AFG and its insurance subsidiaries lease the majority of their office and storage facilities in numerous cities throughout the United States, including the Company’s home offices in Cincinnati. National Interstate occupies approximately 85% 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 8.86, 7.16, 6.59, 9.14 and 11.03 for 2013, 2012, 2011, 2010 and 2009, 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.
The net unrealized gain on fixed maturities is a component of accumulated other comprehensive income and is shown net of related adjustments to deferred policy acquisition costs and certain liabilities in the annuity, long-term care and life businesses.
At December 31, 2013, AFG (parent) held approximately $576 million in cash and securities and had $500 million available under a bank line of credit expiring in December 2016. See “Liquidity and Capital Resources - Parent and Subsidiary Liquidity” for a discussion of the planned acquisition of Summit Holdings Southeast, Inc.
Net earnings attributable to AFG’s shareholders were $158 million ($1.73 per share, diluted) for the fourth quarter of 2013 compared to $50 million ($0.54 per share) in the fourth quarter of 2012, reflecting significantly higher profits in the annuity segment and improved underwriting results in the Specialty property and casualty businesses. The fourth quarter 2012 results include a $99 million ($1.08 per share) after-tax charge to write off deferred policy acquisition costs and strengthen reserves in AFG’s closed block of long-term care insurance. This non-core charge was partially offset by $39 million ($0.43 per share) of tax benefits related to the settlement of open tax years following the favorable resolution of certain tax litigation.
AFG’s ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.15 for the year ended December 31, 2013. Excluding annuity benefits, this ratio was 8.86. 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.
Net Cash Provided by Operating Activities AFG's property and casualty insurance operations typically produce positive net operating cash flows as premiums collected and investment income exceed policy acquisition costs, claims payments and operating expenses. AFG's net cash provided by operating activities is impacted by the level and timing of property and casualty premiums, claim and expense payments and recoveries from reinsurers. AFG's annuity operations typically produce positive net operating cash flows as investment income exceeds acquisition costs and operating expenses. Interest credited on annuity policyholder funds is a non-cash increase in AFG's annuity benefits accumulated liability and annuity premiums, benefits and withdrawals are considered financing activities due to the deposit-type nature of annuities. Net cash provided by operating activities was $760 million, $817 million and $667 million in 2013, 2012 and 2011, respectively. The $57 million decrease in net cash provided by operating activities in 2013 compared to 2012 and the $150 million increase in net cash provided by operating activities in 2012 compared to 2011 is due primarily to the timing of claims payments and reinsurance recoveries in the property and casualty insurance operations.
Net cash used in investing activities was $1.43 billion in 2012 compared to $2.44 billion in 2011, a decrease of $1.01 billion. The $519 million decrease in net cash flows from annuity policyholders in 2012 as compared to 2011 (discussed below under net cash provided by financing activities) reduced the amount of cash available for investment in 2012 compared to 2011. In addition, cash on hand in the annuity and run-off long-term care and life segments increased by $190 million during 2012 from year-end 2011 as net cash flows from annuity policyholders outpaced the investment of the funds received. Net investment activity in the managed investment entities was an $8 million source of cash in 2012 compared to a $172 million use of cash in 2011.
Net cash provided by financing activities was $989 million in 2012 compared to $2.00 billion in 2011, a decrease of $1.01 billion. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $1.53 billion in 2012 compared to $2.04 billion in 2011, resulting in a $519 million decrease in net cash provided by financing activities. During 2012, AFG repurchased 10.9 million shares of its Common Stock for $415 million compared to 9.3 million shares repurchased in 2011 for $315 million, which accounted for $100 million of the decline in net cash provided by financing activities. The retirement of managed investment entity liabilities exceed issuances by $49 million in 2012 while issuances of managed investment entity liabilities exceed retirements by $328 million in 2011, accounting for $377 million of the decrease in net cash provided by financing activities in 2012 compared to 2011.
In January 2014, AFG announced that it had reached a definitive agreement to acquire Summit Holdings Southeast, Inc., from Liberty Mutual for $250 million. Including a planned capital contribution at closing, AFG’s total capital investment in the Summit business will be approximately $400 million.
During 2013, AFG repurchased 1.4 million shares of its Common Stock for $70 million. In December 2013, AFG paid a special cash dividend of $1.00 per share of AFG Common Stock totaling approximately $89 million.
In 2012, AFG issued $125 million of 5-3/4% Senior Notes due 2042 and $230 million of 6-3/8% Senior Notes due 2042 and used the proceeds to redeem outstanding higher rate debt. During 2012, AFG repurchased 10.9 million shares of its Common Stock for $415 million. In December 2012, AFG paid a special cash dividend of $0.25 per share of AFG Common Stock totaling approximately $23 million. During 2011, AFG repurchased 9.3 million shares of its Common Stock for $315 million.
Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions, which provides the annuity operations with a substantial additional source of liquidity. These advances further the FHLB’s mission of improving access to housing by increasing liquidity in the residential mortgage-backed securities market. The FHLB advanced GALIC $240 million in the fourth quarter of 2011 and $200 million in the second quarter of 2013 (included in annuity benefits accumulated). The interest rates on the advances range from 0.02% to 0.23% over LIBOR (average rate of 0.32% at December 31, 2013). While these advances must be repaid between 2016 and 2018, GALIC has the option to prepay all or a portion of the advances. 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.
In November 2012, NATL replaced its $50 million bank credit facility with a five-year, $100 million unsecured credit agreement. There was $12 million borrowed under this agreement at December 31, 2013, bearing interest at 1.11% (three-month LIBOR plus 0.875%). The maximum outstanding balance in 2013 was $12 million.
For statutory accounting purposes, equity securities of non-affiliates are generally carried at fair value. At December 31, 2013, AFG’s insurance companies owned publicly traded equity securities with a fair value of $1.14 billion. In addition, GAI’s investment in NATL common stock had a fair value of $235 million and a statutory carrying value of $186 million at December 31, 2013. Decreases in market prices could adversely affect the insurance group’s capital, potentially impacting the amount of dividends available or necessitating a capital contribution. Conversely, increases in market prices could have a favorable impact on the group’s dividend-paying capability.
Condensed Parent Only Cash Flows AFG's parent holding company only condensed cash flows from operating, investing and financing activities are shown below (in millions):
As a result of discussions with the IRS Appeals Office during the third quarter of 2013, AFG believes that its liability for uncertain tax positions may be reduced by up to the full $19 million balance within the coming year due to a settlement with the IRS. The majority of the reduction in this liability would result in offsetting adjustments to AFG’s deferred tax liability.
AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2013.
AFG’s investment portfolio at December 31, 2013, contained $26.46 billion in “Fixed maturities” classified as available for sale and $1.18 billion in “Equity securities,” all carried at fair value with unrealized gains and losses included in a separate component of shareholders’ equity on an after-tax basis. In addition, $305 million in fixed maturities were classified as trading with changes in unrealized holding gains or losses included in investment income.
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, 2013, the average life of AFG’s fixed maturities was about 6-1/2 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. In addition, AFG communicates directly with pricing services regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the services to value specific securities.
Approximately 86% of the fixed maturities held by AFG at December 31, 2013, were rated “investment grade” (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and non-investment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return.
Based on its analysis of the factors listed above, management believes AFG will recover its cost basis in the securities with unrealized losses and that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, 2013. Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers’ creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG’s ability or intent change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG’s investment portfolio could have a significant adverse effect on AFG’s liquidity. For information on AFG’s realized gains (losses) on securities, including charges for “other-than-temporary” impairment, see “Results of Operations - Consolidated Realized Gains (Losses) on Securities.”
The estimates of liabilities for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon: (i) the accumulation of case estimates for losses reported prior to the close of the accounting periods on direct business written (“case reserves”); (ii) estimates received from ceding reinsurers and insurance pools and associations; (iii) estimates of claims incurred but not reported or “IBNR” (including possible development on known claims); (iv) estimates (based on experience) of expense for investigating and adjusting claims; and (v) the current state of law and coverage litigation.
In determining management’s best estimate of the ultimate liability, management (including Company actuaries) considers items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, the nature and maturity of lines of insurance, general economic trends and the legal environment. In addition, historical trends adjusted for changes in underwriting standards, policy provisions, product mix and other factors are analyzed using actuarial reserve development techniques. Weighing all of the factors, the management team determines a single or “point” estimate that it records as its best estimate of the ultimate liability. Ranges of loss reserves are not developed by Company actuaries. This reserve analysis and review is completed each quarter and for almost every line of business.
The period of time from the occurrence of a loss through the settlement of the liability is referred to as the “tail”. Generally, the same actuarial methods are considered for both short-tail and long-tail lines of business because most of them work properly for both. The methods are designed to incorporate the effects of the differing length of time to settle particular claims. For short-tail
Within each line, results of individual methods are reviewed, supplementary statistical information is analyzed, and all data from underwriting, operating and claim management are considered in deriving management’s best estimate of the ultimate liability. This estimate may be the result of one method, a weighted average of several methods, or a judgmental selection as the management team determines is appropriate.
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 7, the original estimates of AFG’s liability for losses and loss adjustment expenses, net of reinsurance and excluding the effect of special charges for asbestos and environmental exposures, over the past 10 years have developed through December 31, 2013, to be deficient (for one year) by
8.8% and redundant (for nine years) by as much as 18.6%. This development illustrates the historical impact caused by variability in factors considered in estimating insurance reserves.
The judgments and uncertainties surrounding management’s reserve estimation process and the potential for reasonably possible variability in management’s most recent reserve estimates may also be viewed by looking at how recent historical estimates of reserves have developed. The following table shows (dollars in millions) what the impact on AFG’s net earnings would be on the more significant lines of business if the December 31, 2013, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
AFG recorded favorable reserve development of $11 million in 2013, $43 million in 2012 and $50 million in 2011 related to its other liability - occurrence coverage where both the frequency and severity of claims were lower than previously projected.
The general state of the economy and the variability of the stock price of the insured can affect the frequency and severity of shareholder class action suits and other situations that trigger coverage under D&O policies. From 2008 to 2010, economic
AFG recorded adverse prior year reserve development of $37 million in 2013 and $1 million in 2012 for this line of business as claim severity was significantly higher than expected, particularly from accident years 2010 to 2012. AFG recorded favorable prior year loss development of $8 million in 2011 as claim severity was lower than in prior assumptions.
Outside of its property and casualty operations, AFG has reinsurance recoverables totaling $953 million, including $586 million from Hannover Life Reassurance Company of America (rated A+ by A.M. Best) and $200 million from Loyal American Life Insurance Company, a subsidiary of Cigna (rated A- by A.M. Best). This reinsurance is related primarily to the reinsurance of certain benefits in AFG’s run-off long-term care and life operations and the August 2012 sale of its Medicare supplement and critical illness businesses.
As a result of the comprehensive external study completed in 2011, AFG recorded a $50 million pretax special charge to increase its property and casualty group’s asbestos reserves by $28 million (net of reinsurance) and its environmental reserves by $22 million (net of reinsurance). The property and casualty group’s asbestos reserves increase related primarily to exposures on business assumed from other insurers resulting from an increase in anticipated aggregate exposures in several large settlements involving several insurers in which AFG has a small proportional share. Asbestos reserves related to the property and casualty group’s direct 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. 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.
loss recognition charges were recorded and the assumptions used to establish reserves for future policy benefits from the 2012 loss recognition charge continue to be used.
Although management believes that its loss recognition assumptions at December 31, 2013, are reasonable, actual results will depend on how well future experience conforms to these assumptions, including the level and type of claim activity, persistency, expected rate increase approvals, and reinvestment rates. The relationship among these assumptions is complex, with deviations in one assumption often influencing the outcome of others. External factors, including, but not limited to changes in the regulatory and judicial environment, along with medical advancements and innovation in long-term care delivery systems, could have a material impact on the ultimate performance of this closed block of business. The loss recognition charge recorded in 2012 did not include any margin for adverse deviation in the reserve assumptions (in accordance with accounting guidance).
The following table (in millions) illustrates the impact on the loss recognition margin of adverse changes in key loss recognition assumptions. Once the loss recognition margin (approximately $64 million at December 31, 2013) is reduced to zero, the impact of adverse changes in assumptions, unless offset by other favorable assumption changes, would be recorded as an increase in long-term care reserves through a charge to earnings. The result of each assumption change represents a reduction in the loss recognition margin that would result from using the more adverse assumption. Each item reflects a change to a single assumption without changes to other assumptions. For example, assuming increased claim payments did not change the assumption on future rate increases and persistency, nor did it change projected investment yields resulting from cash flow differences. These amounts are valid for a point in time, and will change in future periods as the in-force block ages, and as actual performance deviates from the assumptions used at December 31, 2013.
Contingencies related to Subsidiaries’ Former Operations The A&E studies and reviews discussed above encompassed reserves for various environmental and occupational injury and disease claims and other contingencies arising out of the railroad operations disposed of by American Premier’s predecessor and certain manufacturing operations disposed of by American Premier and its subsidiaries and by Great American Financial Resources, Inc. Charges resulting from the A&E studies and review were $22 million in 2013, and less than $10 million in 2012 and 2011. For a discussion of the $22 million charge recorded for those operations in 2013, see “Holding Company, Other and Unallocated - Results of Operations.” In the third quarter of 2012, AFG recorded a pretax charge of $15 million for an adverse judgment received in a long-standing labor dispute involving American Premier’s former railroad employees, the likelihood of which was previously considered to be remote. Liabilities for claims and contingencies arising from these former railroad and manufacturing operations totaled $96 million at December 31, 2013. For a discussion of the uncertainties in determining the ultimate liability, see Note M - “Contingencies” to the financial statements.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $6 million in each period in distributions recorded as interest expense by the CLOs.
Includes $6 million in net investment income representing the change in fair value of AFG’s CLO investments plus $19 million in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $10 million in distributions recorded as interest expense by the CLOs.
In addition, other realized gains are shown net of noncontrolling interests as follows (in millions):
(b) The valuation allowance is net of $6 million in noncontrolling interest.
RESULTS OF OPERATIONS - QUARTERS ENDED DECEMBER 31, 2013 AND 2012
Segmented Statement of Earnings AFG manages its business as five segments: (i) Property and casualty insurance (“P&C”), (ii) Annuity, (iii) Run-off long-term care and life, (iv) Medicare supplement and critical illness (sold in August 2012) and (v) Other, which includes holding company costs and operations attributable to the noncontrolling interests of the managed investment entities (“MIEs”).
AFG's net earnings attributable to shareholders, determined in accordance with GAAP, include certain items that may not be indicative of its ongoing core operations. The following tables for the quarters ended December 31, 2013 and 2012 identify such items by segment and reconcile net earnings attributable to shareholders to core net operating earnings, a non-GAAP financial measure that AFG believes is a useful tool for investors and analysts in analyzing ongoing operating trends (in millions):
(89%). The increase in pretax earnings reflects significantly higher underwriting profit across each of AFG’s property and casualty insurance sub-segments.
Gross written premiums ("GWP") for AFG's property and casualty insurance segment were $1.07 billion for the fourth quarter of 2013 compared to $965 million for the fourth quarter of 2012, an increase of $106 million (11%). Detail of AFG's property and casualty gross written premiums is shown below (dollars in millions):
Reinsurance premiums ceded ("Ceded") for AFG's property and casualty insurance segment were 23% of gross written premiums for the fourth quarter of 2013 compared to 27% for the fourth quarter of 2012, a decrease of 4 percentage points. Detail of AFG's property and casualty reinsurance premiums ceded is shown below (dollars in millions):
The $106 million increase in gross written premiums for the fourth quarter of 2013 compared to the fourth quarter of 2012 is due primarily to higher premiums in the Specialty casualty sub-segment. Overall average renewal rates increased approximately 3% in the fourth quarter of 2013.
Specialty casualty Gross written premiums increased $75 million (20%) for the fourth quarter of 2013 compared to the fourth quarter of 2012 as a result of increased premiums in nearly all businesses in this group, especially in the workers’ compensation, excess and surplus lines and agency captive insurance businesses. New business opportunities, increased exposures from higher payroll on existing accounts, and sustained pricing increases have contributed to increased premiums in the workers’ compensation businesses. Strong premium growth in the excess and surplus operations is the result of broadening opportunities to write business coupled with the benefit from rate increases over multiple quarters. Average renewal rates were up approximately 3% for this group in the fourth quarter of 2013. Reinsurance premiums ceded as a percentage of gross written premiums declined 3 percentage points for the fourth quarter of 2013 compared to the fourth quarter of 2012 reflecting higher retention of gross premiums in certain operations and changes in the mix of business.
Performance measures such as the combined ratio are often used by property and casualty insurers to help users of their financial statements better understand the company's performance. The combined ratio is the sum of the loss and loss adjustment expenses (“LAE”) and underwriting expense ratios. These ratios are calculated by dividing each of the respective expenses by net earned premiums. The table below (dollars in millions) details the components of the combined ratio for AFG's property and casualty segment:
The Specialty property and casualty insurance operations generated an underwriting profit of $75 million in the fourth quarter of 2013 compared to $15 million in the fourth quarter of 2012, an increase of $60 million (400%). The higher profit in the 2013 quarter reflects higher underwriting profits across each of the property and casualty insurance sub-segments. Catastrophe losses were less than $1 million (0.1 points on the combined ratio), compared to $33 million, including $9 million of reinstatement premiums (3.2 points) in the fourth quarter of 2012.
Property and transportation This group reported an underwriting profit of $17 million for the fourth quarter of 2013, compared to an underwriting loss of $14 million for the fourth quarter of 2012, reflecting higher profitability in the crop insurance and property and inland marine operations. Although the 22% decline in corn pricing at harvest time as compared to 2013 spring discovery prices adversely impacted 2013 results, profitability in the crop insurance operations improved over the 2012 quarter, which was adversely impacted by the effects of the Midwest drought. The improved underwriting profitability in the property and inland marine operations reflects primarily the 2012 fourth quarter losses from Superstorm Sandy. Catastrophe losses were minimal for this group during the fourth quarter of 2013, compared to $28 million, including $8 million of reinstatement premiums (5.1 points) in the fourth quarter of 2012.
Specialty casualty Underwriting profit was $32 million for the fourth quarter of 2013 compared to $8 million in the fourth quarter of 2012, an increase of $24 million (300%). This increase was due primarily to higher profitability in the workers’ compensation businesses and a $5 million improvement in prior year reserve development.
Property and transportation Net adverse reserve development of $3 million in the fourth quarter of 2013 reflects higher than expected claim severity in commercial auto liability business written in the transportation businesses, partially offset by lower than expected claim severity in the ocean marine business. Net favorable reserve development of $2 million in the fourth quarter of 2012 reflects lower severity in the inland marine and ocean marine businesses partially offset by an increase in severity of commercial auto liability insurance claims in the transportation businesses.
AFG generally seeks to reduce its exposure to catastrophes through individual risk selection, including minimizing coastal and known fault-line exposures, and the purchase of reinsurance. Based on data available at December 31, 2013, AFG's exposure to a catastrophic earthquake or windstorm that industry models indicate could occur once in every 500 years (a “500-year event”) is expected to be less than 2.5% of AFG's shareholders' equity.
The overall increase of 3.8% in AFG's expense ratio for the fourth quarter of 2013 as compared to the fourth quarter of 2012, as well as the fluctuations in AFG's sub-components, reflects the timing of the determination of reimbursements for administrative and operating expenses under the Federal crop insurance program, higher profitability-based commissions paid to agents/brokers and lower profitability-based commissions received from reinsurers, partially offset by the impact of higher premiums on the ratio.
Net investment income in AFG's property and casualty operations was $67 million for the fourth quarter of 2013 compared to $69 million in the fourth quarter of 2012, a decrease of $2 million (3%). In recent years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG's investment portfolio yield. The average invested assets and overall earned yield on investments held by AFG's property and casualty operations are provided below (dollars in millions):
Other income and expenses, net for AFG's property and casualty operations was a net expense of $6 million for the fourth quarter of 2013 compared to $7 million for the fourth quarter of 2012, a decrease of $1 million (14%). The table below details the items included in other income and expenses, net for AFG's property and casualty operations (in millions):
AFG’s annuity operations contributed $92 million in pretax earnings in the fourth quarter of 2013 compared to $68 million in the fourth quarter of 2012, an increase of $24 million (35%). Higher pretax earnings were primarily a result of a growing asset base, partially offset by the runoff of higher yielding investments. AFG’s average fixed annuity investments (at amortized cost) were 17% higher for the fourth quarter of 2013 as compared to the fourth quarter of 2012. In addition, results for the fourth quarter of 2013 reflect the positive impact of higher interest rates and strong stock market performance on the fixed-indexed annuity (“FIA”) business. AFG’s periodic detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations resulted in a charge of $2 million in the fourth quarter of 2013 compared to a $14 million charge in the fourth quarter of 2012.
The table below (dollars in millions) details the components of these spreads for AFG's fixed annuity operations (including fixed-indexed annuities):
Net investment income for the fourth quarter of 2013 was $270 million compared to $254 million for the fourth quarter of 2012, an increase of $16 million (6%). This increase reflects primarily the growth in AFG’s annuity business. The overall yield earned on investments in AFG's annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), declined by 0.53 percentage points in the fourth quarter of 2013 compared to the fourth quarter of 2012. This decline in net investment yield reflects (i) the investment of new premium dollars in the recent low interest rate environment, (ii) the impact of the maturity and redemption of higher yielding investments and (iii) the impact of higher non-recurring investment income in the fourth quarter of 2012 as compared to the same period in 2013.
AFG's net interest spread decreased 0.32 percentage points in the fourth quarter of 2013 compared to the same period in 2012 due primarily to the run-off of higher yielding investments. In addition, the 2012 quarter included higher non-recurring investment income as compared to the 2013 quarter. Due to the continued run-off of higher yielding investments, AFG expects its net interest spread to narrow in the future.
Annuity policy charges and other miscellaneous income, which consist primarily of surrender charges, was $14 million in the fourth quarter of 2013 compared to $8 million in the fourth quarter of 2012, an increase of $6 million (75%). The increase reflects $4 million in income from the sale of real estate recorded in the 2013 quarter.
Excluding the impact of unlocking charges, AFG's amortization of DPAC and commission expenses as a percentage of average fixed annuity benefits accumulated was 0.75% for the fourth quarter of 2013 and 0.85% for the fourth quarter of 2012 and has generally ranged between 0.70% and 0.80%. Variances from the general range relate primarily to the impact of (i) material changes in interest rates or the stock market on AFG’s fixed-indexed annuity business, and (ii) differences in actual experience from actuarially projected estimates and assumptions.
Annuity other expenses for the fourth quarter of 2013 were $27 million compared to $17 million for the fourth quarter of 2012, an increase of $10 million (59%). Annuity other expenses represent primarily general and administrative expenses, as well as selling and issuance expenses that are not deferred. As a percentage of average fixed annuity benefits accumulated, these expenses increased 0.14 percentage points for the fourth quarter of 2013 as compared to the fourth quarter of 2012. The fourth quarter of 2013 includes a $7 million charge to write off certain previously capitalized project costs.
See “Annuity Unlocking” below for a discussion of the impact that the periodic review of actuarial assumptions had on annuity and supplemental insurance acquisition expenses. Unanticipated spread compression, decreases in the stock market, adverse mortality experience, and higher than expected lapse rates could lead to future write-offs of DPAC or the present value of future profits on business in force of companies acquired (“PVFP”).
AFG’s net spread earned on fixed annuities increased 0.18 percentage points in the fourth quarter of 2013 compared to the same period in 2012 as the 0.32 percentage points decrease in AFG’s net interest spread and higher other expenses in the 2013 fourth quarter were more than offset by (i) the impact of lower amortization of deferred acquisition costs during the fourth quarter of 2013 compared to the fourth quarter of 2012, (ii) a larger favorable impact from the change in fair value of FIA-related derivatives, and (iii) a higher unlocking charge in the fourth quarter of 2012 compared to the fourth quarter of 2013. AFG expects its net spread earned on fixed annuities to be closer to 1.35% to 1.40% in 2014 as compared to the 1.67% earned in the fourth quarter of 2013.
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, excess benefits expected to be paid on future deaths and annuitizations (“EDAR”) and guaranteed withdrawal benefits. Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati. The following table is a progression of AFG's annuity benefits accumulated liability for the three months ended December 31, 2013 and 2012 (in millions):
AFG's annuity operations generated statutory premiums of $1.38 billion in the fourth quarter of 2013 compared to $560 million in the fourth quarter of 2012, an increase of $821 million (147%). The following table summarizes AFG's annuity sales (dollars in millions):
that AFG has benefited from its strong ratings, and that the entire annuity industry has benefited from the rise in interest rates in 2013, particularly in the financial institutions market.
The 2012 net charge was due primarily to the impact of changes in assumptions related to future investment yields partially offset by changes in assumptions related to crediting rates, surrenders and annuitization and death benefits. For the 2012 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 3.50% in 2013, grading up ratably to an ultimate net reinvestment rate of 5.27% in 2022 and beyond.
(*) Net investment income (as a % of investments) of 5.21% and 5.74% for the three months ended December 31, 2013 and 2012, respectively, multiplied by the difference between average fixed annuity investments (at amortized cost) and average fixed annuity benefits accumulated in each period.
Run-off Long-Term Care and Life Segment - Results of Operations As previously discussed under “Uncertainties - Run-off Long-term Care Insurance,” AFG recorded a $153 million loss recognition charge in the fourth quarter of 2012 to write off deferred policy acquisition costs and strengthen reserves in its closed block of long-term care insurance. The charge was due primarily to lower projected future investment rates resulting from the continued low interest rate environment, as well as changes in claims, expense and persistency assumptions. Excluding this charge, pretax core operating losses for the run-off long-term care and life segment were $3 million in the fourth quarter of 2013 compared to $12 million in the fourth quarter of 2012, an improvement of $9 million (75%). This improvement reflects the impact of higher long-term care benefits expense in the 2012 quarter due to charges to increase reserves related primarily to existing open claims and certain policyholder benefit features. The following table details AFG's GAAP and core losses before income taxes from its run-off long-term care and life operations for the three months ended December 31, 2013 and 2012 (dollars in millions):
Medicare Supplement and Critical Illness Segment - Results of Operations AFG's Medicare supplement and critical illness segment for the fourth quarter of 2012 reflects a $15 million GAAP pretax (non-core) post-closing adjustment to the gain on the August 2012 sale of these businesses. See Note B - “Acquisitions and Sales of Subsidiaries” to the financial statements.
Holding Company, Other and Unallocated - Results of Operations AFG's pretax loss outside of its insurance operations totaled $46 million for the fourth quarter of 2013 compared to $42 million for the fourth quarter of 2012, an increase of $4 million (10%).
The following table details AFG's loss before income taxes from operations outside of its insurance operations for three months ended December 31, 2013 and 2012 (dollars in millions):
Net investment income for the fourth quarter of 2013 was $2 million compared to $1 million in the fourth quarter of 2012. The parent company holds a small portfolio of securities that are classified as “trading” and marked-to-market through investment income. These trading securities increased in value by approximately $2 million in the fourth quarter of 2013 compared to less than $1 million in the 2012 period.
AFG’s holding companies and other operations outside of its insurance operations, recorded other expenses of $34 million in the fourth quarter of 2013 compared to $30 million in the fourth quarter of 2012, an increase of $4 million (13%). The $4 million increase reflects higher expense associated with employee benefit plans that are tied to stock market performance and slightly higher stock-based compensation expense.
As discussed in Note A - “Accounting Policies,” and Note H - “Managed Investment Entities” to the financial statements, the losses of Managed Investment Entities represent CLO losses that ultimately inure to holders of the CLO debt.
RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 2013, 2012 AND 2011
Segmented Statement of Earnings AFG reports its business as five segments: (i) Property and casualty insurance (“P&C”), (ii) Annuity, (iii) Run-off long-term care and life, (iv) Medicare supplement and critical illness (sold in August 2012) and (v) Other, which includes holding company costs and operations attributable to the noncontrolling interests of the managed investment entities (“MIEs”).
AFG's net earnings attributable to shareholders, determined in accordance with GAAP, include certain items that may not be indicative of its ongoing core operations. The following tables for the years ended December 31, 2013, 2012 and 2011 identify such items by segment and reconcile net earnings attributable to shareholders to core net operating earnings, a non-GAAP financial measure that AFG believes is a useful tool for investors and analysts in analyzing ongoing operating trends (in millions):
Property and Casualty Insurance Segment - Results of Operations AFG's property and casualty insurance operations contributed $375 million in GAAP pretax earnings in 2013 compared to $322 million in 2012, an increase of $53 million (16%). Property and casualty core pretax earnings were $429 million for the 2013 compared to $353 million for the 2012, an increase of $76 million (22%). Higher underwriting profits in the Specialty casualty group and Specialty financial group were partially offset by a decline in the underwriting profits in the Property and transportation group during the first half of the year.
in the Property and transportation group due primarily to the effects of the Midwest drought on the crop operations and losses from Superstorm Sandy in 2012.
AFG reports the underwriting performance of its Specialty insurance business in the following sub-components: (i) Property and transportation, (ii) Specialty casualty and (iii) Specialty financial.
The $215 million increase in gross written premiums in 2012 compared to 2011 is due primarily to higher premiums in the Specialty casualty group, particularly in the worker’s compensation and excess and surplus businesses. Overall average renewal rates increased approximately 3% in 2012.
Property and transportation Gross written premiums increased $121 million in 2013 compared to 2012 due primarily to higher crop premiums and growth in the transportation businesses. Average renewal rates were up approximately 5% in 2013. Reinsurance premiums ceded as a percentage of gross written premiums were 35% in both 2013 and 2012. Higher cessions of multi-peril crop business and higher cost of reinsurance on the property business were offset by higher retention of gross premiums in certain operations and lower reinsurance reinstatement premiums due to the impact of large reinsured losses in 2012 (related to Superstorm Sandy).
Gross written premiums decreased $2 million in 2012 compared to 2011 as the impact of lower spring agricultural commodity prices for corn and soybeans, which had the effect of reducing crop insurance premiums, was partially offset by growth in the transportation businesses. Average renewal rates were up approximately 3% in 2012. Reinsurance premiums ceded as a percentage of gross written premiums declined 2 percentage points in 2012 compared to 2011 reflecting lower cessions of multi-peril crop business.
Specialty casualty Gross written premiums increased $306 million (21%) in 2013 compared to 2012 as a result of increased premiums in nearly all businesses in this group, particularly in the workers’ compensation and excess and surplus lines. New business opportunities, increased exposures from higher payroll on existing accounts, strong retentions and higher renewal pricing have contributed to increased premiums in the workers’ compensation businesses. In addition, new business opportunities and general market hardening have generated increased premiums in several of the excess and surplus lines businesses. Average renewal rates were up approximately 5% for this group in 2013. Reinsurance premiums ceded as a percentage of gross written premiums declined 1 percentage point for 2013 compared to 2012 reflecting changes in the mix of business and higher retention of gross premiums in certain operations.
Gross written premiums increased $182 million (14%) in 2012 compared to 2011 as a result of business opportunities in the excess and surplus operations, growth in the workers’ compensation and agency captive insurance businesses and market hardening in many of the other Specialty casualty operations. Average renewal rates were up approximately 4% for this group in 2012. Reinsurance premiums ceded as a percentage of gross written premiums was 33% for both 2012 and 2011.
Specialty financial Gross written premiums increased $56 million (10%) in 2013 compared to 2012. This increase was due primarily to premium growth related to real estate owned and collateral products for financial institutions and growth in the surety operations. Gross written premiums in 2013 include $22 million in risk fees from AFG’s warranty operations. Prior to 2013, fees in the warranty operations were included in other income. Average renewal rates for this group remained relatively unchanged in 2013. Reinsurance premiums ceded as a percentage of gross written premiums declined 5 percentage points in 2013 compared to 2012 reflecting the sale of the service contract business, which was 100% reinsured and lower reinsurance reinstatement premiums reflecting the impact of large reinsured losses in 2012 in the surety and foreign credit businesses.
Gross written premiums increased 37 million (7%) in 2012 compared to 2011 due to higher premiums in the financial institutions business, as well as growth in a service contract business. All of the premiums in the service contract business were ceded under reinsurance agreements. Average renewal rates for this group remained relatively unchanged in 2012. Reinsurance premiums ceded as a percentage of gross written premiums increased 2% percentage points in 2012 compared to 2011 due to the increase in service contract business, which was 100% reinsured.
The table below details the components of the combined ratio for AFG's property and casualty segment for 2013, 2012 and 2011 (dollars in millions):
Specialty casualty Underwriting profit was $102 million in 2013 compared to $53 million in 2012, an increase of $49 million (92%), reflecting improved results in the workers’ compensation business as well as increased favorable reserve development in other operations.
Specialty financial Underwriting profit was $67 million in 2013 compared to $44 million in 2012, an increase of $23 million (52%). The improved results were due primarily to higher underwriting profits in the financial institutions business, primarily from foreclosed and real estate owned property and collateral insurance and the absence of losses from a run-off book of automotive-related business that were included in the results for 2012.
AFG's overall loss and LAE ratio was 63.7%, 65.8% and 63.2% in 2013, 2012 and 2011, respectively. The components of AFG's property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
AFG's Specialty property and casualty operations recorded net favorable reserve development related to prior accident years of $75 million in 2013 compared to $74 million in 2012, an increase of $1 million (1%).
Property and transportation Net favorable reserve development of $1 million in 2013 reflects lower than expected claims handling expense in the crop business and lower claim severity in the property inland marine and ocean marine businesses, substantially offset by adverse development from higher than expected claim severity in commercial auto liability business written in the transportation businesses. Net favorable reserve development of $16 million in 2012 reflects lower than expected loss frequency in crop products, partially offset by higher than expected claim severity in the property and inland marine and commercial auto liability in the transportation businesses. Net favorable reserve development of $26 million in 2011 reflects lower than expected loss frequency in crop products.
Specialty casualty Net favorable reserve development of $40 million in 2013 reflects lower than expected claim severity in directors and officers liability insurance and lower than expected claim severity and frequency in excess liability business, partially offset by adverse development from higher than expected claim frequency and severity in products liability claims and higher than expected claim severity in contractor claims. Net favorable reserve development of $18 million in 2012 is due primarily to the release of loss reserves on claims related to the use of Chinese drywall in residential construction as a result of judicial decisions and class action settlements in 2012 that clarified the liability of insured homebuilders. Favorable reserve development in 2012 also reflects lower claim severity in executive liability products partially offset by higher claim severity on losses in a run-off book of U.S.-based program (motel/hotel, restaurants, taverns and recreational) business and adverse reserve development on run-off Italian public hospital medical malpractice liability products written by Marketform. Favorable reserve development of $71 million in 2011 is due primarily to lower than expected claim severity in directors and officers liability, excess and surplus lines and the run-off legal professional liability business, partially offset by adverse development due to higher frequency and severity on run-off Italian public hospital medical malpractice liability products and a block of program business.
Other specialty In addition to the development discussed above, total specialty net favorable reserve development reflects amortization of the deferred gain on the retroactive insurance transaction entered into in connection with the sale of a business in 1998 and reserve development associated with AFG’s internal reinsurance program.
catastrophe losses in the Property and transportation group in 2012 resulted primarily from Superstorm Sandy. The $29 million in catastrophe losses in the Property and transportation group in 2011 resulted primarily from tornadoes.
The overall increase of 0.7% in AFG's expense ratio in 2013 as compared to 2012, as well as the fluctuations in AFG's sub-components, reflects higher profitability-based commissions paid to agents/brokers and lower profitability-based commissions received from reinsurers, partially offset by the impact of higher premiums on the ratio.
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.1 percentage points in 2013 compared to 2012 reflecting higher profitability-based commissions paid to agents/brokers and lower profitability-based commissions received from reinsurers, partially offset by higher reimbursements for administrative and operating expenses under the Federal crop insurance program and the impact of higher premiums on the ratio.
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.2 percentage points in 2013 compared to 2012 reflecting higher profitability-based commissions related to international business and increases in staffing costs related to business growth, partially offset by the impact of higher premiums on the ratio.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums increased 1.7 percentage points in 2013 compared to 2012 reflecting higher profitability-based commissions and lower ceding commissions from reinsurers, partially offset by the impact of higher premiums on the ratio.
The property and casualty segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 4.12% in 2012 compared to 4.31% in 2011, a decline of 0.19% percentage points. The decline is due primarily to the impact of lower yields available in the financial markets.
Interest expense for AFG's property and casualty operations includes interest charges on long-term debt within the property and casualty operations, primarily notes secured by real estate and other secured borrowings.
Interest credited - fixed in 2013 was $451 million compared to $438 million in 2012, an increase of $13 million (3%). The impact of growth in the annuity business was partially offset by lower interest crediting rates on new premiums as compared to the crediting rates on policyholder funds surrendered or withdrawn as well as the full-year impact of crediting rate reductions on existing policyholder funds that were implemented in the second half of 2012. The average interest rate credited to policyholders, calculated as interest credited divided by average fixed annuity benefits accumulated, decreased 0.27 percentage points in 2013 compared to 2012. During 2013, interest rates credited on new premiums generally ranged from 1.00% to 2.00%.
AFG's net interest spread decreased 0.18 percentage points in 2013 compared to 2012 due primarily to the run-off of higher yielding investments, partially offset by lower crediting rates.
AFG's net interest spread increased 0.12 percentage points in 2012 compared to 2011 due primarily to exceptionally strong investment results in 2012 and lower crediting rates, partially offset by the run-off of higher yielding investments.
Annuity policy charges and other miscellaneous income in 2012 were $38 million compared to $39 million in 2011, a decrease of $1 million (3%), primarily reflecting lower surrender charge rates.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) were $69 million in 2013, $61 million in 2012 and $49 million in 2011, representing an increase of $8 million (13%) in 2013 compared to 2012 and $12 million (24%) in 2012 compared to 2011. In addition to interest credited to policyholders’ accounts, annuity benefits expense also includes the following expenses (in millions, net of guaranteed withdrawal benefit fees):
The $12 million increase in other annuity benefits, net of guaranteed withdrawal benefit fees in 2012 compared to 2011 primarily reflects increased benefit reserves due to low lapse rates.
AFG's amortization of DPAC and commission expenses as a percentage of average fixed annuity benefits accumulated was 0.79% in 2013 compared to 0.75% in 2012 and 0.73% in 2011 and has generally ranged between 0.70% and 0.80%. Variances in these percentages generally relate to the impact of (i) material changes in interest rates or the stock market on AFG’s fixed-indexed annuity business, and (ii) differences in actual experience from actuarially projected estimates and assumptions. For example, the favorable impact of the increase in market interest rates during 2013 on the fair value of derivatives related to fixed-indexed annuities (discussed below) resulted in a partially offsetting acceleration in the amortization of DPAC.
Excluding the non-core ELNY guaranty fund assessments charge, annuity other expenses were $93 million in 2013, $81 million in 2012 and $80 million in 2011, representing an increase of $12 million (15%) in 2013 compared to 2012 and $1 million (1%) in 2012 compared to 2011. Annuity other expenses represent primarily general and administrative expenses, as well as selling and issuance expenses that are not deferred. As a percentage of average fixed annuity benefits accumulated, these expenses were flat in 2013 compared to 2012 and declined 0.07 percentage points in 2012 compared to 2011. In general this percentage is expected to decrease as AFG’s annuity business grows. However, annuity other expenses for 2013 includes a $7 million charge to write off certain previously capitalized project costs.
AFG’s fixed-indexed annuities, which represented approximately 47% of annuity benefits accumulated at December 31, 2013, 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 generally be 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 that must be marked-to-market through earnings each period. The fair values of these derivatives are impacted by actual and expected stock market performance and interest rates as well as other factors. For a list of other factors impacting the fair value of the index-based component of AFG’s annuity benefits accumulated, see Note D - “Fair Value Measurements” to the financial statements. Excluding the impact of unlocking charges, the net change in fair value of derivatives related to fixed-indexed annuities reduced annuity benefits by $26 million in 2013 due to the positive impact of higher market interest rates and the net impact of strong stock market performance on the derivatives. Conversely, the net change in fair value of the derivatives related to fixed-indexed annuities, excluding the impact of unlocking charges, increased annuity benefits expense by $27 million in 2012 and $42 million in 2011 reflecting the negative impact of sharply lower market interest rates on the embedded derivative.
AFG’s net spread earned on fixed annuities increased 0.21 percentage points in 2012 compared to 2011 due primarily to the 0.12 percentage points increase in AFG’s net interest spread and the impact of changes in the fair value of derivatives discussed above.
AFG's annuity operations generated statutory premiums of $4.03 billion in 2013, $2.99 billion in 2012 and $3.09 billion in 2011, an increase of $1.04 billion (35%) in 2013 compared to 2012 and a decrease of $95 million (3%) in 2012 compared to 2011. The following table summarizes AFG's annuity sales (dollars in millions):
The 3% decrease in annuity premiums in 2012 compared to 2011 reflects actions taken by AFG in response to the significant drop in interest rates that began in the second quarter of 2012. These actions included reductions in interest rates credited to policyholders and in commissions paid to agents. Management believes that fixed-indexed annuities continued to sell well in both the retail and financial institutions markets due to their market participation and other features. Conversely, management believes that traditional fixed annuity sales decreased due to low absolute crediting rates in the market, and that this decrease is
The following table reconciles the GAAP and core net spread earned on AFG’s fixed annuities to overall annuity pretax earnings for 2013, 2012 and 2011 (in millions):
(a) Excludes the $5 million pretax non-core charge for ELNY guarantee fund assessments in 2013.
Excludes the pretax non-core loss recognition charge recorded in the fourth quarter of 2012 to increase life, accident and health benefits by $74 million and acquisition expenses by $79 million.
The increase in long-term care benefits expense in 2013 as compared to 2012 is due primarily to an increase in new claims. The decrease in life benefits expense in 2013 as compared to 2012 is due primarily to improved claims experience in the first half of 2013.
Medicare Supplement and Critical Illness Segment - Results of Operations AFG's Medicare supplement and critical illness segment contributed $198 million in GAAP pretax earnings in 2012, which includes a $170 million pretax non-core realized gain on the August 2012 sale of these businesses, and GAAP pretax earnings of $34 million in 2011. See Note B - “Acquisitions and Sales of Subsidiaries” to the financial statements. The following table details AFG's GAAP and core earnings before income taxes from its Medicare supplement and critical illness business (in millions):
Holding Company, Other and Unallocated - Results of Operations AFG’s net GAAP pretax loss outside of its insurance operations (excluding realized gains) totaled $190 million in 2013 compared to $185 million in 2012, an increase of $5 million (3%). AFG's net core pretax loss outside of its insurance operations (excluding realized gains) totaled $168 million in 2013 compared to $160 million in 2012, an increase of $8 million (5%).
AFG’s net GAAP pretax loss outside of its insurance operations (excluding realized gains) totaled $185 million in 2012 compared to $155 million in 2011, an increase of $30 million (19%). AFG's net core pretax loss outside of its insurance operations (excluding realized gains) totaled $160 million in 2012 compared to $146 million in 2011, an increase of $14 million (10%).
The following table details AFG's GAAP and core loss before income taxes from operations outside of its insurance operations in 2013, 2012 and 2011 (dollars in millions):
Excludes pretax non-core special A&E charges of $22 million, $2 million and $9 million in 2013, 2012 and 2011, respectively. Other expenses in 2012 also exclude $23 million in other non-core charges (discussed below).
AFG recorded investment income on investments held outside of its insurance operations of $8 million, $5 million and $5 million in 2013, 2012 and 2011, respectively.
As a result of the comprehensive study of A&E exposures discussed under “Uncertainties - Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG’s holding companies and other operations outside of its insurance operations recorded non-core special charges of $22 million, $2 million and $9 million in 2013, 2012 and 2011, respectively, to increase liabilities related to the A&E exposures of AFG’s former railroad and manufacturing operations. The 2013 charge resulted primarily from slightly higher estimated operation and maintenance costs at sites where remediation is underway, coupled with higher estimated cleanup costs at a limited number of sites. In 2012, these operations also recorded a $15 million non-core charge resulting from an adverse judgment in a long-standing labor contract dispute related to AFG’s former railroad operations and an $8 million non-core loss on the retirement of debt.
During the third quarter of 2012, AFG acquired the remaining 28% of Marketform that it did not already own. Marketform’s losses reflect adverse reserve development in its run-off Italian public hospital medical malpractice business. As discussed in Note A - “Accounting Policies” and Note H - “Managed Investment Entities” to the financial statements, the losses of Managed Investment Entities in 2013, 2012 and 2011 represent CLO losses that ultimately inure to holders of CLO debt other than AFG.
Consolidated Statement of Earnings for the years ended December 31, 2013, 2012 and 2011
Consolidated Statement of Changes in Equity for the years ended December 31, 2013, 2012 and 2011
Selected Quarterly Financial Data has been included in Note N to the Consolidated Financial Statements.
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 the controls and procedures are effective. There have been no changes in AFG’s internal control over financial reporting during the fourth fiscal quarter of 2013 that materially affected, or are reasonably likely to materially affect, AFG’s internal control over financial reporting.
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, 2013, based on the criteria set forth in “Internal Control - Integrated Framework” issued in 1992 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, 2013, based on the COSO criteria.
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, primarily the reclassification of investment expenses and real estate income and expenses to net investment income. 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, 2013, and prior to the filing of this Form 10-K, have been evaluated for potential recognition or disclosure herein.
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. AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in 2013 or 2012.
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other-than-temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses) on securities) and the cost basis of that investment is reduced. 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: (i) the amount related to credit losses (recorded in earnings) and (ii) the amount related to all other factors (recorded in other comprehensive income). 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.
Reinsurance Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG’s property and casualty insurance subsidiaries report as assets (i) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (ii) amounts paid or due to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers as well as ceded premiums retained by AFG’s property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG’s insurance subsidiaries also assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.
A subsidiary cedes life insurance policies to a third party on a funds withheld basis whereby the subsidiary retains the assets (securities) associated with the reinsurance contract. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. This reinsurance contract is considered to contain an embedded derivative (that must be adjusted to fair value) because the yield on the payable is based on a specific block of the ceding company’s assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolio of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to this contract are classified as “trading.” The adjustment to fair value on the embedded derivative offsets the investment income recorded on the adjustment to fair value of the related trading portfolio.
Managed Investment Entities A company is considered the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”) based primarily on its ability to direct the activities of the VIE that most significantly impact that 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.
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Medicare Supplement and Critical Illness Segment In August 2012, AFG completed the sale of its Medicare supplement and critical illness businesses, which included Loyal American Life Insurance Company and four other insurance companies, to Cigna Corporation for $326 million in cash resulting in a pretax gain of $170 million (including post-closing adjustments). Since the transaction includes the ongoing cessions of certain business to Cigna, the operations being sold are not reported as discontinued operations.
Summarized Statement of Earnings information for the Medicare supplement and critical illness segment through the sale date is shown below (in millions):
(*) Reflects revenues and expenses through the end of August 2012.
Sales of property and casualty insurance outside of the United States represented 5% of AFG’s revenues in 2013, 2012 and 2011.
Includes special charges to increase asbestos and environmental (“A&E”) reserves of $54 million, $31 million and $50 million in 2013, 2012 and 2011, respectively.
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 or when the market for a security exhibits significantly less liquidity relative to markets supporting Level 2 fair value measurements. 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.
(a) Variable annuity liabilities equal the fair value of variable annuity assets.
The transfers between Level 1 and Level 2 are reflected in the table below at fair value as of the end of the reporting period (dollars in millions):
Changes in balances of Level 3 financial assets and liabilities carried at fair value during 2013, 2012 and 2011 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.
Total realized/unrealized loss included in net income for the embedded derivatives reflects gains related to the unlocking of actuarial assumptions of $36 million in 2012.
similar credit ratings. The fair value of policy loans is estimated to approximate carrying value; policy loans have no defined maturity dates and are inseparable from insurance contracts. The fair value of annuity benefits was estimated based on expected cash flows discounted using forward interest rates adjusted for the Company’s credit risk and includes the impact of maintenance expenses and capital costs. Fair values of long-term debt are based primarily on quoted market prices.
The non-credit related portion of other-than-temporary impairment charges is included in other comprehensive income. Cumulative non-credit charges taken for securities still owned at December 31, 2013 and December 31, 2012, respectively, were $229 million and $227 million; nearly all of these charges relate to residential MBS.
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, 2013 and 2012.
AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. For 2013, AFG recorded less than $1 million in other-than-temporary impairment charges related to its residential MBS.
A progression of the credit portion of other-than-temporary impairments on fixed maturity securities for which the non-credit portion of an impairment has been recognized in other comprehensive income is shown below (in millions).
The table below sets forth the scheduled maturities of available for sale fixed maturities as of December 31, 2013 (in millions). 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.
Realized gains (losses) and changes in unrealized appreciation (depreciation) related to fixed maturity and equity security investments are summarized as follows (in millions):
Realized gains (losses) on securities include net losses of $3 million in 2013 compared to net gains of $5 million in 2012 and net losses of less than $1 million in 2011 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 in Note A - “Accounting Policies - Derivatives,” 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.
As discussed in Note A - “Accounting Policies - Reinsurance,” certain reinsurance contracts are considered to contain embedded derivatives.
The change in fair value of the embedded derivative includes gains related to unlocking of actuarial assumptions of $2 million in 2013 and $36 million in 2012.
The present value of future profits (“PVFP”) amounts in the table above are net of $198 million and $184 million of accumulated amortization at December 31, 2013 and 2012, respectively. The loss recognition charge recorded in the fourth quarter of 2012 for AFG’s closed block of long-term care insurance resulted in the write off of all remaining deferred policy acquisition costs for this business. During each of the next five years, the PVFP is expected to decrease at a rate of approximately one-sixth of the balance at the beginning of each respective year.
In 2013, AFG formed two new CLOs, which issued an aggregate of $829 million face amount of liabilities (including $85 million face amount purchased by subsidiaries of AFG). During 2013, AFG subsidiaries also purchased $94 million face amount of senior debt tranches of existing CLOs for $89 million and received $142 million in redemption proceeds from its CLO investments. In 2012, AFG formed two new CLOs, which issued an aggregate face amount of $860 million of liabilities (including $74 million face amount purchased by subsidiaries of AFG). In 2012, AFG subsidiaries also purchased $74 million face amount of senior debt tranches of existing CLOs for $69 million. In 2013, two AFG CLOs were substantially liquidated, as permitted by the CLO indentures.
The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $15 million and $29 million at December 31, 2013 and 2012. The aggregate unpaid principal balance of the CLOs’ debt exceeded its fair value by $109 million and $123 million at those dates. The CLO assets include $1 million and $5 million in loans (aggregate unpaid principal balance of $6 million and $12 million, respectively) at December 31, 2013 and 2012, for which the CLOs are not accruing interest because the loans are in default.
Changes in the carrying value of goodwill during 2011, 2012 and 2013, by reporting segment, are presented in the following table (in millions):
AFG can borrow up to $500 million under its revolving credit facility which expires in December 2016. Amounts borrowed under this agreement bear interest at rates ranging from 1.00% to 1.875% (currently 1.375%) over LIBOR based on AFG’s credit rating. No amounts were borrowed under this facility at December 31, 2013 or December 31, 2012.
National Interstate can borrow up to $100 million under its unsecured credit agreement, which expires in November 2017. At December 31, 2013, there was $12 million outstanding under this agreement, bearing interest at 1.11% (three-month LIBOR plus 0.875%).
Includes net unrealized gains of $54 million at December 31, 2013 compared to net unrealized gains of $33 million at December 31, 2012 and net unrealized losses of $16 million at December 31, 2011, related to securities for which only the credit portion of an other-than-temporary impairment has been recorded in earnings.
Other relates to the 2012 acquisition of noncontrolling interest in a subsidiary.
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2013 (in millions):
AFG’s net deferred tax liability at December 31, 2013 and 2012 is included in other liabilities in AFG’s Balance Sheet.
The resolution of the tax case and closure of subsequent tax years during 2012 (discussed above) reduced AFG’s liability for uncertain tax positions by $36 million and the related liability for interest by $14 million. Additionally, the IRS issued new guidance during the third quarter of 2012 that brought certainty to the timing of investment deductions, which caused AFG to reduce its liability for uncertain tax positions by $10 million. Because this was solely a timing issue, the reduction in AFG’s
liability for uncertain tax positions for this item was offset by an increase in AFG’s deferred tax liability with no overall impact on income tax expense.
As a result of discussions with the IRS Appeals Office during the third quarter of 2013, AFG believes it is reasonably possible that its liability for uncertain tax positions may be reduced by up to the full $19 million balance due to a settlement with the IRS that is expected to become final in 2014. The majority of the reduction in this liability would result in offsetting adjustments to AFG’s deferred tax liability. The total unrecognized tax benefits and related interest that, if recognized, would impact the effective tax rate is $4 million at December 31, 2013. AFG’s provision for income taxes included an expense of $1 million in 2013, a benefit of $14 million in 2012 and an expense of $3 million in 2011 of interest (net of federal benefit or expense). AFG’s liability for interest related to unrecognized tax benefits was $1 million at both December 31, 2013 and December 31, 2012 (net of federal benefit); no penalties were accrued at those dates.
The insurance group’s liability for asbestos and environmental reserves was $384 million at December 31, 2013; related recoverables from reinsurers (net of allowances for doubtful accounts) at that date were $83 million.
At December 31, 2013, American Premier and its subsidiaries had liabilities for environmental and personal injury claims and other contingencies aggregating $86 million. The environmental claims consist of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs related to certain sites formerly owned or operated by the railroad and manufacturing operations. Remediation costs are difficult to estimate for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. The personal injury claims and other contingencies include pending and expected claims, primarily by former employees of PCTC, for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the workplace and other labor disputes.
Adverse prior year development (in the table above) for the third quarter of 2013 includes pretax special charges of $54 million to strengthen property and casualty insurance A&E reserves. Results for the third quarter of 2013 also include pretax special charges of $22 million to strengthen reserves for A&E exposures related to AFG’s former railroad and manufacturing operations.
Realized gains (in the table above) for the third quarter of 2012 include a pretax gain of $155 million on the sale of AFG’s Medicare supplement and critical illness segment. Adverse prior year development for the third quarter of 2012 includes pretax special charges of $31 million to strengthen property and casualty insurance A&E reserves. Results for the third quarter of 2012 also include a $28 million benefit from the resolution of AFG’s tax case. Results for the fourth quarter of 2012 include a $15 million additional pretax realized gain resulting from post-closing adjustments related to the sale of the Medicare supplement and critical illness segment, a pretax charge of $153 million to write off deferred policy acquisition costs and strengthen reserves in the closed block of long-term care insurance, pretax catastrophe losses of $33 million, primarily from Superstorm Sandy, a $14 million pretax charge due to a review of major actuarial assumptions in the annuity business, and tax benefits of $39 million from the settlement of open tax years following the resolution of AFG’s tax case.
The following table provides an analysis of changes in the liability for losses and loss adjustment expenses, net of reinsurance (and grossed up), over the past three years (in millions):
Favorable development in 2013 was due primarily to lower than expected severity in directors and officers liability insurance and lower than expected claim severity and frequency in the excess liability business, both within the Specialty casualty sub-segment, lower than expected frequency and severity in the foreign credit and financial institution services businesses within the Specialty financial sub-segment, and favorable reserve development associated with AFG’s internal reinsurance program, partially offset by the $54 million special charge to increase asbestos and environmental reserves. Favorable development in 2012 was due primarily to lower than expected frequency and severity in the homebuilders’ general liability business within the Specialty casualty sub-segment and lower than expected frequency in the crop business within the Property and transportation sub-segment, partially offset by higher frequency and severity in a block of program business in the Specialty casualty sub-segment and the $31 million special charge to increase asbestos and environmental reserves. Favorable development in 2011 was due primarily to lower than expected severity in certain businesses within the Specialty casualty sub-segment and lower than expected frequency in crop business within the Property and transportation sub-segment, partially offset by the $50 million special charge to increase asbestos and environmental reserves.
Closed Block of Long-Term Care Insurance AFG, as well as other companies that sell long-term care products, have accumulated relatively limited claims, lapse and mortality experience, 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. In addition, long-term care claims are incurred much later in the life of a policy than most other health products. These factors made it difficult to appropriately price this product and were instrumental in AFG’s decision to stop writing new policies in January 2010. AFG’s outstanding long-term care policies 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.
FHLB Funding Agreements Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions. Members are required to purchase stock in the FHLB in addition to maintaining collateral deposits that back any funds advanced. GALIC’s $34 million investment in FHLB capital stock at December 31, 2013, is included in other investments at cost. Membership in the FHLB provides the annuity operations with a substantial additional source of liquidity. These advances further the FHLB’s mission of improving access to housing by increasing liquidity in the residential mortgage-backed securities market. In the fourth quarter of 2011, the FHLB advanced GALIC $240 million (included in annuity benefits accumulated at December 31, 2012). In the second quarter of 2013, the FHLB advanced GALIC an additional $200 million, increasing the total amount advanced to $440 million at December 31, 2013. Interest rates under the various funding agreements on these advances range from 0.02% to 0.23% over LIBOR (average rate of 0.32% at December 31, 2013). While these advances must be repaid between 2016 and 2018, GALIC has the option to prepay all or a
portion of the advances. The advances on these agreements are collateralized by mortgage-backed securities with a fair value of $565 million (included in available for sale fixed maturity securities) at December 31, 2013. Interest credited on the funding agreements, which is included in annuity benefits, was $1 million in 2013 and less than $1 million in 2012 and 2011.
Payments of dividends by AFG's insurance companies are subject to various state laws that limit the amount of dividends that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 2014 from its insurance subsidiaries without seeking regulatory clearance is $610 million. Additional amounts of dividends require regulatory approval.
AFG paid common stock dividends to shareholders totaling $161 million, $91 million and $69 million in 2013, 2012 and 2011, respectively. Currently, there are no regulatory restrictions on AFG's retained earnings or net income that materially impact its ability to pay dividends. Based on shareholders' equity at December 31, 2013, AFG could pay dividends in excess of $1 billion without violating its most restrictive debt covenant. However, the payment of future dividends will be at the discretion of AFG's Board of Directors and will be dependent on many factors including AFG's financial condition and results of operations, the capital requirements of its insurance subsidiaries, and rating agency commitments.
AFG has reinsured approximately $13.43 billion of its $17.98 billion in face amount of life insurance at December 31, 2013 compared to $14.54 billion of its $19.44 billion in face amount of life insurance at December 31, 2012. Life written premiums ceded were $44 million, $42 million and $44 million for 2013, 2012 and 2011, respectively.
On January 9, 2014, AFG reached a definitive agreement to acquire Summit Holdings Southeast, Inc. and its related companies (“Summit”), from Liberty Mutual using cash on hand at the parent company. Under the terms of the agreement, AFG will pay an estimated $250 million at closing, subject to adjustment through the closing date primarily for changes in Summit’s GAAP tangible book value. Including an anticipated capital contribution at closing, AFG’s total capital investment in the Summit business will be approximately $400 million. Summit is based in Lakeland, Florida and is a leading provider of workers’ compensation solutions in the southeastern United States, with net written premiums expected to be in excess of $500 million in 2013. Following the transaction, Summit will continue to operate under the Summit brand as a member of AFG’s Great American Insurance Group. The transaction is expected to close in the first or second quarter of 2014, following customary regulatory approvals.
On February 5, 2014, Great American Insurance Company (“GAI”) commenced a tender offer to acquire all of the outstanding shares of National Interstate Corporation common stock not currently owned by GAI for $30.00 per share in cash (as adjusted on February 17). The tender offer and withdrawal rights are scheduled to expire on March 6, 2014, unless the offer is extended or earlier terminated in accordance with the terms of the offer and the applicable Securities and Exchange Commission rules and regulations. GAI intends to pay for any shares acquired in the tender offer with cash on hand. If the tender offer is completed, and following the tender offer, GAI owns at least 90% of the outstanding shares of National Interstate on a fully diluted basis, AFG and GAI intend to cause a second step, short-form, merger of National Interstate into GAI or an affiliate of GAI.
The information required by the following Items will be included in AFG’s definitive Proxy Statement for the 2014 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission within 120 days after the end of the Registrant’s fiscal year and is incorporated herein by reference.
The following financial information from American Financial Group’s Form 10-K for the year ended December 31, 2013, formatted in XBRL (Extensible Business Reporting Language):