At December 31, 2017, AFG (parent) held approximately $369 million in cash and securities and had $500 million available under a bank line of credit, which expires in June 2021.
the fourth quarter 2017 tax benefit related to the Neon Underwriting Ltd. (“Neon”) restructuring,
Full year 2017 net earnings attributable to AFG’s shareholders were $475 million ($5.28 per share, diluted) compared to $649 million ($7.33 per share, diluted) in 2016, reflecting:
higher underwriting profit in the property and casualty insurance segment due primarily to higher favorable prior year reserve development,
the fourth quarter 2017 tax benefit related to the Neon restructuring,
the second quarter 2016 gain on the sale of an apartment property, and
AFG’s ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.72 for the year ended December 31, 2017. Excluding annuity benefits, this ratio was 7.67. Although the ratio excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
Net Cash Used in Investing Activities AFG’s investing activities consist primarily of the investment of funds provided by its property and casualty and annuity products. Net cash used in investing activities was $3.29 billion in 2017 compared to $2.98 billion in 2016, an increase of $311 million. As discussed below (under net cash provided by financing activities), AFG’s annuity group had net cash flows from annuity policyholders of $1.99 billion in 2017 and $2.35 billion in 2016, which is the primary source of AFG’s cash used in investing activities. Settlements of equity index call options exceeded purchases by $285 million in 2017 compared to purchases exceeding settlements by $110 million in 2016, accounting for a $395 million decrease in cash used in investing activities. In general, purchases of equity index call options have increased due to growth in the fixed-indexed annuity business while proceeds from settlements of equity options are impacted by the performance of the stock market during the term of the options. 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 $205 million use of cash in 2017 compared to a $364 million use of cash in 2016, accounting for a $159 million decrease in net cash used in investing activities in 2017 compared to 2016. See Note A - “Accounting Policies - Managed Investment Entities” and Note H - “Managed Investment Entities” to the financial statements.
During 2016, AFG repurchased 1.9 million shares of its Common Stock for $133 million. In December 2016, AFG paid a special cash dividend of $1.00 per share of AFG Common Stock totaling approximately $87 million.
During 2015, AFG repurchased 2.0 million shares of its Common Stock for $126 million. In December 2015, AFG paid a special cash dividend of $1.00 per share of AFG Common Stock totaling approximately $88 million.
For statutory accounting purposes, equity securities of non-affiliates and equity call options used in the fixed-indexed annuity business are generally carried at fair value. At December 31, 2017, AFG’s insurance companies owned publicly traded equity securities with a fair value of $1.61 billion and equity call options with a fair value of $701 million. Decreases in market prices could adversely affect the insurance group’s capital, potentially impacting the amount of dividends available or necessitating a capital contribution. Conversely, increases in market prices could have a favorable impact on the group’s dividend-paying capability.
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 $33.32 billion for annuity benefits accumulated and $658 million for life, accident and health reserves included in AFG’s Balance Sheet as of December 31, 2017. Based on the same assumptions, AFG projects reinsurance recoveries related to life, accident and health reserves totaling $708 million as follows: Within 1 year - $68 million; 2-3 years - $124 million; 4-5 years - $96 million; and thereafter - $420 million. Actual payments and their timing could differ significantly from these estimates.
corresponding increases or decreases (net of tax) included in accumulated other comprehensive income in AFG’s Balance Sheet.
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, 2017, the average life of AFG’s fixed maturities was about 6-1/2 years.
Fair values for AFG’s portfolio are determined by AFG’s internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on published closing prices. For mortgage-backed securities (“MBS”), which comprise approximately 11% of AFG’s fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the remainder of AFG’s fixed maturity portfolio, approximately 76% are priced using pricing services and the balance is priced primarily by using non-binding broker quotes. When prices obtained for the same security vary, AFG’s internal investment professionals select the price they believe is most indicative of an exit price.
Summarized information for AFG’s MBS (including those classified as trading) at December 31, 2017, is shown in the table below (dollars in millions). Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The average life of the residential and commercial MBS is approximately 4-1/2 years and 5-1/2 years, respectively.
The National Association of Insurance Commissioners (“NAIC”) assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC retains third-party investment management firms to assist in the determination of appropriate NAIC designations for 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, 2017, 97% (based on statutory carrying value of $3.75 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, 2017, is shown in the following table (dollars in millions). Approximately $767 million of available for sale fixed maturity securities and $79 million of available for sale equity securities had no unrealized gains or losses at December 31, 2017.
The table below sets forth the scheduled maturities of AFG’s available for sale fixed maturity securities at December 31, 2017, 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.
the extent to which fair value is less than cost basis,
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.
An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. However, future results could vary due to an unexpected change in the underlying cost trends. This unexpected change could arise from a variety of sources including a general increase in economic inflation, inflation from social programs, new medical technologies, or other factors such as those listed below in connection with AFG’s largest lines of business. It is not possible to isolate and measure the potential impact of just one of these variables, and future cost trends could be partially impacted by several such variables. However, it is reasonable to address the sensitivity of the reserves to potential impact from changes in these variables by measuring the effect of a possible overall 1% change in future cost trends that may be caused by one or more variables. Utilizing the effect of a 1% change in overall cost trends enables changes greater than 1% to be estimated by extrapolation. Each additional 1% change in the cost trend would increase the effect on net earnings by an amount slightly (about 4%) greater than the effect of the previous 1%. For example, if a 1% change in cost trends in a line of business would change net earnings by $20 million, a 2% change would change net earnings by approximately $41 million.
AFG recorded adverse prior year reserve development of $37 million in 2017 related to its other liability - occurrence coverage due to continued severity increases in New York contractor claims, as well as increased claim severity across other excess and umbrella liability coverages and general liability coverages. AFG recorded adverse prior year reserve development of $61 million in 2016 due primarily to increased severity in New York contractor claims. AFG recorded favorable prior year reserve development of $7 million in 2015 as both the frequency and severity of claims in excess and umbrella liability coverages were lower than previously projected.
AFG recorded favorable prior year reserve development of $79 million in 2017 related to its workers’ compensation coverage due to lower than anticipated claim severity and improving claim closure rates, particularly in the southeastern United States and California. AFG recorded favorable prior year reserve development of $85 million in 2016 due to lower than anticipated claim severity and improving claim closure rates. AFG recorded favorable prior year reserve development of $45 million in 2015 due to lower than anticipated claim severity across all regions of the country.
The general state of the economy and the variability of the stock price of the insured can affect the frequency and severity of shareholder class action suits and other situations that trigger coverage under D&O policies. For example, from 2008 to 2010, economic conditions led to higher frequency of claims, particularly in the D&O policies for small account and not-for-profit organizations. Since then, claim frequency has consistently decreased from its peak in 2010, offsetting increased claim severity.
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
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 at December 31, 2017) as well as any income due to the closing year of account in return for a premium. The reinsurance to close agreement eliminates any remaining reserve volatility from years of account 2015 and prior, including all medical malpractice exposure. Going forward, significant variables in estimating Neon’s loss reserves include:
Outside of its property and casualty operations, AFG also has reinsurance recoverables totaling $312 million, including $263 million related to the run-off life business. These recoverables include $223 million directly or indirectly from Hannover Life Reassurance Company of America (rated A+ by A.M. Best).
Approximately 42% of AFG’s net asbestos reserves relate to policies written directly by AFG subsidiaries. Claims from these policies generally are product-oriented claims with only a limited amount of non-products exposures, and are dominated by small to mid-sized commercial entities that are mostly regional policyholders with few national target defendants. The remainder is assumed reinsurance business that includes exposures for the periods 1954 to 1983. The asbestos and environmental assumed claims are ceded by various insurance companies under reinsurance treaties. A majority of the individual assumed claims have exposures of less than $100,000 to AFG. Asbestos losses assumed include some of the industry known manufacturers, distributors and installers. Pollution losses include industry known insured names and sites.
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, generally every two years, with an in-depth internal review during the intervening years.
its environmental reserves by $36 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 insurance segment’s asbestos reserve increases in recent years. AFG is seeing modestly increasing estimates for indemnity and defense compared to prior studies. Overall, the rate of new asbestos cases received is down modestly, however, increasing life expectancies in the U.S. have allowed more time for the impacts of asbestos exposure to emerge. AFG’s comprehensive external study incorporates, among other factors, the increase in projected industry ultimate losses attributable to asbestos exposures, as well as revised estimates for future claims emergence, which has resulted in an increase in AFG’s provision for future asbestos claims.
As a result of the comprehensive external study completed in the third quarter of 2015, AFG’s property and casualty insurance segment recorded a $67 million pretax special charge to increase its asbestos reserves by $25 million (net of reinsurance) and its environmental reserves by $42 million (net of reinsurance). The increase in property and casualty asbestos reserves was attributed to increased estimates for indemnity and defense costs. The increase in property and casualty environmental reserves was attributed primarily to increased defense costs and a number of claims where the estimated costs of remediation have increased.
Includes a loss of $6 million representing the change in fair value of AFG’s CLO investments plus $15 million in CLO management fees earned.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $28 million in distributions recorded as interest expense by the CLOs.
Net earnings attributable to shareholders decreased $174 million for the full-year of 2017 compared to the same period in 2016 due primarily to the 2017 tax expense related to the change in the U.S. corporate tax rate, the 2016 tax benefits related to the National Interstate merger and Neon restructuring, higher special A&E charges recorded in 2017 compared to 2016, lower net realized gains on securities in 2017 compared to 2016, gains on the sale of real estate in 2016 and losses on the retirement of debt in 2017, partially offset by a 2016 charge related to the exit of certain lines of business within Neon and favorable development in 2017 on the Neon exited lines in connection with a reinsurance to close transaction, the 2017 benefit from restructuring at Neon and higher core net operating earnings. Core net operating earnings increased $54 million in 2017 compared to 2016 reflecting higher earnings in the property and casualty insurance and annuity segments.
RESULTS OF OPERATIONS - QUARTERS ENDED DECEMBER 31, 2017 AND 2016
AFG’s property and casualty insurance operations contributed $251 million in GAAP pretax earnings in the fourth quarter of 2017 compared to $182 million in the fourth quarter of 2016, an increase of $69 million (38%). Property and casualty core pretax earnings were $233 million in the fourth quarter of 2017 compared to $182 million in the fourth quarter of 2016, an increase of $51 million (28%). The increase in GAAP and core pretax earnings reflects improved underwriting results in the Property and transportation and Specialty casualty insurance sub-segments and lower other expenses. The increase in GAAP
The following table details AFG’s earnings before income taxes from its property and casualty insurance operations for the three months ended December 31, 2017 and 2016 (dollars in millions):
AFG’s statutory combined ratio has been better than the U.S. industry average for 30 of the last 32 years. Management believes that AFG’s insurance operations have performed better than the industry as a result of its specialty niche focus, product line diversification, stringent underwriting discipline and alignment of compensation incentives.
Net written premiums (“NWP”) for AFG’s property and casualty insurance segment were $1.16 billion for the fourth quarter of 2017 compared to $1.08 billion for the fourth quarter of 2016, an increase of $78 million (7%). Detail of AFG’s property and casualty net written premiums is shown below (dollars in millions):
The $130 million increase in gross written premiums in the fourth quarter of 2017 compared to the fourth quarter of 2016 reflects growth in each of the Specialty property and casualty insurance sub-segments. Overall average renewal rates increased approximately 1% in the fourth quarter of 2017.
Specialty casualty Gross written premiums increased $53 million (8%) in the fourth quarter of 2017 compared to the fourth quarter of 2016. Higher gross written premiums at Neon, resulting from the growth of its portfolio in targeted classes of business, higher gross written premiums in the workers’ compensation businesses, primarily the result of rate increases in Florida, and growth in the excess and surplus lines businesses all contributed to the year-over-year growth. Average renewal rates for this group increased approximately 1% in the fourth quarter of 2017. Reinsurance premiums ceded as a percentage of gross written premiums are comparable between periods.
Property and transportation Underwriting profit for this group was $84 million for the fourth quarter of 2017 compared to $75 million in the fourth quarter of 2016, an increase of $9 million (12%) reflecting higher underwriting profit in the transportation businesses, partially offset by lower year-over-year underwriting profits in the agricultural operations. The crop insurance operations reported strong underwriting profitability during the fourth quarter of 2017, albeit at lower levels than in the 2016 fourth quarter. Catastrophe losses had a favorable impact of $3 million (0.6 points on the combined ratio) for the fourth quarter of 2017 compared to a $6 million loss (1.2 points) for the fourth quarter of 2016. Catastrophe losses for the fourth quarter of 2017 include the impact of the favorable reserve development on third quarter catastrophes discussed above.
Other specialty This group reported an underwriting loss of $5 million for the fourth quarter of 2017 compared to underwriting profit of $2 million in the fourth quarter of 2016, a decrease of $7 million (350%). The decrease 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.
Aggregate Aggregate underwriting results for AFG’s property and casualty insurance segment for the fourth quarter of 2017 includes favorable development in the Neon exited lines discussed in more detail below under “Net prior year reserve development.”
The current accident year loss and LAE ratio, excluding catastrophe losses for AFG’s Specialty property and casualty insurance operations was 63.3% for the fourth quarter of 2017 compared to 61.7% for the fourth quarter of 2016, an increase of 1.6 percentage points.
Specialty casualty The 1.1 percentage points improvement in the loss and LAE ratio for the current year, excluding catastrophe losses reflects a decrease in the loss and LAE ratio at Neon.
AFG’s Specialty property and casualty insurance operations recorded net favorable reserve development related to prior accident years of $49 million in the fourth quarter of 2017 compared to net adverse reserve development related to prior accident years of $10 million in the fourth quarter of 2016.
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.2 percentage points in the fourth quarter of 2017 compared to the fourth quarter of 2016 reflecting a change in the mix of business.
Net investment income in AFG’s property and casualty insurance operations was $86 million in the fourth quarter of 2017 compared to $85 million in the fourth quarter of 2016, an increase of $1 million (1%). In recent years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG’s investment portfolio yield. The average invested assets and overall yield earned on investments held by AFG’s property and casualty insurance operations are provided below (dollars in millions):
The increase in average invested assets and net investment income in the property and casualty insurance segment for the fourth quarter of 2017 as compared to the fourth quarter of 2016 is due primarily to growth in the property and casualty insurance segment. The property and casualty insurance segment’s overall yield on investments (net investment income as a percentage of average invested assets) was 3.42% for the fourth quarter of 2017 compared to 3.48% for the fourth quarter of 2016, a decrease of 0.06 percentage points, reflecting the impact of lower yields available in the financial markets and lower income from equity in the earnings of limited partnerships and similar investments.
Other income for AFG’s property and casualty insurance operations for the fourth quarter of 2017 includes a $3 million death benefit on a life insurance policy.
AFG’s annuity operations contributed $97 million in pretax earnings in the fourth quarter of 2017 compared to $132 million in the fourth quarter of 2016, a decrease of $35 million (27%). AFG’s annuity segment results for the fourth quarter of 2017 as compared to the fourth quarter of 2016 reflect the unfavorable impact of lower than expected interest rates on the fair value accounting for fixed-indexed annuities (“FIAs”) in the 2017 quarter compared to the favorable impact of higher than anticipated interest rates in the 2016 quarter, the impact of lower investment yields due to the run-off of higher yielding investments and higher general and administrative expenses, partially offset by a 10% increase in average annuity investments (at amortized cost). Both periods reflect the positive impact of strong stock market performance on fair value accounting for FIAs and exceptionally strong investment income. AFG’s periodic detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations resulted in a net annuity charge of $3 million in the fourth quarter of 2017 compared to a net annuity expense reduction of $1 million in the fourth quarter of 2016.
Net investment income for the fourth quarter of 2017 was $376 million compared to $346 million for the fourth quarter of 2016, an increase of $30 million (9%). This increase reflects the growth in AFG’s annuity business, partially offset by the impact of lower investment yields. The overall yield earned on investments in AFG’s fixed annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), decreased by 0.10 percentage points to 4.62% from 4.72% in the fourth quarter of 2017 compared to the fourth quarter of 2016. This decrease in net investment yield reflects (i) the investment of new premium dollars at lower yields as compared to the existing investment portfolio and (ii) the impact of the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets, partially offset by higher equity in the earnings of limited partnerships and similar investments and favorable investment income resulting from early redemptions and other items. During the full year of 2017, $4.9 billion in annuity segment investments with an average yield of 5.14% were redeemed or sold while the investments purchased during 2017 (with new premium dollars and the redemption/sale proceeds) had an average yield at purchase of 3.94%.
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 $7 million in the fourth quarter of 2017 compared to $13 million in the fourth quarter of 2016, a decrease of $6 million (46%). Excluding the impact of unlocking charges of $3 million in the fourth quarter of 2017 and $1 million in the fourth quarter of 2016 related to unearned revenue, annuity policy charges and other miscellaneous income were $10 million in the fourth quarter of 2017 compared to $14 million in the fourth quarter of 2016, a decrease of $4 million (29%). The fourth quarter of 2016 includes $2 million from the sale of real estate. 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 0.05 percentage points to 0.10% in the fourth quarter of 2017 from 0.15% in the fourth quarter of 2016.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) for the fourth quarter of 2017 were $18 million compared to $28 million for the fourth quarter of 2016, a decrease of $10 million (36%). As a percentage of average fixed annuity benefits accumulated, these net expenses decreased 0.17 percentage points to 0.21% from 0.38% in the fourth quarter of 2017 compared to the fourth quarter of 2016. In addition to interest credited to policyholders’ accounts and the change in fair value of derivatives related to fixed-indexed annuities, annuity benefits expense also includes the following expenses (in millions, net of guaranteed withdrawal benefit fees):
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 decreases when the benefit of stock market participation increases.
Excluding the impact of unlocking charges (expense reductions) discussed under “Annuity Unlocking” below, AFG’s amortization of DPAC and commission expenses as a percentage of average fixed annuity benefits accumulated was 0.60% for the fourth quarter of 2017 compared to 1.06% for the fourth quarter of 2016 and has generally ranged between 0.75% and 0.85%. Variances from the general range relate primarily to the impact of (i) material changes in interest rates or the stock market on AFG’s fixed-indexed annuity business, and (ii) differences in actual experience from actuarially projected estimates and assumptions. For example, the negative impact of the lower than anticipated interest rates during the fourth quarter of 2017 on the fair value of derivatives related to fixed-indexed annuities (discussed below) resulted in a partially offsetting deceleration in the amortization of DPAC. In contrast, the positive impact of significantly higher than anticipated interest rates in the fourth quarter of 2016 on the fair value of derivatives related to fixed-indexed annuities resulted in a partially offsetting acceleration in the amortization of DPAC.
See “Annuity Unlocking” below for a discussion of the impact that the periodic review of actuarial assumptions had on annuity and supplemental insurance acquisition expenses. Unanticipated spread compression, decreases in the stock market, adverse
mortality experience, and higher than expected lapse rates could lead to future write-offs of DPAC or the present value of future profits on business in force of companies acquired (“PVFP”).
Annuity other expenses were $31 million for the fourth quarter of 2017 compared to $27 million for the fourth quarter of 2016, an increase of $4 million (15%). Annuity other expenses represent primarily general and administrative expenses, as well as selling and issuance expenses that are not deferred. The increase in annuity other expenses reflects primarily growth in the business and an increase in the number of sales personnel focused on new initiatives and increased market share within existing financial institutions and retail marketing organizations in the fourth quarter of 2017 compared to the fourth quarter of 2016. As a percentage of average fixed annuity benefits accumulated, these expenses increased 0.02 percentage points to 0.37% from 0.35% for the fourth quarter of 2017 as compared to the fourth quarter of 2016.
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 $11 million in the fourth quarter of 2017 and increased the annuity segment’s earnings before income taxes by $29 million in the fourth quarter of 2016.
AFG’s net spread earned on fixed annuities decreased 0.61 percentage points to 1.21% from 1.82% in the fourth quarter of 2017 compared to the same period in 2016 due primarily to the net impact of changes in the fair value of derivatives and related DPAC amortization offset discussed above.
AFG’s annuity operations generated statutory premiums of $909 million in the fourth quarter of 2017 compared to $1.11 billion in the fourth quarter of 2016, a decrease of $202 million (18%). The following table summarizes AFG’s annuity sales (dollars in millions):
Management attributes the 18% decrease in annuity premiums to AFG’s adherence to pricing discipline in a relatively low and decreasing interest rate environment during the year.
Assumed reinvestment rates exclude default rates of 0.18% in each period.
Management believes that these results over the last several years demonstrate that AFG’s investment rate assumptions are reasonable and prudently conservative. 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 2017, 2016 and 2015 were lower than the long-term default rates of 0.18% assumed in the unlocking in each of the periods above.
Holding Company, Other and Unallocated - Results of Operations AFG’s net GAAP pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $89 million for the fourth quarter of 2017 compared to $50 million for the fourth quarter of 2016, an increase of $39 million (78%). AFG’s net core pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $49 million in the fourth quarter of 2017 compared to $50 million in the fourth quarter of 2016, a decrease of $1 million (2%).
AFG recorded net investment income on investments held outside of its insurance operations of $6 million in the fourth quarter of 2017 compared to less than $1 million in the fourth quarter of 2016. The $6 million increase in the fourth quarter of 2017 as compared to the fourth quarter of 2016 is due primarily to the strong performance of certain fixed maturity investments.
AFG’s holding companies and other operations outside of its insurance operations recorded interest expense of $20 million in the fourth quarter of 2017 compared to $21 million in the fourth quarter of 2016, a decrease of $1 million (5%). This decrease reflects slightly higher average indebtedness, more than offset by lower average interest rates on outstanding debt. The following table details the principal amount of AFG’s long-term debt balances as of December 31, 2017 compared to December 31, 2016 (dollars in millions):
The increase in average indebtedness for the fourth quarter of 2017 as compared to the fourth quarter of 2016 reflects the following financing transactions completed by AFG between October 1, 2016 and December 31, 2017:
Redeemed $230 million of 6-3/8% Senior Notes on June 26, 2017
Redeemed $350 million of 9-7/8% Senior Notes on December 11, 2017
On December 11, 2017, AFG redeemed its $350 million outstanding principal amount of 9-7/8% Senior Notes due 2019 and recorded a pretax loss on retirement of debt of $40 million, primarily a $38 million make-whole premium.
Excluding the loss on retirement of debt discussed above, AFG’s holding companies and other operations outside of its insurance operations recorded other expenses of $37 million in both the fourth quarter of 2017 and the fourth quarter of 2016.
Excluding the tax benefits related to the Neon restructuring, the impact of the change in the U.S. corporate tax rate and the tax benefit related to the acquisition of the noncontrolling interest in NATL, AFG’s effective tax rate was 28% for the three months ended December 31, 2017 and 34% for the three months ended December 31, 2016.
Consolidated Noncontrolling Interests AFG’s consolidated net earnings attributable to noncontrolling interests was less than $1 million for the fourth quarter of 2017 compared to $3 million for the fourth quarter of 2016.
RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 2017, 2016 AND 2015
AFG’s net earnings attributable to shareholders, determined in accordance with GAAP, include certain items that may not be indicative of its ongoing core operations. The following tables for the years ended December 31, 2017, 2016 and 2015 identify such items by segment and reconcile net earnings attributable to shareholders to core net operating earnings, a non-GAAP financial measure that AFG believes is a useful tool for investors and analysts in analyzing ongoing operating trends (in millions):
AFG’s property and casualty insurance operations contributed $577 million in GAAP pretax earnings in 2016 compared to $576 million in 2015, an increase of $1 million. Property and casualty core pretax earnings were $646 million in 2016 compared to $577 million in 2015, an increase of $69 million (12%). The increase in GAAP and core pretax earnings reflects improved underwriting results in the Property and transportation group and higher net investment income, partially offset by lower underwriting profit in the Specialty casualty and Specialty financial groups. GAAP pretax earnings also reflect a pretax non-core charge of $65 million in the second quarter of 2016 related to the exit of certain lines of business within Neon and a $32 million pretax non-core gain on the sale of an apartment property in the second quarter of 2016 compared to a $51 million pretax non-core gain on the sale of a hotel in the second quarter of 2015 and a $15 million pretax non-core gain on the sale of an apartment property in the fourth quarter of 2015, as well as non-core special A&E charges of $36 million in 2016 compared to $67 million in 2015.
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, 2017, 2016 and 2015 (dollars in millions):
Net written premiums (“NWP”) for AFG’s property and casualty insurance segment were $4.75 billion in 2017 compared to $4.39 billion in 2016, an increase of $365 million (8%). NWP increased $59 million (1%) in 2016 compared to 2015. Detail of AFG’s property and casualty net written premiums is shown below (dollars in millions):
Net earned premiums (“NEP”) for AFG’s property and casualty insurance segment were $4.58 billion in 2017 compared to $4.33 billion in 2016, an increase of $251 million (6%). NEP increased $104 million (2%) in 2016 compared to 2015. Detail of AFG’s property and casualty net earned premiums is shown below (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 insurance sub-segments. Overall average renewal rates increased approximately 1% in 2017.
Property and transportation 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.
Gross written premiums increased $49 million (2%) in 2016 compared to 2015. This increase was the result of higher premiums in the agricultural businesses, growth in the transportation businesses and higher gross written premiums from the Singapore branch, which opened for business in June 2015, partially offset by lower gross written premiums in the property and inland marine businesses. Average renewal rates increased approximately 3% for this group in 2016, including a 5% increase in National Interstate’s renewal rates. Reinsurance premiums ceded as a percentage of gross written premiums were comparable in 2016 and 2015.
Gross written premiums increased $53 million (2%) in 2016 compared to 2015. Higher gross written premiums in the excess and surplus, targeted markets and workers’ compensation businesses were partially offset by lower premiums in the general liability business and by Neon’s exit of certain lines of business and implementation of more stringent underwriting standards at Neon. Lower premiums in the general liability business were primarily the result of competitive market conditions, re-underwriting efforts within the Florida homebuilders market and the slowdown within the energy sector. Average renewal rates decreased approximately 1% for this group in 2016, including a decrease of approximately 4% in the workers’ compensation businesses. Excluding the workers’ compensation business, average renewal rates for this group increased approximately 1% during 2016. Reinsurance premiums ceded as a percentage of gross written premiums increased 2 percentage points in 2016 compared to 2015, reflecting the cession of Neon’s UK medical malpractice business and a change in the mix of business at Neon.
Specialty financial Gross written premiums increased $42 million (6%) in 2017 compared to 2016 due primarily to higher premiums in the lending and leasing, fidelity and surety businesses. Average renewal rates for this group decreased approximately 2% in 2017. Reinsurance premiums ceded as a percentage of gross written premiums increased 2 percentage points in 2017 compared to 2016, reflecting higher cessions in the lending and leasing businesses.
The Specialty property and casualty insurance operations generated an underwriting profit of $337 million in 2016 compared to $295 million in 2015, an increase of $42 million (14%). The higher underwriting profit in 2016 reflects higher underwriting profit in the Property and transportation sub-segment, partially offset by lower underwriting profit in the Specialty casualty and Specialty financial sub-segments. Overall catastrophe losses were $55 million (1.3 points on the combined ratio) in 2016 compared to $35 million (0.8 points) in 2015.
Specialty casualty Underwriting profit for this group was $104 million in 2017 compared to $78 million in 2016, an increase of $26 million (33%), reflecting favorable reserve development within Neon, including the portion of the 2015 and prior years reinsurance to close transaction attributed to ongoing lines of business, and higher underwriting profit in the excess and surplus lines and workers’ compensation businesses. These improved results were partially offset by lower underwriting profit in the executive liability business, due primarily to lower favorable prior year reserve development, adverse prior year reserve development in the targeted markets operations and higher catastrophe losses. Catastrophe losses were $71 million (3.3 points on the combined ratio) and related net reinstatement premiums were $6 million in 2017 compared to catastrophe losses of $10 million (0.5 points) in 2016.
Specialty financial Underwriting profit for this group was $61 million in 2017 compared to $84 million in 2016, a decrease of $23 million (27%), reflecting lower underwriting profitability in the financial institutions business due primarily to higher catastrophe losses and adverse prior year reserve development. Catastrophe losses were $30 million (5.2 points on the combined ratio) in 2017 compared to $11 million (2.0 points) in 2016. In connection with catastrophe losses incurred in 2017, the Specialty financial sub-segment reduced profit-based commissions payable to agents by $8 million (1.1 points on the combined ratio) and paid $2 million in reinstatement premiums.
Underwriting profit for this group was $84 million in 2016 compared to $87 million in 2015, a decrease of $3 million (3%). Higher underwriting profit in the fidelity and surety businesses, primarily the result of higher favorable prior year reserve development, was more than offset by lower underwriting profit in the financial institutions and trade credit businesses, resulting primarily from lower favorable prior year reserve development.
Other specialty This group reported an underwriting loss of $2 million in 2017 compared to underwriting profit of $9 million in 2016, a decrease of $11 million (122%). The decrease is due primarily to a $14 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 62.9% in 2017, 61.8% in 2016 and 62.2% in 2015.
The 3.9 percentage points improvement in the loss and LAE ratio for the current year, excluding catastrophe losses in 2016 compared to 2015 reflects a decrease in the loss and LAE ratio of the crop, equine, transportation and property and inland marine businesses and the Singapore branch.
Specialty casualty The 0.8 percentage points improvement in the loss and LAE ratio for the current year, excluding catastrophe losses reflects a decrease in the loss and LAE ratio at Neon.
The loss and LAE ratio for the current year, excluding catastrophe losses is comparable in 2016 and 2015.
Specialty financial 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.
Net favorable reserve development of $23 million in 2016 reflects lower than anticipated claim severity in the fidelity business, lower than expected claim frequency and severity in the surety business and lower than anticipated claim frequency in the financial institutions business.
Other specialty In addition to the reserve development discussed above, total Specialty prior year reserve development includes net adverse reserve development of $8 million in 2017 and net favorable reserve development of $4 million in 2016 and $11 million in 2015. The adverse reserve development in 2017 reflects a $14 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 and favorable reserve development associated with AFG’s internal reinsurance program. Favorable reserve development in 2016 and 2015 reflects amortization of deferred gains on retroactive reinsurance and reserve development associated with AFG’s internal reinsurance program.
Neon exited lines charge See “Net prior year reserve development” under “Results of Operations - Property and Casualty Insurance Segment” for the quarters ended December 31, 2017 and 2016 for a discussion of the $57 million in adverse reserve development recorded as part of a $65 million non-core charge related to the exit of certain lines of business within Neon, AFG’s Lloyd’s insurer. Consistent with the treatment of the exited lines charge in 2016, the $18 million in favorable development related to the Neon exited lines recorded in connection with the December 2017 reinsurance to close transaction (discussed above under Specialty casualty) was treated as non-core.
AFG generally seeks to reduce its exposure to catastrophes through individual risk selection, including minimizing coastal and known fault-line exposures, and the purchase of reinsurance. AFG recorded net catastrophe losses of $140 million in 2017 primarily from storms and tornadoes in several regions of the United States in the first and second quarters, Hurricanes Harvey, Irma and Maria and earthquakes in Mexico in the third quarter and wildfires in California in the fourth quarter. Catastrophe losses of $55 million in 2016 resulted primarily from winter storms in the first quarter, storms in Texas in the second quarter, flooding in Louisiana and multiple storms in the southern United States in the third quarter and Hurricane Matthew in the fourth quarter. Catastrophe losses of $35 million in 2015 resulted primarily from winter storms in the first quarter, multiple storms in the midwestern and central United States in the second and third quarters and flooding in the midwestern United States in the fourth quarter.
Property and transportation Commissions and other underwriting expenses as a percentage of net earned premiums decreased 0.5 percentage points in 2017 compared to 2016 reflecting the impact of higher crop premiums on the ratio.
Commissions and other underwriting expenses as a percentage of net earned premiums increased 0.5 percentage points in 2016 compared to 2015 due primarily to the impact of lower premiums at Neon on the ratio, partially offset by the impact of a charge in the second quarter of 2015 to write off certain previously capitalized project costs.
Commissions and other underwriting expenses as a percentage of net earned premiums decreased 0.5 percentage points in 2016 compared to 2015 reflecting lower profitability-based commissions paid to agents.
Aggregate Aggregate commissions and other underwriting expenses for AFG’s property and casualty insurance segment includes $8 million of restructuring charges recorded as part of the $65 million non-core charge related to the exit of certain lines of business within Neon, AFG’s Lloyd’s insurer, recorded in the second quarter of 2016. See “Net prior year reserve development” under “Results of Operations - Property and Casualty Insurance Segment” for the quarters ended December 31, 2017 and 2016.
GAAP other income and expenses, net for AFG’s property and casualty insurance operations was a net expense of $13 million in 2017, a net expense of $9 million in 2016, and net earnings of $32 million in 2015. Core other income and expenses, net for AFG’s property and casualty insurance operations was a net expense of $13 million, $41 million and $34 million in 2017, 2016 and 2015, respectively. The table below details the items included in GAAP and core other income and expenses, net for AFG’s property and casualty insurance operations (in millions):
The following table details AFG’s earnings before income taxes from its annuity operations for 2017, 2016 and 2015 (dollars in millions):
Net investment income in 2017 was $1.46 billion compared to $1.36 billion in 2016, an increase of $102 million (8%). This increase reflects the growth in AFG’s annuity business, partially offset by the impact of lower investment yields. The overall yield earned on investments in AFG’s annuity operations, calculated as net investment income divided by average investment balances (at amortized cost), decreased by 0.14 percentage points to 4.63% from 4.77% in 2017 compared to 2016. This decline in net investment yield reflects (i) the investment of new premium dollars at lower yields as compared to the existing investment portfolio and (ii) the impact of the reinvestment of proceeds from maturity and redemption of higher yielding investments at the lower yields available in the financial markets. During 2017, $4.9 billion in annuity segment investments with an average yield of 5.14% were redeemed or sold while the investments purchased during 2017 (with new premium dollars and the redemption/sale proceeds) had an average yield at purchase of 3.94%.
Net investment income in 2016 was $1.36 billion compared to $1.22 billion in 2015, an increase of $132 million (11%). This increase reflects primarily the growth in AFG’s annuity business and higher income from certain investments that are required to be carried at fair value through earnings, partially offset by the impact of lower in-force investment yields. The overall yield earned on investments in AFG’s annuity operations decreased by 0.06 percentage points to 4.77% from 4.83% in 2016 compared to 2015. This decline in net investment yield reflects (i) the investment of new premium dollars at lower yields as compared to the existing investment portfolio and (ii) the impact of the reinvestment of proceeds from maturity and redemption
of higher yielding investments at the lower yields available in the financial markets, partially offset by higher investment income from certain investments that are required to be carried at fair value through earnings. During 2016, $4.0 billion in annuity segment investments with an average yield of 5.51% were redeemed or sold while the investments purchased during 2016 (with new premium dollars and the redemption/sale proceeds) had an average yield at purchase of 4.21%.
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, calculated as interest credited divided by average fixed annuity benefits accumulated, decreased 0.03 percentage points to 2.01% in 2017 from 2.04% in 2016.
Annuity policy charges and other miscellaneous income were $50 million in 2016 compared to $55 million in 2015, a decrease of $5 million (9%). Other miscellaneous income includes $5 million in income from the sale of real estate in 2016 compared to $6 million in 2015. Excluding the impact of unlocking charges of $1 million in 2016 and $2 million in 2015 related to unearned revenue, annuity policy charges and other miscellaneous income were $51 million in 2016 compared to $57 million in 2015, a decrease of $6 million (11%). 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 0.03 percentage points to 0.15% in 2016 from 0.18% in 2015.
Other annuity benefits, net of guaranteed withdrawal benefit fees (excluding the impact of unlocking) were $89 million in 2017, $92 million in 2016 and $87 million in 2015, representing a decrease of $3 million (3%) in 2017 compared to 2016 and an increase of $5 million (6%) in 2016 compared to 2015. As a percentage of average fixed annuity benefits accumulated, these net expenses decreased 0.05 percentage points to 0.28% in 2017 from 0.33% in 2016 and decreased 0.02 percentage points to 0.33% in 2016 from 0.35% in 2015. In addition to interest credited to policyholders’ accounts and the change in fair value of derivatives related to fixed-indexed annuities, annuity benefits expense also includes the following expenses (in millions, net of guaranteed withdrawal benefit fees):
An estimate of the acceleration/deceleration in the amortization of deferred policy acquisition costs resulting from fair value accounting for derivatives related to fixed-indexed annuities.
Annuity other expenses were $121 million in 2017, $110 million in 2016 and $96 million in 2015, representing an increase of $11 million (10%) in 2017 compared to 2016 and an increase of $14 million (15%) in 2016 compared to 2015. Annuity other expenses represent primarily general and administrative expenses, as well as selling and issuance expenses that are not deferred. As a percentage of average fixed annuity benefits accumulated, these expenses decreased 0.01 percentage points to 0.37% in 2017 from 0.38% in 2016 and increased 0.02 percentage points to 0.38% in 2016 from 0.36% in 2015. The increase in annuity other expenses in 2017 compared to 2016 and 2016 compared to 2015 reflects primarily growth in the business and an increase in the number of sales personnel focused on new initiatives and increased market share within existing financial institutions and retail marketing organizations.
AFG’s fixed-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 of call options on the appropriate index. AFG’s strategy is designed so that the change in the fair value of the call option assets will generally offset the economic change in the liabilities from the index participation. Both the index-based component of the annuities (an embedded derivative) and the related call 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 index-based component (embedded derivative) of AFG’s annuity benefits accumulated, see Note D - “Fair Value Measurements” to the financial statements. In addition, the change in the fair value of the embedded derivative includes interest accreted on the FIA embedded derivative reserve of $14 million in 2017, $4 million in 2016 and $1 million in 2015 (before the related impact on the amortization of 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 $33 million, $27 million and $23 million in 2017, 2016 and 2015, respectively.
AFG’s annuity operations generated statutory premiums of $4.34 billion in 2017, $4.44 billion in 2016 and $4.14 billion in 2015, a decrease of $94 million (2%) in 2017 compared to 2016 and an increase of $295 million (7%) in 2016 compared to 2015. The following table summarizes AFG’s annuity sales (dollars in millions):
See “Annuity Unlocking” under “Annuity Segment - Results of Operations” for the quarters ended December 31, 2017 and 2016 for a discussion of the overall net expense reduction from the periodic review of actuarial assumptions in 2017 and 2016.
Net investment income (as a % of investments) of 4.63%, 4.77% and 4.83% in 2017, 2016 and 2015, respectively, multiplied by the difference between average fixed annuity investments (at amortized cost) and average fixed annuity benefits accumulated in each period.
Excludes pretax non-core special A&E charges of $24 million, $5 million and $12 million in 2017, 2016 and 2015, respectively, and pretax non-core losses on retirement of debt of $51 million in 2017 and $4 million in 2015.
AFG recorded net investment income on investments held outside of its insurance operations of $14 million, $6 million and $4 million in 2017, 2016 and 2015, respectively. The $8 million increase in 2017 as compared to 2016 is due primarily to the impact of strong market performance on a small portfolio of securities that are classified as “trading” and are carried at fair value through net investment income and strong performance of certain fixed maturity investments.
Summit, a workers’ compensation insurance subsidiary, collects fees from a small group of unaffiliated insurers for providing underwriting, policy administration and claims services. In addition, certain of AFG’s property and casualty businesses collect fees from customers for ancillary services such as workplace safety programs and premium financing. In 2017, AFG collected $66 million in fees for these services compared to $60 million in 2016 and $54 million in 2015. Management views this fee income, net of the $41 million in 2017, $41 million in 2016 and $38 million in 2015, in expenses incurred to generate such fees, as a reduction in the cost of underwriting its property and casualty insurance policies. Consistent with internal management reporting, these fees and the related expenses are netted and recorded as a reduction of commissions and other underwriting expenses in AFG’s segmented results. These fees are shown in other income and the related expenses are shown in other expenses in AFG’s Statement of Earnings.
Other income in the table above includes $18 million, $17 million and $15 million in 2017, 2016 and 2015, respectively 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 Consolidated MIEs column under “Results
of Operations - Segmented Statement of Earnings.” Excluding amounts eliminated in consolidation, AFG recorded other income outside of its insurance operations of $4 million in 2017, $6 million in 2016 and $9 million in 2015.
The increase in average indebtedness for 2017 as compared to 2016 reflects the following financing transactions completed by AFG between January 1, 2016 and December 31, 2017:
On December 11, 2017, AFG redeemed its $350 million outstanding principal amount of 9-7/8% Senior Notes due 2019 and recorded a pretax loss on retirement of debt of $40 million, primarily a $38 million make-whole premium. In addition, AFG wrote off unamortized debt issuance costs of $7 million related to the redemption of its $230 million outstanding 6-3/8% Senior Notes due 2042 at par value on June 26, 2017 and $4 million related to the redemption of its $125 million outstanding 5-3/4% Senior Notes due 2042 at par value on August 25, 2017.
Consolidated Realized Gains (Losses) on Securities AFG’s consolidated realized gains (losses) on securities, which are not allocated to segments, were gains of $5 million in 2017 compared to $19 million in 2016, a decrease of $14 million (74%). AFG’s consolidated realized gains (losses) on securities were gains of $19 million in 2016 compared to losses of $19 million in 2015, an increase of $38 million (200%). Realized gains (losses) on securities consisted of the following (in millions):
Consolidated Realized Gains (Losses) on Subsidiaries In 2015, AFG recorded a pretax realized loss of $166 million on the sale of subsidiaries containing substantially all of AFG’s run-off long-term care insurance business. In the second quarter of 2016, AFG received additional proceeds based on the final closing balance sheet and adjusted certain accrued expense estimates associated with the sale, resulting in a $2 million pretax favorable adjustment to the loss recorded in 2015. See Note B - “Acquisitions and Sale of Businesses” to the financial statements. In addition, AFG recorded a $5 million pretax realized gain in 2015 representing an adjustment to the previously recognized loss on a small property and casualty subsidiary sold several years earlier.
Consolidated Noncontrolling Interests AFG’s consolidated net earnings attributable to noncontrolling interests was $2 million in 2017 compared to $19 million in 2016, a decrease of $17 million (89%). AFG’s consolidated net earnings attributable to noncontrolling interests was $19 million in 2016 compared to $18 million in 2015, an increase of $1 million (6%). The following table details net earnings in consolidated subsidiaries attributable to holders other than AFG (dollars in millions):
Other noncontrolling interests includes $2 million related to the gain on the sale of a hotel property in the first quarter of 2017, $4 million related to the gain on the sale of an apartment property in the second quarter of 2016 and $6 million related to the gain on the sale of a hotel in the second quarter of 2015. All three properties were owned by an 80%-owned subsidiary of GAI.
See Note A - “Accounting Policies - Income Taxes” to the financial statements for a discussion of accounting guidance adopted effective December 31, 2017, which allows the reclassification of amounts stranded in accumulated other comprehensive income from accounting for the Tax Cuts and Jobs Act of 2017 to retained earnings.
See Note A - “Accounting Policies - Managed Investment Entities” to the financial statements for a discussion of accounting guidance adopted on January 1, 2016, which impacts the consolidation of collateralized financing entities such as CLOs, as well as limited partnerships and similar investments.
See Note A - “Accounting Policies - Stock-Based Compensation” to the financial statements for a discussion of accounting guidance adopted in the fourth quarter of 2016 (effective January 1, 2016), which impacted the accounting for share-based payment transactions.
See Note B - “Acquisitions and Sale of Businesses” to the financial statements for a discussion of accounting guidance adopted on January 1, 2015, that impacts the determination of when a component of an entity qualifies for presentation as a discontinued operation.
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 Co-Chief Executive Officers and Chief Financial Officer, AFG conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2017, based on the criteria set forth in “Internal Control - Integrated Framework” issued in 2013 by the Committee of Sponsoring Organizations of the Treadway Commission.
We have audited American Financial Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2017, 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, 2017, 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, 2017 and 2016, 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, 2017, and the related notes and financial statement schedules listed in the Index at Item 15(a)(2) and our report dated February 23, 2018, expressed an unqualified opinion thereon.
To the shareholders and Board of Directors of American Financial Group, Inc. and subsidiaries
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the “Company”) as of December 31, 2017 and 2016, 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, 2017, and the related notes and financial statement schedules listed in the Index at Item 15(a)(2) (collectively referred to as the “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, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
Basis of Presentation The consolidated financial statements include the accounts of American Financial Group, Inc. and its subsidiaries (“AFG”). 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, 2017, and prior to the filing of this Form 10-K, have been evaluated for potential recognition or disclosure herein.
Fair Value Measurements Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in 2017 or 2016.
Derivatives Derivatives included in AFG’s Balance Sheet are recorded at fair value. Changes in fair value of derivatives are included in earnings, unless the derivatives are designated and qualify as highly effective cash flow hedges. Derivatives that do not qualify for hedge accounting under GAAP consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related equity index call options designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products.
Changes in the fair value of derivatives that are designated and qualify as highly effective cash flow hedges are recorded in AOCI and are reclassified into earnings when the variability of the cash flows from the hedged items impacts earnings. Any hedge ineffectiveness is immediately recorded in current period earnings. When the change in the fair value of a qualifying cash flow hedge is included in earnings, it is included in the same line item in the statement of earnings as the cash flows from the hedged item. AFG uses 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.
AFG manages, and has investments in, collateralized loan obligations (“CLOs”) that are VIEs (see Note H - “Managed Investment Entities”). AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) through its investment in the CLO debt tranches, it has exposure to CLO losses (limited to the amount AFG invested) and the right to receive CLO benefits that could potentially be significant to the CLOs.
On January 1, 2016, AFG adopted ASU 2015-02, which amended certain consolidation accounting guidance, including the VIE guidance that applies to collateralized financing entities such as CLOs. The new guidance affects how fee arrangements with CLO asset managers impact the determination of the primary beneficiary of those entities. Due to the significance of AFG’s investments in the CLOs that it manages, the new guidance did not impact the consolidation of AFG’s currently outstanding CLOs. The new guidance also impacted the consolidation analysis that applies to limited partnerships and similar entities, but did not result in a change to the accounting for AFG’s existing investments in those entities.
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the statement of earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Annuity Benefits Accumulated Annuity receipts and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for policy charges are credited to other income.
Variable Annuity Assets and Liabilities Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which AFG earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.
The effect of a change in tax rates on deferred tax assets and liabilities is recorded in net earnings in the period that includes the enactment date. This includes the impact on deferred tax assets or liabilities established through AOCI, which results in an amount equal to the difference between the deferred tax at the historical corporate rate and the newly enacted rate stranded in AOCI. As permitted under guidance adopted effective December 31, 2017 (ASU 2018-02), AFG reclassified the $145 million stranded in AOCI from accounting for the Tax Cuts and Jobs Act of 2017 to retained earnings at December 31, 2017. See Note L - “Income Taxes” for further information.
In the fourth quarter of 2016, AFG early adopted ASU 2016-09, which, among other things, requires excess tax benefits or deficiencies for share-based payments to be recorded through income tax expense in the statement of earnings instead of directly to capital surplus (as required under the previous guidance). As a result, AFG’s Statement of Earnings includes a tax benefit of $17 million in 2017 and $9 million in 2016 that under the previous guidance would have been recorded directly to capital surplus. In addition, the new guidance allows entities to elect to account for forfeitures of awards when they occur rather than accruing expense based on an estimate of expected forfeitures (as required under the previous guidance). AFG has elected to account for forfeitures as they occur. The resulting cumulative effect of accounting change of less than $1 million was recorded directly to retained earnings on January 1, 2016.
Benefit Plans 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 employees earn such benefits.
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: 2017 - 2.0 million, 2016 - 1.6 million and 2015 - 1.8 million.
AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: 2017 - none, 2016 - 0.4 million and 2015 - 1.1 million. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2017, 2016 and 2015 periods.
Revenue Recognition Guidance Effective in 2018 In May 2014, the FASB issued ASU 2014-09, which requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Revenue is recognized when (or as) the entity satisfies a performance obligation under the contract. The new guidance also updates the accounting for certain costs associated with obtaining and fulfilling contracts with customers and requires disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Revenue recognition for insurance contracts and financial instruments, which are AFG’s primary sources of revenue, is excluded from the scope of the new guidance. AFG will adopt the new guidance effective January 1, 2018. Because the new guidance would have applied to 2% of AFG’s 2017 consolidated revenues and the impact of the new guidance on the recognition of those revenues would not have been material, management does not expect the new guidance to have a material impact on AFG’s results of operations and financial position.
Sale of Long-term Care Business In December 2015, AFG completed the sale of substantially all of its run-off long-term care insurance business (which was included in the run-off long-term care and life segment) to HC2 Holdings, Inc. (“HC2”) for 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. The legal entities involved in the transaction, United Teacher Associates Insurance Company (“UTA”) and Continental General Insurance Company (“CGIC”), contained substantially all of AFG’s long-term care insurance reserves (96% as measured by net statutory reserves as of November 30, 2015), as well as smaller blocks of annuity and life insurance business. Following the sale of these subsidiaries, AFG has only a small block of long-term care insurance (1,600 policies) with approximately $39 million in reserves at December 31, 2017. AFG had ceased new sales of long-term care insurance in January 2010, but continued to accept renewal premiums on its outstanding policies, which are guaranteed renewable.
In addition to the net proceeds received at closing and the $13 million of potential additional proceeds in the future from the release of statutory liabilities, AFG received a total of $97 million in tax benefits in 2016 related to the sale through reduced estimated tax payments and a tax refund resulting from the carryback of the tax-basis capital loss. The receivables for these tax benefits were reflected in AFG’s financial statements at December 31, 2015.
Under accounting guidance effective in January 2015, only disposals of components of an entity that represent a strategic shift and that have a major effect on a reporting entity’s operations and financial results are reported as discontinued operations. Due to the run-off nature of the business and the immaterial expected impact on AFG’s results of operations, the sale of AFG’s long-term care insurance business has not been reported as a discontinued operation.
The impact of the sale of the run-off long-term care insurance business is shown below (in millions):
Includes special charges to increase asbestos and environmental (“A&E”) reserves of $89 million, $36 million and $67 million in 2017, 2016 and 2015, respectively. Also includes $18 million in favorable development related to the Neon exited lines recorded in connection with a reinsurance to close transaction in 2017 and a charge of $65 million related to Neon exited lines in 2016.
AFG sold substantially all of its run-off long-term care insurance business in December 2015.
Primarily holding company interest and expenses, including losses on retirement of debt of $51 million in 2017 and $4 million in 2015, and special charges to increase A&E reserves related to AFG’s former railroad and manufacturing operations ($24 million in 2017, $5 million in 2016 and $12 million in 2015).
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, mortgage-backed securities (“MBS”) 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, 2017, 2016 and 2015 are reflected in the table below at fair value as of the end of the reporting period (dollars in millions):
Approximately 5% of the total assets carried at fair value on December 31, 2017, were Level 3 assets. Approximately 79% ($1.80 billion) of the Level 3 assets were priced using non-binding broker quotes, for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AFG. Since internally developed Level 3 asset fair values represent less than 10% of AFG’s Shareholders’ Equity, any justifiable changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.
The only significant Level 3 assets or liabilities carried at fair value in the financial statements that were not measured using broker quotes are the derivatives embedded in AFG’s fixed-indexed annuity liabilities, which are measured using a discounted cash flow approach and had a fair value of $2.54 billion at December 31, 2017. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note F - “Derivatives.”
Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $25 million in 2017.
Total realized/unrealized gains (losses) included in net earnings for the embedded derivatives reflects losses related to the unlocking of actuarial assumptions of $28 million in 2015.
Fair Value of Financial Instruments The carrying value and fair value of financial instruments that are not carried at fair value in the financial statements at December 31 are summarized below (in millions):
The determination of whether unrealized losses are “other-than-temporary” requires judgment based on subjective as well as objective factors. Factors considered and resources used by management include:
AFG recorded $55 million in other-than-temporary impairment charges on common stocks in 2017. At December 31, 2017, the gross unrealized losses on common stocks of $22 million relate to 16 securities, none of which has been in an unrealized loss position for more than 12 months.
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, 2017. As discussed in Note A - “Accounting Policies - Investments,” effective January 1, 2018, all equity securities currently classified as “available for sale” will be required to be carried at fair value through net earnings instead of accumulated other comprehensive income and will therefore no longer be evaluated for other-than-temporary impairment.
Primarily adjustments to deferred policy acquisition costs and reserves related to the annuity business.
The MBS with embedded derivatives consist primarily of interest-only MBS with interest rates that float inversely with short-term rates. AFG records the entire change in the fair value of these securities in earnings. These investments are part of AFG’s overall investment strategy and represent a small component of AFG’s overall investment portfolio.
Warrants to purchase shares of publicly traded companies, which represent a small component of AFG’s overall investment portfolio, are considered to be derivatives that are required to be carried at fair value through earnings.
AFG’s fixed-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 of call options on the appropriate index. AFG receives collateral from certain of its counterparties to support its purchased call option assets. This collateral ($389 million at December 31, 2017 and $380 million at December 31, 2016) 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 option assets 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 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.
As discussed under “Reinsurance” in Note A, AFG has a reinsurance contract that is considered to contain an embedded derivative.
The change in fair value of the embedded derivative includes losses related to unlocking of actuarial assumptions of $25 million in 2017 compared to $17 million in 2016 and $28 million in 2015.
Since the terms of the interest rate swap matched the terms of the hedged debt, changes in the fair value of the interest rate swap were offset by changes in the fair value of the hedged debt attributable to changes in interest rates. The fair value of the interest rate swap (asset of $1 million at December 31, 2016) and the offsetting adjustment to the carrying value of the 9-7/8% Senior Notes were both included in long-term debt on AFG’s Balance Sheet. Accordingly, the net impact on AFG’s earnings during the period that the swap was outstanding was that the interest expense associated with the hedged debt was effectively recorded at the floating rate. The net reduction in interest expense from the swap for 2017, 2016 and 2015 was $2 million, $3 million and $2 million, respectively.
Unrealized adjustments to DPAC includes net unrealized gains/losses on securities and net unrealized gains/losses on cash flow hedges.
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.
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 $215 million (including $130 million invested in the most subordinate tranches) at December 31, 2017, and $216 million at December 31, 2016.
The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $55 million and $75 million at December 31, 2017 and 2016. The aggregate unpaid principal balance of the CLOs’ debt exceeded its carrying value by $118 million and $159 million at those dates. The CLO assets include loans with an aggregate fair value of $1 million at both December 31, 2017 and December 31, 2016, for which the CLOs are not accruing interest because the loans are in default (aggregate unpaid principal balance of $8 million and $10 million at those dates, respectively).
Changes in the carrying value of goodwill during 2015, 2016 and 2017, by reporting segment, are presented in the following table (in millions):
Goodwill decreased by $2 million in the fourth quarter of 2015 due to the sale of UTA and CGIC as discussed in Note B - “Acquisitions and Sale of Businesses.”
Included in other assets in AFG’s Balance Sheet is $26 million at December 31, 2017 and $34 million at December 31, 2016 of amortizable intangible assets related to property and casualty insurance acquisitions. These amounts are net of accumulated amortization of $30 million and $25 million, respectively. Amortization of intangibles was $8 million in each of 2017, 2016 and 2015. Future amortization of intangibles (weighted average amortization period of 3 years) is estimated to be $8 million per year in each of 2018 through 2020 and $2 million in 2021.
At December 31, 2017, scheduled principal payments on debt for the subsequent five years and thereafter were as follows: 2018 - none; 2019 - none; 2020 - none; 2021 - none; 2022 - none and thereafter - $1.32 billion.
In June 2017, AFG issued $350 million in 4.50% Senior Notes due in 2047 at a price of 99.46%. The net proceeds of the offering were used to redeem AFG’s $230 million outstanding principal amount of 6-3/8% Senior Notes due June 2042 at par value and to redeem AFG’s $125 million outstanding principal amount of 5-3/4% Senior Notes due August 2042 at par value in June 2017 and August 2017, respectively.
AFG issued 47,826 shares of Common Stock (fair value of $96.13 per share) in the first quarter of 2017 and 40,336 shares (fair value of $71.05 per share) in the first quarter of 2016 under its Equity Bonus Plan.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries for 2017, 2016 and 2015 was $30 million, $28 million and $27 million, respectively. AFG’s provision for income tax includes tax benefits of $27 million in 2017, $19 million in 2016 and $8 million in 2015 related to AFG’s stock incentive plans. The tax benefit of $27 million in 2017 and $19 million in 2016 includes $17 million and $9 million, respectively, that under the previous guidance would have been recorded directly to capital surplus. At December 31, 2017, there was $7 million and $31 million of unrecognized compensation expense related to nonvested stock options and restricted stock awards, respectively. The nonvested stock options and restricted stock awards amounts are expected to be recognized over a weighted average of 1.7 years and 2.6 years, respectively.
(a) The reclassification adjustment out of net unrealized gains on securities affected the following lines in AFG’s Statement of Earnings:
In January 2008, AFG paid $75 million in cash to acquire approximately 67% of Neon Underwriting Limited (“Neon”, formerly known as Marketform Group Limited), a United Kingdom-based Lloyd’s insurer. During 2012, AFG acquired the then-remaining shares of Neon that it did not already own for $17 million. AFG’s investment in Neon includes the cost of acquiring the company as well as additional capital provided to Neon since the date of acquisition.
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 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 connection with the reorganization of the Neon Lloyd’s business, in December 2016, AFG undertook a restructuring that included the liquidation for tax purposes of the foreign subsidiary that is the parent of the Neon Lloyd’s operations, resulting in a taxable loss for U.S. tax purposes. AFG reported a $111 million tax benefit associated with this loss in the fourth quarter of 2016. Approximately $29 million of the $111 million tax benefit recorded in 2016 reduced current taxes payable for 2016, while the remaining tax benefit was received in 2017 from the carry-back of the tax-basis capital loss to offset capital gains in prior years. An additional loss associated with the 2016 restructuring was deferred under U.S. tax laws, resulting in an unrecognized potential tax benefit of $48 million at December 31, 2016. The sale of the noncontrolling interest in Neon resulted
As discussed in Note B - “Acquisitions and Sale of Businesses,” AFG acquired the noncontrolling interest in NATL in November 2016. This transaction allowed NATL and its subsidiaries to become members of the AFG consolidated tax group, which resulted in a tax benefit of $66 million to AFG during the fourth quarter of 2016.
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2017 (in millions):
“Foreign underwriting losses” in the table above include the net operating loss carryforward and other deferred tax assets related to the Neon Lloyd’s insurance business. Due to uncertainty concerning the realization of the deferred tax benefits associated with these losses, AFG maintains a full valuation allowance of $80 million against these deferred tax assets at December 31, 2017. In addition to the valuation allowance related to the Neon Lloyd’s insurance business, the gross deferred tax asset has also been reduced by a $27 million valuation allowance related to AFG’s net operating loss carryforwards (“NOL”) subject to the separate return limitation year (“SRLY”) tax rules. A SRLY NOL can be used only by the entity that created it and only in years that both it and the consolidated group have taxable income. Approximately $13 million of AFG’s SRLY NOLs expired unutilized at December 31, 2017. Since AFG maintains a full valuation allowance against its SRLY NOLs, the expiration of these loss carryforwards was offset by corresponding reduction in the valuation allowance and had no overall impact on AFG’s income tax expense or results of operations.
The total unrecognized tax benefits and related interest and penalties that, if recognized, would impact the effective tax rate is less than $1 million at December 31, 2017 and December 31, 2016. AFG’s provision for income taxes included a benefit of less than $1 million in 2017 and an expense of less than $1 million in 2016 and 2015 of interest (net of federal benefit or expense). AFG’s liability for interest related to unrecognized tax benefits was less than $1 million at December 31, 2017 and December 31, 2016 (net of federal benefit). AFG’s provision for income taxes in 2017 and 2016 included penalties of less than $1 million; no penalties were recorded in 2015. AFG’s liability for penalties related to unrecognized tax benefits was less than $1 million at December 31, 2017 and December 31, 2016.
Cash payments for income taxes, net of refunds, were $194 million, $308 million and $234 million for 2017, 2016 and 2015, respectively.
AFG completed a comprehensive external study of its asbestos and environmental (“A&E”) exposures in the third quarter of 2017 with the aid of specialty actuarial, engineering and consulting firms and outside counsel. The study resulted in special A&E charges of $89 million for the property and casualty group and $24 million for the former railroad and manufacturing operations. AFG completed an in-depth internal review of its A&E exposures in the third quarter of 2016. The review resulted in special A&E charges of $36 million for the property and casualty group and $5 million for the former railroad and manufacturing operations. AFG completed a comprehensive external study of its A&E exposures in the third quarter of 2015 with the aid of specialty actuarial, engineering and consulting firms and outside counsel. The study resulted in special A&E charges of $67 million for the property and casualty group and $12 million for the former railroad and manufacturing operations.
The following are quarterly results of consolidated operations for the two years ended December 31, 2017 (in millions, except per share amounts). Quarterly earnings per share do not add to year-to-date amounts due to changes in shares outstanding.
Fixed-indexed annuities (“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 of call options on the appropriate index. AFG’s strategy is designed so that the change in the fair value of the call option assets 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 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.
AFG’s property and casualty operations recorded catastrophe losses totaling $140 million in 2017, including $107 million in the third quarter (primarily from Hurricanes Harvey, Irma and Maria and earthquakes in Mexico). Catastrophe losses for 2016 totaling $55 million were spread somewhat evenly across the four quarters.
Results include pretax gains (included in other income) of $13 million from the sale of a hotel in the first quarter of 2017 and$32 million from the sale of an apartment property in the second quarter of 2016.
Net earnings in the fourth quarter of 2017 includes $56 million in tax benefits related to the Neon restructuring. Net earnings in the fourth quarter of 2016 includes $177 million in tax benefits related to the NATL merger and Neon restructuring. See Note L - “Income Taxes.”
The liability for losses and LAE for a very limited number of claims with long-term scheduled payments under certain workers’ compensation policies has been discounted at 4.5% at both December 31, 2017 and 2016, which represents an approximation of long-term investment yields. Because of the limited amount of claims involved, the net impact of discounting did not materially impact AFG’s total liability for unpaid losses and loss adjustment expenses (net reductions from discounting of $15 million and $16 million at December 31, 2017 and 2016, respectively).
Reflects the 2016 reinsurance to close transactions at Neon (discussed below).
severity in New York contractor claims (all within the Specialty casualty sub-segment) and (iv) a charge to adjust to the deferred gain on the retroactive reinsurance transaction entered into in connection with the sale of businesses in 1998 (included in Other specialty sub-segment).
A reconciliation of incurred and paid claims development information to the aggregate carrying amount of the liability for unpaid losses and LAE, with separate disclosure of reinsurance recoverables on unpaid claims is shown below (in millions):
Fixed Annuities For certain products, the liability for “annuity benefits accumulated” includes reserves for excess benefits expected to be paid on future deaths and annuitizations (“EDAR”), guaranteed withdrawal benefits and accrued persistency and premium bonuses. The liabilities included in AFG’s Balance Sheet for these benefits, excluding the impact of unrealized gains on securities, were as follows at December 31 (in millions):
Operating Leases Total rental expense for various leases of office space and equipment was $69 million in 2017, $67 million in 2016 and $70 million in 2015. 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, 2017, were as follows: 2018 - $63 million; 2019 - $57 million; 2020 - $50 million; 2021 - $42 million; 2022 - $34 million; and $100 million thereafter.
Selected Quarterly Financial Data is included in Note N to the Consolidated Financial Statements.
The following financial information from American Financial Group’s Form 10-K for the year ended December 31, 2017, formatted in XBRL (Extensible Business Reporting Language):
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.