Fourth quarter 2016 net earnings attributable to AFG’s shareholders were $385 million ($4.33 per share, diluted) compared to $129 million ($1.45 per share, diluted) in the fourth quarter of 2015, reflecting:
net realized gains on securities in the fourth quarter of 2016 compared to net realized losses in the fourth quarter of 2015.
Full year 2016 net earnings attributable to AFG’s shareholders were $649 million ($7.33 per share, diluted) compared to $352 million ($3.94 per share, diluted) in 2015, reflecting:
net realized gains on securities in 2016 compared to net realized losses on securities in 2015,
the 2015 loss on the sale of substantially all of AFG’s run-off long-term care business,
See “Liquidity and Capital Resources - Uncertainties” for a discussion of insurance reserves, recoverables from reinsurers, and contingencies related to American Premier’s former operations and “Liquidity and Capital Resources - Investments” for a discussion of impairments on investments. Deferred policy acquisition costs (“DPAC”) and certain liabilities related to annuities are amortized in relation to the present value of expected gross profits on the policies. Assumptions considered in determining expected gross profits involve significant judgment and include management’s estimates of interest rates and investment spreads, surrenders, annuitizations, renewal premiums and mortality. Should actual experience require management to change its assumptions (commonly referred to as “unlocking”), a charge or credit would be recorded to adjust DPAC or annuity liabilities to the levels they would have been if the new assumptions had been used from the inception date of each policy.
The ratio of debt to total capital is a non-GAAP measure that management believes is useful for investors, analysts and independent ratings agencies to evaluate AFG’s financial strength and liquidity and to provide insight into how AFG finances its operations. In addition, maintaining a ratio of debt, excluding subordinated debt and debt secured by real estate, to total capital of 35% or lower is a financial covenant in AFG’s bank credit facility. The ratio is calculated by dividing the principal amount of AFG’s long-term debt by its total capital, which includes long-term debt, noncontrolling interests and shareholders’ equity (excluding unrealized gains (losses) on fixed maturity investments).
The NAIC’s model law for risk based capital (“RBC”) applies to both life and property and casualty companies. RBC formulas determine the amount of capital that an insurance company needs so that it has an acceptable expectation of not becoming financially impaired. At December 31, 2016, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements.
Net Cash Used in Investing Activities AFG’s investing activities consist primarily of the investment of funds provided by its property and casualty and annuity products. Net cash used in investing activities was $2.98 billion in 2016 compared to $4.57 billion in 2015, a decrease of $1.59 billion. The $151 million decrease in net cash flows from annuity policyholders in 2016 as compared to 2015 (discussed below under net cash provided by financing activities) decreased the amount of cash available for investment in 2016 compared to 2015. In addition, AFG’s cash on hand increased by $887 million during 2016, primarily in the property and casualty and annuity segments reflecting the timing of investing available cash in those segments. Investing activities also include the purchase and disposal of managed investment entity investments (collateralized loan obligations), which are presented separately in AFG’s Balance Sheet. Net investment activity in the managed investment entities was a $364 million use of cash in 2016 compared to a $675 million use of cash in 2015, accounting for a $311 million decrease in net cash used in investing activities in 2016 compared to 2015. See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements.
Net cash used in investing activities was $4.57 billion in 2015 compared to $3.63 billion in 2014, an increase of $945 million. The $537 million increase in net cash flows from annuity policyholders in 2015 as compared to 2014 increased the amount of cash available for investment in 2015 compared to 2014. Net investment activity in the managed investment entities was a $675 million use of cash in 2015 compared to a $275 million use of cash in 2014, accounting for a $400 million increase in net cash used in investing activities in 2015 compared to 2014.
Net Cash Provided by Financing Activities AFG’s financing activities consist primarily of transactions with annuity policyholders, issuances and retirements of long-term debt, repurchases of common stock and dividend payments. Net cash provided by financing activities was $2.72 billion in 2016 compared to $3.10 billion in 2015, a decrease of $379 million. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $2.35 billion in 2016 compared to $2.50 billion in 2015, resulting in a $151 million decrease in net cash provided by financing activities in 2016 compared to 2015. AFG issued $300 million of 3.50% Senior Notes in 2016 and $150 million of 6% Subordinated Debentures in 2015, the
Net cash provided by financing activities was $3.10 billion in 2015 compared to $2.10 billion in 2014, an increase of $996 million. Annuity receipts exceeded annuity surrenders, benefits, withdrawals and transfers by $2.50 billion in 2015 compared to $1.97 billion in 2014, resulting in a $537 million increase in net cash provided by financing activities. Redemptions of long-term debt resulted in a $192 million use of cash in 2015. AFG issued $150 million of 6% Subordinated Debentures in 2015 and $150 million of 6-1/4% Subordinated Debentures in 2014, the net proceeds of each issuance contributed $145 million to net cash provided by financing activities in those years. During 2015, AFG repurchased $126 million of its Common Stock compared to $191 million in 2014, which accounted for a $65 million increase in net cash provided by financing activities in 2015 compared to 2014. Issuances of managed investment entity liabilities exceeded retirements by $890 million in 2015 compared to $306 million in 2014, accounting for a $584 million increase in net cash provided by financing activities in 2015 compared to 2014.
In August 2016, AFG issued $300 million of 3.50% Senior Notes due 2026. AFG used the net proceeds from the offering to fund a portion of the acquisition of NATL mentioned above.
In September 2014, AFG issued $150 million of 6-1/4% Subordinated Debentures due 2054. During 2014, AFG repurchased 3.3 million shares of its Common Stock for $191 million. In December 2014, AFG paid a special cash dividend of $1.00 per share of AFG Common Stock totaling approximately $88 million.
Under a tax allocation agreement with AFG, its 80%-owned U.S. subsidiaries generally pay taxes to (or recover taxes from) AFG based on each subsidiary’s contribution to amounts due under AFG’s consolidated tax return.
AFG’s weighted average cost of funds for newly issued traditional fixed and fixed-indexed annuities was 2.28% for 2016 compared to 2.31% for 2015. In the first half of 2016, AFG lowered the crediting rates on new annuity sales due to the decline in market investment yields experienced during that period. Conversely, AFG raised crediting rates on new annuity sales in the
Parent Net Cash Provided by Operating Activities Parent holding company cash flows from operating activities consist primarily of dividends and tax payments received from AFG’s insurance subsidiaries, reduced by tax payments to the IRS and holding company interest and other expenses. Parent holding company net cash provided by operating activities was $555 million in 2016 compared to $162 million in 2015 and $372 million in 2014. Higher dividends received from subsidiaries in 2016 as compared to 2015 were the primary driver of the $393 million increase in net cash provided by operating activities. The $210 million decrease in net cash provided by operating activities in 2015 as compared to 2014 was primarily the result of lower dividends received.
Amounts presented in the table represent estimated cash payments under such contracts, based on significant assumptions related to mortality, morbidity, lapse, renewal, retirement and annuitization. These assumptions also include interest and index crediting consistent with assumptions used to amortize DPAC and assess loss recognition. All estimated cash payments are undiscounted for the time value of money. As a result, total outflows for all years exceed the corresponding liabilities of $29.91 billion for annuity benefits accumulated and $691 million for life, accident and health reserves included in AFG’s Balance Sheet as of December 31, 2016. Based on the same assumptions, AFG projects reinsurance recoveries related to life, accident and health reserves totaling $769 million as follows: Within 1 year - $81 million; 2-3 years - $129 million; 4-5 years - $110 million; and thereafter - $449 million. Actual payments and their timing could differ significantly from these estimates.
Dollar amounts and time periods are estimates based on historical net payment patterns applied to the gross reserves and do not represent actual contractual obligations. Based on the same assumptions, AFG projects reinsurance recoveries related to these reserves totaling $2.30 billion as follows: Within 1 year - $600 million; 2-3 years - $600 million; 4-5 years - $300 million; and thereafter - $800 million. Actual payments and their timing could differ significantly from these estimates.
AFG’s investment portfolio at December 31, 2016, contained $34.54 billion in fixed maturity securities and $1.50 billion in equity securities classified as available for sale and carried at fair value with unrealized gains and losses included in a separate component of shareholders’ equity on an after-tax basis. In addition, $359 million in fixed maturities and $56 million in equity securities were classified as trading with changes in unrealized holding gains or losses included in net investment income.
Fair values for AFG’s portfolio are determined by AFG’s internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on published closing prices. For mortgage-backed securities (“MBS”), which comprise approximately 15% of AFG’s fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the remainder of AFG’s fixed maturity portfolio, approximately 79% are priced using pricing services and the balance is priced primarily by
In general, the fair value of AFG’s fixed maturity investments is inversely correlated to changes in interest rates. The following table demonstrates the sensitivity of such fair values to reasonably likely changes in interest rates by illustrating the estimated effect on AFG’s fixed maturity portfolio and accumulated other comprehensive income that an immediate increase of 100 basis points in the interest rate yield curve would have at December 31, 2016 (dollars in millions). Effects of increases or decreases from the 100 basis points illustrated would be approximately proportional.
Approximately 89% of the fixed maturities held by AFG at December 31, 2016, 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.
Summarized information for AFG’s MBS (including those classified as trading) at December 31, 2016, is shown in the table below (dollars in millions). Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The average life of the residential and commercial MBS is approximately 4-1/2 years and 4 years, respectively.
The National Association of Insurance Commissioners (“NAIC”) assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC retains third-party investment management firms to assist in the determination of appropriate NAIC designations for mortgage-backed securities based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At December 31, 2016, 97% (based on statutory carrying value of $4.75 billion) of AFG’s MBS had an NAIC designation of 1.
Municipal bonds represented approximately 19% of AFG’s fixed maturity portfolio at December 31, 2016. AFG’s municipal bond portfolio is high quality, with 98% of the securities rated investment grade at that date. The portfolio is well diversified across the states of issuance and individual issuers. At December 31, 2016, approximately 76% of the municipal bond portfolio was held in revenue bonds, with the remaining 24% held in general obligation bonds. General obligation securities of California, Illinois, Michigan, New Jersey, New York and Puerto Rico collectively represented approximately 1% of this portfolio.
When a decline in the value of a specific investment is considered to be other-than-temporary, a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced by the amount of the charge. The determination of whether unrealized losses are other-than-temporary requires judgment based on subjective as well as objective factors. Factors considered and resources used by management include:
Uncertainties As more fully explained in the following paragraphs, management believes that the areas posing the greatest risk of material loss are the adequacy of its insurance reserves and contingencies arising out of its former railroad and manufacturing operations.
In April 2014, AFG acquired Summit Holding Southeast, Inc. and related companies, a leading provider of workers’ compensation solutions in the southeastern United States. The Summit acquisition significantly increased AFG’s volume of workers’ compensation business and improved its geographic diversity. Approximately 24% and 18% of AFG’s workers’ compensation reserves at December 31, 2016 relate to policies written in Florida and California, respectively. Over the past 13 years in both states, there have been numerous revisions to workers’ compensation regulations and operating environments, adding difficulty and uncertainty to the estimation of related liabilities.
AFG recorded favorable prior year reserve development of $85 million in 2016 due to lower than anticipated claim severity and improving claim closure rates. AFG recorded favorable prior year reserve development of $45 million in 2015 due to lower than anticipated claim severity across all regions of the country. AFG recorded favorable prior year reserve development of $7 million in 2014, as favorable reserve development in the business written in California was partially offset by adverse reserve development in other states.
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. For example, from 2008 to 2010, economic conditions led to higher frequency of claims, particularly in the D&O policies for small account and not-for-profit organizations. Since then, claim frequency has continually decreased from its peak in 2010, offsetting increased claim severity.
AFG recorded favorable prior year reserve development of $24 million in 2016, $12 million in 2015 and $18 million in 2014 on its D&O business as claim severity was less than expected across several prior accident years.
During the second quarter of 2016, Neon completed a strategic review of its business under a new leadership team. As part of its strategic review, Neon sold and/or exited certain historical lines of business including its medical malpractice and general liability classes. As a result of Neon’s claims review of its exited lines of business, AFG recorded a charge of approximately $65 million, including $57 million to increase loss reserves (adverse development) primarily related to its medical malpractice and general liability lines. In addition to the exited lines charge, Neon recorded adverse prior year reserve development of $21 million in 2016, $44 million in 2015 and $14 million in 2014. The adverse development in 2016 outside of the exited lines charge was attributable to reserve strengthening in several lines of business, including political risk and personal accident. The adverse development in 2015 and 2014 was attributable to reserve strengthening in several lines of business, primarily Dutch hospital medical malpractice, Australian and other general liability and personal accident insurance.
Outside of its property and casualty operations, AFG also has reinsurance recoverables totaling $343 million, including $296 million related to the run-off life business. These recoverables include $254 million directly or indirectly from Hannover Life Reassurance Company of America (rated A+ by A.M. Best).
Approximately 41% of AFG’s net asbestos reserves relate to policies written directly by AFG subsidiaries. Claims from these policies generally are product-oriented claims with only a limited amount of non-products exposures, and are dominated by small to mid-sized commercial entities that are mostly regional policyholders with few national target defendants. The remainder is assumed reinsurance business that includes exposures for the periods 1954 to 1983. The asbestos and environmental assumed claims are ceded by various insurance companies under reinsurance treaties. A majority of the individual assumed claims have exposures of less than $100,000 to AFG. Asbestos losses assumed include some of the industry known manufacturers, distributors and installers. Pollution losses include industry known insured names and sites.
The manner by which bankruptcy courts are addressing asbestos liabilities is in flux.
An in-depth internal review of AFG’s A&E reserves was completed in the third quarter of 2016 by AFG’s internal A&E claims specialists and actuaries in consultation with specialty outside counsel and an outside consultant. As a result of the review, AFG’s property and casualty insurance segment recorded a $36 million pretax special charge to increase its asbestos reserves by
As a result of the in-depth internal review completed in the third quarter of 2014, AFG’s property and casualty insurance segment recorded a $24 million pretax special charge to increase its asbestos reserves by $4 million (net of reinsurance) and its environmental reserves by $20 million (net of reinsurance). The increase in property and casualty environmental reserves was attributed primarily to AFG’s increased defense costs and a number of claims where the estimated costs of remediation have increased.
Includes a gain of $8 million in the fourth quarter of 2016 and a loss of $11 million in the fourth quarter of 2015, representing the change in fair value of AFG’s CLO investments plus $5 million and $4 million in the fourth quarter of 2016 and 2015, respectively, in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $8 million and $7 million in the fourth quarter of 2016 and 2015, respectively, in distributions recorded as interest expense by the CLOs.
Net earnings attributable to shareholders increased $297 million for the full-year of 2016 compared to the same period in 2015 due primarily to the 2016 tax benefits related to the National Interstate merger and Neon restructuring, lower special A&E charges recorded in 2016 compared to 2015, net realized gains on securities in 2016 compared to net realized losses on securities in 2015, the estimated loss on the sale of the subsidiaries containing substantially all of AFG’s run-off long-term care insurance business that was recorded in the first quarter of 2015 and higher core net operating earnings, partially offset by a charge related to the exit of certain lines of business within Neon, and lower gains on the sale of real estate in 2016 compared to 2015. Core net operating earnings increased $48 million in 2016 compared to 2015 reflecting higher underwriting profit and net investment income in the ongoing property and casualty insurance operations and higher earnings in the annuity segment, partially offset by lower profitability in the run-off long-term care and life segment and higher holding company expenses.
Segmented Statement of Earnings AFG reports its business as four segments: (i) Property and casualty insurance (“P&C”), (ii) Annuity, (iii) Run-off long-term care and life and (iv) Other, which includes holding company costs and income and expenses related to 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, 2016 and 2015 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):
$18 million (11%). The increase in GAAP and core pretax earnings reflects higher underwriting profit in the Property and transportation and Specialty financial insurance sub-segments and higher net investment income, partially offset by lower underwriting profit in the Specialty casualty sub-segment. GAAP earnings also includes a $15 million pretax gain on the sale of an apartment property in the fourth quarter of 2015.
The following table details AFG’s GAAP and core earnings before income taxes from its property and casualty insurance operations for the three months ended December 31, 2016 and 2015 (dollars in millions):
Specialty casualty Gross written premiums increased $23 million (3%) in the fourth quarter of 2016 compared to the fourth quarter of 2015. Higher gross written premiums in the targeted markets and executive liability businesses were partially offset by lower premiums in the excess and surplus lines operations, primarily the result of more stringent underwriting standards related to New York contractors business, as well as lower premiums within the workers’ compensation businesses. Average renewal rates for this group were flat in the fourth quarter of 2016, and include a decrease of approximately 2% in the workers’ compensation business. Excluding the workers’ compensation business, average renewal rates for this group increased approximately 1% during the quarter. Reinsurance premiums ceded as a percentage of gross written premiums increased 1 percentage point for the fourth quarter of 2016 compared to the fourth quarter of 2015, reflecting a change in the mix of business.
Specialty financial Gross written premiums increased $1 million (1%) in the fourth quarter of 2016 compared to the fourth quarter of 2015, due primarily to growth in the fidelity and crime, surety and equipment leasing businesses, partially offset by lower premiums in the financial institutions business. Average renewal rates for this group were down approximately 1% in the fourth quarter of 2016. Reinsurance premiums ceded as a percentage of gross written premiums are comparable between periods.
Specialty casualty Underwriting profit for this group was $13 million for the fourth quarter of 2016 compared to $50 million in the fourth quarter of 2015, a decrease of $37 million (74%). This decrease is due primarily to underwriting losses in one of the excess and surplus lines businesses, primarily related to coverage written for New York contractors, and lower profitability in the targeted markets business.
Other specialty Underwriting profit for this group was $2 million for the fourth quarter of 2016 compared to $1 million in the fourth quarter of 2015, an increase of $1 million (100%).
Specialty casualty The 4.6 percentage point increase in the loss and LAE ratio for the current year, excluding catastrophe losses reflects an increase in the loss and LAE ratio of the targeted markets, general liability, excess and surplus and workers’ compensation businesses and at Neon.
Specialty financial Net favorable reserve development of $6 million in the fourth quarter of 2016 reflects lower than expected claim frequency in the financial institutions business and lower than anticipated claim severity in the fidelity and crime business. Net favorable reserve development of $5 million in the fourth quarter of 2015 reflects lower than anticipated claim severity in the fidelity business, lower than expected claim frequency and severity in the surety business and lower than expected claim severity on a run-off block of collateral value insurance, partially offset by higher than expected claim severity in products for financial institutions and in the trade credit business.
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, 2016, 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 4% of AFG’s Shareholders’ Equity. Catastrophe losses of $12 million in the fourth quarter of 2016 resulted primarily from Hurricane Matthew. The $5 million of catastrophe losses in the Specialty financial group in the fourth quarter of 2015 resulted primarily from flooding in the midwestern United States.
The following table details AFG’s earnings before income taxes from its annuity operations for the three months ended December 31, 2016 and 2015 (dollars in millions):
Interest credited - fixed for the fourth quarter of 2016 was $148 million compared to $138 million for the fourth quarter of 2015, an increase of $10 million (7%). 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. The average interest rate credited to policyholders, calculated as interest credited divided by average fixed annuity benefits accumulated, decreased 0.10 percentage points to 2.02% from 2.12% in the fourth quarter of 2016 compared to the fourth quarter of 2015.
Excluding the impact of unlocking charges (expense reductions) discussed under “Annuity Unlocking” below, AFG’s amortization of DPAC and commission expenses as a percentage of average fixed annuity benefits accumulated was 1.06% for the fourth quarter of 2016 compared to 0.75% for the fourth quarter of 2015 and has generally ranged between 0.75% and 0.85%. 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. For example, the positive impact of the significantly higher than anticipated interest rates and strong stock market performance during the fourth quarter of 2016 on the fair value of derivatives related to fixed-indexed annuities (discussed below) resulted in a partially offsetting acceleration in the amortization of DPAC. During the third quarter of 2015, the deceleration in the amortization of DPAC caused by the negative impact of poor stock market performance on the fair value accounting for derivatives related to fixed-indexed annuities was limited on certain recently issued products. This prior period limitation had a $5 million favorable impact on the amortization of DPAC related to the fair value accounting for those derivatives when the stock market rebounded during the fourth quarter of 2015. This favorable impact is reported in the impact on DPAC of derivatives related to FIAs.
As illustrated in the table above, the change in fair value of derivatives related to fixed-indexed annuities, including the related impact on amortization of DPAC, increased the annuity segment’s earnings before income taxes by $29 million in the fourth quarter of 2016 and by $5 million in the fourth quarter of 2015.
Annuity premiums received and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited and other benefits are charged to expense and decreases for surrender and other policy charges are credited to other income.
AFG continues to implement product and process changes needed to comply with the Department of Labor (“DOL”) fiduciary rule and is proceeding under the premise the DOL rule becomes effective in April 2017 in its current form. There is considerable discussion surrounding the possibility of a delay or other action impacting the rule. On February 9, 2017, the DOL filed a notice with the Office of Management and Budget to delay implementation of the regulation. However, until there is some definitive action impacting the rule, AFG intends to continue to pursue necessary changes.
The following table details AFG’s loss before income taxes from operations outside of its insurance operations for three months ended December 31, 2016 and 2015 (dollars in millions):
Summit, the workers’ compensation insurance business that AFG acquired in April 2014, collects fees from a small group of unaffiliated insurers for providing underwriting, policy administration and claims services. In addition, certain of AFG’s property and casualty businesses collect fees from customers for ancillary services such as workplace safety programs and premium financing. In the fourth quarter of 2016, AFG collected $17 million in fees for these services compared to $16 million in the fourth quarter of 2015. Management views this fee income, net of the $11 million in the fourth quarter of 2016 and $10 million in the fourth quarter of 2015, in expenses incurred to generate such fees, as a reduction in the cost of underwriting its property and casualty insurance policies. Consistent with internal management reporting, these fees and the related expenses are netted and recorded as a reduction of commissions and other underwriting expenses in AFG’s segmented results.
The increase in average indebtedness for the fourth quarter of 2016 as compared to the fourth quarter of 2015 reflects the following financing transactions completed by AFG between October 1, 2015 and October 1, 2016:
Issued $300 million of 3.50% Senior Notes on August 22, 2016.
Issued $150 million of 6% Subordinated Debentures on November 17, 2015.
AFG’s holding companies and other operations outside of its insurance operations recorded other expenses of $37 million in the fourth quarter of 2016 compared to $38 million in the fourth quarter of 2015, a decrease of $1 million (3%).
AFG’s impairment charges on securities for the fourth quarter of 2016 consist of $10 million on equity securities and $1 million on fixed maturities compared to $46 million on equity securities, $11 million on fixed maturities and $3 million on other investments in the fourth quarter of 2015. Approximately $7 million in impairment charges in the fourth quarter of 2016 are related to an equity investment in a pharmaceutical company. Approximately $26 million of the charges in the fourth quarter of 2015 are attributable to real estate and mortgage related investments, $12 million are on investments in asset managers and $8 million are on energy related investments.
Consolidated Income Taxes AFG’s consolidated provision (credit) for income taxes was a benefit of $71 million for the fourth quarter of 2016 compared to an expense of $80 million in the fourth quarter of 2015, a decrease of $151 million (189%). The following is a reconciliation of income taxes at the statutory rate of 35% to the provision (credit) for income taxes as shown in the segmented statement of earnings (dollars in millions):
The changes in valuation allowance in the table above are primarily increases in the valuation allowance on tax benefits related to losses in the Neon Lloyd’s insurance business. Due to the uncertainty concerning the realization of the deferred tax benefits associated with these losses, AFG maintains a full valuation allowance against these deferred tax assets.
Consolidated Noncontrolling Interests AFG’s consolidated net earnings attributable to noncontrolling interests was $3 million for the fourth quarter of 2016 compared to $1 million for the fourth quarter of 2015.
RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 2016, 2015 AND 2014
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, 2016, 2015 and 2014 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 $577 million in GAAP pretax earnings in 2016 compared to $576 million in 2015, an increase of $1 million. Property and casualty core pretax earnings were $646 million in 2016 compared to $577 million in 2015, an increase of $69 million (12%). The increase in GAAP and core pretax earnings reflects improved underwriting results in the Property and transportation group and higher net investment income, partially offset by lower underwriting profit in the Specialty casualty and Specialty financial groups. GAAP pretax earnings also reflect a pretax non-core charge of $65 million in the second quarter of 2016 related to the exit of certain lines of business within Neon and a $32 million pretax non-core gain on the sale of an apartment property in the second quarter of 2016 compared to a $51 million pretax non-core gain on the sale of a hotel in the second quarter of 2015 and a $15 million pretax non-core gain on the sale of an apartment property in the fourth quarter of 2015, as well as non-core special A&E charges of $36 million in 2016 compared to $67 million in 2015.
AFG’s property and casualty insurance operations contributed $576 million in GAAP pretax earnings in 2015 compared to $456 million in 2014, an increase of $120 million (26%). Property and casualty core pretax earnings were $577 million in 2015
Net written premiums (“NWP”) for AFG’s property and casualty insurance segment were $4.39 billion in 2016 compared to $4.33 billion in 2015, an increase of $59 million (1%). NWP increased $307 million (8%) in 2015 compared to 2014. Detail of AFG’s property and casualty net written premiums is shown below (dollars in millions):
Net earned premiums (“NEP”) for AFG’s property and casualty insurance segment were $4.33 billion in 2016 compared to $4.22 billion in 2015, an increase of $104 million (2%). NEP increased $346 million (9%) in 2015 compared to 2014. Detail of AFG’s property and casualty net earned premiums is shown below (dollars in millions):
The $355 million (6%) increase in gross written premiums in 2015 compared to 2014 reflects $535 million in premiums from Summit (acquired in April 2014) in 2015 compared to $414 million in 2014 as well as significant growth in other businesses within the Specialty casualty and Property and transportation groups. Overall average renewal rates increased approximately 1% in 2015.
Gross written premiums increased $113 million (5%) in 2015 compared to 2014. This increase is the result of higher gross written premiums in the transportation businesses due primarily to new accounts, higher gross written premiums in the agricultural businesses and new gross written premiums from the Singapore branch, which opened for business in June 2015, partially offset by lower gross written premiums in the property and inland marine businesses. Average renewal rates were up approximately 4% for this group in 2015, including a 5% increase in National Interstate’s renewal rates. Reinsurance premiums ceded as a percentage of gross written premiums were comparable in 2015 and 2014.
Specialty casualty Gross written premiums increased $53 million (2%) in 2016 compared to 2015. Higher gross written premiums in the excess and surplus, targeted markets and workers’ compensation businesses were partially offset by lower premiums in the general liability business and by Neon’s exit of certain lines of business and implementation of more stringent underwriting standards at Neon. Lower premiums in the general liability business were primarily the result of competitive market conditions, re-underwriting efforts within the Florida homebuilders market and the slowdown within the energy sector. Average renewal rates decreased approximately 1% for this group in 2016, including a decrease of approximately 4% in the workers’ compensation businesses. Excluding the workers’ compensation business, average renewal rates for this group increased approximately 1% during 2016. Reinsurance premiums ceded as a percentage of gross written premiums increased 2 percentage points in 2016 compared to 2015, reflecting the cession of Neon’s UK medical malpractice business and a change in the mix of business at Neon.
Gross written premiums increased $210 million (8%) in 2015 compared to 2014 reflecting $535 million in gross written premiums from Summit (acquired in April 2014) in 2015 compared to $414 million in 2014. Excluding premiums from Summit, gross written premiums increased 4% in 2015 compared to 2014. While most of the businesses in this group reported growth, the workers’ compensation, excess and surplus lines and targeted markets businesses were primary drivers of the higher premiums, partially offset by lower premiums in the general liability business, primarily the result of competitive market conditions, re-underwriting efforts within the Florida homebuilders market and the slowdown within the energy sector. Average renewal rates for this group were down 1% in 2015 due primarily to lower pricing in the workers’ compensation businesses. Excluding the workers’ compensation business, average renewal rates in this group increased 1% during 2015. Reinsurance premiums ceded as a percentage of gross written premiums declined 1 percentage point in 2015 compared to 2014 reflecting the impact of the acquisition of Summit, which cedes only about 1% of its premiums.
Gross written premiums increased $32 million (5%) in 2015 compared to 2014 due primarily to higher gross written premiums in the surety, financial institutions and equipment leasing businesses. Average renewal rates for this group were flat in 2015. Reinsurance premiums ceded as a percentage of gross written premiums decreased 4 percentage points in 2015 compared to 2014, reflecting a decline in auto dealer business, which is heavily reinsured.
The table below (dollars in millions) details the components of the combined ratio for AFG’s property and casualty insurance segment for 2016, 2015 and 2014:
Specialty casualty Underwriting profit for this group was $78 million in 2016 compared to $146 million in 2015, a decrease of $68 million (47%). Higher underwriting profitability in the workers’ compensation businesses, due primarily to higher favorable prior year reserve development, and improved results in the general liability business were more than offset by adverse prior year reserve development in the excess and surplus and targeted markets businesses, current accident year trade credit losses in Neon’s political risk and trade credit business and higher catastrophe losses.
Underwriting profit for this group was $146 million in 2015 compared to $136 million in 2014, an increase of $10 million (7%). This increase is due primarily to higher profitability in the workers’ compensation and targeted markets businesses, partially offset by higher adverse prior year reserve development at Neon and in the general liability and excess and surplus businesses and lower favorable prior year reserve development in the executive liability business.
Specialty financial Underwriting profit for this group was $84 million in 2016 compared to $87 million in 2015, a decrease of $3 million (3%). Higher underwriting profit in the fidelity and crime and surety businesses, primarily the result of higher favorable prior year reserve development, was more than offset by lower underwriting profit in the financial institutions and trade credit businesses, resulting primarily from lower favorable prior year reserve development.
The current accident year loss and LAE ratio, excluding catastrophe losses for AFG’s Specialty property and casualty insurance operations was 61.8% in 2016, 62.2% in 2015 and 63.5% in 2014.
The 0.3 percentage point increase in the loss and LAE ratio for the current year, excluding catastrophe losses in 2015 compared to 2014 reflects the inclusion of Summit following its acquisition in April 2014, which has a higher loss and LAE ratio than AFG’s overall Specialty casualty group.
Specialty financial The loss and LAE ratio for the current year, excluding catastrophe losses is comparable in 2016 and 2015.
The 3.2 percentage point decrease in the loss and LAE ratio for the current year, excluding catastrophe losses in 2015 compared to 2014 reflects an improvement in the loss and LAE ratio of the financial institutions, fidelity and equipment leasing businesses.
AFG’s Specialty property and casualty insurance operations recorded net favorable reserve development related to prior accident years of $61 million in 2016 compared to $37 million in 2015 and $19 million in 2014, an increase of $24 million (65%) and $18 million (95%), respectively.
Property and transportation Net favorable reserve development of $21 million in 2016 reflects lower than expected losses in the crop operations and lower than expected claim severity in the property and inland marine and trucking businesses, partially offset by reserve strengthening at National Interstate and higher than expected claim frequency in the ocean marine business.
Specialty financial Net favorable reserve development of $23 million in 2016 reflects lower than anticipated claim severity in the fidelity and crime business, lower than expected claim frequency and severity in the surety business and lower than anticipated claim frequency in the financial institutions business.
Net favorable reserve development of $17 million in 2014 reflects lower than expected claim severity in the surety and fidelity businesses and lower than expected claim frequency and severity in the trade credit business and products for financial institutions.
Other specialty In addition to the reserve development discussed above, total Specialty prior year reserve development includes net favorable reserve development of $4 million in 2016 and $11 million in both 2015 and 2014, reflecting
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. Catastrophe losses of $55 million in 2016 resulted primarily from winter storms in the first quarter, storms in Texas in the second quarter, flooding in Louisiana and multiple storms in the southern United States in the third quarter and Hurricane Matthew in the fourth quarter. Catastrophe losses of $35 million in 2015 resulted primarily from winter storms in the first quarter, multiple storms in the midwestern and central United States in the second and third quarters and flooding in the midwestern United States in the fourth quarter. Catastrophe losses of $20 million in the Property and transportation group in 2014 were primarily from winter storms in the month of January and multiple storms in the midwestern and central United States in the second quarter.
AFG’s property and casualty commissions and other underwriting expenses (“U/W Exp”) were $1.33 billion in 2016 compared to $1.30 billion in 2015, an increase of $26 million (2%). AFG’s underwriting expense ratio was 30.7% in 2016 compared to 30.9% in 2015, a decrease of 0.2 percentage points.
AFG’s overall expense ratio decreased 0.2% in 2016 as compared to 2015.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums decreased 0.5 percentage points in 2016 compared to 2015 reflecting lower profitability-based commissions paid to agents.
Net investment income in AFG’s property and casualty operations was $350 million in 2016 compared to $319 million in 2015, an increase of $31 million (10%). Net investment income in AFG’s property and casualty operations was $319 million in 2015 compared to $294 million in 2014, an increase of $25 million (9%). 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 yield earned on investments held by AFG’s property and casualty operations are provided below (dollars in millions):
AFG and its consolidated subsidiaries incurred $3 million in transaction expenses related to the February 2014 tender offer by GAI to acquire all of the NATL common stock that it did not already own. These expenses consisted primarily of financial advisory and legal services. The tender offer was terminated in March 2014.
Interest expense for AFG’s property and casualty operations includes interest charges on long-term debt within the property and casualty operations.
AFG’s annuity operations contributed $331 million in pretax earnings in 2015 compared to $328 million in 2014, an increase of $3 million (1%). While AFG’s average annuity investments (at amortized cost) were 12% higher in 2015 as compared to 2014, the benefit of this growth and the impact that fluctuations in interest rates had on the fair value accounting for FIAs was offset by the negative impact that the stock market decrease had on certain annuity reserves in 2015 compared to a stock market increase in 2014, the run-off of higher yielding investments and higher general and administrative expenses in 2015 compared to 2014. Operating earnings also include a net unlocking expense reduction of $10 million in 2015 compared to $1 million in 2014.
Interest credited - fixed in 2016 was $574 million compared to $532 million in 2015, an increase of $42 million (8%). 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. The average interest rate credited to policyholders, calculated as interest credited divided by average fixed annuity benefits accumulated, decreased 0.10 percentage points to 2.04% from 2.14% in 2016 compared to 2015.
Annuity policy charges and other miscellaneous income, which consist primarily of surrender charges, amortization of deferred upfront policy charges (unearned revenue) and income from sales of real estate, were $50 million in 2016 compared to $55 million in 2015, a decrease of $5 million (9%). Other miscellaneous income includes $5 million in income from the sale of real estate in 2016 compared to $6 million in 2015. Excluding the impact of unlocking charges of $1 million in 2016 and $2 million in 2015 related to unearned revenue, annuity policy charges and other miscellaneous income were $51 million in 2016 compared to $57 million in 2015, a decrease of $6 million (11%). As a percentage of average fixed annuity benefits accumulated, annuity policy charges and other miscellaneous income decreased 0.03 percentage points to 0.15% from 0.18% in 2016 compared to 2015.
The $24 million increase in other annuity benefits, net of guaranteed withdrawal benefit fees in 2015 compared to 2014 reflects higher expenses related to products with guaranteed withdrawal benefit features.
Excluding the impact of unlocking charges (expense reductions) discussed under “Annuity Unlocking” below, AFG’s amortization of DPAC and commission expenses as a percentage of average fixed annuity benefits accumulated was 0.70% in 2016 compared to 0.74% in 2015 and 0.67% in 2014 and has generally ranged between 0.75% and 0.85%. 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. For example, the negative impact of significantly lower than anticipated interest rates during 2016, the significant stock market decrease in 2015 and slightly lower than anticipated interest rates during 2014 on the fair value of derivatives related to fixed-indexed annuities (discussed below) resulted in a partially offsetting deceleration in the amortization of DPAC.
Annuity other expenses were $110 million in 2016, $96 million in 2015 and $82 million in 2014, representing an increase of $14 million (15%) in 2016 compared to 2015 and an increase of $14 million (17%) in 2015 compared to 2014. 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 0.02 percentage points to 0.38% from 0.36% in 2016 compared to 2015 and 0.02 percentage points to 0.36% from 0.34% in 2015 compared to 2014. The increase in annuity other expenses in 2016 compared to 2015 primarily reflects growth in the business as well as an increase in the number of sales personnel focused on new initiatives and increased market share within existing financial institutions and retail marketing associations. The increase in annuity other expenses in 2015 compared to 2014 primarily reflects higher expenses related to professional services and employee compensation plans in 2015. Annuity other expenses for 2014 includes the favorable impact of settling certain accrued expenses at a lower cost than previously estimated.
As illustrated in the table above, the change in fair value of derivatives related to fixed-indexed annuities, including the related impact on amortization of DPAC decreased the annuity segment’s earnings before income taxes by $27 million, $23 million and $34 million in 2016, 2015 and 2014, respectively.
AFG’s net spread earned on fixed annuities increased 0.03 percentage points to 1.29% from 1.26% in 2016 compared to 2015 due primarily to the 0.04 percentage point increase in AFG’s net interest spread.
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 2016, 2015 and 2014 (in millions):
AFG’s annuity operations generated statutory premiums of $4.44 billion in 2016, $4.14 billion in 2015 and $3.70 billion in 2014, an increase of $295 million (7%) in 2016 compared to 2015 and an increase of $444 million (12%) in 2015 compared to 2014. The following table summarizes AFG’s annuity sales (dollars in millions):
The decrease in long-term care net earned premiums and benefit expense in 2016 compared to 2015 is due to the sale of subsidiaries containing substantially all of AFG’s run-off long-term care insurance business in December of 2015.
AFG’s net GAAP pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $176 million in 2015 compared to $149 million in 2014, an increase of $27 million (18%). AFG’s net core pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $160 million in 2015 compared to $143 million in 2014, an increase of $17 million (12%).
The following table details AFG’s GAAP and core loss before income taxes from operations outside of its insurance operations in 2016, 2015 and 2014 (dollars in millions):
Excludes pretax non-core special A&E charges of $5 million, $12 million and $6 million in 2016, 2015 and 2014, respectively, and a pretax non-core loss on retirement of debt of $4 million in 2015.
AFG recorded net investment income on investments held outside of its insurance operations of $6 million, $4 million and $5 million in 2016, 2015 and 2014, respectively.
Summit, the workers’ compensation insurance business that AFG acquired in April 2014, collects fees from a small group of unaffiliated insurers for providing underwriting, policy administration and claims services. In addition, certain of AFG’s property and casualty businesses collect fees from customers for ancillary services such as workplace safety programs and premium financing. In 2016, AFG collected $60 million in fees for these services compared to $54 million in 2015. Management views this fee income, net of the $41 million in 2016 and $38 million in 2015, in expenses incurred to generate such fees, as a reduction in the cost of underwriting its property and casualty insurance policies. Consistent with internal management reporting, these fees and the related expenses are netted and recorded as a reduction of commissions and other underwriting expenses in AFG’s segmented results. Beginning with the first quarter of 2015, these fees are shown in other income and the related expenses are shown in other expenses in AFG’s Statement of Earnings.
AFG recorded other income outside of its insurance operations of $6 million in 2016, $9 million in 2015 and $11 million in 2014.
The increase in average indebtedness for 2016 as compared to 2015 reflects the following financing transactions completed by AFG between January 1, 2015 and December 31, 2016:
AFG’s holding companies and other operations outside of its insurance operations recorded interest expense of $73 million in 2015 compared to $70 million in 2014, an increase of $3 million (4%). This increase reflects higher average indebtedness during 2015 compared to 2014, partially offset by a lower weighted average interest rate on outstanding debt and the favorable impact of the interest rate swap entered into in June 2015.
As a result of the internal reviews and comprehensive external 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 $5 million in 2016, $12 million in 2015 and $6 million in 2014 to increase liabilities related to the A&E exposures of AFG’s former railroad and manufacturing operations. The charge in 2016 is due to relatively small movements across several sites that primarily reflect changes in the scope and costs of investigation. The charges in 2015 and 2014 related to slightly higher estimated costs at sites where remediation is underway, coupled with higher estimated cleanup costs at a limited number of sites. Total charges recorded to increase liabilities for A&E exposures of AFG’s former railroad and manufacturing operations (included in other expenses) were $20 million in 2016, $22 million in 2015 and $13 million in 2014.
Excluding the non-core special A&E charges and the non-core loss on retirement of debt discussed above, AFG’s holding companies and other operations outside of its insurance operations recorded other expenses of $128 million in 2016 compared to $115 million in 2015, an increase of $13 million (11%). This increase reflects higher holding company expenses related to employee benefit plans that are tied to stock market performance, a $5 million donation to the University of Cincinnati College of Business in 2016 and higher expenses related to AFG’s former railroad and manufacturing operations. AFG’s holding companies and other operations outside of its insurance operations recorded other expenses of $115 million in 2015 compared to $114 million in 2014, an increase of $1 million (1%).
Consolidated Realized Gains (Losses) on Securities AFG’s consolidated realized gains (losses) on securities, which are not allocated to segments, were gains of $19 million in 2016 compared to losses of $19 million in 2015, an increase of $38 million (200%). AFG’s consolidated realized losses on securities were $19 million in 2015 compared to gains of $52 million in 2014, a decrease of $71 million (137%). Realized gains (losses) on securities consisted of the following (in millions):
AFG’s impairment charges on securities in 2015 consist of $94 million on equity securities, $43 million on fixed maturities and $3 million on other investments. Approximately $41 million of the charges are on real estate and mortgage related investments, $38 million are on energy related investments and $12 million are on investments in asset managers.
Consolidated Realized Gains (Losses) on Subsidiaries In 2015, AFG recorded a pretax realized loss of $166 million on the sale of subsidiaries containing substantially all of AFG’s run-off long-term care insurance business. In the second quarter of 2016, AFG received additional proceeds based on the final closing balance sheet and adjusted certain accrued expense estimates associated with the sale, resulting in a $2 million pretax favorable adjustment to the loss recorded in 2015. See Note B - “Acquisitions and Sale of Businesses” to the financial statements. In addition, AFG recorded a $5 million pretax realized gain in 2015 representing an adjustment to the previously recognized loss on a small property and casualty subsidiary sold several years ago.
Consolidated Noncontrolling Interests AFG’s consolidated net earnings (loss) attributable to noncontrolling interests was earnings of $19 million in 2016 compared to $18 million in 2015, an increase of $1 million (6%). AFG’s consolidated net earnings (loss) attributable to noncontrolling interests was earnings of $18 million in 2015 compared to a net loss of $46 million in 2014, an improvement of $64 million (139%). The following table details net earnings (loss) in consolidated subsidiaries attributable to holders other than AFG (dollars in millions):
The losses of Managed Investment Entities in 2014 represent CLO losses that ultimately inure to holders of the CLO debt. See Note A - “Accounting Policies - Managed Investment Entities” to the financial statements for a discussion of accounting
In February 2016, the FASB issued ASU 2016-02, Leases, which requires entities that lease assets for terms longer than one year to recognize the assets and liabilities for the rights and obligations created by those leases on the balance sheet based on the present value of cash flows. Qualitative and quantitative disclosures of the amount, timing and uncertainty of cash flows arising from leases will also be required. Although the guidance allows for early adoption, AFG expects to adopt the updated guidance effective January 1, 2019 (when it is required). The guidance will require the earliest comparative period presented to include the measurement and recognition of existing leases with an adjustment to shareholders’ equity as if the updated guidance had always been applied. Although the guidance will result in higher assets and higher liabilities from the recognition of assets and liabilities related to operating leases, it does not change the manner in which lease expense is recognized in the statement of earnings. Although management is currently evaluating the impact of this guidance, AFG does not expect it to have a material effect on its results of operations or financial position.
recorded immediately in the income statement through realized gains (losses). AFG will be required to adopt this guidance effective January 1, 2020. AFG cannot estimate the impact that the updated guidance will have on its results of operations, financial position or liquidity until the updated guidance is adopted.
Consolidated Statement of Earnings for the years ended December 31, 2016, 2015 and 2014
Consolidated Statement of Cash Flows for the years ended December 31, 2016, 2015 and 2014
AFG’s management, with participation of its Co-Chief Executive Officers and its Chief 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 CFO 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 2016 that materially affected, or are reasonably likely to materially affect, AFG’s internal control over financial reporting.
Based on AFG’s evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2016. The attestation report of AFG’s independent registered public accounting firm on AFG’s internal control over financial reporting as of December 31, 2016, is set forth on the next page.
We have audited American Financial Group, Inc. and subsidiaries’ (the Company’s) internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, American Financial Group, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Financial Group, Inc. and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of earnings, comprehensive income, changes in equity and cash flows for each of the three years in the period ended December 31, 2016, and our report dated February 24, 2017, expressed an unqualified opinion thereon.
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of earnings, comprehensive income, changes in equity and cash flows for each of the three years in the period ended December 31, 2016. Our audits also included the financial statement schedules listed in the Index at Item 15(a)(2). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Financial Group, Inc. and subsidiaries at December 31, 2016 and 2015 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
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. Other than the fair value measurements used in recording the loss on the sale of substantially all of its long-term care business in 2015 (see Note B - “Acquisitions and Sale of Businesses”), AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in 2016 or 2015.
In January 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-01, which, among other things, will require all equity securities currently classified as “available for sale” to be reported at fair value, with holding gains and losses recognized in net income, instead of AOCI. AFG will be required to adopt this guidance effective January 1, 2018.
Premiums and discounts on fixed maturity securities are amortized using the interest method. Mortgage-backed securities (“MBS”) are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
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
Deferred Policy Acquisition Costs (“DPAC”) Policy acquisition costs (principally commissions, premium taxes and certain underwriting and policy issuance costs) directly related to the successful acquisition or renewal of an insurance contract are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues. See “Life, Accident and Health Reserves” below for details on the impact of loss recognition on the accounting for traditional life and health insurance contracts.
when an election has been made to account for that entity’s assets and liabilities at fair value. The fair values of a CLO’s assets may differ from the separately measured fair values of its liabilities even though the CLO liabilities only have recourse to the CLO assets. Under the new guidance, AFG elected to set the carrying value of the CLO liabilities equal to the fair value of the CLO assets (which have more observable fair values) as an alternative to reporting those liabilities at a separately measured fair value. CLO earnings attributable to AFG’s shareholders continue to be measured by the change in the fair value of AFG’s investments in the CLOs and management fees earned.
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, guaranteed withdrawals and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liabilities for EDAR and guaranteed withdrawals are accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and annuity policy charges, and unearned revenues once they are recognized as income.
For long-duration contracts (such as traditional life and long-term care policies), loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums (including reasonably expected rate increases) are not expected to cover the present value of future claims payments and related settlement and maintenance costs (excluding overhead) as well as unamortized acquisition costs. If a block of business is determined to be in loss recognition, a charge is recorded in earnings in an amount equal to the excess of the present value of expected future claims costs and unamortized acquisition costs over existing reserves plus the present value of expected future premiums (with no provision for adverse deviation). The charge is recorded first to reduce unamortized acquisition costs and then as an additional reserve (if unamortized acquisition costs have been reduced to zero).
Noncontrolling Interests For balance sheet purposes, noncontrolling interests represents the interests of shareholders other than AFG in consolidated entities. In the statement of earnings, net earnings and losses attributable to noncontrolling interests represents such shareholders’ interest in the earnings and losses of those entities.
Earnings Per Share Although basic earnings per share only considers shares of common stock outstanding during the period, the calculation of diluted earnings per share includes the following adjustments to weighted average common shares related to stock-based compensation plans: 2016 - 1.6 million, 2015 - 1.8 million and 2014 - 2.0 million.
Acquisition of Noncontrolling Interest in National Interstate Corporation On November 10, 2016, AFG acquired the 49% of National Interstate Corporation (“NATL”) not previously owned by AFG’s wholly-owned subsidiary, Great American Insurance Company (“GAI”) for $315 million ($32.00 per share) in a merger transaction. In addition, NATL paid a one-time special cash dividend of $0.50 per share to its shareholders immediately prior to the merger closing ($5 million was paid to noncontrolling shareholders). Expenses related to the merger were approximately $10 million and were expensed as incurred.
Sale of Long-term Care Business In December 2015, AFG completed the sale of substantially all of its run-off long-term care insurance business (which was included in the run-off long-term care and life segment) to HC2 Holdings, Inc. (“HC2”) for an initial payment of $7 million in cash and HC2 securities with a fair value of $11 million. AFG may also receive up to $13 million of additional proceeds from HC2 in the future contingent upon the release of certain statutory-basis liabilities of the legal entities sold by AFG. In connection with obtaining regulatory approval for the transaction, AFG agreed to provide up to an aggregate of $35 million of capital support for the insurance companies, on an as-needed basis to maintain specified surplus levels, subject to immediate reimbursement by HC2 through a five-year capital maintenance agreement. The legal entities involved in the transaction, United Teacher Associates Insurance Company (“UTA”) and Continental General Insurance Company (“CGIC”), contained substantially all of AFG’s long-term care insurance reserves (96% as measured by net statutory reserves as of November 30, 2015), as well as smaller blocks of annuity and life insurance business. Following the sale of these subsidiaries, AFG has only a small block of long-term care insurance (1,600 policies) with approximately $37 million in reserves at December 31, 2016. AFG had ceased new sales of long-term care insurance in January 2010, but continued to service and accept renewal premiums on its outstanding policies, which are guaranteed renewable.
Includes a special charge of $65 million related to the exit of certain lines of business within AFG’s Lloyd’s-based insurer, Neon, in the second quarter of 2016 and special charges to increase asbestos and environmental (“A&E”) reserves of $36 million, $67 million and $24 million in 2016, 2015 and 2014, 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 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, and prior to 2015 certain liabilities of the CLOs.
In December 2015, AFG completed the sale of substantially all of its run-off long-term care insurance business. As discussed in Note B - “Acquisitions and Sale of Businesses,” AFG recorded a loss in the first quarter of 2015 to write down the net carrying value of the assets and liabilities to be disposed to the estimated net sale proceeds (estimated fair value less costs to sell). The estimate of fair value used to determine that loss was derived using significant unobservable inputs (Level 3). At the closing date, approximately $11 million (excluding cash) of the net proceeds was measured at fair value. These fair value measurements are categorized in the fair value hierarchy as follows: Level 1 - $5 million; Level 2 - $2 million and Level 3 - $4 million.
Approximately 4% of the total assets carried at fair value on December 31, 2016, were Level 3 assets. Approximately 78% ($1.37 billion) of the Level 3 assets were priced using non-binding broker quotes, for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AFG. Since internally developed Level 3 asset fair values represent less than 10% of AFG’s Shareholders’ Equity, any justifiable changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.
The range of adjustments for insurance subsidiary’s credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AFG’s individual fixed-indexed annuity products with an expected range of 6% to 10% in the majority of future calendar years (3% to 21% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flows assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.
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, 2016 and December 31, 2015, respectively, were $189 million and $205 million. Gross unrealized gains on such securities at December 31, 2016 and December 31, 2015 were $130 million and $134 million, respectively. Gross unrealized losses on such securities at December 31, 2016 and December 31, 2015 were $3 million and $6 million, respectively. These amounts represent the non-credit other-than-temporary impairment charges recorded in AOCI adjusted for subsequent changes in fair values and relate to residential MBS.
The following tables show gross unrealized losses (dollars 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, 2016 and 2015.
At December 31, 2016, the gross unrealized losses on fixed maturities of $245 million relate to 1,242 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 84% of the gross unrealized loss and 91% of the fair value.
AFG recorded $4 million in other-than-temporary impairment charges on preferred stock in 2016. At December 31, 2016, the gross unrealized losses on preferred stocks of $7 million relate to 24 securities. Only one preferred stock has been in an unrealized loss position for 12 months or more and it has an investment grade rating.
There were no investments in individual issuers that exceeded 10% of shareholders’ equity at December 31, 2016 or 2015.
(*) Net unrealized gains on fixed maturity investments supporting AFG’s annuity benefits accumulated.
As discussed under “Derivatives” in Note A - “Accounting Policies” to the financial statements, AFG uses derivatives in certain areas of its operations.
The following table summarizes the gain (loss) included in AFG’s Statement of Earnings for changes in the fair value of derivatives that do not qualify for hedge accounting for 2016, 2015 and 2014 (in millions):
The change in fair value of the embedded derivative includes losses related to unlocking of actuarial assumptions of $17 million in 2016 compared to losses of $28 million in 2015 and gains related to unlocking of actuarial assumptions of $58 million in 2014.
Derivative Designated and Qualifying as a Fair Value Hedge In June 2015, AFG entered into an interest rate swap to mitigate the interest rate risk associated with its fixed-rate 9-7/8% Senior Notes due June 2019 by effectively converting the interest rate on those notes to a floating rate of three-month LIBOR plus 8.099% (9.0624% at December 31, 2016). Since the terms of the interest rate swap match the terms of the hedged debt, changes in the fair value of the interest rate swap are offset by changes in the fair value of the hedged debt attributable to changes in interest rates. The fair value of the interest rate swap (asset of $1 million and $2 million at December 31, 2016 and December 31, 2015, respectively) and the offsetting adjustment to the carrying value of the 9-7/8% Senior Notes are both included in long-term debt on AFG’s Balance Sheet. Accordingly, the net impact on AFG’s current period earnings is that the interest expense associated with the hedged debt is effectively recorded at the floating rate. The net reduction in interest expense from the swap for 2016 and 2015 was $3 million and $2 million, respectively.
AFG is the investment manager and its subsidiaries have investments ranging from 15.0% to 64.4% of the most subordinate debt tranche of fifteen collateralized loan obligation entities or “CLOs,” which are considered variable interest entities. AFG’s subsidiaries also own portions of the senior debt tranches of certain of these CLOs. Upon formation between 2004 and 2016, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG’s investments in the subordinate debt tranches of these entities receive residual income from the CLOs only after the CLOs pay expenses (including management fees to AFG) and interest on and returns of capital to senior levels of debt securities. There are no contractual requirements for AFG to provide additional funding for these entities. AFG has not provided and does not intend to provide any financial support to these entities.
The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $75 million and $214 million at December 31, 2016 and 2015. The aggregate unpaid principal balance of the CLOs’ debt exceeded its carrying value by $159 million and $205 million at those dates. The CLO assets include $1 million in loans at both December 31, 2016 and December 31, 2015, for which the CLOs are not accruing interest because the loans are in default (aggregate unpaid principal balance of $10 million at both of those dates).
At December 31, 2016, scheduled principal payments on debt for the subsequent five years and thereafter were as follows: 2017 - none; 2018 - none; 2019 - $350 million; 2020 - none; 2021 - none and thereafter - $958 million.
Cash interest payments on long-term debt were $75 million in 2016, $75 million in 2015 and $72 million in 2014. In 2016 and 2015, AFG received $3 million and $2 million, respectively, in interest under the interest rate swap discussed above.
Stock Incentive Plans Under AFG’s stock incentive plans, employees of AFG and its subsidiaries are eligible to receive equity awards in the form of stock options, stock appreciation rights, restricted stock awards, restricted stock units and stock awards. At December 31, 2016, there were 9.3 million shares of AFG Common Stock reserved for issuance under AFG’s stock incentive plans.
AFG issued 40,336 shares of Common Stock (fair value of $71.05 per share) in the first quarter of 2016 and 54,732 shares (fair value of $62.55 per share) in the first quarter of 2015 under its Equity Bonus Plan.
AFG did not grant any stock options in 2016. Options granted in years prior to 2016 have an exercise price equal to the market price of AFG Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant and expire ten years after the date of grant.
AFG used the Black-Scholes option pricing model to calculate the fair value of its option grants issued during 2015 and 2014 (no options were granted in 2016). The expected dividend yield is based on AFG’s current dividend rate. To determine expected volatility, AFG considers its daily historical volatility as well as implied volatility on traded options. The expected term was estimated based on historical exercise patterns and post vesting cancellations. The risk-free rate for periods associated with the expected term is based upon the U.S. Treasury yield curve in effect on the grant date.
The following is a reconciliation of income taxes at the statutory rate of 35% to the provision for income taxes as shown in AFG’s Statement of Earnings (dollars in millions):
In connection with the ongoing reorganization of the Neon Lloyd’s business, in December 2016, AFG undertook a restructuring that included the liquidation for tax purposes of the foreign subsidiary that is the parent of the Neon Lloyd’s operations, resulting in a taxable loss for U.S. tax purposes. AFG reported the $111 million tax benefit associated with this loss in the fourth quarter of 2016. Approximately $29 million of the $111 million tax benefit reduced current taxes payable while the remaining tax benefit will be received from the carry-back of the tax-basis capital loss to offset capital gains in prior tax years.
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2016 (in millions):
AFG’s net deferred tax asset at December 31, 2016 and 2015 is included in other assets in AFG’s Balance Sheet.
“Foreign underwriting losses” in the table above include the net operating loss carryforward and other deferred tax assets related to the Neon Lloyd’s insurance business. Due to uncertainty concerning the realization of the deferred tax benefits
“Subsidiaries not in AFG’s tax return” in the table above represents a deferred tax liability related to AFG’s investment in NATL during the time that it was a less than 80%-owned subsidiary of AFG. In November 2016, AFG completed the acquisition of the noncontrolling interest in NATL. This transaction allowed NATL and its subsidiaries to become members of AFG’s consolidated tax group, which enabled AFG to release the deferred tax liability ($66 million at the transaction date) associated with its investment in NATL.
Cash payments for income taxes, net of refunds, were $308 million, $234 million and $347 million for 2016, 2015 and 2014, respectively.
railroad and manufacturing operations. AFG completed a comprehensive external study of its A&E exposures in the third quarter of 2015 with the aid of specialty actuarial, engineering and consulting firms and outside counsel. The study resulted in special A&E charges of $67 million for the property and casualty group and $12 million for the former railroad and manufacturing operations. AFG completed an in-depth internal review of its A&E exposures in the third quarter of 2014, which resulted in special A&E charges of $24 million for the property and casualty group and $6 million for the former railroad and manufacturing operations.
The property and casualty group’s liability for asbestos and environmental reserves was $443 million at December 31, 2016; related recoverables from reinsurers (net of allowances for doubtful accounts) at that date were $106 million.
See Note B - “Acquisitions and Sale of Businesses” for a discussion of the five-year capital maintenance agreement that AFG entered into in connection with obtaining regulatory approval for the sale of substantially all of its run-off long-term care insurance business in December 2015.
The following are quarterly results of consolidated operations for the two years ended December 31, 2016 (in millions, except per share amounts). Quarterly earnings per share do not add to year-to-date amounts due to changes in shares outstanding.
In determining management’s best estimate of the ultimate liability, management (with the assistance of 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 business within AFG’s property and casualty sub-segments.
The liability for losses and LAE for a very limited number of claims with long-term scheduled payments under certain workers’ compensation policies has been discounted at 4.5% at both December 31, 2016 and 2015, which represents an approximation of long-term investment yields. Because of the limited amount of claims involved, the net impact of discounting did not materially impact AFG’s total liability for unpaid losses and loss adjustment expenses (net reductions from discounting of $16 million and $18 million at December 31, 2016 and 2015, respectively).
Net adverse reserve development in 2014 reflects higher than expected severity in commercial auto liability losses written in the transportation businesses (within the Property and transportation sub-segment), higher than expected claims severity in contractor claims and in a run-off book of casualty business and adverse reserve development at Neon (all within the Specialty casualty sub-segment), and the $24 million special charge to increase asbestos and environmental reserves. This adverse reserve development was offset by (i) lower than expected claim severity in directors and officers liability insurance, lower than expected claim severity and frequency in excess liability insurance and lower than anticipated claim severity in specialty workers’ compensation business (all within the Specialty casualty sub-segment), and (ii) lower than expected claim severity in the surety and fidelity businesses and lower than expected claim frequency and severity in the foreign credit business and products for financial institutions (all within the Specialty financial sub-segment).
The National Association of Insurance Commissioners’ (“NAIC”) model law for risk based capital (“RBC”) applies to both life and property and casualty insurance companies. RBC formulas determine the amount of capital that an insurance company needs so that it has an acceptable expectation of not becoming financially impaired. Companies below specific trigger points or ratios are subject to regulatory action. At December 31, 2016 and 2015, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements. AFG’s insurance companies did not use any prescribed or permitted statutory accounting practices that differed from the NAIC statutory accounting practices at December 31, 2016 or 2015.
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 2017 from its insurance subsidiaries without seeking regulatory approval is $693 million. Additional amounts of dividends require regulatory approval.
In March 2014, AFG’s property and casualty insurance operations entered into a reinsurance agreement to obtain additional catastrophe protection through a catastrophe bond structure with Riverfront Re Ltd. (“Riverfront”). The reinsurance agreement provided supplemental reinsurance coverage for catastrophe losses occurring between April 1, 2014 and January 6, 2017. In connection with the reinsurance agreement, Riverfront issued notes to unrelated investors for the full amount of coverage provided under the reinsurance agreement. At the time of the agreement, AFG concluded that Riverfront is a variable interest entity, but that it did not have a variable interest in the entity because the variability in Riverfront’s results was expected to be absorbed entirely by the investors in Riverfront. Accordingly, Riverfront is not consolidated in AFG’s financial statements and the reinsurance agreement is accounted for as ceded reinsurance. AFG’s cost for this coverage was approximately $5 million per year.
AFG’s aggregate allowance for uncollectible reinsurance recoverables was $22 million at both December 31, 2016 and 2015. AFG reviews the allowance quarterly and adjusts it as necessary to reflect changes in estimates of uncollectible balances. In 2016 and 2015, AFG recorded net expense reductions of less than $1 million and $3 million, respectively, against the allowance. In 2014, AFG recorded a charge of $4 million against the allowance (included in losses and loss adjustment expenses). In 2014, the allowance was reduced by reinsurance recoverable write-offs of $6 million.
Financial Instruments - Unfunded Commitments On occasion, AFG and its subsidiaries have entered into financial instrument transactions that may present off-balance-sheet risks of both a credit and market risk nature. These transactions include commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. At December 31, 2016, AFG and its subsidiaries had commitments to fund credit facilities and contribute capital to limited partnerships and limited liability corporations of approximately $377 million.
Benefit Plans AFG expensed approximately $43 million in 2016, $34 million in 2015 and $30 million in 2014 for its retirement and employee savings plans.
Amended and Restated Non-Employee Directors Compensation Plan, filed as Exhibit 10 to the Form S-8 Registration Statement (File No. 333-181913) filed by AFG on November 13, 2012.
Stock Purchase Agreement dated January 9, 2014 by and between Liberty Mutual Group Inc. and Great American Holding, Inc. (Summit Holdings Southeast, Inc.), filed as Exhibit 10(h) to AFG’s Form 10-K for 2013.