net realized losses on securities in the fourth quarter of 2018 compared to net realized gains on securities in the fourth quarter of 2017. The 2018 period reflects the change in the fair value of equity securities that are required to be carried at fair value through net earnings under new accounting guidance adopted on January 1, 2018,
higher net investment income in the property and casualty insurance segment,
the fourth quarter 2017 tax expense related to the change in the U.S. corporate tax rate.
net realized losses on securities in 2018 compared to net realized gains on securities in 2017,
the fourth quarter 2017 tax benefit related to the Neon restructuring, and
the measurement of the derivatives embedded in fixed-indexed and variable-indexed annuity liabilities,
Condensed Consolidated Cash Flows AFG’s principal sources of cash include insurance premiums, income from its investment portfolio and proceeds from the maturities, redemptions and sales of investments. Insurance premiums in excess of acquisition expenses and operating costs are invested until they are needed to meet policyholder obligations or made available to the parent company through dividends to cover debt obligations and corporate expenses, and to provide returns to shareholders through share repurchases and dividends. Cash flows from operating, investing and financing activities as detailed in AFG’s Consolidated Statement of Cash Flows are shown below (in millions):
Net Cash Provided by Operating Activities AFG’s property and casualty insurance operations typically produce positive net operating cash flows as premiums collected and investment income exceed policy acquisition costs, claims payments and operating expenses. AFG’s net cash provided by operating activities is impacted by the level and timing of property and casualty premiums, claim and expense payments and recoveries from reinsurers. AFG’s annuity operations typically produce positive net operating cash flows as investment income exceeds acquisition costs and operating expenses. Interest credited on annuity policyholder funds is a non-cash increase in AFG’s annuity benefits accumulated liability and annuity premiums, benefits and withdrawals are considered financing activities due to the deposit-type nature of annuities. Cash flows provided by operating activities also include the activity of AFG’s managed investment entities (collateralized loan obligations) other than those activities included in investing or financing activities. The changes in the assets and liabilities of the managed investment entities included in operating activities increased cash flows from operating activities by $148 million in 2018, increased cash flows from operating activities by $60 million in 2017 and reduced cash flows from operating activities by $279 million in 2016, accounting for a $88 million increase in cash flows from operating activities in 2018 compared to 2017 and a $339 million increase in cash flows from operating activities in 2017 compared to 2016. As discussed in Note A - “Accounting Policies - Managed Investment Entities” to the financial statements, AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities and such assets and liabilities are shown separately in AFG’s Balance Sheet. Excluding the impact of the managed investment entities, net cash provided by operating activities was $1.94 billion, $1.74 billion and $1.43 billion in 2018, 2017 and 2016, respectively.
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 businesses. Net cash used in investing activities was $5.35 billion in 2018 compared to $3.29 billion in 2017, an increase of $2.06 billion. As discussed below (under net cash provided by financing activities), AFG’s annuity group had net cash flows from annuity policyholders of $2.76 billion in 2018 and $1.99 billion in 2017, which is the primary source of AFG’s cash used in investing activities. In addition, AFG’s cash on hand decreased by $823 million during 2018 as AFG invested a large portion of its cash on hand at December 31, 2017. In addition to the investment of funds provided by the insurance operations, investing activities also include the purchase and disposal of managed investment entity investments, which are presented separately in AFG’s Balance Sheet. Net investment activity in the managed investment entities was a $169 million use of cash in 2018 compared to a $205 million use of cash in 2017, accounting for a $36 million
In November 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 cash 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). See Note B - “Acquisitions and Sale of Businesses” to the financial statements.
Subsidiary Liquidity Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions, which provides the annuity operations with an additional source of liquidity. At December 31, 2018, GALIC had $1.1 billion in outstanding advances from the FHLB (included in annuity benefits accumulated), bearing interest at rates ranging from 0.15% to 0.24% over LIBOR (average rate of 2.68% at December 31, 2018). While these advances must be repaid between 2019 and 2021 ($445 million in 2019, $40 million in 2020 and $611 million in 2021), GALIC has the option to prepay all or a portion of the advances. GALIC has invested the proceeds from the advances in fixed maturity securities with similar expected lives as the advances for the purpose of earning a spread over the interest payments due to the FHLB. At December 31, 2018, GALIC estimated that it had additional borrowing capacity of approximately $300 million from the FHLB.
In the fourth quarter of 2018, GALIC, AFG’s primary annuity subsidiary, entered into a reinsurance treaty with Hannover Life Reassurance Company of America that transfers the risk of certain surrender activity in GALIC’s fixed-indexed annuity business. This treaty meets the statutory risk transfer rules and resulted in a $510 million increase in statutory surplus (through an after-tax reserve credit). The treaty reduces statutory capital and surplus volatility related to GALIC’s fixed-indexed annuity policies from stock market fluctuations, which could impact GALIC’s risk-based capital and the amount of dividends available in future periods. Under GAAP, this transaction does not meet the GAAP insurance risk transfer criteria and did not have a material impact on AFG’s financial statements.
Parent Net Cash Provided by (Used in) Investing Activities Parent holding company investing activities consist of capital contributions to and returns of capital from subsidiaries and, to a much lesser extent, parent company investment activity. Parent holding company net cash provided by investing activities was $10 million in 2018 compared to net cash used in
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 $36.62 billion for annuity benefits accumulated and $635 million for life, accident and health reserves included in AFG’s Balance Sheet as of December 31, 2018. Based on the same assumptions, AFG projects reinsurance recoveries related to life, accident and health reserves totaling $651 million as follows: Within 1 year - $65 million; 2-3 years - $113 million; 4-5 years - $85 million; and thereafter - $388 million. Actual payments and their timing could differ significantly from these estimates.
AFG’s investment portfolio at December 31, 2018, contained $42.00 billion in fixed maturity 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 and $105 million in fixed maturities classified as trading with holding gains and losses included in net investment income. In addition, AFG’s investment portfolio includes $1.63 billion in equity securities carried at fair value with
Fixed income investment funds are generally invested in securities with intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions. At December 31, 2018, the average life of AFG’s fixed maturities was about 6 years.
Approximately 91% of the fixed maturities held by AFG at December 31, 2018, 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.
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 MBS 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, 2018, 96% (based on statutory carrying value of $3.33 billion) of AFG’s MBS had an NAIC designation of 1.
Summarized information for the unrealized gains and losses recorded in AFG’s Balance Sheet at December 31, 2018, is shown in the following table (dollars in millions). Approximately $463 million of available for sale fixed maturity securities had no unrealized gains or losses at December 31, 2018.
The table below sets forth the scheduled maturities of AFG’s available for sale fixed maturity securities at December 31, 2018, based on their fair values. Securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
Based on its analysis of the factors listed above, management believes AFG will recover its cost basis in the fixed maturity securities with unrealized losses and that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, 2018. Although AFG has the ability to continue holding its fixed maturity investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers’ creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG’s ability or intent change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG’s investment portfolio could have a significant adverse effect on AFG’s liquidity. For information on AFG’s realized gains (losses) on securities, including charges for other-than-temporary impairment, see “Results of Operations - Consolidated Realized Gains (Losses) on Securities.”
The following table shows (in millions) the breakdown of AFG’s property and casualty insurance reserves between case reserves, IBNR reserves and LAE reserves (estimated amounts required to adjust, record and settle claims, other than the claim payments themselves) at December 31, 2018 and gross written premiums for the year ended December 31, 2018.
The judgments and uncertainties surrounding management’s reserve estimation process and the potential for reasonably possible variability in management’s most recent reserve estimates may also be viewed by looking at how recent historical estimates of reserves have developed. The following table shows (dollars in millions) what the impact on AFG’s net earnings would be on the more significant lines of business if the December 31, 2018, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
AFG recorded favorable prior year reserve development of $26 million in 2018 for this line of business due primarily to lower than expected claim severity. AFG recorded adverse prior year reserve development of $2 million in 2017 and $28 million in 2016 for this line of business. Claim severity trends had been significantly higher than expected beginning with accident years 2010, but have more recently stabilized.
In the fourth quarter of 2017, Neon entered into a reinsurance to close agreement for 2015 and prior years of account, which transfers the responsibility for all of the liabilities that attach to the transferred year of account (gross reserves of $385 million
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 Neon’s medical malpractice and general liability lines. In addition to the prior year reserve development related to the Neon exited lines charge, Neon recorded adverse prior year reserve development of $21 million in 2016, attributable to reserve strengthening in several lines of business, including political risk and personal accident.
Outside of its property and casualty operations, AFG also has reinsurance recoverables totaling $298 million, including $247 million related to the run-off life business. These recoverables include $210 million directly or indirectly from Hannover Life Reassurance Company of America (rated A+ by A.M. Best).
Asbestos claims against manufacturers, distributors or installers of asbestos products were presented under the products liability section of their policies, which typically had aggregate limits that capped an insurer’s liability. In recent years, a number of asbestos claims are being presented as “non-products” claims, such as those by installers of asbestos products and by property
The survival ratio is a measure often used by industry analysts to compare A&E reserves strength among companies. This ratio is typically calculated by dividing reserves for A&E exposures by the three-year average of paid losses, and therefore measures the number of years that it would take to pay off current reserves based on recent average payments. Because this ratio can be significantly impacted by a number of factors such as loss payout variability, caution should be exercised in attempting to determine reserve adequacy based simply on the survival ratio. At December 31, 2018, the property and casualty insurance segment’s three-year survival ratios compare favorably with industry survival ratios derived from data published by A.M. Best (as of December 31, 2017) as detailed in the following table:
In addition to its ongoing internal monitoring of asbestos and environmental exposures, AFG has periodically conducted comprehensive external studies of its asbestos and environmental reserves relating to the run-off operations of its property and casualty insurance segment and exposures related to its former railroad and manufacturing operations with the aid of specialty actuarial, engineering and consulting firms and outside counsel, every two years in recent periods, with an in-depth internal review during the intervening years. AFG is currently evaluating the frequency of future external studies.
An in-depth internal review of AFG’s A&E reserves was completed in the third quarter of 2018 by AFG’s internal A&E claims specialists in consultation with specialty outside counsel and an outside consultant. As a result of the review, AFG’s property and casualty insurance segment recorded an $18 million pretax special charge to increase its asbestos reserves by $6 million (net of reinsurance) and its environmental reserves by $12 million (net of reinsurance). Over the past few years, the focus of AFG’s asbestos claims litigation has shifted to smaller companies and companies with ancillary exposures. AFG’s insureds with these exposures have been the driver of the property and casualty segment’s asbestos reserve increases in recent years. AFG is seeing modestly increasing estimates for indemnity and defense compared to prior studies on certain specific open claims.
Contingencies related to Subsidiaries’ Former Operations The A&E studies and reviews discussed above encompassed reserves for various environmental and occupational injury and disease claims and other contingencies arising out of the railroad operations disposed of by American Premier’s predecessor and certain manufacturing operations disposed of by American Premier and its subsidiaries and by Great American Financial Resources, Inc. Charges resulting from the A&E study and reviews were $9 million in 2018, $24 million in 2017 and $5 million in 2016. For a discussion of the charges recorded for those operations, see “Results of Operations - Holding Company, Other and Unallocated.” Liabilities for claims and contingencies arising from these former railroad and manufacturing operations totaled $91 million at December 31, 2018. For a discussion of the uncertainties in determining the ultimate liability, see Note M - “Contingencies” to the financial statements.
Fixed-indexed Annuity Embedded Derivatives As of December 31, 2018, annuity benefits accumulated in AFG’s Balance Sheet includes $2.72 billion for the fair value of the derivatives embedded in its fixed-indexed and variable-indexed annuities. As discussed in Note F - “Derivatives” to the financial statements, AFG’s fixed-indexed and variable-indexed annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market or other financial index. Under GAAP, this index participation is considered an embedded derivative that is required to be carried at fair value in the financial statements. AFG attempts to mitigate the risk in the index-based component of these products through the purchase and sale of call and put options on the appropriate index. AFG’s strategy is designed so that the change in the fair value of the call and put options will generally offset the economic change in the liabilities from the index participation. The fair value of the embedded derivatives represents an estimate of the present value of projected policyholder benefits from the equity participation in excess of the projected minimum guaranteed contract values based on the estimated present value of certain projected future cash flows. As discussed in Note D - “Fair Value Measurements” to the financial statements, the fair value of the embedded derivatives is impacted by fluctuations in interest rates, the stock market (including the cost of options), policyholder behavior and other factors. Certain of these fluctuations, such as changes in interest rates and the performance of the stock market, are not economic in nature for the current reporting period, but rather impact the timing of reported results.
Run-off Long-term Care Insurance In December 2015, AFG completed the sale of United Teacher Associates Insurance Company and Continental General Insurance Company, the legal entities containing substantially all of its run-off long-term care insurance business, to HC2 Holdings, Inc. (“HC2”) for approximately $13 million in net proceeds. 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 expiring in 2020. With the completion of this sale, AFG divested substantially all of its long-term care business (96% as measured by net statutory reserves as of November 30, 2015) and retained only a small block of long-term care insurance (1,500 policies) with approximately $45 million of reserves at December 31, 2018. AFG will continue to accept renewal premiums on its remaining outstanding policies, which are guaranteed renewable.
Accounting standards require AFG to consolidate its investments in collateralized loan obligation (“CLO”) entities that it manages and owns an interest in (in the form of debt). See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements. The effect of consolidating these entities is shown in the tables below (in millions). The “Before CLO Consolidation” columns include AFG’s investment and earnings in the CLOs on an unconsolidated basis.
Includes a loss of $4 million in the fourth quarter of 2018 and income of $7 million in the fourth quarter of 2017 representing the change in fair value of AFG’s CLO investments plus $4 million in both the fourth quarter of 2018 and 2017 in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $6 million in both the fourth quarter of 2018 and 2017 in distributions recorded as interest expense by the CLOs.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $21 million and $32 million in 2018 and 2017, respectively, in distributions recorded as interest expense by the CLOs.
Includes income of $37 million representing the change in fair value of AFG’s CLO investments plus $17 million in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $29 million in distributions recorded as interest expense by the CLOs.
General 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. For example, core net operating earnings excludes realized gains (losses) on securities because such gains and losses are influenced significantly by financial markets, interest rates and the timing of sales. Similarly, significant gains and losses from the sale of real estate are excluded from core earnings as they are influenced by the timing of sales and realized gains (losses) and significant tax benefits (charges) related to subsidiaries are excluded because such gains and losses are largely the result of the changing business strategy and market opportunities. In addition, special charges related to coverage that AFG no longer writes, such as the Neon exited lines and for asbestos and environmental exposures are excluded from core earnings. The following table (in millions, except per share amounts) identifies non-core items and reconciles net earnings attributable to shareholders to core net operating earnings, a non-GAAP financial measure. AFG believes core net operating earnings is a useful tool for investors and analysts in analyzing ongoing operating trends and for management to evaluate financial performance against historical results because it believes this provides a more comparable measure of its continuing business.
Net earnings attributable to shareholders increased $55 million for the full-year of 2018 compared to the same period in 2017 due primarily to higher core net operating earnings, lower special A&E charges recorded in 2018 compared to 2017, losses on the retirement of debt in 2017 and the 2017 tax expense related to the change in the U.S. corporate tax rate, partially offset by net realized losses on securities in 2018 compared to net realized gains on securities in 2017, the 2017 favorable development in the Neon exited lines in connection with a reinsurance to close transaction and the 2017 tax benefit from restructuring at Neon. Core net operating earnings increased $173 million in 2018 compared to 2017 reflecting higher net investment income in the property and casualty insurance segment, lower interest charges on borrowed money, lower holding company expenses and a lower corporate income tax rate, partially offset by lower earnings in the annuity segment and income from the sale of real estate in 2017. Realized losses on securities in 2018 includes the decline in fair value of equity securities that are required to be carried at fair value through net earnings under new accounting guidance adopted on January 1, 2018. Included in the $210 million of non-core net realized losses on securities in 2018 were $214 million in net losses on equity securities that AFG continued to own at December 31, 2018.
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 three months ended December 31, 2018 and 2017 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 Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their financial statements better understand the company’s performance. Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of losses and loss adjustment expenses, and commissions and other underwriting expenses to premiums. A combined ratio under 100% indicates an underwriting profit. The combined ratio does not reflect net investment income, other income, other expenses or federal income taxes.
AFG’s property and casualty insurance operations contributed $208 million in GAAP pretax earnings in the fourth quarter of 2018 compared to $251 million in the fourth quarter of 2017, a decrease of $43 million (17%). Property and casualty core pretax earnings were $208 million in the fourth quarter of 2018 compared to $233 million in the fourth quarter of 2017, a decrease of $25 million (11%). The decrease in GAAP and core pretax earnings reflects lower underwriting profits in the Property and transportation and Specialty casualty sub-segments, partially offset by higher net investment income due to higher
Gross written premiums (“GWP”) for AFG’s property and casualty insurance segment were $1.61 billion for the fourth quarter of 2018 compared to $1.57 billion for the fourth quarter of 2017, an increase of $42 million (3%). Detail of AFG’s property and casualty gross written premiums is shown below (dollars in millions):
Net earned premiums (“NEP”) for AFG’s property and casualty insurance segment were $1.27 billion for the fourth quarter of 2018 compared to $1.23 billion for the fourth quarter of 2017, an increase of $45 million (4%). Detail of AFG’s property and casualty net earned premiums is shown below (dollars in millions):
Property and transportation Gross written premiums increased $25 million (4%) in the fourth quarter of 2018 compared to the fourth quarter of 2017. This increase was largely the result of a change in the timing of two large policy renewals in one of the transportation businesses from the third quarter to the fourth quarter of 2018. Excluding the impact of the timing of these policy renewals, gross written premiums increased 1% in the fourth quarter of 2018 compared to the fourth quarter of 2017. Lower year-over-year premiums in the crop insurance business and underwriting actions on under-performing accounts in the Singapore branch also impacted fourth quarter premiums. Average renewal rates increased approximately 3% for this group in the fourth quarter of 2018. Reinsurance premiums ceded as a percentage of gross written premiums decreased 1 percentage point for the fourth quarter of 2018 compared to the fourth quarter of 2017. Lower cessions in the crop insurance business were partially offset by reinstatement premiums in the aviation business.
Other specialty The amounts shown as reinsurance premiums ceded represent business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty property and casualty insurance sub-segments. Reinsurance premiums assumed increased $11 million (42%) in the fourth quarter of 2018 compared to the fourth quarter of 2017, reflecting an increase in premiums retained, primarily from businesses in the Specialty casualty sub-segment.
Property and transportation Underwriting profit for this group was $64 million for the fourth quarter of 2018 compared to $84 million in the fourth quarter of 2017, a decrease of $20 million (24%). Improved underwriting results in the transportation, property and inland marine and ocean marine operations were more than offset by lower underwriting profits in the agricultural businesses and the Singapore branch. The crop insurance operations reported strong profitability in the fourth quarter of 2018, albeit at lower levels than the fourth quarter of 2017. Catastrophe losses for this group had a favorable impact of $2 million in
the fourth quarter of 2018, compared to a favorable impact of $3 million in the 2017 fourth quarter, with catastrophe losses reported from the previous quarter developing favorably in the fourth quarters of both years.
Specialty casualty Underwriting profit for this group was $22 million for the fourth quarter of 2018 compared to $58 million for the fourth quarter of 2017, a decrease of $36 million (62%). Lower underwriting profit within Neon, primarily the result of higher 2018 catastrophe losses and lower year-over-year favorable reserve development due to the fourth quarter 2017 Neon reinsurance to close transaction, and to a lesser extent, lower profitability in the workers’ compensation businesses contributed to the decrease in underwriting profit in the fourth quarter of 2018 compared to the prior year period. Higher underwriting profits in the excess and surplus lines and targeted markets businesses partially offset these results. Catastrophe losses were $28 million (4.7 points on the combined ratio) for the fourth quarter of 2018 compared to $14 million (2.5 points) and related net reinstatement premiums paid of $4 million for the fourth quarter of 2017. Catastrophe losses for the fourth quarter of 2017 include the impact of the favorable reserve development on third quarter catastrophes discussed above.
Specialty financial Underwriting profit for this group was $20 million for the fourth quarter of 2018 compared to $19 million in the fourth quarter of 2017, an increase of $1 million (5%). Each business within this group achieved profitable underwriting results in both periods. Catastrophe losses were $10 million (7.1 points on the combined ratio) for the fourth quarter of 2018 compared to the favorable impact of catastrophes of $5 million (3.7 points) for the fourth quarter of 2017. Catastrophe losses reported from the previous quarter developed favorably in the fourth quarters of both years.
Other specialty This group reported an underwriting loss of $4 million for the fourth quarter of 2018 compared to $5 million in the fourth quarter of 2017, an improvement of $1 million (20%). The underwriting loss in the fourth quarter of 2018 is due primarily to losses in the business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty sub-segments. The underwriting loss in the fourth quarter of 2017 is due primarily to an $8 million charge to adjust the deferred gain on the retroactive reinsurance transaction entered into in connection with the sale of businesses in 1998.
The current accident year loss and LAE ratio, excluding catastrophe losses for AFG’s Specialty property and casualty insurance operations was 64.4% for the fourth quarter of 2018 compared to 63.3% for the fourth quarter of 2017, an increase of 1.1 percentage points.
Specialty casualty The 1.5 percentage points increase in the loss and LAE ratio for the current year, excluding catastrophe losses reflects an increase in the loss and LAE ratio at Neon.
Specialty financial The 1.5 percentage points decrease in the loss and LAE ratio for the current year, excluding catastrophe losses reflects a decrease in the loss and LAE ratio of the equipment leasing and financial institutions businesses.
AFG’s Specialty property and casualty insurance operations recorded net favorable reserve development related to prior accident years of $61 million in the fourth quarter of 2018 compared to $49 million in the fourth quarter of 2017, an increase of $12 million (24%).
Specialty financial Net favorable reserve development of $7 million in the fourth quarter of 2018 reflects lower than expected claim frequency and severity in the surety business and lower than anticipated claim frequency in run-off businesses. Net adverse reserve development of $1 million in the fourth quarter of 2017 reflects higher than expected claim severity in the financial institutions business, partially offset by lower than anticipated claim frequency and severity in the surety business.
Other specialty In addition to the reserve development discussed above, total Specialty prior year reserve development for the fourth quarter of 2018 includes net adverse reserve development of $5 million, reflecting adverse development associated with AFG’s internal reinsurance program, partially offset by amortization of deferred gains on retroactive reinsurance. Total Specialty prior year reserve development for the fourth quarter of 2017 includes net adverse reserve development of $6 million, reflecting an $8 million charge to adjust the deferred gain on the retroactive reinsurance transaction entered into in connection with the sale of businesses in 1998, partially offset by the amortization of deferred gains on retroactive reinsurance.
Aggregate Aggregate net prior accident years reserve development for AFG’s property and casualty insurance segment for the fourth quarter of 2017 includes the favorable development on the Neon exited lines discussed above and adverse reserve development of $1 million related to business outside of the Specialty group that AFG no longer writes.
AFG maintains comprehensive catastrophe reinsurance coverage, including a $15 million per occurrence net retention for its U.S.-based property and casualty insurance operations for losses up to $100 million and a separate $25 million per occurrence retention for Neon for losses up to $250 million. AFG’s property and casualty insurance operations further maintain supplemental fully collateralized reinsurance coverage up to 95% of $200 million for catastrophe losses in excess of $104 million of traditional catastrophe reinsurance through a catastrophe bond.
Catastrophe losses of $39 million in the fourth quarter of 2018 resulted primarily from Hurricane Michael and wildfires in California. Catastrophe losses of $8 million in the fourth quarter of 2017 resulted primarily from wildfires in California,
AFG’s property and casualty commissions and other underwriting expenses (“U/W Exp”) were $372 million in the fourth quarter of 2018 compared to $336 million for the fourth quarter of 2017, an increase of $36 million (11%). AFG’s underwriting expense ratio, calculated as commissions and other underwriting expenses divided by net premiums earned, was 29.3% for the fourth quarter of 2018 compared to 27.5% for the fourth quarter of 2017, an increase of 1.8 percentage points. Detail of AFG’s property and casualty commissions and other underwriting expenses and underwriting expense ratios is shown below (dollars in millions):
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums increased 2.1 percentage points in the fourth quarter of 2018 compared to the fourth quarter of 2017 reflecting growth at Neon, which has a higher expense ratio than AFG’s overall Specialty casualty group, higher dividends paid to policyholders in the workers’ compensation businesses and lower underwriting, policy administration and claims services fees collected from unaffiliated insurers in the workers’ compensation businesses.
Net investment income in AFG’s property and casualty insurance operations was $115 million in the fourth quarter of 2018 compared to $86 million in the fourth quarter of 2017, an increase of $29 million (34%). The average invested assets and overall yield earned on investments held by AFG’s property and casualty insurance operations are provided below (dollars in millions):
The increase in net investment income in the property and casualty insurance segment for the fourth quarter of 2018 as compared to the fourth quarter of 2017 reflects growth in the property and casualty insurance segment and strong earnings from limited partnerships and similar investments. The property and casualty insurance segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 4.32% for the fourth quarter of 2018 compared to 3.42% for the fourth quarter of 2017, an increase of 0.90 percentage points, reflecting the higher earnings of limited partnerships and
similar investments. AFG’s property and casualty insurance operations recorded $22 million in earnings from partnerships and similar investments and AFG-managed CLOs in the fourth quarter of 2018 compared to $6 million in the fourth quarter of 2017, an increase of $16 million (267%). The annualized yield earned on these investments was 13.8% in the fourth quarter of 2018 compared to 4.1% in the prior year period. The high returns from limited partnerships and similar investments should not be expected to repeat in future periods.
Other income and expenses, net for AFG’s property and casualty insurance operations was a net expense of $8 million for both the fourth quarter of 2018 and the fourth quarter of 2017. The table below details the items included in other income and expenses, net for AFG’s property and casualty insurance operations (in millions):
AFG’s annuity operations contributed $20 million in pretax earnings in the fourth quarter of 2018 compared to $97 million in the fourth quarter of 2017, a decrease of $77 million (79%). This decrease in AFG’s annuity segment results for the fourth quarter of 2018 as compared to the fourth quarter of 2017 is due primarily to the unfavorable impact of the significant decline in stock market performance on annuities with guaranteed withdrawal benefits and on the fair value of derivatives related to fixed-indexed annuities (“FIAs”) in the fourth quarter of 2018. AFG’s periodic detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations resulted in a net annuity charge of $4 million in the fourth quarter of 2018 and $3 million in the fourth quarter of 2017.
The following tables provide analysis of AFG’s annuity earnings before income taxes (dollars in millions):
AFG’s net interest spread decreased 0.04 percentage points to 2.58% from 2.62% in the fourth quarter of 2018 compared to the same period in 2017 due primarily to higher crediting rates on new business and lower fixed maturity investment yields, partially offset by higher earnings from limited partnerships and similar investments. Features included in current annuity product offerings allow AFG to achieve its desired profitability at a lower net interest spread than historical product offerings. As a result, AFG expects its net interest spread to narrow in the future.
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 $10 million in the fourth quarter of 2018 and $7 million the fourth quarter of 2017, an increase of $3 million (43%). Excluding the impact of unlocking charges of $3 million in the fourth quarter of 2017 related to unearned revenue, annuity policy charges and other miscellaneous income were $10 million in both the fourth quarter of 2018 and 2017. Excluding the impact of unlocking charges related to unearned revenue, annuity policy charges and other miscellaneous income as a percentage of average fixed annuity benefits accumulated decreased 0.02 percentage points to 0.08% in the fourth quarter of 2018 from 0.10% in the fourth quarter of 2017.
As discussed under “Annuity Benefits Accumulated” in Note A - “Accounting Policies” to the financial statements, guaranteed withdrawal benefit reserves are accrued for and modified using assumptions similar to those used in establishing and amortizing deferred policy acquisition costs. The guaranteed withdrawal benefit reserve related to FIAs can be inversely impacted by the calculated FIA embedded derivative reserve as the value to policyholders of the guaranteed withdrawal benefits increases when the benefit of stock market participation decreases. As shown in the table above, the change in the stock market increased AFG’s guaranteed withdrawal benefit reserve by $22 million in the fourth quarter of 2018 compared to a favorable impact of $5 million in the fourth quarter of 2017. This $27 million increase (540%) was the primary cause of the $27 million overall increase in other annuity benefits, net of guaranteed withdrawal fees in the fourth quarter of 2018 compared to the fourth quarter of 2017.
Annuity acquisition expenses for the fourth quarter of 2018 were $56 million compared to $15 million for the fourth quarter of 2017, an increase of $41 million (273%). Excluding the $1 million and $35 million favorable impact on amortization of DPAC from the unlocking recorded in the fourth quarter of 2018 and 2017, respectively, annuity acquisition expenses were $57 million for the fourth quarter of 2018 compared to $50 million for the fourth quarter of 2017, an increase of $7 million (14%), reflecting growth in the business. Excluding the impact of unlocking charges discussed under “Annuity Unlocking” below, AFG’s amortization of DPAC and commission expenses as a percentage of average fixed annuity benefits accumulated was 0.59% for the fourth quarter of 2018 compared to 0.60% for the fourth quarter of 2017 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 FIA business, and (ii) differences in actual experience from actuarially projected estimates and assumptions. For example, the unfavorable impact of the significant decline in stock market performance during the fourth quarter of 2018 and the unfavorable impact of lower than anticipated interest rates in the fourth quarter of 2017 on the fair value of derivatives related to FIAs both resulted in a partially offsetting deceleration in the amortization of DPAC.
AFG’s fixed-indexed (including variable-indexed) annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market or other financial index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase and sale of call and put options on the appropriate index. AFG’s strategy is designed so that the change in the fair value of the call option assets and put option liabilities will generally offset the economic change in the net liability from the index participation. Both the index-based component of the annuities (an embedded derivative) and the related call and put options are considered derivatives that must be adjusted for changes in fair value through earnings each period. The fair values of these derivatives are impacted by actual and expected stock market performance and interest rates as well as other factors. For a list of other factors impacting the fair value of the embedded derivative component of AFG’s annuity benefits accumulated, see Note D - “Fair Value Measurements” to the financial statements. Fluctuations in certain of these factors, such as changes in interest rates and the performance of the stock market, are not economic in nature for the current reporting period, but rather impact the timing of reported results.
An estimate of the related acceleration/deceleration of amortization of deferred sales inducements and deferred policy acquisition costs.
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 $47 million in the fourth quarter of 2018 and $11 million in the fourth quarter of 2017.
See “Annuity Unlocking” below for a discussion of the impact that the periodic review of actuarial assumptions had on the change in the fair value of the embedded derivative liability.
AFG’s net spread earned on fixed annuities decreased 0.96 percentage points to 0.25% from 1.21% in the fourth quarter of 2018 compared to the same period in 2017 due primarily to the net impact of poor stock market performance on annuities with guaranteed withdrawal benefits, changes in the fair value of derivatives and related DPAC amortization offset discussed above and the 0.04 percentage points decrease 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 the three months ended December 31, 2018 and 2017 (in millions):
In the fourth quarters of 2018 and 2017, AFG conducted a detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded a net charge related to its annuity business of $4 million in 2018 and $3 million in 2017, which impacted AFG’s financial statements as follows (in millions):
The net charge from unlocking annuity assumptions in the fourth quarter of 2018 reflects the favorable impact of an increase in projected net interest spreads on in-force business (due primarily to higher actual yields than previously anticipated), more than offset by a slight increase in projected expenses and the unfavorable impact of changes in projected policyholder annuitization and lapse behavior. Reinvestment rate assumptions are based primarily on 7-year and 10-year corporate bond yields. For the fourth quarter 2018 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 4.68% in 2019, grading up ratably to an ultimate net reinvestment rate of 5.54% in 2025 and beyond.
The table below compares the reinvestment rate assumed on assets purchased to directly support “fixed annuity benefits accumulated” in AFG’s fourth quarter unlockings for the next calendar year to the actual reinvestment rate achieved in that period (both net of investment expenses):
Management believes that these results over the last several years demonstrate that AFG’s investment rate assumptions are reasonable and prudent. During 2018, credit spreads widened resulting in a higher achieved reinvestment rate than assumed in the 2017 unlocking. During 2017, long-term interest rates were lower than anticipated and credit spreads narrowed, resulting in a lower achieved reinvestment rate than assumed in the 2016 unlocking. In addition to the reinvestment rates above, actual default rates in 2018, 2017 and 2016 were lower than the long-term default rates of 0.18% assumed in the unlocking in each of the periods above.
The 2017 net charge reflects the unfavorable impacts of a decrease in projected net interest spreads on in-force business (due primarily to lower than previously anticipated reinvestment rates), a slight increase in projected expenses (due primarily to an increase in projected trailer commissions) and slightly higher projected option costs in the near term, substantially offset by the favorable impact of changes in projected policyholder annuitization and lapse behavior. For the 2017 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 3.99% in 2018, grading up ratably to an ultimate net reinvestment rate of 5.55% in 2023 and beyond.
The following table reconciles the net spread earned on AFG’s fixed annuities to overall annuity pretax earnings for the three months ended December 31, 2018 and 2017 (in millions):
Holding Company, Other and Unallocated - Results of Operations AFG’s net GAAP pretax loss outside of its property and casualty insurance and annuity operations (excluding realized gains and losses) totaled $29 million for the fourth quarter of 2018 compared to $87 million for the fourth quarter of 2017, a decrease of $58 million (67%). AFG’s net core pretax loss outside of its property and casualty insurance and annuity operations (excluding realized gains and losses) totaled $29 million in the fourth quarter of 2018 compared to $47 million in the fourth quarter of 2017, a decrease of $18 million (38%).
The following table details AFG’s GAAP and core loss before income taxes from operations outside of its property and casualty insurance and annuity operations for the three months ended December 31, 2018 and 2017 (dollars in millions):
AFG’s run-off long-term care and life insurance operations recorded net earned premiums of $6 million and related benefits and acquisition expenses of $10 million in the fourth quarter of 2018 compared to net earned premiums of $5 million and related benefits and acquisition expenses of $7 million in the fourth quarter of 2017. The $3 million (60%) increase in life, accident and health benefits reflects higher claims in the run-off long-term care business.
AFG recorded net investment income on investments held outside of its property and casualty insurance and annuity operations of $4 million in the fourth quarter of 2018 compared to $10 million in the fourth quarter of 2017, a decrease of $6 million
(60%). The parent company holds a small portfolio of securities that are carried at fair value through net investment income. These securities decreased in value by $5 million in the fourth quarter of 2018 compared to an increase of $2 million in the fourth quarter of 2017.
Other income in the table above includes $4 million in both the fourth quarter of 2018 and 2017, in management fees paid to AFG by the AFG-managed CLOs (AFG’s consolidated managed investment entities). The management fees are eliminated in consolidation - see the other income line in the Consolidate MIEs column under “Results of Operations - Segmented Statement of Earnings.” Excluding amounts eliminated in consolidation, AFG recorded $5 million in other income outside of its property and casualty insurance and annuity operations in the fourth quarter of 2018 compared to $1 million in the fourth quarter of 2017. The increase in other income is due primarily to the impact of a loss recorded on the disposal of equipment in the fourth quarter of 2017.
Excluding the non-core loss on retirement of debt discussed below, AFG’s holding companies and other operations outside of its property and casualty insurance and annuity operations recorded other expenses of $22 million in the fourth quarter of 2018 compared to $40 million in the fourth quarter of 2017, a decrease of $18 million (45%). This decrease is due primarily to the impact of lower holding company expenses related to employee benefit plans that are tied to stock market performance in the fourth quarter of 2018 compared to the fourth quarter of 2017.
Issued an additional $240 million of 4.50% Senior Notes on November 9, 2017
Consolidated Realized Gains (Losses) on Securities AFG’s consolidated realized gains (losses) on securities, which are not allocated to segments, were net losses of $238 million in the fourth quarter of 2018 compared to net gains of $6 million in the fourth quarter of 2017, a decrease of $244 million (4,067%). Realized gains (losses) on securities consisted of the following (in millions):
As discussed in Note A - “Accounting Policies - Investments,” beginning in January 2018, all equity securities other than those accounted for under the equity method are carried at fair value through net earnings. This amount includes a $228 million net loss on securities that were still held at December 31, 2018.
The $223 million net realized loss from the change in the fair value of equity securities in the fourth quarter of 2018 includes losses of $65 million on banks and financing companies, $23 million on asset management companies, $22 million on energy exploration and production companies and $21 million on technology companies. AFG’s impairment charges on securities for the fourth quarter of 2018 consist of $23 million on fixed maturities compared to $14 million on equity securities, $5 million on fixed maturities and $4 million on other investments in the fourth quarter of 2017. The 2018 fourth quarter impairment charges consisted of $17 million on corporate bonds and $6 million on residential MBS. Approximately $11 million in impairment charges in the fourth quarter of 2017 related to financial institutions and $4 million related to investments in pharmaceutical companies.
Consolidated Income Taxes AFG’s consolidated provision (credit) for income taxes was a credit of $4 million for the fourth quarter of 2018 compared to an expense of $101 million in the fourth quarter of 2017. The following is a reconciliation of income taxes at the statutory rate (21% in 2018 and 35% in 2017) 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 related to the cumulative 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. The $61 million decrease in the valuation allowance in the fourth quarter of 2017 related to the change in the U.S. corporate tax rate is included in “Change in U.S. corporate tax rate” in the table above.
The Tax Cuts and Jobs Act of 2017 (“TCJA”), which lowered the U.S. corporate tax rate to 21% and made other widespread changes to the U.S. tax code beginning in 2018, was enacted on December 22, 2017. Because the TCJA was enacted in December 2017, AFG recorded the $83 million decrease in its net deferred tax asset resulting from the changes in the tax code (primarily the lower corporate tax rate applicable to 2018 and future years) in the fourth quarter of 2017. See Note L - “Income Taxes” to the financial statements. Although accounting for the TCJA reduced AFG’s net deferred tax asset, AFG’s effective tax rate and net earnings attributable to shareholders for the full-year 2018 were favorably impacted by the lower corporate income tax rate.
Excluding the tax benefits related to the Neon restructuring and the impact of the change in the U.S. corporate tax rate, AFG’s effective tax rate was 28% for the three months ended December 31, 2017.
Consolidated Noncontrolling Interests AFG’s consolidated net earnings (losses) attributable to noncontrolling interests was a net loss of $6 million for the fourth quarter of 2018 related to losses at Neon, AFG’s United Kingdom-based Lloyd’s insurer, compared to earnings of less than $1 million for the fourth quarter of 2017.
investments should not be expected to repeat in future periods. The increase in GAAP pretax earnings also reflects lower special A&E charges in 2018 compared to 2017, partially offset by the impact of favorable reserve development of $18 million in the fourth quarter of 2017 in the Neon exited lines in connection with a reinsurance to close transaction.
The following table details AFG’s GAAP and core earnings before income taxes from its property and casualty insurance operations for the years ended December 31, 2018, 2017 and 2016 (dollars in millions):
The $521 million (9%) increase in gross written premiums in 2017 compared to 2016 reflects growth in each of the Specialty property and casualty sub-segments. Overall average renewal rates increased approximately 1% in 2017.
Property and transportation Gross written premiums decreased $43 million (2%) in 2018 compared to 2017. This decrease was largely the result of lower year-over-year premiums in the crop insurance business and underwriting actions on under-performing accounts in the Singapore branch. Average renewal rates increased approximately 3% for this group in 2018. Reinsurance premiums ceded as a percentage of gross written premiums were comparable in 2018 and 2017.
Gross written premiums increased $184 million (7%) in 2017 compared to 2016. This increase was the result of higher gross written premiums in the crop, transportation and property and inland marine businesses, and the Singapore branch. This growth was partially offset by lower premiums resulting from an exit from the customs bond business, which was part of the ocean marine operations. Average renewal rates increased approximately 3% for this group in 2017. Reinsurance premiums ceded as a percentage of gross written premiums increased 1 percentage point in 2017 compared to 2016, reflecting a change in the mix of business and the impact of reinstatement premiums in 2017 resulting from reinsured hurricane losses.
Specialty casualty Gross written premiums increased $358 million (12%) in 2018 compared to 2017 due primarily to growth at Neon. Higher gross written premiums in the excess and surplus, targeted markets and executive liability businesses also contributed to the year-over-year growth. Average renewal rates decreased approximately 1% for this group in 2018. Excluding the workers’ compensation businesses, renewal rates for this group increased approximately 3% in 2018. Reinsurance premiums ceded as a percentage of gross written premiums increased 1 percentage point in 2018 compared to 2017, reflecting higher cessions to AFG’s internal reinsurance program, which is included in Other specialty and higher cessions in the workers’ compensation businesses.
Specialty financial Gross written premiums increased $23 million (3%) in 2018 compared to 2017 due primarily to higher premiums in the financial institutions business. Average renewal rates for this group increased approximately 5% in 2018. Reinsurance premiums ceded as a percentage of gross written premiums increased 2 percentage points in 2018 compared to 2017, reflecting higher cessions in the financial institutions and equipment leasing businesses and the impact of a reinstatement premium in 2018 related to a reinsured loss in the fidelity business.
Other specialty The amounts shown as reinsurance premiums ceded represent business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty property and casualty insurance sub-segments. Reinsurance premiums assumed increased $48 million (44%) in 2018 compared to 2017, reflecting an increase in premiums retained, primarily from businesses in the Specialty casualty sub-segment.
The table below (dollars in millions) details the components of the combined ratio for AFG’s property and casualty insurance segment for 2018, 2017 and 2016:
The Specialty property and casualty insurance operations generated an underwriting profit of $317 million in 2017 compared to $337 million in 2016, a decrease of $20 million (6%). The lower underwriting profit in 2017 as compared to 2016 reflects lower underwriting profits in the Property and transportation and Specialty financial insurance sub-segments, partially offset by higher underwriting profit in the Specialty casualty insurance sub-segment. Results for each of the Specialty property and casualty insurance sub-segments reflect higher catastrophe losses in 2017 compared to 2016. Overall catastrophe losses were $140 million (3.0 points on the combined ratio) for 2017 compared to $55 million (1.3 points) for 2016. In connection with catastrophe losses incurred in 2017, AFG reduced profit-based commissions payable to agents by $8 million in the Specialty financial sub-segment and paid $10 million in net reinstatement premiums, resulting in a total pretax loss from catastrophes of $142 million in 2017.
results in the ocean marine operations. Catastrophe losses were $26 million (1.5 points on the combined ratio) in 2018 compared to catastrophe losses of $36 million (2.1 points) and related reinstatement premiums of $2 million in 2017.
Specialty financial Underwriting profit for this group was $66 million in 2018 compared to $61 million in 2017, an increase of $5 million (8%) due primarily to favorable prior year reserve development in run-off businesses. Catastrophe losses were $28 million (4.7 points on the combined ratio) in 2018 compared to $30 million (5.2 points) in 2017. In connection with catastrophe losses incurred in 2018, the Specialty financial sub-segment paid $1 million in reinstatement premiums compared to a reduction of profit-based commissions payable to agents of $8 million (1.1 points on the combined ratio) and reinstatement premiums of $2 million in 2017.
This group reported an underwriting loss of $2 million in 2017 compared to an underwriting profit of $9 million in 2016, a decrease of $11 million (122%). The decrease is due primarily to the $14 million charge to adjust the deferred gain on the retroactive reinsurance transaction entered into in connection with the sale of businesses in 1998.
AFG’s overall loss and LAE ratio was 61.7%, 64.5% and 63.8% in 2018, 2017 and 2016, respectively. The components of AFG’s property and casualty losses and LAE amounts and ratio are detailed below (dollars in millions):
Net favorable reserve development of $86 million in 2017 includes favorable reserve development on ongoing lines of business within Neon recorded in connection with the reinsurance to close agreement entered into in December 2017 for the 2015 and prior years of account, lower than anticipated claim severity in the workers’ compensation businesses and lower than expected losses in the executive liability business, partially offset by higher than anticipated claim severity in the targeted markets and general liability businesses and higher than anticipated severity in New York contractor claims.
In the fourth quarter of 2017, Neon entered into a reinsurance to close agreement for its 2015 and prior years of account, which transfers the responsibility for all of the liabilities that attach to the transferred year of account as well as any income due to the closing year of account in return for a premium. As a result of the reinsurance to close agreement, Neon recorded favorable development of $42 million, of which $24 million related to its ongoing lines of business (included in Specialty casualty) and $18 million related to the exited lines of business (discussed below and included in Neon exited lines charge).
Net favorable reserve development of $21 million in 2017 reflects lower than anticipated claim severity in the fidelity business and lower than expected claim frequency and severity in the surety business.
Asbestos and environmental reserve charges As previously discussed under “Uncertainties” - “Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG has established property and casualty reserves for claims related to environmental exposures and asbestos claims. Total charges recorded to increase reserves (net of reinsurance recoverable) for A&E exposures of AFG’s property and casualty group (included in loss and loss adjustment expenses) were $18 million in 2018, $89 million in 2017 and $36 million in 2016.
AFG’s overall expense ratio increased 1.9% in 2018 as compared to 2017 and decreased 0.5% in 2017 compared to 2016.
Specialty casualty Commissions and other underwriting expenses as a percentage of net earned premiums increased 2.0 percentage points in 2018 compared to 2017 reflecting growth at Neon, which has a higher expense ratio than AFG’s overall Specialty casualty group, higher dividends paid to policyholders in the workers’ compensation businesses and lower underwriting, policy administration and claims services fees collected from unaffiliated insurers in the workers’ compensation businesses.
Commissions and other underwriting expenses as a percentage of net earned premiums decreased 2.9 percentage points in 2017 compared to 2016 reflecting lower profitability-based commissions paid to agents in the financial institutions business, including an $8 million commission expense reduction due to hurricane losses.
AFG’s annuity operations contributed $361 million in pretax earnings in 2018 compared to $380 million in 2017, a decrease of $19 million (5%). AFG’s annuity segment results in 2018 compared to 2017 reflect a 10% increase in average annuity investments (at amortized cost) and higher earnings from limited partnerships and similar investments, more than offset by higher unlocking charges, the impact of lower investment yields due to the run-off of higher yielding investments and the impact from changes in stock market performance and interest rates discussed below. The high returns on limited partnerships and similar investments should not be expected to repeat in future periods.
AFG’s annuity operations contributed $380 million in pretax earnings in 2017 compared to $368 million in 2016, an increase of $12 million (3%). The increase in AFG’s annuity segment results in 2017 compared to 2016 reflect an 11% increase in average annuity investments (at amortized cost), partially offset by lower investment yields due to the run-off of higher yielding investments and higher general and administrative expenses. The change in fair value of derivatives related to FIAs had a negative impact of $33 million in 2017 compared to $27 million in 2016. Both periods reflect the negative impact of lower than anticipated interest rates, partially offset by the positive impact of a higher stock market on the fair value accounting for FIAs. Operating earnings also included a net unlocking annuity charge of $3 million in 2017 compared to a net annuity expense reduction of $1 million in 2016.
The following table details AFG’s earnings before income taxes from its annuity operations for 2018, 2017 and 2016 (dollars in millions):
Interest credited - fixed in 2018 was $704 million compared to $633 million in 2017, an increase of $71 million (11%), reflecting the impact of growth in the annuity business. The average interest rate credited to policyholders, calculated as interest credited divided by average fixed annuity benefits accumulated, increased 0.02 percentage points to 2.03% in 2018 from 2.01% in 2017 due primarily to higher crediting rates on new business.
Interest credited - fixed in 2017 was $633 million compared to $574 million in 2016, an increase of $59 million (10%). 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 decreased 0.03 percentage points to 2.01% in 2017 from 2.04% in 2016.
Annuity policy charges and other miscellaneous income were $43 million in 2017 compared to $50 million in 2016, a decrease of $7 million (14%). Excluding the impact of unlocking charges of $3 million in 2017 and $1 million in 2016 related to unearned revenue, annuity policy charges and other miscellaneous income were $46 million in 2017 compared to $51 million in 2016, a decrease of $5 million (10%). Other miscellaneous income includes $1 million in income from the sale of real estate in 2017 compared to $5 million in 2016. Excluding the impact of unlocking charges related to unearned revenue, annuity policy charges and other miscellaneous income as a percentage of average fixed annuity benefits accumulated decreased 0.04 percentage points to 0.11% in 2017 from 0.15% in 2016.
AFG’s fixed-indexed (including variable-indexed) annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market or other financial index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase and sale of call and put options on the appropriate index. AFG’s strategy is designed so that the change in the fair value of the call option assets and put option liabilities will generally offset the economic change in the net liability from the index participation. Both the index-based component of the annuities (an embedded derivative) and the related call and put options are considered derivatives that must be adjusted for changes in fair value through earnings each period. The change in the fair value of the embedded derivative includes an ongoing expense for interest accreted on the embedded derivative. The interest accreted in any period is generally based on the size of the embedded derivative and current interest rates. The fair values of these derivatives are impacted by actual and expected stock market performance and interest rates as well as other factors. For a list of other factors impacting the fair value of the embedded derivative component of AFG’s annuity benefits accumulated, see Note D - “Fair Value Measurements” to the financial statements. Fluctuations in certain of these factors, such as changes in interest rates and the performance of the stock market, are not economic in nature for the current reporting period, but rather impact the timing of reported results.
AFG’s net spread earned on fixed annuities decreased 0.16 percentage points to 1.07% in 2018 from 1.23% in 2017 due primarily to the net impact of changes in the fair value of derivatives and related DPAC amortization offset discussed above and the impact of the unlocking of actuarial assumptions discussed below, partially offset by the 0.08 percentage points increase in AFG’s net interest spread.
AFG’s annuity operations generated statutory premiums of $5.41 billion in 2018, $4.34 billion in 2017 and $4.44 billion in 2016, an increase of $1.07 billion (25%) in 2018 compared to 2017 and a decrease of $94 million (2%) in 2017 compared to 2016. The following table summarizes AFG’s annuity sales (dollars in millions):
Management believes the 25% increase in annuity premiums in 2018 compared to 2017 is the result of the introduction of new products, efforts to expand in the retail and broker dealer markets and an improving interest rate environment in 2018.
Management attributes the 2% decrease in annuity premiums in 2017 compared to 2016 to AFG’s adherence to pricing discipline in a relatively low and decreasing interest rate environment during the year, as well as from aggressive pricing in certain of AFG’s competitors.
AFG’s net GAAP pretax loss outside of its property and casualty insurance and annuity operations (excluding realized gains and losses) totaled $252 million in 2017 compared to $177 million in 2016, an increase of $75 million (42%). AFG’s net core pretax loss outside of its property and casualty insurance and annuity operations (excluding realized gains and losses) totaled $177 million in 2017 compared to $174 million in 2016, an increase of $3 million (2%).
AFG recorded net investment income on investments held outside of its property and casualty insurance and annuity operations of $25 million, $34 million and $27 million in 2018, 2017 and 2016, respectively. The $9 million (26%) decrease in 2018 as
compared to 2017 and the $7 million (26%) increase in 2017 as compared to 2016 is due primarily to the impact of the market performance on a small portfolio of securities that are carried at fair value through net investment income. These securities decreased in value by $4 million in 2018 and increased in value by $6 million in 2017.
Excluding the non-core special A&E charges and the non-core losses on retirement of debt discussed below, AFG’s holding companies and other operations outside of its property and casualty insurance and annuity operations recorded other expenses of $126 million in 2018 compared to $144 million in 2017, a decrease of $18 million (13%). This decrease reflects lower holding company expenses related to employee benefit plans that are tied to stock market performance, partially offset by a $5 million charge to increase liabilities related to the environmental exposures of AFG’s former railroad and manufacturing operations in 2018. AFG’s holding companies and other operations outside of its property and casualty insurance and annuity operations recorded other expenses of $144 million in 2017 compared to $137 million in 2016, an increase of $7 million (5%). This increase reflects higher holding company expenses related to employee benefit plans that are tied to stock market performance, partially offset by the impact of a $5 million donation to the University of Cincinnati College of Business in 2016.
The following table details the principal amount of AFG’s long-term debt balances as of January 1, 2018, January 1, 2017 and January 1, 2016 (dollars in millions):
Consolidated Realized Gains (Losses) on Securities AFG’s consolidated realized gains (losses) on securities, which are not allocated to segments, were net losses of $266 million in 2018 compared to net gains of $5 million in 2017, a decrease of $271 million (5,420%). AFG’s consolidated realized gains (losses) on securities were net gains of $5 million in 2017 compared to $19 million in 2016, a decrease of $14 million (74%). Realized gains (losses) on securities consisted of the following (in millions):
As discussed in Note A - “Accounting Policies - Investments,” beginning in January 2018, all equity securities other than those accounted for under the equity method are carried at fair value through net earnings. This amount includes a $279 million net loss on securities that were still held at December 31, 2018.
Consolidated Noncontrolling Interests AFG’s consolidated net earnings (losses) attributable to noncontrolling interests was a net loss of $13 million in 2018 compared to net earnings of $2 million in 2017, an increase of $15 million (750%). AFG’s consolidated net earnings (losses) attributable to noncontrolling interests was earnings of $2 million in 2017 compared to $19 million in 2016, a decrease of $17 million (89%). The following table details net earnings (losses) in consolidated subsidiaries attributable to holders other than AFG (dollars in millions):
In the fourth quarter of 2017, AFG adopted Accounting Standards Update (“ASU”) 2017-04, which simplifies the test for goodwill impairment. Under the previous guidance, if the quantitative test for impairment indicated that the carrying value of a reporting unit exceeded its fair value, an entity had to perform procedures to determine the fair value (at the impairment testing date) of its assets and liabilities (including unrecognized assets and liabilities) following the procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Under the new guidance, an impairment charge is measured as the excess of the reporting unit’s carrying value over its fair value (up to the full amount of the goodwill). Because the annual impairment testing of AFG’s goodwill in 2017 did not require quantitative testing, the implementation of the new guidance had no impact on AFG’s results of operations or financial position. In addition, AFG does not expect the new guidance to have a material effect on its results of operations or financial position in future periods.
See Note A - “Accounting Policies - Lease Accounting Guidance Effective in 2019” to the financial statements for a discussion of accounting guidance adopted on January 1, 2019, 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.
Consolidated Statement of Comprehensive Income for the years ended December 31, 2018, 2017 and 2016
Consolidated Statement of Changes in Equity for the years ended December 31, 2018, 2017 and 2016
Consolidated Statement of Cash Flows for the years ended December 31, 2018, 2017 and 2016
We have audited American Financial Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2018, 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). In our opinion, American Financial Group, Inc. and subsidiaries (the “Company”) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheets of the Company as of December 31, 2018 and 2017, 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, 2018, and the related notes and financial statement schedules listed in the Index at Item 15(a)(2) and our report dated February 26, 2019, 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, 2018 and 2017, 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, 2018, and the related notes and financial statement schedules listed in the Index at Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles.
Fair Value Measurements Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in 2018 or 2017.
Investments On January 1, 2018, AFG adopted Accounting Standards Update (“ASU”) 2016-01, which requires all equity securities other than those accounted for under the equity method to be reported at fair value with holding gains and losses recognized in net earnings. At December 31, 2017, AFG had $1.60 billion in equity securities classified as “available for sale” under the prior guidance with holding gains and losses included in accumulated other comprehensive income (“AOCI”) instead of net earnings. At the date of adoption, the $221 million net unrealized gain on equity securities included in AOCI was reclassified to retained earnings as the cumulative effect of an accounting change. The cumulative effect of the accounting change also includes the net unrealized gain on AFG’s small number of limited partnerships and similar investments carried at cost under the prior guidance that are carried at fair value through net earnings under the new guidance ($4 million net of tax at the date of adoption).
Under the new guidance, AFG recorded holding losses of $257 million on equity securities in net earnings during 2018 on securities that were still owned at December 31, 2018. Under the prior guidance, these holding losses would have been recorded in AOCI (with the exception of any impairment charge that may have been recorded). Because almost all of the equity
For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses and unamortized acquisition costs exceed the related unearned premiums. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.
In addition, reserves for traditional life and long-term care policies are subject to adjustment for loss recognition charges that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.
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: 2018 - 1.6 million, 2017 - 2.0 million and 2016 - 1.6 million.
AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: 2018 and 2017 - none and 2016 - 0.4 million. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2018, 2017 and 2016 periods.
ABA Insurance Services Inc. In November 2018, AFG acquired ABA Insurance Services Inc. (“ABAIS”) from American Bankers Mutual Insurance, Ltd. for approximately $30 million using cash on hand at the parent company. Additional contingent consideration of up to $3 million could be due after four years based on achieving certain operating milestones. ABAIS is based in Ohio and is a market-leading provider of directors and officers liability and other complementary insurance solutions for banks, small businesses and nonprofit organizations.
AFG manages its business as three segments: (i) Property and casualty insurance, (ii) Annuity and (iii) Other, which includes holding company assets and costs, revenues and costs of AFG’s limited insurance operations outside of property and casualty insurance and annuities, and operations attributable to the noncontrolling interests of the managed investment entities.
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets. AFG’s Level 2 financial instruments include separate account assets, corporate and municipal fixed maturity securities, asset-backed securities (“ABS”), mortgage-backed securities (“MBS”), non-affiliated common stocks, equity index options and investments of managed investment entities priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, corroborated broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2.
The transfers between Level 1 and Level 2 for the years ended December 31, 2018, 2017 and 2016 are reflected in the table below at fair value as of the end of the reporting period (dollars in millions):
Approximately 7% of the total assets carried at fair value on December 31, 2018, were Level 3 assets. Approximately 69% ($2.41 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.
Internally developed Level 3 asset fair values represent approximately $1.05 billion at December 31, 2018. Of this amount, approximately $590 million relates to fixed maturity securities that were priced using management’s best estimate of an appropriate credit spread over the treasury yield (of a similar duration) to discount future expected cash flows using a third party model. The credit spread applied by management is the significant unobservable input. For this group of approximately 100 securities, the average spread used was 585 basis points over the reference treasury yield and the spreads ranged from 131 basis points to 2,966 basis points (approximately 80% of the spreads were between 400 and 700 basis points). Had management used higher spreads, the fair value of this group of securities would have been lower. Conversely, if the spreads used were lower, the fair values would have been higher. For the remainder of the internally developed prices, any justifiable changes in unobservable inputs used to determine fair value would not have resulted in a material change in AFG’s financial position.
The range of adjustments for insurance subsidiary’s credit risk is based on the Moody’s corporate A2 bond index and 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 and variable-indexed annuity products with an expected range of 7% to 11% in the majority of future calendar years (3% to 23% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flow assumptions in the table above would increase the fair value of the fixed-indexed and variable-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.
Changes in balances of Level 3 financial assets and liabilities carried at fair value during 2018, 2017 and 2016 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs and $29 million of equity securities transferred into Level 3 in the first quarter of 2018 related to a small number of limited partnerships and similar investments carried at cost under the prior guidance that are carried at fair value through net earnings under new guidance adopted on January 1, 2018, as discussed in Note A - “Accounting Policies - Investments.” All transfers are reflected in the table at fair value as of the end of the reporting period.
Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $44 million in 2018.
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, 2018 and December 31, 2017, respectively, were $140 million and $158 million. Gross unrealized gains on such securities at December 31, 2018 and December 31, 2017 were $119 million and $137 million, respectively. Gross unrealized losses on such securities at both December 31, 2018 and December 31, 2017 were $4 million. These amounts represent the non-credit other-than-temporary impairment charges recorded in AOCI adjusted for subsequent changes in fair values and relate primarily to residential MBS.
As discussed in Note A - “Accounting Policies - Investments,” AFG implemented new accounting guidance effective on January 1, 2018, which requires all equity securities previously classified as “available for sale” to be reported at fair value, with holding gains and losses recognized in net earnings. Equity securities reported at fair value consisted of the following at December 31, 2018 (in millions):
The following tables show gross unrealized losses (dollars in millions) on available for sale fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at the following balance sheet dates.
At December 31, 2018, the gross unrealized losses on fixed maturities of $603 million relate to 2,324 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 92% of the gross unrealized loss and 96% of the fair value.
AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which
Management believes AFG will recover its cost basis in the securities with unrealized losses and that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, 2018.
As discussed in Note A - “Accounting Policies - Investments,” effective January 1, 2018, all equity securities previously classified as “available for sale” are required to be carried at fair value through net earnings instead of accumulated other comprehensive income and therefore are no longer evaluated for other-than-temporary impairment. In 2017 and 2016, AFG recorded other-than-temporary impairment charges on equity securities classified as available for sale of $64 million and $93 million, respectively.
Net Unrealized Gain on Marketable Securities In addition to adjusting fixed maturity securities and equity securities classified as “available for sale” to fair value, GAAP requires that deferred policy acquisition costs and certain other balance sheet amounts related to annuity, long-term care and life businesses be adjusted to the extent that unrealized gains and losses from securities would result in adjustments to those balances had the unrealized gains or losses actually been realized. The following table shows (in millions) the components of the net unrealized gain on securities that is included in AOCI in AFG’s Balance Sheet.
As discussed in Note A - “Accounting Policies - Investments,” AFG adopted guidance in January 2018 that requires all equity securities other than those accounted for under the equity method to be reported at fair value with holding gains and losses recognized in net earnings. Although the change in the fair value of the majority of AFG’s equity securities is recorded in realized gains (losses) on securities, AFG records holding gains and losses in net investment income on equity securities classified as “trading” under the previous guidance and on a small portfolio of limited partnership and similar investments that do not qualify for the equity method of accounting.
As discussed in Note A - “Accounting Policies - Investments,” effective January 1, 2018, all equity securities other than those accounted for under the equity method are carried at fair value through net earnings. AFG recorded net holding gains (losses) on equity securities during 2018 on securities that were still owned at December 31, 2018 as follows (in millions):
During 2017 and 2016, AFG recorded gross gains of $87 million and $110 million and gross losses of $17 million and $4 million, respectively, on available for sale equity securities.
AFG’s fixed-indexed and variable-indexed annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market or other financial index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase and sale of call and put options on the appropriate index. AFG receives collateral from certain counterparties to support its purchased call option assets (net of collateral required under put option contracts with the same counterparties). This collateral ($103 million at December 31, 2018 and $389 million at December 31, 2017) is included in other assets in AFG’s Balance Sheet with an offsetting liability to return the collateral, which is included in other liabilities. AFG’s strategy is designed so that the change in the fair value of the call and put options will generally offset the economic change in the liabilities from the index participation. Both the index-based component of the annuities and the related call and put options are considered derivatives. Fluctuations in interest rates and the stock market, among other factors, can cause volatility in the periodic measurement of fair value of the embedded derivative that management believes can be inconsistent with the long-term economics of these products.
The following table summarizes the gains (losses) included in AFG’s Statement of Earnings for changes in the fair value of derivatives that do not qualify for hedge accounting for 2018, 2017 and 2016 (in millions):
Derivatives Designated and Qualifying as Cash Flow Hedges As of December 31, 2018, AFG has entered into sixteen interest rate swaps that are designated and qualify as highly effective cash flow hedges to mitigate interest rate risk related to certain floating-rate securities included in AFG’s portfolio of fixed maturity securities. The purpose of each of these swaps is to effectively convert a portion of AFG’s floating-rate fixed maturity securities to fixed rates by offsetting the variability in cash flows attributable to changes in short-term LIBOR.
Under the terms of the swaps, AFG receives fixed-rate interest payments in exchange for variable interest payments based on short-term LIBOR. The notional amounts of the interest rate swaps generally decline over each swap’s respective life (the swaps expire between August 2019 and June 2030) in anticipation of the expected decline in AFG’s portfolio of fixed maturity securities with floating interest rates based on short-term LIBOR. The total outstanding notional amount of AFG’s interest rate swaps increased to $2.35 billion at December 31, 2018 compared to $1.58 billion at December 31, 2017, reflecting six new swaps with an aggregate notional amount at issuance of $911 million entered into in 2018, partially offset by the scheduled amortization discussed above. The fair value of the effective portion of the interest rate swaps in an asset position and included in other assets was $16 million at December 31, 2018 and less than $1 million at December 31, 2017. The fair value of the effective portion of interest rate swaps in a liability position and included in other liabilities was $46 million at December 31, 2018 and $31 million at December 31, 2017. The net unrealized gain or loss on cash flow hedges is included in AOCI, net of DPAC and deferred taxes. Amounts reclassified from AOCI (before DPAC and taxes) to net investment income were losses of
AFG is the investment manager and its subsidiaries have investments ranging from 15.0% to 60.9% 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 2018, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank
AFG’s maximum exposure to economic loss on its CLOs is limited to its investment in the CLOs, which had an aggregate fair value of $188 million (including $125 million invested in the most subordinate tranches) at December 31, 2018, and $215 million at December 31, 2017.
The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $232 million and $55 million at December 31, 2018 and 2017. The aggregate unpaid principal balance of the CLOs’ debt exceeded its carrying value by $241 million and $118 million at those dates. The CLO assets include loans with an aggregate fair value of $1 million at December 31, 2017, for which the CLOs are not accruing interest because the loans are in default (aggregate unpaid principal balance of $8 million; none at December 31, 2018).
In November 2017, AFG issued an additional $125 million of 3.50% Senior Notes due in 2026 at a price of 99.698% and $240 million of 4.50% Senior Notes due in 2047 at a price of 102.374%. The net proceeds of the offering were used to redeem AFG’s $350 million outstanding principal amount of 9-7/8% Senior Notes due in June 2019 for $388 million (including a make-whole premium of $38 million) in December 2017.
In August 2016, AFG issued $300 million in 3.50% Senior Notes due in 2026 at a price of 99.608%. The net proceeds of the offering were used to fund a portion of the November 2016 acquisition of the noncontrolling interest in NATL (discussed in Note B - “Acquisitions and Sale of Businesses”). At the acquisition date, the $18 million outstanding under NATL’s bank credit facility, including $6 million borrowed in September 2016, was repaid and the credit agreement was terminated.
To achieve a desired balance between fixed and variable rate debt, AFG entered into an interest rate swap in June 2015, which effectively converted its 9-7/8% Senior Notes to a floating rate of three-month LIBOR plus 8.099%. In December 2017, AFG settled the interest rate swap contemporaneously with the redemption of the 9-7/8% Senior Notes.
Cash interest payments on long-term debt were $59 million in 2018, $85 million in 2017 and $75 million in 2016. In 2017 and 2016, AFG received $2 million and $3 million, respectively, in interest under the interest rate swap discussed above.
AFG issued 45,804 shares of Common Stock (fair value of $115.49 per share) in the first quarter of 2018 and 47,826 shares (fair value of $96.13 per share) in the first quarter of 2017 under its Equity Bonus Plan.
The total intrinsic value of options exercised during 2018, 2017 and 2016 was $57 million, $65 million and $38 million, respectively. During 2018, 2017 and 2016, AFG received $29 million, $34 million and $32 million, respectively, in cash from the exercise of stock options. The total tax benefit related to the exercises was $9 million, $18 million and $11 million during those years, respectively.
Includes net unrealized gains of $58 million at December 31, 2018 compared to net unrealized gains of $68 million and $52 million at December 31, 2017 and 2016, related to securities for which only the credit portion of an other-than-temporary impairment has been recorded in earnings.
On January 1, 2018, AFG adopted new guidance that requires all equity securities other than those accounted for under the equity method to be reported at fair value with holding gains and losses recognized in net earnings. At the date of adoption, the $221 million net unrealized gain on equity securities classified as available for sale (with unrealized holding gains and losses reported in AOCI) under the prior guidance was reclassified from AOCI to retained earnings as the cumulative effect of an accounting change. Other also includes the December 2017 reclassification of $145 million stranded in AOCI from accounting for the Tax Cuts and Jobs Act of 2017 to retained earnings (see Note A - “Accounting Policies - Income Taxes”), the impact on AOCI of the December 2017 sale of redeemable noncontrolling interests in Neon and the November 2016 acquisition of the noncontrolling interest in NATL (see Note B - “Acquisitions and Sale of Businesses”).
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. The $61 million decrease in the valuation allowance in 2017 related to the change in the U.S. corporate tax rate is included in “Change in U.S. corporate tax rate” in table above.
In addition to the lower U.S. corporate tax rate, the TCJA implemented a new global minimum tax on income earned by foreign subsidiaries of U.S.-based entities known as the Global Intangible Low-taxed Income (“GILTI”) provision. Since almost all of AFG’s earnings are taxable based on U.S. tax rates, the GILTI is not expected to be material to AFG’s results of operations and will be recorded in the period that any tax arises.
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2018 (in millions):
At December 31, 2018, American Premier and its subsidiaries had liabilities for environmental and personal injury claims and other contingencies aggregating $83 million. The environmental claims consist of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs related to certain sites formerly owned or operated by the railroad and manufacturing operations. Remediation costs are difficult to estimate for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. The personal injury claims and other contingencies include pending and expected claims, primarily by former employees of PCTC, for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the workplace and other labor disputes.
In addition, AFG and its subsidiaries are involved in litigation from time to time, generally arising in the ordinary course of business. This litigation may include, but is not limited to, general commercial disputes, lawsuits brought by policyholders, employment matters, reinsurance collection matters and actions challenging certain business practices of insurance subsidiaries. None of these matters are expected to have a material adverse impact on AFG’s results of operations or financial condition.
The following are quarterly results of consolidated operations for the two years ended December 31, 2018 (in millions, except per share amounts). Quarterly earnings per share do not add to year-to-date amounts due to changes in shares outstanding.
still owned at December 31, 2018 of $228 million and $279 million, respectively. Under the prior guidance, these holding losses would have been recorded in AOCI (with the exception of any impairment charge that may have been recorded).
FIAs provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market or other financial index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase and sale of call and put options on the appropriate index. AFG’s strategy is designed so that the change in the fair value of the call and put options will generally offset the economic change in the liabilities from the index participation. Both the index-based component of the annuities and the related call and put options are considered derivatives that must be marked-to-market through earnings each period. Fluctuations in interest rates and the stock market, among other factors, can cause volatility in the periodic measurement of fair value of the embedded derivative that management believes can be inconsistent with the long-term economics of these products. In the table above, the impact of changes in the fair value of the derivatives related to FIAs is presented net of an estimate of the related acceleration/deceleration of the amortization of deferred policy acquisition costs and deferred sales inducements.
The vast majority of AFG’s FIAs are indexed to the S&P 500, which decreased 14% in the fourth quarter of 2018. This poor stock market performance adversely impacted AFG’s earnings before income taxes from its annuity operations for the fourth quarter of 2018 beyond the impact on derivatives related to FIAs by $30 million, particularly related to FIAs with guaranteed withdrawal benefits.
AFG’s property and casualty operations recorded catastrophe losses totaling $103 million in 2018 (primarily from Hurricanes Florence and Michael and wildfires in California). Catastrophe losses for 2017 totaled $140 million, including $107 million in the third quarter (primarily from Hurricanes Harvey, Irma and Maria and earthquakes in Mexico).
Results include pretax gains (included in other income) of $13 million from the sale of a hotel in the first quarter of 2017.
Results for the third quarter of 2018 and 2017 include pretax special charges of $9 million and $24 million, respectively, to strengthen reserves for A&E exposures related to AFG’s former railroad and manufacturing operations.
In 2017, AFG recorded pretax losses on the retirement of debt of $7 million in the second quarter, $4 million in the third quarter and $40 million in the fourth quarter.
Net earnings in the fourth quarter of 2017 includes $56 million in tax benefits related to the Neon restructuring. See Note L - “Income Taxes.”
Cash and securities owned by U.S.-based insurance subsidiaries, having a carrying value of approximately $1.06 billion at December 31, 2018, were on deposit as required by regulatory authorities. In addition, $118 million was on deposit in support of AFG’s underwriting activities at Lloyd’s. At December 31, 2018, AFG and its subsidiaries had $296 million in undrawn letters of credit (none of which was collateralized) supporting the underwriting capacity of its U.K.-based Lloyd’s insurer, Neon.
Each review includes in-depth analysis of several hundred subdivisions of the business, employing multiple actuarial techniques. For each subdivision, actuaries use informed, professional judgment to adjust these techniques as necessary to respond to specific conditions in the data or within the business.
The net decrease in the provision for claims of prior years in 2018 reflects (i) lower than expected losses in the crop business and lower than expected claim severity at National Interstate (within the Property and transportation sub-segment), (ii) lower than anticipated claim severity in the workers’ compensation businesses, lower than expected emergence in assumed 2017 property catastrophe losses at Neon and lower than expected claim severity in the executive liability business (within the Specialty casualty sub-segment) and (iii) lower than expected claim frequency and severity in the surety business, lower than expected claim severity in the fidelity business and lower than expected claim frequency in run-off businesses (within the Specialty financial sub-segment). This favorable development was partially offset by (i) the $18 million special charge to increase asbestos and environmental reserves and (ii) higher than expected claim frequency and severity in the Singapore branch and aviation operations (within the Property and transportation sub-segment).
In December 2017, the Neon Lloyd’s syndicate entered into a reinsurance to close transaction for the 2015 and prior years of account with StarStone Underwriting Limited, a subsidiary of Enstar Group Limited, which was effective as of December 31, 2017 and settled in early 2018. In the Lloyd’s market, a reinsurance to close transaction transfers the responsibility for discharging all of the liabilities that attach to the transferred year of account plus the right to any income due to the closing year of account in return for a premium. This transaction provides Neon with finality on its legacy business. As a result of the reinsurance to close agreement, Neon was able to better estimate its ultimate liability for the 2015 and prior years of account as of December 31, 2017, resulting in favorable development of $42 million, of which $24 million related to its ongoing lines of business (included in Specialty casualty) and $18 million related to its exited lines of business (discussed below and included in Neon exited lines charge). In November 2016, the Neon Lloyd’s syndicate completed a similar reinsurance to close transaction with StarStone, which covered liabilities relating to the syndicate’s 2007 and prior years of account. That transaction also included a quota share of the Italian public hospital business written in Neon’s 2008 year of account and represented Neon’s complete exit from the Italian public hospital medical malpractice business.
Represents the cumulative percentage paid of incurred claims and allocated LAE (net of reinsurance, as estimated at December 31, 2018).
The amounts shown in Other specialty represent business assumed by AFG’s internal reinsurance program from the operations that make up AFG’s other Specialty property and casualty insurance sub-segments. Accordingly, the liability for incurred claims and allocated LAE represents additional reserves held on claims counted in the tables provided for the other sub-segments (above).
Closed Block of Long-Term Care Insurance Following the completion of the sale of substantially all of its run-off long-term care insurance business in December 2015, AFG’s remaining long-term care insurance reserves were $45 million at December 31, 2018 and $39 million at December 31, 2017, net of reinsurance recoverables and excluding the impact of unrealized gains on securities. AFG’s remaining outstanding long-term care policies have level premiums and are guaranteed renewable. Premium rates can potentially be increased in reaction to adverse experience; however, any rate increases would require regulatory approval.
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, 2018 and 2017, 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, 2018 or 2017.
In June 2017, AFG’s property and casualty insurance subsidiaries entered into a reinsurance agreement to obtain supplemental catastrophe protection through a catastrophe bond structure with Riverfront Re Ltd. (“Riverfront”). The reinsurance agreement provides supplemental reinsurance coverage up to 95% of $200 million (fully collateralized) for catastrophe losses in excess of $104 million (per occurrence and annual aggregate) occurring between June 1, 2017 and December 31, 2020. In connection with the reinsurance agreement, Riverfront issued notes to unrelated investors for the full amount of coverage provided under the reinsurance agreement. Through December 31, 2018, AFG’s incurred catastrophe losses have not reached the level of attachment for the catastrophe bond structure. Riverfront is a variable interest entity in which AFG does not have a variable interest because the variability in Riverfront’s results will 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 is approximately $11 million per year.
AFG’s property and casualty insurance operations entered into a similar reinsurance agreement in March 2014 to obtain additional catastrophe protection through a catastrophe bond structure with Riverfront, which provided supplemental reinsurance coverage for catastrophe losses occurring between April 1, 2014 and January 6, 2017.
Operating Leases Total rental expense for various leases of office space and equipment was $70 million in 2018, $69 million in 2017 and $67 million in 2016. Future minimum rentals, related principally to office space, required under operating leases having initial or remaining noncancelable lease terms in excess of one year at December 31, 2018, were as follows: 2019 - $65 million; 2020 - $57 million; 2021 - $50 million; 2022 - $40 million; 2023 - $35 million; and $79 million thereafter.
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, 2018, AFG and its subsidiaries had commitments to fund credit facilities and contribute capital to limited partnerships and limited liability corporations of approximately $949 million.
The information required by the following Items will be included in AFG’s definitive Proxy Statement for the 2019 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after the end of the Registrant’s fiscal year and is incorporated herein by reference.