011, 2010 and 2009 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.
The non-credit related portion of other-than-temporary impairment charges are included in other comprehensive income (loss). Such charges taken for residential MBS still owned at December 31, 2011 and 2010, respectively, were $227 million and $258 million.
At December 31, 2011, the gross unrealized losses on fixed maturities of $249 million relate to approximately 850 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 38% of the gross unrealized loss and 62% of the fair value.
Net Unrealized Gain on Marketable Securities In addition to adjusting equity securities and fixed maturity securities classified as “available for sale” to fair value, GAAP requires that deferred policy acquisition costs related to annuities and certain other balance sheet amounts be adjusted to the extent that unrealized gains and losses from securities would result in adjustments to those balances had the unrealized gains or losses actually been realized. The following table shows (in millions) the components of the net unrealized gain on securities that is included in Accumulated Other Comprehensive Income in AFG’s Balance Sheet.
Realized gains (losses) on securities include net losses of less than $1 million in 2011 and net gains of $50 million in 2010 and $157 million in 2009 from the mark-to-market of certain MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. Gross realized gains and losses (excluding impairment writedowns and mark-to-market of derivatives) on available for sale fixed maturity and equity security investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
As discussed under “Derivatives” in Note A, AFG uses derivatives in certain areas of its operations. AFG’s derivatives do not qualify for hedge accounting under GAAP; changes in the fair value of derivatives are included in earnings.
AFG has entered into $1 billion 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 $29 million to purchase these swaptions, which represents its maximum potential economic loss over the life of the contracts.
Deferred policy acquisition costs consisted of the following at December 31 (in millions):
During 2011, 2010 and 2009, AFG capitalized $20 million, $33 million and $32 million respectively, relating to sales inducements offered to annuity policyholders. Amortization of sales inducements was $21 million, $36 million and $20 million in these periods, respectively.
AFG is the investment manager and has investments ranging from 7.5% to 51.1% of the most subordinate debt tranche of seven collateralized loan obligation entities or “CLOs,” which are considered variable interest entities. Upon formation between 2004 and 2011, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG’s investments in the subordinate debt tranches of these entities receive residual income from the CLOs only after the CLOs pay operating expenses (including management fees to AFG), interest on and returns of capital to senior levels of debt securities. There are no contractual requirements for AFG to provide additional funding for these entities. AFG has not provided and does not intend to provide any financial support to these entities.
In February 2012, one of the AFG CLOs was substantially liquidated at the instruction of the holder of the majority of the most subordinate debt tranche, as permitted by the CLO indentures. AFG intends to begin marketing a new CLO with a similar structure to the existing CLOs, which is expected to initially have both assets and liabilities of approximately $410 million (similar in size to the liquidated CLO).
Included in other assets in AFG’s Balance Sheet is $41 million at December 31, 2011 and $49 million at December 31, 2010 in amortizable intangible assets related to property and casualty insurance acquisitions. These amounts are net of accumulated amortization of $47 million and $35 million, respectively. Amortization of these intangibles was $12 million in each of 2011 and 2010 and $22 million in 2009. Future amortization of intangibles (weighted average amortization period of 3 years) is estimated to be $14 million in 2012, $13 million in each of 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, 2011, scheduled principal payments on debt for the subsequent five years were as follows: 2012 - $34 million, 2013 - $20 million, 2014 - $2 million, 2015 - $14 million and 2016 - $45 million.
The total intrinsic value of options exercised during 2011, 2010 and 2009 was $23 million, $19 million and $11 million, respectively. During 2011, 2010 and 2009, AFG received $33 million, $27 million and $10 million, respectively, in cash from the exercise of stock options. The total tax benefit related to the exercises was $7 million, $6 million and $4 million, respectively.
AFG issued 188,302 shares of Common Stock (fair value of $33.99 per share) in the first quarter of 2011 under the Annual Co-CEO Equity Bonus Plan.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries for 2011, 2010 and 2009 was $22 million, $20 million and $13 million, respectively. Related tax benefits totaled $7 million in 2011, $6 million in 2010 and $3 million in 2009. At December 31, 2011, there was $23 million and $8 million of unrecognized compensation expense related to nonvested stock options and restricted stock awards, respectively. These amounts are expected to be recognized over a weighted average of 3.2 and 2.4 years, respectively.
Total earnings before income taxes include losses subject to tax in foreign jurisdictions of $31 million in 2011, $12 million in 2010 and $71 million in 2009.
AFG’s net deferred tax liability at December 31, 2011 and 2010, is included in other liabilities in AFG’s Balance Sheet.
“Foreign underwriting losses” in the table above include the net operating loss carryforward and other deferred tax assets related to the Marketform Lloyd’s insurance business, which resulted primarily from underwriting losses in its run-off Italian public hospital medical malpractice business that has not been written since 2008. During the fourth quarter of 2011, AFG recorded losses in other lines written by its Lloyd’s insurance business. Net operating losses can be carried forward indefinitely to offset future taxable income in the United Kingdom, and management expects these businesses to produce underwriting profits in future years. Nevertheless, because the Marketform Lloyd’s insurance business is in a cumulative loss position for the last three years, and the fourth quarter 2011 losses were not limited to the run-off Italian public hospital medical malpractice business, there is uncertainty concerning the realization of the deferred tax benefits associated with the losses. Accordingly, AFG recorded a $44 million valuation allowance against the deferred tax assets related to the Lloyd’s insurance business in 2011, approximately $34 million of which related to prior year losses. AFG will be able to reduce this valuation allowance in future periods when income is generated by the Lloyd’s business.
The changes in the deferred tax liabilities related to investment securities and deferred acquisition costs at year end 2011 compared to 2010 are due primarily to the increase in unrealized gains on fixed maturity securities.
AFG’s 2011, 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. In June 2010, the Court issued a final summary judgment in favor of AFG. The IRS has appealed the decision and the Sixth Circuit Court of Appeals is scheduled to hear the case in early March 2012. 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 $15 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.
Establishing property and casualty insurance reserves for claims related to environmental exposures, asbestos and other mass tort claims 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 range of reasonably possible losses cannot be estimated. In addition, 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”) and its subsidiaries, prior to its bankruptcy reorganization in 1978 and certain manufacturing operations disposed of by American Premier and GAFRI.
At December 31, 2011, GAFRI had a liability of approximately $8 million for environmental costs and certain other matters associated with the sales of its former manufacturing operations.
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 Verisk 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, 2011, were on deposit as required by regulatory authorities. At December 31, 2011, AFG and its subsidiaries had $173 million in undrawn letters of credit ($16 million of which was collateralized) supporting the underwriting capacity of its U.K.-based Lloyd’s insurer.
AFG has reinsured approximately $16 billion in face amount of life insurance at December 31, 2011 and $18 billion at December 31, 2010. Life written premiums ceded were $44 million, $49 million and $54 million for 2011, 2010 and 2009, respectively.
Variable Annuities At December 31, 2011, 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 $63 million, compared to $52 million at December 31, 2010. Death benefits paid in excess of the variable annuity account balances were less than $1 million in each of the last three years.
Losses and loss adjustment expenses included charges for possible losses on reinsurance recoverables of less than $1 million in 2011, 2010 and 2009. The aggregate allowance for losses on reinsurance recoverables amounted to approximately $26 million and $28 million at December 31, 2011 and 2010.
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, 2011, AFG and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling up to $25 million.
Benefit Plans AFG expensed approximately $26 million in 2011, $30 million in 2010 and $34 million in 2009 for its retirement and employee savings plans.
ITEM 10 Directors, Executive Officers of the Registrant and Corporate Governance
ITEM 12 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Grossed up for reinsurance recoverables of $2,238 and $2,249 at December 31, 2011 and 2010, respectively.
Amended and Restated Code of Regulations, filed as Exhibit 3 to AFG’s Form 8-K filed on December 11, 2008.
2011 Co-CEO Equity Bonus Plan, filed as Annex A to AFG’s Proxy statement filed on March 30, 2011.