Reflects the results of Transport Insurance Company, which was sold in the fourth quarter of 2004.
Reflects the implementation of accounting changes mandated by recently enacted accounting standards.
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent only basis while others are best done on a total enterprise basis. In addition, since most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
In 2004, AFG and GAFRI replaced their existing bank credit lines with four-year lines of $300 million and $150 million, respectively. No amounts were borrowed under these facilities at December 31, 2004.
AFG received $82 million in cash during the fourth quarter of 2004 from the issuance of 2.7 million shares of Common Stock.
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance and in the sale of retirement annuities and supplemental insurance and life products. With the sale of Infinity in 2003, AFG narrowed the focus of its property and casualty business to its specialized commercial products for businesses.
As discussed in the following pages under "Results of Operations," the profitability of AFG's property and casualty business improved during the hard market despite the negative impact of adverse development on prior year claims and lower yields on newly invested funds.
Net realized gain of $134.4 million on the sale of Provident Financial Group securities.
Charge of $33.8 million related to the settlement of environmental litigation.
AFG's debt to total capital ratio (at the parent holding company level) was approximately 22% at December 31, 2004, compared to 21% at December 31, 2003.
AFG's ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 2.43 (1.91 excluding the Provident gain) for the year ended December 31, 2004. Excluding annuity benefits, this ratio was 7.07 (4.85 excluding the Provident gain) for 2004. Although the ratio excluding interest on annuities 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.
The NAIC's model law for risk based capital ("RBC") applies to both life and property and casualty companies. RBC formulas determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 2004, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements. The lowest capital ratio of any operating AFG subsidiary was over 3 times its authorized control level RBC.
For statutory accounting purposes, equity securities of non-affiliates are generally carried at market value. At December 31, 2004, AFG's insurance companies owned publicly traded equity securities with a market value of $537 million. In addition, Great American Insurance Company owns GAFRI common stock with a market value of $670 million and a statutory carrying value of $469 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.
Under tax allocation agreements with AFG, its 80%-owned U.S. subsidiaries generally compute tax provisions as if filing separate returns based on book taxable income computed in accordance with generally accepted accounting principles. The resulting provision (or credit) is currently payable to (or receivable from) AFG.
In January 2005, National Interstate Corporation ("NIC"), a majority-owned subsidiary that specializes in property and casualty insurance for the passenger transportation industry, issued 3,350,000 shares of its common stock in an initial public offering. A portion of the $40.6 million of net proceeds from this offering were used to repay NIC's $15 million promissory note to another AFG subsidiary. The remainder will be used for other general corporate purposes. After the offering, AFG owns approximately 54% of NIC.
AFG attempts to optimize investment income while building the value of its portfolio, placing emphasis upon long-term performance.
Approximately two-thirds of AFG's consolidated assets are invested in marketable securities. AFG's investment portfolio at December 31, 2004, contained $13 billion in "Fixed maturities" classified as available for sale and $537 million in "Other stocks", all carried at market value with unrealized gains and losses reported as a separate component of shareholders' equity on an after-tax basis. At December 31, 2004, AFG had pretax net unrealized gains of $376.2 million on fixed maturities and $81.1 million on other stocks.
Approximately 94% of the fixed maturities held by AFG were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies at December 31, 2004. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or noninvestment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return.
Investments in mortgage backed securities ("MBSs") represented approximately one-fourth of AFG's fixed maturities at December 31, 2004. MBSs are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates. Due to the significant decline in the general level of interest rates in recent years, AFG has experienced an increase in the level of prepayments on its MBSs; these prepayments have not been reinvested at interest rates comparable to the rates earned on the prepaid MBSs. Substantially all of AFG's MBSs are investment grade quality, with over 95% rated "AAA" at December 31, 2004.
The table below sets forth the scheduled maturities of AFG's available for sale fixed maturity securities at December 31, 2004, based on their market values. Asset backed securities and other securities with sinking funds are reported at average
AFG realized aggregate losses of $3.9 million during 2004 on $180.2 million in sales of fixed maturity securities (7 issues; 6 issuers) that had individual unrealized losses greater than $500,000 at December 31, 2003. Market values of six of the securities increased an aggregate of $3.1 million from year-end 2003 to date of sale. The market value of the remaining security decreased $428,000 from year-end 2003 to the sale date.
Based on its analysis of the factors enumerated above, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability and intent to hold the securities until they mature or recover in value. Should either of these beliefs change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other than temporary impairment could be material to results of operations in a future period. Management believes it is not likely that future impairment charges will have a significant effect on AFG's liquidity.
(a) Includes adjustments to reflect the impact of realized gains and losses on the
As more fully explained in the following paragraphs, management believes that the areas posing the greatest risk of material loss are the adequacy of its insurance reserves and American Premier's contingencies arising out of its former operations.
written ("case reserves"); (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience("IBNR"); (d) estimates based on experience of expense for investigating and adjusting claims; and (e) the current state of law and coverage litigation. Using these items as well as historical trends adjusted for changes in underwriting standards, policy provisions, product mix and other factors, management, including company actuaries, determines a single or "point" estimate which it records as its best estimate of the liabilities. Recorded amounts are analyzed and tested on a quarterly basis by company actuaries. Ranges of loss reserves are not developed by company actuaries.
Estimating the liability for unpaid losses and LAE is inherently judgmental and is influenced by factors which are subject to significant variation. Through the use of analytical reserve development techniques, management considers items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, general economic trends and the legal environment.
Quarterly reviews of unpaid loss and LAE reserves are prepared using standard actuarial techniques. These may include (but may not be limited to):
Within each line, Company actuaries review the results of individual tests, supplementary statistical information, and input from underwriting, operating and claim management, to select their point estimate of the ultimate liability. This estimate may be one test, or a weighted average of several tests, or a judgmental selection as the actuaries determine is appropriate. The actuarial review is performed each quarter as a test of the reasonableness of management's point estimate.
The level of detail in which data is analyzed varies among the different lines of business. Data is generally analyzed by major product or by coverage within product, using countrywide data; however, in some situations, data may be reviewed by state for a few large volume states. Appropriate segmentation of the data is determined based on data volume, data credibility, mix of business, and other actuarial considerations. Overall, Company actuaries review over 500 identified line components. Best estimates are selected based on test indications and judgment.
Following is a discussion of certain variables affecting the estimation of the more significant lines of business (asbestos and environmental liabilities are separately discussed below). Many other variables may also impact ultimate claim costs.
An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. To estimate the sensitivity of recorded reserves to an unexpected change in the trends, 1% was added to the trend that is embedded in the factors used to determine the reserves for ultimate liabilities. 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 our largest lines of business. Utilizing the effect of a 1% change in 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 6%) greater than the effect of the previous 1%. For example, if a 1% change in cost trends would change net earnings by $20 million, a 2% change would change net earnings by $41 million. The estimated cumulative impact that a one percent change would have on our net earnings is shown below (in millions).
This line of business provides coverage to employees who may be injured in the course of employment. Some of the important variables affecting estimation of loss reserves for workers' compensation include:
AFG's workers' compensation business is written primarily in California. There have been significant reforms passed by the California state legislature in 2003 and in 2004 that will impact future settlement payments for claims outstanding. The magnitude of these potential cost savings depends on the implementation and interpretation of the reforms throughout the California workers' compensation system over the next several years.
This line of business consists mostly of directors and officers' liability, and professional liability, mostly for lawyers. Some of the important variables affecting estimation of loss reserves for other liability - claims made include:
Asbestos reserves include claims asserting alleged injuries and damages from exposure to asbestos. Environmental reserves include claims relating to polluted waste sites. Other mass tort claims include alleged injuries and damages from exposure to lead, silica and various chemical substances, as well as other toxic hazards.
Approximately one-half of AFG's asbestos reserves relate to policies written by AFG subsidiaries. Claims from these policies generally are product oriented claims with only a limited amount of non-product exposures, and are dominated by small to mid-sized commercial entities that are mostly regional policyholders with few national target defendants.
Establishing reserves for A&E claims relating to policies and participations in reinsurance treaties and former operations is subject to uncertainties that are significantly greater than those presented by other types of claims. For this group of claims, traditional actuarial techniques that rely on historical loss development trends cannot be used and a meaningful range of loss cannot be estimated. Management makes its best estimate of these reserves based on prior ground up studies adjusted for payments and identifiable changes. Case reserves and expense reserves are established by the claims department as specific policies are identified. In addition to the case reserves established for known claims, management establishes additional reserves for claims not yet known or reported and for possible development on known claims. These additional reserves are management's best estimate based on its review of industry trends and other industry information about such claims, with due consideration to individual claim situations. Estimating ultimate liability for asbestos claims presents a unique and difficult challenge to the insurance industry due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage. The casualty insurance industry is engaged in extensive litigation over these coverage and liability issues as the volume and severity of claims against asbestos defendants continue to increase.
Claimants' counsel continue to file claims based on emerging toxic exposures such as silica.
While management believes that AFG's reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims, the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, whether claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims. A 1% variation in loss cost trends, caused by any of the factors previously described, would change net income by approximately $12 million.
The settlement is for $123.5 million (Great American has the option to pay in cash or over time with 5.25% interest), all but $30 million of which was covered by reserves established prior to September 30, 2002, and anticipated reinsurance recoverables for this matter. As a result, AFG recorded a $30 million pretax charge ($19.5 million after tax) in the fourth quarter of 2002. The agreement allows up to 10% of the settlement to be paid in AFG Common Stock.
Amounts paid (net of amounts received from reinsurers) for asbestos, environmental and other mass tort claims, including loss adjustment expenses, were as follows (in millions):
At December 31, 2004, American Premier had liabilities aggregating $103.5 million for various environmental and occupational injury and disease claims and other contingencies arising out of the railroad operations and certain manufacturing operations disposed of by American Premier and its predecessor. For information on the settlement of American Premier's largest outstanding environmental exposure and a discussion of the uncertainties in determining American Premier's ultimate liability for remediation costs at the remaining sites, see Note O - "Commitments and Contingencies" to the Financial Statements.
Following the disposal of substantially all of its Personal insurance business in 2003, AFG revised its reporting of the Specialty insurance business into the following components: (i) Property and Transportation, which includes inland and ocean marine, agricultural-related business and commercial automobile, (ii) Specialty Casualty, which includes executive and professional liability, umbrella and excess liability and excess and surplus, (iii) Specialty Financial, which includes fidelity and surety bonds and collateral protection, and (iv) California Workers' Compensation.
The Personal group wrote private passenger auto insurance and, to a lesser extent, homeowners' insurance.
Underwriting profitability is measured by the combined ratio which is a sum of the ratios of underwriting losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. A combined ratio under 100% is indicative of an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.
Over the last several years, AFG has been realigning its property and casualty business mix and focusing on rate adequacy in order to improve its operating profitability. Management has continued to direct capital in order to take advantage of certain specialty market opportunities. Management believes these actions have been successful and that the current mix of specialty businesses positions the company for solid growth and continuing improved profitability in the foreseeable future.
(b) Includes 1.8 points in 2004 for the effect of hurricane losses.
(c) Includes 2.3 points in 2003 for the effect of an arbitration decision relating
to a claim arising from a business in runoff and 1.2 points for 2002 relating
The prior year development in Property and transportation related primarily to higher than anticipated frequency of claims in the 1993 through 2001 accident years for certain portions of the homebuilders' liability business which are in runoff. In 2004, the adverse development was partially offset by favorable development in inland marine and agricultural-related coverages.
Specialty casualty development includes amounts related to executive liability, other liability excess casualty runoff and commutation of reinsurance. Executive liability development impacted all three years and resulted primarily from claim severity on directors' and officers' liability policy coverages for 1996 through 2000, as both settlement and defense costs related to shareholder lawsuits have increased beyond estimates; the development in 2004 and 2003 in particular related to two claims (one in each year). Development in other liability impacted both 2003 and 2002 reflecting an unexpected shift of judicial climate in some previously conservative states; verdicts, judgments, and settlements have increased. Development in excess casualty runoff impacted all three years reflecting higher frequency and severity of claims related to the 1999 through 2001 accident years. In 2004, the development includes a $9 million charge relating to commuting reinsurance agreements.
Specialty financial development in 2004 related to severity of a few fidelity and crime claims and higher claim severity in the surety business.
The development in California workers' compensation in 2004 reflects the effect of additional information received on individual claims from prior years.
The arbitration settlement represents a charge in the second quarter of 2003 for an unfavorable decision resulting from Great American's share of a 1995 property fire and business interruption claim. Great American was a 9.5% participant with a number of other companies in the insurance pool that insured the loss during the 1995 coverage year.
Asbestos development was due primarily to a charge of $30 million for the settlement of asbestos-related coverage in litigation in 2002. See "Uncertainties -Asbestos and Environmental-related Reserves" for additional information about these claims.
Property and transportation gross written premiums increased about 17% during 2004 reflecting primarily volume increases in the crop, equine and transportation insurance businesses. Net written premiums increased 33% for 2004 reflecting an overall reduction in reinsurance ceded. The combined ratio for 2004 included 4.7 points for the effect of the hurricane losses. Even with the hurricane losses, the combined ratio improved 7.1 points over 2003 reflecting exceptionally strong profitability in the crop business.
Gross and net written premiums increased 29% and 25%, respectively, for 2003 compared to 2002 reflecting significant volume growth in the federal crop insurance program. In addition, the other property and transportation business experienced rate increases and volume growth in 2003. The 2.3 point improvement in property and transportation's combined ratio for 2003 compared to 2002 reflects rate increases, partially offset by $13 million in additional prior year development in 2003 compared to 2002.
Gross and net written premiums increased 14% and 11%, respectively, for 2003 compared to 2002 primarily due to rate increases. Rate increases also led to an 8.4 point combined ratio improvement compared to 2002.
Specialty financial gross written premiums increased 18% for 2004 due to substantial volume growth in collateral protection products for financial institutions. The 31% increase in net written premiums also reflects a decrease in reinsurance ceded, including the impact of premiums returned in connection with the commutation of a reinsurance agreement. The impact of the commutation increased the 2004 combined ratio by about 4.1 points, driving it slightly higher than 2003.
The Personal group results represent primarily Infinity's underwriting results through the public offering in mid-February 2003 and the direct-to-consumer auto business, which was sold in April 2003. AFG's remaining personal lines business generated about 3% of net written premiums in 2003 and 2002. Beginning in 2004, the remaining former Personal business is included in Specialty transportation (2004 net written premium of $27 million and underwriting profit of $3 million) and Other lines (businesses in runoff; 2004 net written premium of $6 million and underwriting loss of $2 million).
The increase in life, accident and health premiums and benefits in 2004 and 2003 reflects the addition of new distribution sources for GAFRI's supplemental insurance products, partially offset by lower sales of life insurance products. Beginning in the second quarter of 2004, GALIC stopped issuing life insurance policies due to inadequate volume and returns. GAFRI will continue to service and accept renewal premiums on its in force block of these policies. GAFRI will also continue to sell life products through its supplemental insurance operations and Great American Life Puerto Rico.
Other income increased $51.9 million (19%) for 2004 compared to 2003 due primarily to a $14.5 million increase in revenues earned by AFG's warranty business, a $10.6 million increase in fee income in certain other property and casualty insurance operations, and an $11.4 million increase in policy fees earned in the annuity and life operations.
Annuity benefits reflect amounts accrued on annuity policyholders' funds accumulated. On its deferred annuities (annuities in the accumulation phase), GAFRI generally credits interest to policyholders' accounts at their current stated interest rates. Furthermore, for "two-tier" deferred annuities (annuities under which a higher interest amount can be earned if a policy is annuitized rather than surrendered), GAFRI accrues an additional liability to provide for expected deaths and annuitizations. Changes in crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect this accrual. In 2004, this accrual was increased by approximately $5 million due to trends in actual experience.
The majority of GAFRI's fixed annuity products permit GAFRI to change the crediting rate at any time subject to minimum interest rate guarantees (as determined by applicable law). In the fourth quarter of 2003, GAFRI began issuing products with guaranteed minimum crediting rates of less than 3% in states where required approvals have been received. At December 31, 2004, approximately 4% of annuity benefits accumulated related to policies with a minimum crediting rate of less than 3%. The remaining balance is split almost evenly between policies with minimum guarantee rates of 3% and 4%.
The increase in annuity benefits in 2004 compared to 2003 reflects the acquisition of the block of National Health Insurance Company business.
Annuity and life acquisition expenses include amortization of annuity and life, accident and health deferred policy acquisition costs ("DPAC") as well as a portion of commissions on sales of insurance products. Annuity and life acquisition expenses also include amortization of the present value of future profits of businesses acquired.
2004 compared to 2003 Annuity and life acquisition expenses for 2004 were reduced by $5.1 million related to trends in actual experience. Conversely, in 2003, these expenses included net charges of $15.2 million related to spread narrowing.
The 2003 provision for income taxes includes a benefit of $136 million related to the AFG/AFC merger for the effect of the elimination of deferred tax liabilities associated with AFC's holding of AFG stock and reflects $5.5 million in tax benefits related to AFG's basis in Infinity stock. The 2002 provision for income taxes includes $31 million in tax benefits for the reduction of previously accrued amounts due to the resolution of certain tax matters. See Note L to the Financial Statements for more information on the effects of the AFG/AFC merger and an analysis of items affecting AFG's effective tax rate.
In January 2004, AFG recorded a $1.8 million charge (after tax and minority interest) resulting from GAFRI's implementation of Statement of Position ("SOP") 03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts." This charge resulted primarily from a change in accounting for persistency bonuses and two-tier annuities.
In July 2004, AFG recorded a $3.8 million after-tax charge resulting from implementation of EITF 03-16, "Accounting for Investments in Limited Liability Companies." This charge reflects the cumulative effect of changing from the cost method to the equity method of accounting for AFG's investment in a limited liability company. This charge reduced AFG's investment in this entity to zero. Management believes the fair value of this investment substantially exceeds its carrying value prior to the writedown.
See Note A - "Accounting Policies" - "Managed Investment Entity" and "Payable to Subsidiary Trusts." The cumulative effect of implementing FIN 46 was an increase in income of $6.3 million.
"Selected Quarterly Financial Data" has been included in Note P to the
In conducting AFG's evaluation of the effectiveness of its internal control over financial reporting, AFG has excluded the 2004 acquisition of the fixed annuity business of National Health Insurance Company. This acquisition constituted less than 4% of total assets as of December 31, 2004 and less than 1% of total revenues and net earnings for the year then ended. Refer to Note B to the consolidated financial statements for further discussion of this acquisition.
In our opinion, management's assessment that American Financial Group, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, American Financial Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
As discussed in Notes A and E to the consolidated financial statements, in 2002 the Company implemented Statement of Financial Accounting Standards No. 142, which required a change in the method of accounting for goodwill, in 2003 the Company implemented FASB interpretation No. 46, which required a change in consolidation policy related to variable interest entities, and in 2004 the Company implemented Statement of Position 03-01, which required a change in the method of accounting for certain nontraditional long duration insurance contracts and separate accounts and EITF 03-16, which required a change in the method of accounting for limited liability companies.
We also have audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of American Financial Group, Inc.'s internal control over financial reporting as of December 31, 2004, based upon criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2005 expressed an unqualified opinion thereon.
The FASB issued revised Interpretation ("FIN") No. 46, "Consolidation of Variable Interest Entities" ("VIE") in December 2003. FIN 46 sets forth the requirements for consolidating entities that do not share economic risk and reward through typical equity ownership, but rather through contractual relationships that distribute economic risks and rewards among various parties. Once an entity is determined to be a VIE, it is generally required to be consolidated by the primary beneficiary (the party with a majority of either the expected losses or residual rewards or both). Under FIN 46, AFG is considered to be the primary beneficiary of a collateralized debt obligation ("CDO") in which it owns subordinated notes (considered equity) representing approximately two-thirds of the CDO's equity (but less than 50% of the voting power) and 5% of the total notes issued by the CDO. Accordingly, AFG implemented FIN 46 effective December 31, 2003; the cumulative difference between accounting for the CDO as an investment and as a consolidated subsidiary at that date is shown in the Statement of Earnings as the cumulative effect of an accounting change. Since AFG has no right to use the CDO assets and the CDO liabilities can be extinguished only by using CDO assets, the assets and liabilities of the CDO are shown separate from AFG's other assets and liabilities in the Balance Sheet. Income and expenses of the CDO are shown separately in the Statement of Earnings; related minority interest is shown in Note J under "Minority Interest Expense."
Goodwill represents the excess of cost of subsidiaries over AFG's equity in their underlying net assets. Goodwill is subject to an impairment test at least annually. As required under Statement of Financial Accounting Standards ("SFAS") No. 142, AFG completed the transitional test for goodwill impairment (as of January 1, 2002) in the fourth quarter of 2002. The resulting write-down was reported by restating first quarter 2002 results for the cumulative effect of a change in accounting principle.
As discussed under "Reinsurance" below, unpaid losses and loss adjustment expenses and unearned premiums have not been reduced for reinsurance recoverable.
Subsidiaries of AFG's 82%-owned subsidiary, Great American Financial Resources, Inc. ("GAFRI"), cede life insurance policies to a third party on a funds withheld basis where GAFRI retains the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance (including realized gains and losses) of the retained assets. Effective October 1, 2003, GAFRI implemented SFAS No. 133 Implementation Issue B36 ("B36"). Under B36, these reinsurance contracts are considered to contain embedded derivatives (that must be marked to market) because the yield on the payables is based on specific blocks of the ceding companies' assets, rather than the overall creditworthiness of the ceding company. GAFRI determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. As permitted under B36, GAFRI reclassified the securities related to these transactions from "available for sale" to "trading". The $16.1 million cumulative effect of marking to market the derivatives embedded in the payables at October 1, 2003, was offset by the initial effect of transferring the related securities from available for sale to trading. Beginning in the fourth quarter of 2003, the mark to market on the embedded derivatives offsets the investment income recorded on the mark to market of the related trading portfolios.
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. In spite of the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Separate accounts related to variable annuities represent deposits invested in underlying investment funds on which GAFRI earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.
Payable to Subsidiary Trusts (Issuers of Preferred Securities) Under FIN 46, AFG deconsolidated wholly-owned subsidiary trusts (formed prior to 2003) because they are "variable interest entities" in which AFG is not considered to be the primary beneficiary. These subsidiary trusts were formed to issue preferred securities and, in turn, purchase a like amount of subordinated debt from their parent company which provides interest and principal payments to fund the respective trust obligations. Accordingly, the subordinated debt due to the trusts is shown as a liability in the Balance Sheet, and beginning in 2004, the related interest expense is shown in the Statement of Earnings as "interest on subsidiary trust obligations." Prior to 2004, this interest was included in the Statement of Earnings as "minority interest expense, net of tax." Implementation of FIN 46 with respect to the preferred securities had no effect on earnings.
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment." SFAS 123(R) revises SFAS 123 and eliminates the use of the intrinsic value method prescribed by APB 25. Under SFAS 123(R), companies must recognize compensation expense for all new share-based awards (including employee stock options), and the nonvested portions of prior awards, based on their fair value at the date of grant. AFG expects to implement the new standard on July 1, 2005 on a prospective basis. After that date, all share-based grants will be recognized as compensation expense over the vesting period. While AFG currently uses the Black-Scholes pricing model to measure the fair value of employee stock options for purposes of disclosing pro forma earnings, the use of other models is also permitted. AFG has not yet determined which model it will use to measure the fair value of future stock option grants.
In November 2004, AFG completed the sale of Transport Insurance Company, realizing a pretax loss of $2.3 million. See Note M - "Discontinued Operations."
In April 2003, AFG sold two of its subsidiaries that market automobile insurance directly to customers for $32.2 million, realizing a pretax gain of $3.4 million on the sale. The transaction included the transfer of the right of Great American Insurance Company ("GAI"), an AFG subsidiary, to renew certain of its personal automobile insurance business written on a direct basis in selected markets. Premiums generated by the businesses sold were approximately $79 million in 2002.
In public offerings in February and December of 2003, AFG sold all the shares of Infinity Property and Casualty Corporation ("Infinity", its Personal auto business) for a total of $400 million, realizing a net pretax gain of $17.1 million. The businesses sold generated aggregate net written premiums of approximately $690 million in 2002.
Since AFG disposed of substantially all of its Personal group business in 2003, it has revised its reporting of the Specialty insurance business into the following components: (i) Property and transportation, which includes inland and ocean marine, agricultural-related business and commercial automobile, (ii) Specialty casualty, which includes executive and professional liability, umbrella and excess liability and excess and surplus, (iii) Specialty financial, which includes fidelity and surety bonds and collateral protection and (iv) California workers' compensation. AFG's annuity, supplemental insurance and life business markets primarily retirement annuities and various forms of supplemental insurance and life products. AFG's reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
transfer, beginning in 2004, of the remaining former Personal business to Specialty
2004, 2003 and 2002. Excluding realized gains (losses), investment income comprises
$43.8 million in 2003 for an arbitration decision relating to a 1995 property claim
from a discontinued business. Includes a special charge of $30 million in 2002
(g) Operating profit (loss) for 2004 includes a third quarter pretax charge of
Gross gains and losses on available for sale fixed maturity investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
The assets (substantially all cash and investments carried at market as "trading securities") of this managed investment entity are separately disclosed in the Balance Sheet because they are not available for use to satisfy AFG obligations. Likewise, the CDO liabilities (substantially all debt) are separately disclosed because they represent claims against only the CDO's assets and not against AFG's other assets. Accordingly, AFG's exposure to loss on this investment is limited to its investment (approximately $15.6 million at December 31, 2004).
AFG began liquidating its consolidated CDO during the first quarter of 2005. The liquidation is expected to be completed in April 2005.
AFG completed its initial test in the fourth quarter of 2002 which resulted in a $40.4 million ($.59 per share, basic and diluted) impairment charge, net of tax, reported by restating first quarter 2002 results for the cumulative effect of a change in accounting principle.
Changes in the carrying value of goodwill during 2003 and 2004, by reporting segment, are presented in the following table (in thousands):
At December 31, 2004, sinking fund and other scheduled principal payments on debt for the subsequent five years were as follows (in millions):
GAFRI has entered into interest rate swaps that effectively convert its 6-7/8% fixed-rate Senior Notes to a floating rate of 3-month LIBOR plus 2.9%. The swaps realign GAFRI's mix of floating and fixed rate debt.
In November 2004, AFG replaced its existing credit agreement with a $300 million, four-year credit facility. Amounts borrowed bear interest at rates ranging from 1% to 2% over LIBOR based on AFG's credit rating. In August 2004, GAFRI replaced its existing line of credit with a credit agreement under which it can borrow up to $150 million through August 2008 at interest rates ranging from 1% to 2% over LIBOR based on GAFRI's credit rating.
AFG and GAFRI effectively provide unconditional guarantees of their respective trusts' obligations. The AFG 9-1/8% trust preferred securities and the GAFRI
9-1/4% trust preferred securities were redeemed at face value in the first quarter of 2004. In addition, during the first quarter of 2004, GAFRI repurchased $27.2 million of its 8-7/8% preferred securities for $28.5 million in cash.
At December 31, 2004, there were 8.3 million shares of AFG Common Stock reserved for issuance under AFG's Stock Option Plan. Options are granted with an exercise price equal to the market price of AFG Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant; those granted to non-employee directors of AFG are fully exercisable upon grant. Options generally expire ten years after the date of grant. Data for AFG's Stock Option Plan is presented below:
No compensation cost has been recognized for stock option grants. For information about the SFAS #123 "fair value" of options granted, see Note A - "Accounting Policies - Stock-based Compensation." AFG realizes a tax benefit upon the exercise of non-qualified stock options and disqualifying dispositions of
The change in unrealized gain (loss) on marketable securities included the following (in millions):
For income tax purposes, AFG and certain members of its consolidated tax group had the following carryforwards available at December 31, 2004 (in millions):
The American Jobs Creation Act of 2004 provides a special one-time dividends received deduction on the repatriation of certain foreign earnings. While AFG is still evaluating whether it will remit any qualified foreign earnings under this provision in 2005, it does not believe the impact of any such election will be material to its results of operations.
Cash payments for income taxes, net of refunds, were $55.1 million, $51.8 million and $31.2 million for 2004, 2003 and 2002, respectively.
Transport's results are reflected as discontinued for all periods presented in the Statement of Earnings; 2003 Balance Sheet amounts have not been reclassified. The carrying amount of the major classes of Transport's assets and liabilities and a summary of the discontinued operations follow (in millions):
At December 31, 2004, American Premier had liabilities for environmental and personal injury claims aggregating $103.5 million. The environmental claims consist of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs related to certain sites formerly owned or operated by the railroad and manufacturing operations. Remediation costs are difficult to estimate for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. The personal injury claims include pending and expected claims, primarily by former employees of PCTC, for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the workplace.
AFG's insurance subsidiaries continue to receive claims related to environmental exposures, asbestos and other mass tort claims. Establishing reserves for these claims is subject to uncertainties that are significantly greater than those presented by other types of claims. The liability for asbestos and environmental reserves at December 31, 2004 and 2003, respectively, was $401 million and $515 million; related recoverables from reinsurers (net of allowances for doubtful accounts) at those dates were $59 million and $92 million, respectively. The 2003 amounts include the reserves ($70 million) and reinsurance recoverables ($18 million) of Transport Insurance Company, which AFG sold in 2004.
Results for the third quarter of 2004 include a $214.3 million pretax gain on the sale of Provident Financial Group, partially offset by a $52 million charge based on APU's settlement of litigation related to environmental clean-up costs at a former railroad site and $35 million in losses related to hurricanes in the Southeastern United States.
Results for 2003 include (i) a $5.5 million first quarter tax benefit related to AFG's investment in Infinity, (ii) a $43.8 million second quarter charge for an arbitration decision relating to a 1995 property claim, (iii) a $12.5 million second quarter charge related to the narrowing of spreads on GAFRI's fixed annuities, (iv) a $35.5 million third quarter charge related to a litigation settlement, (v) a fourth quarter tax benefit of $136 million related to the elimination of deferred taxes in connection with the AFG/AFC merger, and (vi) a fourth quarter $55 million charge related to the planned sale of Transport Insurance Company (included in discontinued operations).
The liability for losses and loss adjustment expenses for long-term scheduled payments under certain workers' compensation insurance has been discounted at about 7%, an approximation of long-term investment yields. As a result, the total liability for losses and loss adjustment expenses at December 31, 2004, has been reduced by $31 million.
GAFRI has reinsured approximately $26 billion and $28 billion in face amount of life insurance as of December 31, 2004 and 2003, respectively. Life premiums ceded were $86 million, $85 million and $61 million for 2004, 2003 and 2002, respectively.
Fair values are based on prices quoted in the most active market for each security. If quoted prices are not available, fair value is estimated based on discounted cash flow models, fair value of comparable securities, or similar methods. The fair value of the liability for annuities in the payout phase is assumed to be the present value of the anticipated cash flows, discounted at current interest rates. Fair value of annuities in the accumulation phase is assumed to be the policyholders' cash surrender amount. Fair value of shareholders' equity is based on the quoted market price of AFG's Common Stock.
On occasion, AFG and its subsidiaries have entered into financial instrument transactions which may present off-balance-sheet risks of both a credit and market risk nature. These transactions include commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. At December 31, 2004, AFG and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling up to $23 million.
In 2000, GAFRI received an $18.9 million subordinated note in connection with the sale of its minority ownership interest in an ethanol company back to that company. Following the sale, AFG's Chairman beneficially owns 100% of the ethanol company. The note bore interest at 12-1/4% and was repaid as follows: $6 million in 2001, $1 million in 2002 and the remaining $11.9 million in 2003. In December 2003, the ethanol company repaid a GAFRI subsidiary $4.0 million under a subordinated note that bore interest at 14%. In 2004, AFG's Chairman assumed AFG's obligation for a line of credit under which the ethanol company could borrow up to $10 million; AFG no longer has any interest or investment in the ethanol company.
An AFG majority-owned subsidiary, National Interstate Corporation, issued 3.4 million of its common shares in a January 2005 initial public offering. National Interstate used $15 million of the $40.6 million in proceeds to repay a loan to Great American and the balance for general corporate purposes. Following the IPO, AFG owned approximately 54% of National Interstate's common stock.
(*) For periods prior to the AFG/AFC merger in November 2003, the Parent Only
(c) Grossed up for prepaid reinsurance premiums of $522 and $620 at December 31, 2004 and 2003, respectively.