New accounting guidance issued by the Financial Accounting Standards Board limits the types of costs incurred in issuing or renewing insurance contracts that can be deferred. AFG adopted this guidance retrospectively on January 1, 2012. See Note A - “Accounting Policies - Accounting Standards Adopted in 2012” to the financial statements for disclosures of the impact of adopting this guidance.
Includes a special cash dividend of $0.25 per share paid in December 2012.
At December 31, 2012, AFG (parent) held approximately $323 million in cash and securities and had $500 million available under a bank line of credit expiring in December 2016.
The property and casualty business is cyclical in nature with periods of high competition resulting in low premium rates, sometimes referred to as a “soft market” or “downcycle” followed by periods of reduced competition and higher premium rates, referred to as a “hard market” or “upcycle.” For several years, AFG’s property and casualty insurance operations have experienced soft market conditions. Renewal prices in AFG’s specialty businesses started to harden in the latter part of 2011 and continued that trend during 2012.
AFG reported net earnings attributable to AFG’s shareholders of $488 million ($5.09 per share, diluted) in 2012 compared to $342 million ($3.32 per share, diluted) in 2011. Improved results in the annuity operations, higher realized gains, including the gain on the sale of AFG’s Medicare supplement and critical illness businesses, and tax benefits related to the favorable resolution of certain tax litigation and settlement of open tax years were partially offset by lower underwriting earnings and
lower investment income in the property and casualty operations and a fourth quarter charge to write off deferred policy acquisition costs and strengthen reserves in AFG’s closed block of long-term care insurance.
See “Liquidity and Capital Resources - Uncertainties” for a discussion of insurance reserves, recoverables from reinsurers, and contingencies related to American Premier’s former operations and “Liquidity and Capital Resources - Investments” for a discussion of impairments on investments. DPAC and certain liabilities related to annuities and universal life insurance products are amortized in relation to the present value of expected gross profits on the policies. Assumptions considered in determining expected gross profits involve significant judgment and include management’s estimates of assumed interest rates and investment spreads, surrenders, annuitizations, renewal premiums and mortality. Should actual experience require management to change its assumptions (commonly referred to as “unlocking”), a charge or credit would be recorded to adjust DPAC or annuity liabilities to the levels they would have been if the new assumptions had been used from the inception date of each policy.
Reserves for future policy benefits related to AFG’s closed block of long-term care insurance are established (and related acquisition costs are amortized) over the life of the policies based on policy benefit assumptions as of the date of issuance, including investment yields, mortality, morbidity, persistency, and expenses. Once these assumptions are established for a given policy or group of policies, they are not changed over the life of the policy unless a loss recognition event (premium deficiency) occurs. Loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums, including reasonably expected rate increases, are not expected to cover the present value of future claims payments and related settlement and maintenance costs as well as unamortized acquisition costs. AFG recorded a loss recognition charge in its long-term care business in the fourth quarter of 2012. As a result of this charge, all remaining unamortized acquisition costs in the long-term care business were written off and policy benefit assumptions were reset to current assumptions, resulting in an increase to the reserve for future policy benefits. These assumptions will not be changed again unless a future loss recognition event occurs. Adverse changes in any of the new policy benefit assumptions could result in a future loss recognition event and additional charges to earnings.
The ratio of debt to total capital is a non-GAAP measure that management believes is useful for investors, analysts and independent ratings agencies to evaluate AFG’s financial strength and liquidity and to provide insight into how AFG finances
In December 2012, AFG replaced its bank credit facility with a four-year, $500 million revolving credit line. Amounts borrowed under this agreement bear interest at rates ranging from 1.00% to 1.875% (currently 1.375%) over LIBOR based on AFG’s credit rating. There were no borrowings under this agreement, or under any other parent company short-term borrowing arrangements, during 2012.
In August 2012, AFG issued $125 million of 5-3/4% Senior Notes due 2042 and used the proceeds to redeem the outstanding AFG 7-1/8% Senior Debentures due 2034 at par value in September 2012. In June 2012, AFG issued $230 million of 6-3/8% Senior Notes due 2042 and used the proceeds to redeem the outstanding AAG Holding Company, Inc. (a subsidiary of AFG) 7-1/2% Senior Debentures due 2033 and 7-1/4% Senior Debentures due 2034 at par value in July 2012. During 2012, AFG repurchased 10.9 million shares of its Common Stock for $415 million. In December 2012, AFG declared and paid a special, one-time cash dividend of $0.25 per share of AFG Common Stock totaling approximately $23 million.
During 2011, AFG repurchased 9.3 million shares of its Common Stock for $315 million. During 2010, AFG issued $132 million of 7% Senior Notes due 2050 and repurchased 10.3 million shares of its Common Stock for $292 million.
Subsidiary Liquidity Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions, which provides the annuity operations with a substantial additional source of liquidity. In the fourth quarter of 2011 the FHLB advanced GALIC $240 million (included in annuity benefits accumulated) at interest rates ranging from 0.02% to 0.03% over LIBOR (average rate of 0.23% at December 31, 2012). While these advances must be repaid within 5 to 7 years, GALIC has the option to prepay all or a portion of the advances on a monthly basis. GALIC has invested the proceeds from the advances in fixed maturity securities for the purpose of earning a spread over the interest payments due to the FHLB.
In November 2012, National Interstate Corporation (“NATL”), a 52%-owned property and casualty insurance subsidiary, replaced its $50 million bank credit facility with a five-year, $100 million unsecured credit agreement. There was $12 million borrowed under this agreement at December 31, 2012, bearing interest at a rate equal to three-month LIBOR plus 0.875% (1.186% at December 31, 2012). The maximum outstanding balance in 2012 was $51 million.
Historically, cash flows from premiums and investment income have generally provided more than sufficient funds to meet these requirements. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
AFG’s $19 million liability for unrecognized tax benefits (including $1 million in interest) as of December 31, 2012, is not included because the period of payment cannot be reliably estimated.
Off-Balance Sheet Arrangements See Note P - “Additional Information - Financial Instruments with Off-Balance-Sheet Risk” to the financial statements.
As detailed under “Net Unrealized Gain on Marketable Securities” in Note E to the financial statements, unrealized gains and losses on AFG’s fixed maturity and equity securities are included in shareholders’ equity after adjustments for related changes in DPAC and certain liabilities related to annuity, long-term care and life businesses, noncontrolling interests and deferred income taxes. DPAC and certain other balance sheet amounts applicable to annuity, long-term care and life businesses are adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding increases or decreases (net of tax) included in accumulated other comprehensive income in AFG’s Balance Sheet.
Approximately 86% of the fixed maturities held by AFG at December 31, 2012, were rated “investment grade” (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and non-investment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return.
MBS 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. Although interest rates have been low for the last few years, a weak housing market and uncertain economic conditions have led to tighter lending standards, which have resulted in fewer buyers being able to refinance the mortgages underlying much of AFG’s non-agency residential MBS portfolio.
Summarized information for AFG’s MBS (including those classified as trading) at December 31, 2012, is shown (in millions) in the table below. 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 majority of the Alt-A securities and substantially all of the subprime securities are backed by fixed-rate mortgages. The average life of both the residential and commercial MBS is approximately 4 years.
Municipal bonds represented approximately 18% of AFG’s fixed maturity portfolio at December 31, 2012. AFG’s municipal bond portfolio is high quality, with 99% of the securities rated investment grade at that date. The portfolio is well diversified across the states of issuance and individual issuers. At December 31, 2012, approximately 76% of the municipal bond portfolio was held in revenue bonds, with the remaining 24% held in general obligation bonds. State general obligation securities of California, Illinois, New Jersey and New York collectively represented less than 2% of this portfolio.
Summarized information for the unrealized gains and losses recorded in AFG’s Balance Sheet at December 31, 2012, is shown in the following table (dollars in millions). Approximately $151 million of available for sale “Fixed maturities” and $61 million of “Equity securities” had no unrealized gains or losses at December 31, 2012.
The table below sets forth the scheduled maturities of AFG’s available for sale fixed maturity securities at December 31, 2012, based on their fair values. Asset-backed securities and other 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.
AFG recorded favorable reserve development of $43 million in 2012, $50 million in 2011 and $108 million in 2010 related to its other liability - occurrence coverage where both the frequency and severity of claims were lower than previously projected.
AFG recorded $28 million of favorable reserve development during 2012 on claims related to the use of Chinese drywall in residential construction in prior years. Much of the uncertainty in estimating the potential exposure and possible liabilities for such claims was clarified this year by favorable judicial decisions and the announcements of settlements of class action lawsuits making the potential liabilities better defined and more effectively anticipated.
AFG’s subsidiary that writes workers’ compensation business in California recorded favorable reserve development of less than $1 million in 2012 compared to $5 million in 2011 and $11 million in 2010.
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. From 2008 to 2010, economic conditions led to higher frequency and severity of claims, particularly in the D&O policies for small account and not-for-profit organizations. As the economy recovers, results are expected to improve as claim frequency decreases.
AFG recorded favorable prior year loss development of $16 million in 2012, $66 million in 2011 and $40 million in 2010 on its D&O business as claim severity was less than expected across several prior accident years.
AFG recorded adverse prior year reserve development of $38 million in 2012, $13 million in 2011 and $19 million in 2010 on this line of business. The adverse development resulted from higher claim frequency and severity in a block of program business related to motel/hotel, apartments, restaurants, taverns and recreation. This adverse development more than offset
Marketform recorded adverse prior year reserve development of $10 million in 2012, $44 million in 2011 and $55 million in 2010 related primarily to its Italian public hospital medical malpractice business, which it ceased writing in 2008. The development resulted from significant issues related to third party administration of claims and a challenging legal environment in Italy. Management believes that current reserves, which represent its best estimate of future liabilities, are adequate. Nonetheless, it concluded that sufficient uncertainty exists with respect to Italian public hospital medical malpractice reserves to leave open the 2007 year of account, in accordance with Lloyd’s provisions until a larger percentage of claims have been paid and the ultimate liabilities can be estimated with greater certainty. Included in AFG’s liability for unpaid losses and loss adjustment expenses at December 31, 2012, are reserves of $109 million related to this business.
certain benefits in AFG’s run-off long-term care and life operations and the August 2012 sale of its Medicare supplement and critical illness businesses.
Approximately 62% 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-product exposures, and are dominated by small to mid-sized commercial entities that are mostly regional policyholders with few national target defendants. The remainder is assumed reinsurance business that includes exposures for the periods 1954 to 1983. The asbestos and environmental assumed claims are ceded by various insurance companies under reinsurance treaties. A majority of the individual assumed claims have exposures of less than $100,000 to AFG. Asbestos losses assumed include some of the industry known manufacturers, distributors and installers. Pollution losses include industry known insured names and sites.
The survival ratio is a measure often used by industry analysts to compare A&E reserves strength among companies. This ratio is typically calculated by dividing reserves for A&E exposures by the three year average of paid losses, and therefore measures the number of years that it would take to pay off current reserves based on recent average payments. Because this ratio can be significantly impacted by a number of factors such as loss payout variability, caution should be exercised in attempting to determine reserve adequacy based simply on the survival ratio. At December 31, 2012, AFG’s three year survival ratios were 16.6 times paid losses for the asbestos reserves and 10.5 times paid losses for the total A&E reserves. Excluding amounts associated with the settlements of asbestos-related coverage litigation for A.P. Green Industries (see Item 3 - “Legal Proceedings”) and another large claim, AFG’s three year survival ratios were 10.2 and 7.2 times paid losses for the asbestos reserves and total A&E reserves, respectively. Data published by Conning Research & Consulting in June 2012 indicate that industry survival ratios were 10.1 for asbestos reserves and 9.0 for total A&E reserves at December 31, 2011.
In the third quarter of 2012, AFG completed an in-depth internal review of its asbestos and environmental exposures relating to the run-off operations of its property and casualty group and its exposures related to former railroad and manufacturing operations and sites. The review was completed by AFG’s internal A&E claims specialists and actuaries in consultation with specialty outside counsel and an outside consultant. As a result of the review, AFG recorded a $31 million special charge (net of reinsurance) to increase the property and casualty group’s asbestos reserves by $19 million and its environmental reserves by $12 million. The charge relates primarily to an increase in environmental investigative costs and related loss adjustment expenses. There were no newly identified issues that management believes would materially impact the overall adequacy of
AFG’s A&E reserves. A comprehensive study of AFG’s A&E reserves was completed in the second quarter of 2011 with the aid of outside actuarial and engineering firms and specialty outside counsel. The study relied on a ground-up exposure analysis. With respect to asbestos, it considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development. As a result of the study, AFG recorded a $50 million special charge (net of reinsurance) to increase its property and casualty group’s asbestos reserves by $28 million and its environmental reserves by $22 million. The property and casualty group’s asbestos reserves increase related primarily to exposures on business assumed from other insurers resulting from an increase in anticipated aggregate exposures in several large settlements involving several insurers in which AFG has a small proportional share. Some insurers have settled long-standing asbestos exposures with their insureds and are seeking payment from reinsurers. Asbestos reserves related to the property and casualty group’s direct asbestos exposures were increased to reflect higher frequency and severity of mesothelioma and other cancer claims as well as increased defense costs on many of these claims. These trends were partially offset by a decline in the number of claims without serious injury and fewer new claims that required payment being reported to AFG. The increase in the property and casualty group’s environmental reserves was attributed primarily to a small number of increases on specific environmental claims at several sites. An in-depth internal review completed in 2010 resulted in only minor adjustments to the A&E reserves. See Management’s Discussion and Analysis - “Results of Operations - Asbestos and Environmental Reserve Charges” for the amount of A&E reserve strengthening recorded in 2012, 2011 and 2010.
In performing loss recognition testing on the closed block of long-term care business, AFG estimates future claims, persistency, expenses, investment performance, and reinvestment rates, among other assumptions. At December 31, 2012, assumptions for claim costs, expense and persistency assumptions were updated based on the results of AFG's periodic internal analysis of claim experience, including the impact of supplemental data from an external actuarial study that used a large, uniform database of industry experience. Ultimate voluntary lapse rates for most in-force business range from 0.5% to 2.5%, varying by policy form, marital status, and the presence of inflation protection. Projected reinvestment rates are based on assumptions about future treasury rates, investment spreads and the types and duration of future investments. In aggregate, net reinvestment rates (net of expense and default assumptions) are estimated at 4.54% for 2013, and increase gradually to 6.00% in 2023. After 2023, reinvestment rates are projected to be relatively flat. As a result of the updated assumptions discussed above, AFG recorded a $153 million loss recognition charge in the fourth quarter of 2012 to write off deferred policy acquisition costs and strengthen reserves in this business.
For example, assuming increased claim payments did not change the assumption on future rate increases and persistency, nor did it change projected investment yields resulting from cash flow differences. These amounts are valid for a point in time, and will change in future periods as the in-force block ages, and as actual performance deviates from the assumptions used at December 31, 2012.
Elimination of the change in fair value of AFG’s investments in the CLOs, including $18 million and $10 million in 2012 and 2011, respectively, in distributions recorded as interest expense by the CLOs.
Includes $17 million in investment income representing the change in fair value of AFG’s CLO investments plus $15 million in CLO management fees earned.
(b) The valuation allowance is net of $6 million in non-controlling interest.
Gross and net written premiums increased in 2012 compared to 2011 due primarily to higher premiums in the Specialty casualty group, particularly the workers’ compensation and excess and surplus businesses. Overall average renewal rates increased approximately 3% in 2012 when compared to 2011.
and lower favorable reserve development in several of the Specialty casualty businesses. Results for 2012 include $74 million (2.6 points on the combined ratio) of favorable reserve development compared to $120 million (4.3 points) in 2011. Losses from catastrophes totaled $52 million (1.8 points) in 2012, compared to $46 million (1.7 points) in 2011.
The Specialty insurance operations generated an underwriting profit of $231 million in 2011, $86 million lower than in 2010. Lower favorable reserve development, poor results in a block of program business and lower profitability in the crop operations were partially offset by improved results in the excess and surplus businesses. Results for 2011 include 4.3 points of favorable reserve development compared to 6.7 points in 2010 and 1.7 points of catastrophe losses compared to 1.9 points in 2010.
Gross and net written premiums for 2011 were up slightly when compared to the 2010 period. Growth in the international operations and higher premiums in the excess and surplus and targeted markets operations more than offset the non-renewal of two major programs that did not meet return thresholds and a decision to exit the excess workers’ compensation business. This group reported an underwriting profit of $35 million in 2011, $10 million lower than the prior year. Improved results in the excess and surplus businesses were more than offset by underwriting losses in a block of program business and an $18 million decrease in favorable reserve development.
Asbestos and Environmental Reserve Charges As previously discussed under “Uncertainties - Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG has established property and casualty insurance reserves for claims related to environmental exposures and asbestos claims. AFG also has recorded liabilities for various environmental and occupational injury and disease claims arising out of former railroad and manufacturing operations. Total charges recorded to
increase reserves (net of reinsurance recoverable) for A&E exposures of AFG’s property and casualty group (included in loss and loss adjustment expenses) and its former railroad and manufacturing operations (included in other operating and general expenses) were as follows (in millions):
Loss development As shown in Note O - “Insurance - Property and Casualty Insurance Reserves,” AFG’s property and casualty operations recorded favorable loss development of $30 million in 2012, $69 million in 2011 and $158 million in 2010 related to prior accident years. Major areas of favorable (adverse) development were as follows (in millions):
Favorable reserve development in the Property and transportation group in 2012, 2011 and 2010 reflects lower than expected loss frequency in crop products. The favorable reserve development in 2012 was partially offset by higher than expected claim severity in the property and inland marine business and higher claim frequency in the commercial auto line. The favorable reserve development in this group also reflects lower severity in auto liability products in 2010 and lower than expected loss frequency in ocean marine products.
Favorable reserve development in the Specialty casualty group in 2012 is due primarily to the release of loss reserves on claims related to the use of Chinese drywall in residential construction as a result of judicial decisions and class action settlements in 2012 that clarified the liability of insured homebuilders. Favorable reserve development in the Specialty casualty group in 2012 also reflects lower claim severity in executive liability products partially offset by higher claim severity on losses in a run-off book of U.S.-based program (motel/hotel, restaurants, taverns and recreational) business and adverse reserve development on run-off Italian public hospital medical malpractice liability products written by Marketform. Favorable reserve development in the Specialty casualty group in 2011 is due primarily to lower than expected claim severity in directors and officers liability, excess and surplus lines and the run-off legal professional liability business, partially offset by adverse development due to higher frequency and severity on run-off Italian public hospital medical malpractice liability products and a block of program business. Favorable reserve development in the Specialty casualty group in 2010 is due to lower than expected severity on claims in general liability, directors and officers liability and the run-off legal professional liability business, partially offset by adverse development on run-off Italian medical malpractice liability products in Marketform.
Favorable reserve development in the Specialty financial group in 2012 and 2011 is due to lower than expected frequency and severity in the surety, fidelity, crime, foreign credit and financial institution services businesses as economic conditions did not affect these lines as adversely as had been anticipated. Favorable reserve development in Specialty financial in 2010 related to lower than expected frequency and severity in the run-off RVI operations due to favorable trends in used car sale prices and lower loss severity in AFG’s surety, fidelity and crime products.
Operating earnings before income taxes (excluding realized gains (losses)) of the annuity operations increased $68 million (36%) to $256 million in 2012 due primarily to AFG's ability to maintain spreads on a larger base of invested assets as well as exceptionally strong investment results. Operating earnings also include a pretax charge of $14 million in 2012 due to a review (“unlocking”) of the major actuarial assumptions compared to a charge of $1 million in 2011.
Statutory Annuity Premiums The following table summarizes AFG’s annuity sales (in millions):
Bank annuities represent annuity premiums generated through banks by independent agents and brokers, as well as through direct relationships with certain financial institutions.
As previously discussed under “Uncertainties - Run-off Long-term Care Insurance,” AFG recorded a $153 million loss recognition charge in the fourth quarter of 2012 to write off deferred policy acquisition costs and strengthen reserves in its closed block of long-term care insurance. The charge was due primarily to lower projected future investment rates resulting from the continued low interest rate environment, as well as changes in claims, expense and persistency assumptions. Excluding this charge, pretax operating earnings (losses) (excluding realized gains (losses)) were a loss of $4 million in 2012 compared to earnings of less than $1 million in 2011 and $7 million in 2010.
In January 2010, AFG ceased new sales of long-term care insurance. Renewal premiums will be accepted unless those policies lapse. The $153 million loss recognition charge recorded in the fourth quarter of 2012 for AFG’s closed block of long-term care insurance discussed under “Uncertainties - Run-off Long-term Care Insurance” includes a $74 million increase in long-term care benefits.
Investment Income 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 $71 million increase in investment income in 2012 compared to 2011 and $50 million increase in 2011 compared to 2010, reflect higher average invested assets, primarily related to growth in the annuity business.
Investment income includes $26 million in 2012, $27 million in 2011 and $56 million in 2010 of interest income earned on interest-only and similar MBS, primarily non-agency interest-only securities with interest rates that float inversely with short-term rates.
Approximately $9 million, $57 million and $79 million of the impairment charges in 2012, 2011 and 2010, respectively, related to fixed maturity investments, primarily corporate bonds and MBS.
Realized Gains and Losses on Subsidiaries In August 2012, AFG recorded a pretax gain of approximately $170 million on the sale of its Medicare supplement and critical illness businesses. See Note B - “Acquisitions and Sales of Subsidiaries.”
Annuity Unlockings In the fourth quarters of 2012, 2011 and 2010, AFG conducted its detailed review (“unlocking”) of the major actuarial assumptions underlying its annuity operations. As a result of these reviews, AFG recorded expense reductions (charges) in annuity benefits expense and annuity and supplemental insurance acquisition expenses related to its annuity business as follows (in millions):
Annuity and Supplemental Insurance Acquisition Expenses Annuity and supplemental insurance acquisition expenses includes amortization of DPAC and the present value of future profits of businesses acquired (“PVFP”), as well as the portion of commissions on sales of insurance products that is not deferred.
Income Taxes Income tax expense for 2012 includes $67 million in benefits related to the favorable resolution of certain tax litigation and settlement of open tax years. See Note L - “Income Taxes” to the financial statements for analysis of items affecting AFG’s effective tax rate.
During the third quarter of 2012, AFG acquired the remaining 28% of Marketform that it did not already own. Marketform’s losses reflect adverse reserve development in its run-off Italian public hospital medical malpractice business. As discussed in Notes A and H to the financial statements, the losses of Managed Investment Entities in 2012, 2011 and 2010 represent CLO losses that ultimately inure to holders of CLO debt other than AFG.
Consolidated Statement of Comprehensive Income for the years ended December 31, 2012, 2011 and 2010
Consolidated Statement of Changes in Equity for the years ended December 31, 2012, 2011 and 2010
AFG’s management, with participation of its Co-Chief Executive Officers and its principal financial officer, has evaluated AFG’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG’s Co-CEOs and principal financial officer concluded that the controls and procedures are effective. There have been no changes in AFG’s internal control over financial reporting during the fourth fiscal quarter of 2012 that materially affected, or are reasonably likely to materially affect, AFG’s internal control over financial reporting.
AFG’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including AFG’s principal executive officers and principal financial officer, AFG conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2012, based on the criteria set forth in “Internal Control - Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have audited American Financial Group, Inc. and subsidiaries’ (the Company’s) internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
Gains or losses on securities are determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other-than-temporary at the balance sheet date, a provision for impairment is charged to earnings (included in realized gains (losses) on securities) and the cost basis of that investment is reduced. If management can assert that it does not intend to sell an impaired fixed maturity security and it is not more likely than not that it will have to sell the security before recovery of its amortized cost basis, then the other-than-temporary impairment is separated into two components: 1) the amount related to credit losses (recorded in earnings) and 2) the amount related to all other factors (recorded in other comprehensive income). The credit-related portion of an other-than-temporary impairment is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge. Both components are shown in the Statement of Earnings. If management intends to sell an impaired security, or it is more likely than not that it will be required to sell the security before recovery, an impairment charge to earnings is recorded to reduce the amortized cost of that security to fair value.
Deferred Policy Acquisition Costs (“DPAC”) Policy acquisition costs (principally commissions, premium taxes and certain underwriting and policy issuance costs) directly related to the successful acquisition or renewal of an insurance contract are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses. As discussed previously under “Accounting Standards Adopted in 2012,” AFG’s accounting for DPAC changed effective January 1, 2012, and amounts previously reported have been adjusted retrospectively.
DPAC includes the present value of future profits on business in force of annuity and life, accident and health insurance companies acquired (“PVFP”). PVFP represents the portion of the costs to acquire companies that is allocated to the value of the right to receive future cash flows from insurance contracts existing at the date of acquisition. PVFP is amortized with
interest in relation to expected gross profits of the acquired policies for annuities and universal life products and in relation to the premium paying period for traditional life and health insurance products.
Because AFG has no right to use the CLO assets and no obligation to pay the CLO liabilities, the assets and liabilities of the CLOs are shown separately in AFG’s Balance Sheet (at fair value). Prior to adoption of guidance requiring the consolidation of VIEs beginning in 2010, the CLOs were not consolidated. Upon adoption of the guidance, the $261 million excess of fair value of the CLOs’ assets over the fair value of the liabilities was recorded in AFG’s Balance Sheet as appropriated retained earnings - managed investment entities, representing the cumulative effect of adopting the new guidance that ultimately will inure to the benefit of the CLO debt holders.
AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The net gain or loss from accounting for the CLO assets and liabilities at fair value subsequent to January 1, 2010, is separately presented in AFG’s Statement of Earnings. CLO earnings attributable to AFG’s shareholders represent the change in fair value of AFG’s investments in the CLOs (including distributions) and management fees earned. All other CLO earnings (losses) are not attributable to AFG’s shareholders and will ultimately inure to the benefit of the other CLO debt holders. As a result, such CLO earnings (losses) are included in net earnings (loss) attributable to noncontrolling interests in AFG’s Statement of Earnings and in appropriated retained earnings - managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2023), it is expected that losses attributable to noncontrolling interests will reduce appropriated retained earnings towards zero as the fair values of the assets and liabilities converge and the CLO assets are used to pay the CLO debt.
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, guaranteed withdrawals and excess benefits expected to be paid on future deaths and annuitizations (“EDAR”). The liability for EDAR is accrued for and modified using assumptions consistent with those used in determining DPAC and DPAC amortization, except that amounts are determined in relation to the present value of total expected assessments. Total expected assessments consist principally of estimated future investment margin, surrender, mortality, and other life and annuity policy charges, and unearned revenues once they are recognized as income.
Stock-Based Compensation All share-based grants are recognized as compensation expense on a straight-line basis over their vesting periods based on their calculated fair value at the date of grant. AFG uses the Black-Scholes pricing model to measure the fair value of employee stock options. See Note K - “Shareholders’ Equity” for further information.
Earnings Per Share Basic earnings per share is calculated using the weighted average number of 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: 2012 - 1.7 million, 2011 - 1.6 million and 2010 - 1.3 million.
Vanliner Group, Inc. (“Vanliner”) In July 2010, National Interstate (“NATL”), a 52%-owned subsidiary of AFG, completed the acquisition of Vanliner, a market leader in providing insurance for the moving and storage industry for $114 million (including post-closing adjustments). The initial purchase price (funded primarily with cash on hand) was based on Vanliner’s estimated tangible book value at the date of closing and is subject to certain adjustments, including a four and one-half year balance sheet guarantee whereby both favorable and unfavorable developments related to the closing balance sheet inure to the seller, UniGroup, Inc. In accordance with accounting guidance, all assets acquired and liabilities assumed were recognized at their fair values as of the acquisition date. The purchase price allocation based on these fair values resulted in a gain on purchase of $7 million (included in realized gains (losses) on subsidiaries). Vanliner’s premiums associated with policies in force as of December 31, 2012 totaled approximately $107 million. Pro forma results of operations for AFG assuming the acquisition of Vanliner had taken place at the beginning of 2010 would not differ significantly from actual reported results.
Medicare Supplement and Critical Illness Businesses On August 31, 2012, AFG completed the sale of its Medicare supplement and critical illness businesses, which included Loyal American Life Insurance Company and four other insurance companies, to Cigna Corporation for $326 million in cash resulting in a pretax gain of $170 million (including post-closing
adjustments). Since the transaction includes the ongoing cessions of certain business to Cigna, the operations being sold are not reported as discontinued operations. Following the sale, AFG’s former supplemental insurance operations consist solely of its run-off long-term care business.
The impact of the August 2012 sale of the Medicare supplement and critical illness businesses on AFG’s financial statements is shown below (in millions):
Summarized Statement of Earnings information for the Medicare supplement and critical illness businesses through the sale date is shown below (in millions):
Other Businesses During 2012, AFG acquired the outstanding 28% of Marketform, its London-based Lloyd’s property and casualty insurance operation, that it did not already own for $17 million and sold an additional small annuity company for $7 million.
AFG manages its business as five segments: (i) property and casualty insurance, (ii) annuity, (iii) run-off long-term care and life, (iv) Medicare supplement and critical illness and (v) other, which includes holding company assets and costs, and the assets and operations attributable to the noncontrolling interests of the managed investment entities.
excess and surplus, general liability, executive liability, umbrella and excess liability, customized programs for small to mid-sized businesses and workers’ compensation, and (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions (including collateral and mortgage protection insurance), surety and fidelity products and trade credit insurance. AFG’s annuity business markets traditional fixed and fixed-indexed annuities in the individual, bank and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
Sales of property and casualty insurance outside of the United States represented 5% of AFG’s revenues in 2012 and 2011 and 4% in 2010.
Includes third quarter 2012 and second quarter 2011 special charges of $31 million and $50 million, respectively, to increase asbestos and environmental reserves.
Assets and liabilities measured and carried at fair value in the financial statements at December 31 are summarized below (in millions):
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 $465 million at December 31, 2012. 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 loss included in net income includes losses of $3 million related to liabilities outstanding as of December 31, 2011. See Note H - “Managed Investment Entities.”
The non-credit related portion of other-than-temporary impairment charges is included in other comprehensive income. Cumulative charges taken for residential MBS still owned at both December 31, 2012 and December 31, 2011 were $227 million.
The following tables show gross unrealized losses (in millions) on fixed maturities and equity securities by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2012 and 2011.
At December 31, 2012, the gross unrealized losses on fixed maturities of $66 million relate to approximately 365 securities. Investment grade securities (as determined by nationally recognized rating agencies) represented approximately 23% of the gross unrealized loss and 63% of the fair value.
AFG analyzes its MBS securities for other-than-temporary impairment each quarter based upon expected future cash flows. Management estimates expected future cash flows based upon its knowledge of the MBS market, cash flow projections (which reflect loan to collateral values, subordination, vintage and geographic concentration) received from independent sources, implied cash flows inherent in security ratings and analysis of historical payment data. For 2012, AFG recorded in earnings $7 million in other-than-temporary impairment charges related to its residential MBS.
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, 2012.
AFG has $800 million notional amount of pay-fixed interest rate swaptions (options to enter into pay-fixed/receive floating interest rate swaps at future dates expiring between 2013 and 2015) outstanding at December 31, 2012, which are used to mitigate interest rate risk in its annuity operations. AFG paid $23 million to purchase these swaptions, which represents its maximum potential economic loss over the life of the contracts.
AFG’s fixed-indexed annuities, which represented approximately 40% of annuity benefits accumulated at December 31, 2012, provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG’s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be generally offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives. As shown in the table below, both the embedded derivative and call options declined in value during 2011. The decline in fair value of the options reflects the relatively flat stock market during 2011. However, the negative impact of lower interest rates more than offset the positive impact of the flat stock market on the fair value of the fixed-indexed annuities embedded derivative.
As discussed under “Reinsurance” in Note A, certain reinsurance contracts are considered to contain embedded derivatives.
The PVFP amounts in the table above are net of $184 million and $195 million of accumulated amortization at December 31, 2012 and 2011, respectively. The loss recognition charge recorded in the fourth quarter of 2012 for AFG’s closed block of long-term care insurance resulted in the write off of all remaining deferred policy acquisition costs for this business. During each of
the next five years, the PVFP is expected to decrease at a rate of approximately one-sixth of the balance at the beginning of each respective year.
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 $257 million (including $89 million invested in the most subordinate debt tranches) at December 31, 2012, and $98 million at December 31, 2011.
The aggregate unpaid principal balance of the CLOs’ fixed maturity investments exceeded the fair value of the investments by $29 million and $120 million at December 31, 2012 and 2011. The aggregate unpaid principal balance of the CLOs’ debt exceeded its fair value by $123 million and $306 million at those dates. The CLO assets include $5 million and $2 million in loans (aggregate unpaid principal balance of $12 million and $7 million, respectively) at December 31, 2012 and 2011, for which the CLOs are not accruing interest because the loans are in default.
In the third quarter of 2010, management decided to de-emphasize the sale of supplemental health insurance products through career agents, including the sale of a marketing subsidiary. As a result of this decision, AFG performed an interim impairment test of the goodwill associated with the reporting unit using an income valuation method based on discounted cash flows. Based on the results of this test, AFG recorded a goodwill impairment charge of $22 million (included in realized gains (losses) on subsidiaries) to write off all of the goodwill related to this reporting unit. In the third quarter of 2012, goodwill decreased $1 million due to the sale of a small annuity subsidiary.
Included in other assets in AFG’s Balance Sheet is $28 million at December 31, 2012 and $41 million at December 31, 2011 in amortizable intangible assets related to property and casualty insurance acquisitions. These amounts are net of accumulated amortization of $61 million and $47 million, respectively. Amortization of these intangibles was $14 million in 2012 and $12 million in each of 2011 and 2010. Future amortization of intangibles (weighted average amortization period of 2 years) is estimated to be $14 million in 2013, $13 million in 2014 and $1 million in 2015. Other assets also include $8 million in non-amortizable intangible assets related to property and casualty insurance acquisitions.
In December 2012, AFG replaced its existing credit facility with a new four-year, $500 million revolving credit facility which expires in December 2016. Amounts borrowed under this agreement bear interest at rates ranging from 1.00% to 1.875% (currently 1.375%) over LIBOR based on AFG’s credit rating. No amounts were borrowed under this facility at December 31, 2012.
Stock Incentive Plans Under AFG’s Stock Incentive Plans, employees of AFG and its subsidiaries are eligible to receive equity awards in the form of stock options, stock appreciation rights, restricted stock awards, restricted stock units and stock awards.
AFG issued 111,270 shares of Common Stock (fair value of $38.38 per share) in the first quarter of 2012 and 188,302 shares (fair value of $33.99 per share) in the first quarter of 2011 under its Equity Bonus Plan.
Total compensation expense related to stock incentive plans of AFG and its subsidiaries for 2012, 2011 and 2010 was $26 million, $22 million and $20 million, respectively. Related tax benefits totaled $8 million in 2012, $7 million in 2011 and $6 million in 2010. At December 31, 2012, there was $23 million and $8 million of unrecognized compensation expense related to nonvested stock options and restricted stock awards, respectively. These amounts are expected to be recognized over a weighted average of 3.3 and 2.3 years, respectively.
Accumulated Other Comprehensive Income, Net of Tax (“AOCI”) Comprehensive income is defined as all changes in Shareholders’ Equity except those arising from transactions with shareholders. Comprehensive income includes net earnings and other comprehensive income, which consists primarily of changes in net unrealized gains or losses on available for sale securities. The progression of the components of accumulated other comprehensive income follows (in millions):
Other reflects the cumulative effect of accounting change in 2010 and the acquisition of noncontrolling interest in a subsidiary in 2012.
Total earnings before income taxes include losses subject to tax in foreign jurisdictions of $5 million in 2012, $31 million in 2011 and $12 million in 2010.
AFG’s net deferred tax liability at December 31, 2012 and 2011 is included in other liabilities in AFG’s Balance Sheet.
“Foreign underwriting losses” in the table above include the net operating loss carryforward and other deferred tax assets related to the Marketform Lloyd’s insurance business, which resulted primarily from underwriting losses in its run-off Italian public hospital medical malpractice business that has not been written since 2008. During the fourth quarter of 2011, AFG recorded losses in other lines written by its Lloyd’s insurance business. Net operating losses can be carried forward indefinitely to offset future taxable income in the United Kingdom, and management expects these businesses to produce underwriting profits in future years. Nevertheless, because the Marketform Lloyd’s insurance business was in a cumulative loss position for the three years ended December 31, 2011, and the fourth quarter 2011 losses were not limited to the run-off Italian public hospital medical malpractice business, there was uncertainty concerning the realization of the deferred tax benefits associated with the losses. Accordingly, AFG recorded a $44 million valuation allowance against the deferred tax assets related to the Lloyd’s insurance business in 2011, approximately $34 million of which related to prior year losses. AFG will be able to reduce this valuation allowance in future periods when income is generated by the Lloyd’s business.
AFG completed an in-depth internal review of its asbestos and environmental (”A&E”) exposures in the third quarter of 2012. The study resulted in A&E charges of $31 million for the property and casualty group and $2 million for the former railroad and manufacturing operations. In the second quarter of 2011, AFG completed a comprehensive study of A&E exposures with the assistance of outside actuarial and engineering firms and specialty outside counsel. The study resulted in A&E charges of $50 million for the property and casualty group and $9 million for the former railroad and manufacturing operations.
The insurance group’s liability for asbestos and environmental reserves was $471 million at December 31, 2012; related recoverables from reinsurers (net of allowances for doubtful accounts) at that date were $98 million.
At December 31, 2012, GAFRI had a liability of approximately $9 million for environmental costs and certain other matters associated with the sales of its former manufacturing operations.
asbestos and environmental exposures. Results for the third quarter of 2012 also include a $28 million benefit from the resolution of AFG’s tax case. Results for the fourth quarter of 2012 include a $15 million additional pretax realized gain resulting from post-closing adjustments to the Medicare supplement and critical illness sale, a pretax charge of $153 million to write off deferred policy acquisition costs and strengthen reserves in the closed block of long-term care insurance, pretax catastrophe losses of $32 million from Superstorm Sandy, a $14 million pretax charge due to a review of major actuarial assumptions in the annuity business, and tax benefits of $39 million from the closure of the 2004 through 2007 tax years following the settlement of AFG’s tax case.
Securities owned by U.S.-based insurance subsidiaries having a carrying value of approximately $1.1 billion at December 31, 2012, were on deposit as required by regulatory authorities. At December 31, 2012, AFG and its subsidiaries had $198 million in undrawn letters of credit ($16 million of which was collateralized) supporting the underwriting capacity of its U.K.-based Lloyd’s insurer.
FHLB Funding Agreements Great American Life Insurance Company (“GALIC”), a wholly-owned annuity subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions. Members are required to purchase stock in the FHLB in addition to maintaining collateral deposits that back any funds advanced. GALIC’s $26 million investment in FHLB capital stock at December 31, 2012, is included in other investments at cost. Membership in the FHLB provides the annuity operations with a substantial additional source of liquidity. In the fourth quarter of 2011, the FHLB advanced GALIC $240 million (included in annuity benefits accumulated at December 31, 2012 and 2011). Interest rates under the various funding agreements on these advances range from 0.02% to 0.03% over LIBOR (average rate of 0.23% at December 31, 2012). These advances must be repaid within 5 to 7 years, but GALIC has the option to prepay all or a portion of the advances on a monthly basis. The advances on these agreements are collateralized by commercial mortgage-backed securities with a fair value of $316 million (included in available for sale fixed maturity securities) at December 31, 2012. Interest credited on the funding agreements, which is included in annuity benefits, was less than $1 million in 2012 and 2011.
Losses and loss adjustment expenses included charges for possible losses on reinsurance recoverables of less than $1 million in 2012, 2011 and 2010. The aggregate allowance for losses on reinsurance recoverables amounted to approximately $26 million at both December 31, 2012 and 2011.
Benefit Plans AFG expensed approximately $27 million in 2012, $26 million in 2011 and $30 million in 2010 for its retirement and employee savings plans.
Discounted at approximately 4.5% and 6% at December 31, 2012 and 2011, respectively.
Grossed up for prepaid reinsurance premiums of $471 and $409 at December 31, 2012 and 2011, respectively.
Registrant has no outstanding debt issues exceeding 10% of the assets of Registrant and consolidated subsidiaries.
Amended and restated Nonqualified Auxiliary RASP, filed as Exhibit 10(f) to AFG’s Form 10-K for 2008.
The following financial information from American Financial Group’s Form 10-K for the year ended December 31, 2012, formatted in XBRL (Extensible Business Reporting Language):