AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, because most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
At December 31, 2009, AFG (parent) held approximately $223 million in cash and securities and had $500 million available under a bank line of credit expiring in March 2011.
The property and casualty business is cyclical in nature with periods of high competition resulting in low premium rates, sometimes referred to as a "soft market" or "downcycle" followed by periods of reduced competition and higher premium rates, referred to as a "hard market" or "upcycle." The 1990's were a soft market period; prices started to harden in 2000 and accelerated significantly following the terrorist attacks in 2001. Rate increases for AFG's specialty businesses moderated during the latter part of 2003 and that trend continued until 2005, when renewal rates were flat. While AFG's workers' compensation operations experienced significant rate decreases from 2005 through 2008, reflecting the improved claims environment from reform legislation, overall average renewal pricing was down about 2% in 2006, 4% in 2007 and 2008 and unchanged in 2009.
the establishment of asbestos and environmental reserves of former railroad and manufacturing operations, and
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.58 for the year ended December 31, 2009. Excluding annuity benefits, this ratio was 11.06 for 2009. Although the ratio excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
AFG can borrow up to $500 million under a revolving credit facility, which expires in March 2011. There were no borrowings outstanding under this agreement at December 31, 2009.
AFG retired the $136 million of 7-1/8% Senior Debentures at maturity in April 2009, using cash on hand. In June 2009, AFG issued $350 million of 9-7/8% Senior Notes due 2019. As a result of this issuance, AFG terminated its 364 day credit facility under which it could borrow up to $120 million and voided its intercompany credit facility with a subsidiary under which it could borrow up to $50 million.
During 2007, AFG repurchased 6.9 million shares of its Common Stock for $199 million, funded the $239 million in costs associated with GAFRI's purchase of its Common Stock not previously owned by AFG, and redeemed the $59 million of 7-1/8% Debentures that matured in December 2007.
Great American Life Insurance Company ("GALIC"), a wholly-owned annuity and supplemental insurance subsidiary, became a member of the Federal Home Loan Bank of Cincinnati ("FHLB") in the third quarter of 2009. The FHLB makes loans and provides other banking services to member institutions. Members are required to purchase stock in the FHLB in addition to maintaining collateral deposits that back any funds borrowed. GALIC's $14 million investment in FHLB capital stock at December 31, 2009, is included in other investments at cost. Membership in the FHLB provides the annuity and supplemental insurance operations with a substantial additional source of liquidity. No funds have been borrowed from the FHLB.
In 2008, GAFRI used cash on hand to redeem its $28 million in 6-7/8% notes at maturity. In 2007, AAG Holding used funds borrowed under a bank credit line to redeem its $22 million in outstanding 8-7/8% Subordinated Debentures for $23 million in cash.
In 2007, National Interstate Corporation ("NATL"), a 53%-owned subsidiary of GAI, entered into a five-year unsecured credit agreement under which it can borrow
Dollar amounts and time periods are estimates based on historical net payment patterns applied to the gross reserves and do not represent actual contractual obligations. Based on the same assumptions, AFG projects reinsurance recoveries related to these reserves totaling $2.5 billion as follows: Within 1 year - $700 million; 2-3 years - $800 million; 4-5 years - $500 million; and thereafter - $513 million. Actual payments and their timing could differ significantly from these estimates.
AFG's $46 million liability for unrecognized tax benefits as of December 31, 2009, is not included because the period of payment cannot be reliably estimated.
AFG owns interests in certain variable interest entities which are not presently required to be consolidated. See "Collateralized Loan Obligations" in Note P to the financial statements. There are no contractual requirements or intentions to make additional investments in these entities.
AFG's investment portfolio at December 31, 2009, contained $16.8 billion in "Fixed maturities" classified as available for sale and $411 million in "Equity securities", all carried at fair value with unrealized gains and losses included in a separate component of shareholders' equity on an after-tax basis. In addition, $373 million in fixed maturities were classified as trading with changes in unrealized holding gains or losses included in investment income.
Fixed income investment funds are generally invested in securities with intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions. At December 31, 2009, the average life of AFG's fixed maturities was about six years.
Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG's internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), changes in interest rates, general economic conditions and the credit quality of the specific issuers. Prices obtained from a broker or pricing service are adjusted only in cases where they are deemed not to be representative of an appropriate exit price (fewer than 1% of the securities).
Increasing turmoil in the global financial markets caused credit spreads (the difference in rates between U.S. government bonds and other fixed maturities) to widen significantly during 2008 and early 2009. These wider spreads, as well as a lack of liquidity and the collapse of several financial institutions, were the primary cause of AFG's pretax net unrealized loss on fixed maturities rising from $47 million at December 31, 2007, to $1.9 billion at December 31, 2008. The impact of improving market conditions on the fair value of AFG's portfolio beginning in the second quarter of 2009 resulted in a pretax net unrealized gain of $93 million at December 31, 2009.
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. Beginning with year-end 2009 reporting of MBS by insurance companies, the NAIC retained a third-party investment management firm to assist in the determination of appropriate NAIC designations for all non-agency residential mortgage-backed securities based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At December 31, 2009, 98% (based on statutory carrying value of $5.5 billion) of AFG's MBS securities had an NAIC designation of 1 or 2.
The table below summarizes (in millions) the credit quality of AFG's investments that have been enhanced by monoline insurers at December 31, 2009.
Based on its analysis of the factors listed above, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability to hold the securities until they recover in value and, at December 31, 2009, had no intent to sell them. Although AFG has the ability to continue holding its investments with unrealized losses, its intent may change due to deterioration in the issuers' creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG's ability or intent change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG's investment portfolio could have a significant adverse effect on AFG's liquidity. For information on AFG's realized gains (losses) on securities, including charges for "other-than-temporary" impairment, see Management's Discussion and Analysis - "Results of Operations - Realized Gains (Losses) on Securities."
The estimates of liabilities for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon: (a) the accumulation of case estimates for losses reported prior to the close of the accounting periods on direct business written ("case reserves"); (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of claims incurred but not reported or "IBNR" (including possible development on known claims); (d) estimates (based on experience) of expense for investigating and adjusting claims; and (e) the current state of law and coverage litigation.
In determining management's best estimate of the ultimate liability, management (including Company actuaries) considers items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, the nature and maturity of lines of insurance, general economic trends and the legal environment. In addition, historical trends adjusted for changes in underwriting standards, policy provisions, product mix and other factors are analyzed using actuarial reserve development techniques. Weighing all of the factors, the management team determines a single or "point" estimate that it records as its best estimate of the ultimate liabilities. Ranges of loss reserves are not developed by Company actuaries. This reserve analysis and review is completed each quarter and for every line of business.
Each quarterly review includes in-depth analysis of over 500 subdivisions of the business, employing multiple actuarial techniques. For each particular subdivision, actuaries use informed, professional judgment to adjust these techniques as necessary to respond to specific conditions in the data or within the business.
While current factors and reasonably likely changes in variable factors are considered in estimating the liability for unpaid losses, there is no method or system that can eliminate the risk of actual ultimate results differing from such estimates. As shown in footnote (a) to the reserve development table (loss triangle) on page 8, the original estimates of AFG's liability for losses and loss adjustment expenses, net of reinsurance, over the past 10 years have developed through December 31, 2009, to be deficient (for five years) by as much as 20.6% and redundant (for five years) by as much as 12.0% (excluding the effect of special charges for asbestos, environmental and other mass tort exposures). This development illustrates the historical impact caused by variability in factors considered in estimating insurance reserves.
AFG recorded favorable development of $55 million in 2009, $72 million in 2008 and $91 million in 2007 related to its other liability-occurrence coverage where both the frequency and severity of claims were lower than previously projected.
This long-tail line of business provides coverage to employees who may be injured in the course of employment. Some of the important variables affecting estimation of loss reserves for workers' compensation include:
AFG's workers' compensation business is written primarily in California. Significant reforms passed by the California state legislature in 2003 and in 2004 reduced employer premiums and set treatment standards for injured workers. AFG recorded favorable prior year loss development of $20 million in 2009, $32 million in 2008 and $22 million in 2007 due primarily to the impact of the legislation on medical claim costs being more favorable than previously anticipated. As claims incurred in 2003 through 2006 are now reaching a higher percentage of settlement and maturity, management is able to estimate the ultimate costs of these claims with more precision.
This line of business is a mix of coverage protecting the insured against legal liability for property damage or personal injury to others arising from the operation of commercial motor vehicles. The property damage liability exposure is usually short-tail with relatively quick reporting and settlement of claims. The
AFG recorded favorable prior year loss development of $6 million in 2009, $8 million in 2008 and $7 million in 2007 for this line of business as claim severity was significantly lower than in prior assumptions.
This long-tail line of business consists of two or more coverages protecting the insured from various property and liability risk exposures. The commercial multi-peril line of business includes coverage similar to other liability - occurrence, so in general, variables affecting estimation of loss reserves for commercial multi-peril include those mentioned above for other liability - occurrence. In addition, this line includes reserves for a run-off book of homebuilders business covering contractors' liability for construction defects. Variables important to estimating the liabilities for this coverage include:
Reserves of foreign operations relate primarily to the operations of Marketform Group, Limited, AFG's 67%-owned United Kingdom-based Lloyd's insurer. Historically, the largest line of business written by Marketform has been non-U.S. medical malpractice, which provides coverage for injuries and damages caused by medical care providers, including but not limited to, hospitals and their physicians. Although Marketform offers this product in approximately 30 countries, the majority of the business has been written in the United Kingdom, Australia and Italy.
Marketform recorded adverse prior year reserve development of $56 million in 2009 related primarily to its Italian public hospital medical malpractice business, which it ceased writing in 2008. The development resulted from significant issues related to third party administration of claims and a challenging legal environment in Italy. Management believes that current reserves, which represent its best estimate of future liabilities, are adequate. Nonetheless, it concluded that sufficient uncertainty exists with respect to Italian public hospital medical malpractice reserves to leave open the 2007 year of account, in accordance with Lloyd's provisions until a larger percentage of claims have been paid and the ultimate liabilities can be estimated with greater certainty.
Establishing reserves for A&E claims relating to policies and participations in reinsurance treaties and former operations is subject to uncertainties that are significantly greater than those presented by other types of claims. For this group of claims, traditional actuarial techniques that rely on historical loss development trends cannot be used and a meaningful range of loss cannot be estimated. Case reserves and expense reserves are established by the claims department as specific policies are identified. In addition to the case reserves established for known claims, management establishes additional reserves for claims not yet known or reported and for possible development on known claims. These additional reserves are management's best estimate based on periodic comprehensive studies and internal reviews adjusted for payments and identifiable changes, supplemented by management's review of industry information about such claims, with due consideration to individual claim situations. Management believes that estimating the ultimate liability for asbestos claims presents a unique and difficult challenge to the insurance industry due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage. The casualty insurance industry is engaged in extensive litigation over these coverage and liability issues as the volume and severity of claims against asbestos defendants continue to increase.
While management believes that AFG's reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims, the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, how claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims. A 1% variation in loss cost trends, caused by any of the factors previously described, would change net income by approximately $19 million.
During 2009, AFG completed a comprehensive study of its asbestos and environmental reserves with the assistance of outside actuarial and engineering firms and specialty outside counsel. Similar studies were completed in 2007, 2005 and 2003, respectively. The 2009 study resulted in minor adjustments to A&E reserves.
An in-depth internal review completed in 2008 resulted in a $12 million pretax charge (net of reinsurance recoverables) to increase the property and casualty group's A&E reserves. The 2007 study resulted in AFG recording a pretax charge of $44 million (net of reinsurance recoverables) to increase its insurance A&E reserves. Management expects to conduct a comprehensive study every two years with an in-depth internal review during the intervening years. For a discussion of the A&E reserve strengthening, see Management's Discussion and Analysis - "Results of Operations - Asbestos and Environmental Reserve Charges."
Amounts paid (net of amounts received from reinsurers) for asbestos and environmental claims, including loss adjustment expenses, were as follows (in millions):
The A&E studies and review 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 GAFRI. Charges resulting from the A&E studies and review were less than $10 million in 2009 and 2008. As a result of the 2007 study, A&E reserves were increased by $43 million reflecting higher estimates of the cost of mesothelioma claims (partially offset by lower claim counts) and increased clean-up estimates at certain former rail and manufacturing sites. Liabilities for claims and contingencies arising from these former operations totaled $95 million at December 31, 2009. For a discussion of the uncertainties in determining the ultimate liability, see Note M - "Contingencies" to the financial statements.
AFG reports its Specialty insurance business in the following sub-segments: (i) Property and transportation, (ii) Specialty casualty, (iii) Specialty financial, and (iv) California workers' compensation. Due to the decreasing size of the California workers' compensation business, AFG intends to include it in the Specialty casualty sub-segment beginning in 2010.
AFG's combined ratio has been better than the industry average for twenty-three of the last twenty-four years and excluding AFG's special A&E charges, for all twenty-four years. Management believes that AFG's insurance operations have performed better than the industry as a result of product line diversification, stringent underwriting discipline, alignment of incentives, and, more recently, a specialty niche focus.
Gross and net written premiums decreased 12% and 20%, respectively, in 2009 compared to 2008. A soft market, a decision to exit certain automotive-related lines of business, depressed economic conditions and lower crop prices contributed to the decline in gross written premiums. Increased cessions under a crop reinsurance agreement further reduced net written premiums. Excluding crop operations, gross and net written premiums decreased 8% and 10%, respectively, in 2009. Overall average renewal rates in 2009 were flat when compared with the prior year period.
The Specialty insurance operations generated an underwriting profit of $424 million in 2009, $60 million higher than in 2008. The 2009 combined ratio improved 4.9 points from 2008 primarily as a result of higher crop underwriting profits and lower catastrophe losses, partially offset by lower favorable development. Results for 2009 include $205 million (8.5 points) of favorable reserve development compared to $251 million (8.7 points) in 2008. Catastrophe losses totaled $18 million (.7 points) in 2009 compared to $59 million (2.1 points) in 2008.
Property and transportation gross and net written premiums decreased significantly in 2009 as a result of lower spring commodity prices on crop operations, planned volume reductions in the inland marine operations and soft market conditions in the property and inland marine and transportation operations. Increased cessions under a crop reinsurance treaty also reduced net written premiums in 2009. Excluding crop, net written premiums for this group decreased 11% in 2009 when compared to the 2008 period. This group reported 2009 underwriting profits of $236 million, a 51% improvement over the 2008 period. The combined ratio improved 13.8 points to 74.1%. Favorable crop yields and relatively stable commodity prices resulted in record profitability for the crop operations and contributed in large measure to these results. The other property and transportation businesses reported strong underwriting profits notwithstanding soft market conditions. Results for 2009 include $52 million (5.7 points) of favorable reserve development compared to $65 million (5.0 points) in 2008. Catastrophe losses for this group were $7 million in 2009 compared to $50 million in 2008.
gross and net written premiums decreased in 2009 in large measure due to the rate reductions in traditional workers' compensation business in California and reductions in employer payrolls. This group reported a small underwriting loss, compared to an underwriting gain of $45 million in 2008. The 2009 combined ratio was 100.1%, an increase of 21.9 points from the prior year period, reflecting the competitive pricing environment in California and rising average cost of claims. AFG received approval for an 8% rate increase, effective January 1, 2010. Renewal rates for business written in California were up 3% for 2009.
At December 31, 2009, the property and casualty group's A&E reserves were $378 million, net of reinsurance recoverables. 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.
Loss development As shown in Note O - "Insurance - Insurance Reserves," AFG's property and casualty operations recorded favorable loss development of $198 million in 2009, $242 million in 2008 and $99 million in 2007 related to prior accident years. Major areas of favorable (adverse) development were as follows (in millions):
Favorable reserve development in Specialty casualty in 2008 reflects lower severity on claims in the nursing home liability product, general liability, homebuilders and executive liability for large accounts as well as lower than expected frequency in homebuilders, executive liability for small accounts and the program (leisure camps, fairs and festivals, and sports and leisure) business. The favorable reserve development in Specialty casualty during 2007 was the result of lower than expected frequency and severity in the nursing home liability product and general liability business.
The increase in annuity premiums in 2008 compared to 2007 reflects sales through the new bank distribution channel, as well as increased sales of traditional fixed annuities, partly offset by lower sales of indexed annuities in the single premium market.
The following table summarizes AFG's life, accident and health premiums and benefits as shown in the Consolidated Statement of Earnings (in millions):
The decrease in life, accident and health benefits in 2008 compared to 2007 is due primarily to favorable results in AFG's long term care business.
Investment income increased $77 million for 2009 compared to 2008 and $118 million for 2008 compared to 2007 due primarily to higher yields on certain fixed maturity investments. Investment income includes $130 million in 2009 and $77 million in 2008 of interest income earned on interest-only and similar MBS, primarily non-agency interest-only securities with interest rates that float inversely with short-term rates. These MBS, the majority of which were purchased in late 2007 and early 2008, had a carrying value of $226 million at December 31, 2009. These securities have benefited from a slowing rate of prepayments and significantly lower short-term interest rates, which are reflective of the weak housing market and general economic conditions over the past two years.
Realized gains on disposals for 2009 include a fourth quarter gain of approximately $76 million on the sale of 3.6 million shares of Verisk Analytics, Inc. Realized losses on disposals for 2008 includes third quarter losses of $80 million on the sales of securities issued by Fannie Mae, Freddie Mac, Washington Mutual, Lehman Brothers and AIG.
The change in fair value of derivatives includes gains of $157 million in 2009, $81 million in 2008 and $5 million in 2007 from the mark-to-market of MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. See Note F - "Derivatives."
In the fourth quarters of 2009 and 2008, AFG conducted its detailed review of actual results and future assumptions underlying its annuity operations. As a result of the reviews, AFG recorded a $5 million charge in 2009 and a $19 million charge in 2008 to annuity benefits related to changes in these assumptions (primarily related to investment yields). Excluding these charges, annuity benefits increased $31 million in 2009 compared to 2008 reflecting growth in the annuity business as well as the impact of changes in interest rates on the fair value of the embedded derivatives related to the indexed annuity business. The $27 million increase in annuity benefits for 2008 compared to 2007 reflects growth in the annuity business.
Annuity and supplemental insurance acquisition expenses include amortization of annuity, supplemental insurance and life business deferred policy acquisition costs ("DPAC") as well as a portion of commissions on sales of insurance products. Annuity and supplemental insurance acquisition expenses also include amortization of the present value of future profits of businesses acquired ("PVFP").
The $61 million decrease in other operating and general expenses for 2008 compared to 2007 reflects a $45 million decrease in the expenses of AFG's warranty business and special charges of $3 million in 2008 compared to $43 million in 2007 to increase liabilities for asbestos and environmental exposures related to AFG's former railroad and manufacturing operations. For a discussion of the internal review and outside studies that resulted in the A&E charges, see "Asbestos and Environmental Reserve Charges" under Results of Operations - "Property and Casualty Insurance - Underwriting."
See Note K - "Income Taxes" to the financial statements for an analysis of items affecting AFG's effective tax rate.
The following table details net earnings in consolidated subsidiaries attributable to shareholders other than AFG (in millions):
The portion of National Interstate's net earnings attributable to noncontrolling shareholders declined in 2008 due primarily to net realized losses from investments and an increase in large loss severity related to its charter passenger transportation business. Marketform's loss in 2009 reflects $56 million of adverse reserve development in its Italian public hospital medical malpractice business. The amount shown above for GAFRI reflects the noncontrolling shareholders' share of GAFRI's earnings prior to GAFRI becoming a wholly-owned subsidiary of AFG in September 2007.
New accounting standards implemented in 2009, are discussed in Note A - "Accounting Policies" under the following subheadings.
In June 2009, the FASB issued a new standard changing how a company determines when a company is the primary beneficiary, and therefore must consolidate, a variable interest entity ("VIE"). In addition to the VIE's purpose and design, this determination is based primarily on a company's ability to direct the activities of the entity that most significantly impacts the entity's economic performance and the obligation to absorb losses of the entity or receive benefits from the entity that could potentially be significant to the VIE. The new standard requires disclosures about the reporting company's continuing involvement with the VIE as well as its effect on the company's financial statements. The new standard is effective January 1, 2010. At December 31, 2009, AFG had an investment of approximately $700,000 ($6.4 million fair value) in unconsolidated collateralized loan obligation entities that it manages having assets of $2.3 billion that are expected to be consolidated under the new standard. Consolidation would add similar amounts of assets and liabilities to future AFG balance sheets and, depending upon the accounting policies selected to account for these items, also impact future income statements. AFG is still analyzing the impact of the new standard.
"Selected Quarterly Financial Data" has been included in Note N to the
AFG's management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including AFG's principal executive officers and principal financial officer, AFG conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2009, based on the criteria set forth in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have audited American Financial Group, Inc. and subsidiaries' (the Company's) internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company's management is responsible for maintaining effective internal control over financial reporting, and for its assessment of internal control over financial reporting included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Financial Group, Inc. and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of earnings, changes in equity and cash flows for each of the three years in the period ended December 31, 2009, and our report dated February 26, 2010, expressed an unqualified opinion thereon.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Financial Group, Inc. and subsidiaries' internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2010, expressed an unqualified opinion thereon.
The consolidated financial statements include the accounts of American Financial Group, Inc. ("AFG") and its subsidiaries. Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to December 31, 2009, and prior to the filing of this Form 10-K, have been evaluated for potential recognition or disclosure herein.
Effective January 1, 2008, AFG adopted a new accounting standard on fair value measurements, with the exception of the application of the standard to nonrecurring fair value measurements of nonfinancial assets and liabilities that was adopted pursuant to the standard as of January 1, 2009. The standard defines 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 standard establishes 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. As of January 1, 2009, AFG adopted new accounting guidance on estimating the fair value of an asset or liability when there is no active market and on identifying transactions that are not orderly. The guidance did not change the objective of fair value measurements. Adoption of these standards did not have a significant impact on AFG's financial condition or results of operations.
Fixed maturity and equity securities classified as "available for sale" are reported at fair value with unrealized gains and losses included in a separate component of shareholders' equity. Fixed maturity and equity securities classified as "trading" are reported at fair value with changes in unrealized holding gains or losses during the period included in investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.
Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities ("MBS") are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
In April 2009, AFG adopted new accounting guidance relating to the recognition and presentation of other-than-temporary impairments. Under the guidance, if management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then an entity may separate other-than-temporary impairments into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income (loss)). The credit-related portion of an other-than-temporary impairment is measured by comparing a security's amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are required to be shown in the Statement of Earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge is required to reduce the amortized cost of that security to fair value. AFG adopted this guidance effective January 1, 2009, and recorded a cumulative effect adjustment of $17.5 million to reclassify the non-credit component of previously recognized impairments from retained earnings to accumulated other comprehensive income (loss). Additional disclosures required by this guidance are contained in Note E - "Investments."
Certain AFG subsidiaries loan fixed maturity and equity securities to other institutions for short periods of time. The borrower is required to provide collateral on which AFG earns investment income, net of a fee to the lending agent. AFG records the collateral held (included in other assets) in its Balance Sheet at fair value. The obligation to return the collateral is included in other liabilities. The securities loaned remain a recorded asset on AFG's Balance Sheet.
On January 1, 2009, AFG adopted a new accounting standard relating to disclosures about derivative instruments and hedging activities. The standard requires enhanced disclosures about objectives and strategies for using derivatives, how they are accounted for and how the instruments affect the entity's financial statements. See Note F - "Derivatives" for the related disclosures. Adoption of this standard had no impact on AFG's financial position or results of operations.
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG's property and casualty insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers as well as ceded premiums retained by AFG's property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG's insurance subsidiaries also assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.
Policy acquisition costs (principally commissions, premium taxes and other marketing and underwriting expenses) related to the production of new business are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses.
DPAC related to annuities and universal life insurance products is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and variable annuity policy charges, less death and annuitization benefits in excess of account balances and estimated future policy administration expenses. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains (losses).
DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of "Accumulated Other Comprehensive Income (Loss), net of tax" in the Shareholders' Equity section of the Balance Sheet.
Property and casualty premiums are earned generally over the terms of the policies on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. On reinsurance assumed from other insurance companies or written through various underwriting organizations, unearned premiums are based on information received from such companies and organizations. For traditional life, accident and health products, premiums are recognized as revenue when legally collectible from policyholders. For interest-sensitive life and universal life products, premiums are recorded in a policyholder account, which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses.
For Balance Sheet purposes, noncontrolling interests represents the interests of shareholders other than AFG in consolidated entities. In the Statement of Earnings, net earnings attributable to noncontrolling interests represents such shareholders' interest in the earnings of those entities.
AFG implemented new accounting guidance related to accounting for uncertainty in income taxes on January 1, 2007. The guidance sets forth criteria for recognition and measurement of tax positions taken or expected to be taken in a tax return and requires that companies recognize the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. It also provides guidance on derecognition, classification, interest, penalties, accounting in interim periods and disclosure. The cumulative effect of applying the guidance was recorded as a reduction to retained earnings at January 1, 2007 and is shown separately in the Statement of Changes in Equity. See Note K - "Income Taxes."
All share-based grants are recognized as compensation expense over their vesting periods based on their calculated "fair value" at the date of grant. AFG uses the Black-Scholes pricing model to measure the fair value of employee stock options. See Note J - "Shareholders' Equity" for further information on stock options.
AFG provides retirement benefits to qualified employees of participating companies through the AFG 401(k) Retirement and Savings Plan, a defined contribution plan. AFG makes all contributions to the retirement fund portion of the plan and matches a percentage of employee contributions to the savings fund. Company contributions are expensed in the year for which they are declared. AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period the employees earn such benefits.
For cash flow purposes, "investing activities" are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. "Financing activities" include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, benefits and withdrawals are also reflected as financing activities. All other activities are considered "operating." Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.
In 2007, Great American Financial Resources, Inc. ("GAFRI") completed the acquisition of the 9.2 million shares (19%) of its common stock not previously owned by AFG at a price of $24.50 per share in cash. Total cost of the acquisition ($239 million), including cash paid for vested options and merger costs, was provided by AFG (parent company).
(d) Includes holding company expenses and second quarter charges of $43.0 million in 2007
related to asbestos and environmental liabilities at former railroad and manufacturing
Changes in balances of Level 3 financial assets and liabilities during 2009 and 2008 are presented below (in millions). Transfers into (out of) Level 3 are due to a change in the availability of market observable inputs for individual securities and are reflected in the table at fair value as of the date of transfer.
The carrying amount of cash and cash equivalents approximates fair value. Fair values for mortgage loans are estimated by discounting the future contractual cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings. The fair value of policy loans is estimated to approximate carrying value; policy loans have no defined maturity dates and are inseparable from insurance contracts. The fair value of annuity benefits was estimated based on expected cash flows discounted using forward interest rates adjusted for the Company's credit risk and includes the impact of maintenance expenses and capital costs. Fair values of long-term debt are based primarily on quoted market prices.
The non-credit related portion of other-than-temporary impairment charges are included in other comprehensive income (loss). Such charges taken for securities still owned at December 31, 2009 were $284 million for residential MBS, $3 million for commercial MBS and $4 million for corporate bonds.
An additional $14 million (12%) of the unrealized loss on "all other corporate" securities with unrealized losses for more than one year related to investments in insurance companies. Investment grade rated securities represented 70% of the unrealized loss and 88% of the fair value. Approximately $2 million of the unrealized loss (1 security) was more than 20% impaired, compared to $34 million (9 securities) at December 31, 2008.
The remaining $50 million in unrealized losses for "all other corporate" securities that have been in a loss position for more than one year relates to 161 securities spread across a wide variety of industries and issuers. Approximately $10 million of the unrealized loss (13 securities) relates to securities that were more than 20% impaired, compared to $186 million (105 securities) at December 31, 2008.
The following table is a progression of the credit portion of other-than-temporary impairments on fixed maturity securities for which the non-credit portion of an impairment has been recognized in other comprehensive income (loss) (in millions).
There were no investments in individual issuers (other than U.S. Treasury Notes) that exceeded 10% of Shareholders' Equity at December 31, 2009 or 2008. AFG subsidiaries held collateral for securities on loan of approximately $1 million and $85 million at December 31, 2009 and 2008. Fair value of securities loaned (plus accrued interest) was approximately $94 million at December 31, 2008.
As discussed under "Derivatives" in Note A, AFG uses derivatives in certain areas of its operations. AFG's derivatives do not qualify for hedge accounting under GAAP; changes in the fair value of derivatives are included in earnings.
AFG's indexed annuities, which represented 25% of annuity benefits accumulated at December 31, 2009, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG's strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be generally offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives.
The following derivatives and securities with embedded derivatives are included in AFG's Balance Sheet at December 31, 2009 (in millions):
During 2009, 2008 and 2007, AFG capitalized $32.3 million, $53.0 million and $63.3 million, respectively, relating to sales inducements offered to annuity policyholders. Amortization of sales inducements was $19.9 million, $10.4 million and $21.1 million in these periods, respectively.
As shown below at December 31 (in millions), the majority of AFG's long-term debt is unsecured obligations of the holding company and its subsidiaries:
In April 2009, AFG paid $136.1 million to redeem its outstanding 7-1/8% Senior Debentures at maturity. In June 2009, AFG issued $350 million of 9-7/8% Senior
In the second quarter of 2008, AFG paid $189.7 million in cash and issued 2.4 million shares of Common Stock to redeem its Senior Convertible Notes. As permitted by the terms of the Notes, AFG elected to pay cash in lieu of Common Stock for all conversions of the Notes prior to the redemption. Since AFG had previously expressed its intent to use cash for the accreted value of the Notes and the option to use stock for the conversion premium, shares issuable for amounts in excess of the accreted value of the Notes are included in AFG's calculation of diluted earnings per share for 2008 and 2007.
In May 2008, National Interstate borrowed $15 million under its credit facility to redeem its $15 million in outstanding variable rate Subordinated Debentures due May 2033. In June 2008, GAFRI paid $28.5 million to redeem its outstanding 6-7/8% Senior Notes at maturity.
In the first quarter of 2009, AFG issued 79,801 shares of restricted Common Stock with a fair value of $19.10 per share. The total fair value of $1.5 million will be expensed over the four year vesting period.
At December 31, 2009, there were 11.6 million shares of AFG Common Stock reserved for issuance under AFG's stock incentive plan. Options are granted with an exercise price equal to the market price of AFG Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant; those granted to non-employee directors of AFG are fully exercisable upon grant. Options expire ten years after the date of grant. Data for stock options issued under AFG's stock incentive plans is presented below:
The total intrinsic value of options exercised during 2009, 2008 and 2007 was $10.8 million, $13.8 million and $10.5 million, respectively. During 2009, 2008 and 2007, AFG received $10.4 million, $17.0 million and $15.9 million, respectively, in cash from the exercise of stock options. The total tax benefit related to the exercises was $3.6 million, $4.7 million and $2.5 million, respectively.
benefits totaled $3.1 million in both 2009 and 2008 and $3.2 million in 2007. Included in these totals are $2.4 million in 2009, $2.9 million in 2008 and $2.9 million in 2007 in compensation expense and $677,000 in 2009, $825,000 in 2008 and $907,000 in 2007 in tax benefits related to stock incentive plans of AFG subsidiaries. As of December 31, 2009, there was a total of $22.1 million of total unrecognized compensation expense related to nonvested stock options granted under AFG's plans. That cost is expected to be recognized over a weighted average of 2.9 years.
Total earnings (loss) before income taxes include income (losses) subject to tax in foreign jurisdictions of ($70.7 million) in 2009, $26.2 million in 2008 and $24.1 million in 2007.
The likelihood of realizing deferred tax assets will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period during which developments requiring an adjustment become known.
AFG increased its liabilities for uncertain tax positions and related interest and penalties, and reduced retained earnings by $14.9 million for the cumulative effect of an accounting change on January 1, 2007. A progression of the liability for uncertain tax positions, excluding interest and penalties, follows (in millions):
Establishing property and casualty insurance reserves for claims related to environmental exposures, asbestos and other mass tort claims is subject to uncertainties that are significantly greater than those presented by other types of claims. In addition, accruals (included in other liabilities) have been recorded for various environmental and occupational injury and disease claims and other contingencies arising out of the railroad operations disposed of by American Premier's predecessor, Penn Central Transportation Company ("PCTC") and its subsidiaries, prior to its bankruptcy reorganization in 1978 and certain manufacturing operations disposed of by American Premier and GAFRI. Comprehensive studies completed in the second quarters of 2009 and 2007 with the assistance of outside actuarial and engineering firms and specialty outside counsel resulted in asbestos and environmental charges of $4 million and $44 million, respectively, for the property and casualty group and $6 million and $43 million, respectively, for the former railroad and manufacturing operations. AFG's comprehensive internal review of asbestos and environmental exposures in the second quarter of 2008 resulted in charges of $12 million for
the run-off operations of its property and casualty group and $3 million for the former railroad and manufacturing operations and sites.
Results for 2008 include pretax catastrophe losses of $25.1 million in the second quarter, primarily from tornadoes in the Midwestern part of the United States and $37.5 million in the third quarter, primarily from wind-related storm damage from hurricanes Gustav and Ike. Results for the fourth quarter of 2008 include $79.4 million of losses from the run-off RVI business.
Securities owned by U.S.-based insurance subsidiaries having a carrying value of approximately $1.3 billion at December 31, 2009, were on deposit as required by regulatory authorities. At December 31, 2009, AFG and its subsidiaries had $128 million in undrawn letters of credit ($43 million of which was collateralized) supporting the underwriting capacity of its U.K.-based Lloyd's insurers.
The liability for losses and LAE for long-term scheduled payments under certain workers' compensation insurance has been discounted at 6%, an approximation of long-term investment yields. As a result, the total liability for losses and loss adjustment expenses at December 31, 2009, has been reduced by $33 million.
AFG's U.S.-based insurance subsidiaries are required to file financial statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Net earnings (loss) and policyholders' surplus on a statutory basis for the insurance subsidiaries were as follows (in millions):
In the normal course of business, AFG's insurance subsidiaries cede reinsurance to other companies to diversify risk and limit maximum loss arising from large claims. To the extent that any reinsuring companies are unable to meet obligations under agreements covering reinsurance ceded, AFG's insurance subsidiaries would remain liable. The following table shows (in millions) (i) amounts deducted from property and casualty written and earned premiums in connection with reinsurance ceded, (ii) written and earned premiums included in income for reinsurance assumed and (iii) reinsurance recoveries represent ceded losses and loss adjustment expenses.
At December 31, 2009, the aggregate guaranteed minimum death benefit value (assuming every variable annuity policyholder died on that date) on AFG's variable annuity policies exceeded the fair value of the underlying variable annuities by $85 million, compared to $191 million at December 31, 2008. Death benefits paid in excess of the variable annuity account balances were less than $1 million in each of the last three years.
Losses and loss adjustment expenses included charges for possible losses on reinsurance recoverables of $.1 million in 2009, $.3 million in 2008 and $7.9 million in 2007. The aggregate allowance for losses on reinsurance recoverables amounted to approximately $28 million at December 31, 2009 and 2008.
Total rental expense for various leases of office space and equipment was $40 million, $39 million and $37 million for 2009, 2008 and 2007, respectively. AFG has committed to lease approximately 530,000 square feet of office space in a building under construction under a 15-year lease beginning in 2011. Rentals, which escalate over the lease term, average approximately $16.9 million per year. 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, 2009, were as follows: 2010 - $34 million; 2011 - $42 million; 2012 - $37 million; 2013 - $34 million; 2014 - $30 million; and $227 million thereafter.
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, 2009, AFG and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling up to $27 million.
AFG is the investment manager and has investments (included in fixed maturities) ranging from 7.5% to 24.4% of the most subordinate tranche of six collateralized loan obligation entities ("CLOs"), which are considered variable interest entities. Upon formation between 2004 and 2007, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank loans, which serve as collateral for the securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG's investments in these entities are credited with residual income of the CLO only after the CLOs pay operating expenses (including management fees to AFG), interest on and returns of capital to senior levels of securities. There are no contractual requirements for AFG to provide additional funding for these entities. AFG has not provided and does not intend to provide any financial support to these entities.
In analyzing all expected cash flows, AFG determined that it will not receive a majority of the residual returns nor absorb a majority of the entities' expected losses. Accordingly, AFG has not been required to consolidate these variable interest entities because it was not the primary beneficiary. Beginning in 2010, accounting standards for determining the primary beneficiary of a variable interest entity changed from the above quantitative assessment to a qualitative one based on the power to direct the activities of the entity and the obligation to absorb the entity's losses or the right to receive benefits that could potentially be significant to the entity. Should AFG determine it is the primary beneficiary of its CLOs under the new guidance, it will consolidate the CLOs beginning January 1, 2010.
At December 31, 2009 and 2008, the fair value of investments managed by these entities was approximately $2.3 billion and $1.7 billion, respectively. Each CLO's assets can only be used to satisfy that CLO's obligations and the related liabilities are non-recourse to AFG. Accordingly, AFG's maximum exposure to economic loss is limited to its investment in the CLOs, which had an aggregate amortized cost of approximately $700,000 ($6.4 million fair value) at December 31, 2009. AFG recorded management fee income of $2.3 million, $9.2 million and $8.0 million for the years ended 2009, 2008 and 2007, respectively.
Payments of dividends, loans and advances by AFG's subsidiaries are subject to various state laws, federal regulations and debt covenants that limit the amount of dividends, loans and advances that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 2010 from its insurance subsidiaries without seeking regulatory clearance is approximately $673 million. Additional amounts of dividends, loans and advances require regulatory approval.
AFG expensed approximately $34 million in 2009, $19 million in 2008 and $21 million in 2007 for its retirement and employee savings plans.
(c) Grossed up for prepaid reinsurance premiums of $381 and $406 at December 31, 2009 and 2008, respectively.