AFG's insurance subsidiaries lease the majority of their office and storage facilities in numerous cities throughout the United States, including Great American's and GAFRI's home offices in Cincinnati. In December 2007, AFG signed a 15-year lease (the effectiveness of which is subject to certain contingencies) in a new office tower to be built in downtown Cincinnati. The new building is scheduled for completion in 2011 and will enable AFG to consolidate operations from several leased locations into one. A property and casualty insurance subsidiary owns approximately 177,000 square feet of office space on 17.5 acres of land in Richfield, Ohio, approximately two-thirds of which it occupies; the remaining space is leased to unaffiliated tenants. A GAFRI subsidiary owns a 45,000 square foot office building in Mission, Kansas which is now for sale. The Company will continue to occupy the building for at least the first half of 2008.
The ratio of earnings to fixed charges excluding interest credited to annuity policyholders' accounts was 8.49, 9.15, 4.58, 7.02 and 3.66 for 2007, 2006, 2005, 2004 and 2003, respectively. Although the ratio of earnings to fixed charges excluding interest on annuities is not required or encouraged to be disclosed under Securities and Exchange Commission rules, some investors and lenders may not consider interest credited to annuity policyholders' accounts a borrowing cost for an insurance company, and accordingly, believe this ratio is meaningful.
At December 31, 2007, AFG (parent) held approximately $50 million in cash and securities and had borrowed $95 million under its bank line of credit. AAG Holding had $21 million borrowed under this line at December 31, 2007. Through February 15, 2008, total borrowings under this line increased by $119 million due primarily to the funding of an acquisition.
AFG reported net earnings of $383.2 million ($3.10 per share diluted) in 2007 compared to $453.4 million ($3.75 per share diluted) in 2006. Improved underwriting results in the Company's ongoing property and casualty insurance operations and higher investment income were more than offset by lower gains from sales of real estate, realized losses on securities due to impairment writedowns on equity securities and the effect of charges to strengthen reserves for asbestos and other environmental exposures ("A&E") within the property and casualty insurance run-off operations and A&E exposures related to former railroad and manufacturing operations.
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 so that it has an acceptable expectation of not becoming financially impaired. At December 31, 2007, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements.
Management believes AFG has sufficient resources to meet its liquidity requirements. If funds generated from operations, including dividends and tax payments from subsidiaries, are insufficient to meet fixed charges in any period, AFG would be required to utilize parent company cash and marketable securities or to generate cash through borrowings, sales of other assets, or similar transactions.
Through February 15, 2008, AFG borrowed an additional $119 million under its revolving credit facility primarily to finance an acquisition. Management anticipates that it will call its Senior Convertible Notes for redemption on June 2, 2008, and pay holders who convert cash for the accreted value (approximately $190 million) and cash or stock for the conversion premium (amount to be based on the market price of AFG Common Stock).
During 2007, AFG repurchased 6.9 million shares of its common stock for approximately $199 million, funded the $239 million in costs associated with GAFRI's purchase of its common stock not previously owned by AFG, and redeemed the $59.5 million of 7-1/8% Debentures that matured in December 2007. Through February 22, 2008, AFG has repurchased an additional 350,000 shares for approximately $9.5 million.
All debentures issued by AFG (and AAG Holding) are rated investment grade by three nationally recognized rating agencies. Under a currently effective shelf registration statement, AFG can offer additional equity or debt securities. The shelf registration provides AFG with flexibility to access the capital markets from time to time as market and other conditions permit.
For statutory accounting purposes, equity securities of non-affiliates are generally carried at fair value. At December 31, 2007, AFG's insurance companies owned publicly traded equity securities with a fair value of $888 million. In addition, Great American Insurance Company owns National Interstate Corporation ("NATL") common stock with a fair value of $338 million and a statutory carrying value of $266 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.
During 2006, AAG Holding repurchased $68.5 million of its 6-7/8% Senior Notes due 2008 for $70.8 million in cash. In 2005, AAG Holding repurchased $20.8 million of its 8-7/8% trust preferred securities for $22.6 million in cash.
In 2005, NATL, 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 $40.4 million of net proceeds from this offering was used to repay NATL's $15 million promissory note to another AFG subsidiary. The remainder was used for other general corporate purposes. At December 31, 2007, AFG owned approximately 53% of NATL's common stock.
patterns applied to the gross reserves and do not represent actual contractual
The upheaval in the housing and credit markets in the second half of 2007 and continuing in 2008 has caused many financial institutions to record significant asset writedowns. This has had an adverse impact on AFG's investment portfolio.
Summarized information for the unrealized gains and losses recorded in AFG's Balance Sheet at December 31, 2007, is shown in the following table (dollars in millions). Approximately $201 million of available for sale "Fixed maturities" and $161 million of "Equity securities" had no unrealized gains or losses at December 31, 2007.
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.
in National City Corporation to fair value at December 31, 2007.
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.
While current factors and reasonably likely changes in variable factors are considered in estimating the liability for unpaid losses, there is no method or system that can eliminate the risk of actual ultimate results differing from such estimates. As shown in footnote (a) to the reserve development table (loss triangle) on page 7, the original estimates of AFG's liability for losses and loss adjustment expenses, net of reinsurance, over the past 10 years have developed through December 31, 2007, to be deficient (for eight years) by as much as 18.9% and redundant (for two years) by as much as 3.8% (excluding the effect of special charges for asbestos, environmental and other mass tort exposures). This development illustrates the historical impact caused by variability in factors considered in estimating its insurance reserves.
Following is a discussion of certain critical variables affecting the estimation of the more significant lines of business (asbestos, environmental and other mass tort liabilities are separately discussed below). Many other variables may also impact ultimate claim costs.
AFG's workers' compensation business is written primarily in California. Significant reforms passed by the California state legislature in 2003 and in 2004 reduced employer premiums and set treatment standards for injured workers. AFG recorded favorable prior year loss development of $22 million in 2007, $23 million in 2006 and $24 million in 2005 due primarily to the impact of the legislation on medical claim costs being more favorable than previously anticipated.
This long-tail 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:
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 that trigger coverage under directors' and officers' liability policies.
Some of the important variables affecting estimation of loss reserves for Commercial Auto/Truck Liability/Medical are similar to Other Liability - Occurrence and include:
AFG recorded favorable prior year loss development of $7 million in 2007, $25 million in 2006 and $10 million in 2005 for this line of business as claim severity was significantly lower than in prior assumptions.
Over the years, certain portions of the homebuilders business have experienced adverse interpretations of coverage, coupled with certain statutory changes relating to liability, causing higher than expected emergence of claims from older years. AFG recorded adverse prior year loss development of $21 million in 2007, $7 million in 2006 and $15 million in 2005 on its run-off homebuilders business (mostly from exposures in California and Nevada). Management believes that changes in policy forms and endorsements implemented in 1998 will reduce AFG's exposure to such adverse interpretations.
See Item 1 - "Business" - "Property and Casualty Operations - Reinsurance" for more information on AFG's reinsurance programs. For additional information on the effect of reinsurance on AFG's historical results of operations see Note M -
Asbestos and environmental reserves of the property and casualty group consisted of the following (in millions):
($.21 per share) in 2006 and $8.8 million ($.07 per share) in 2005.
Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of 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.
AFG's combined ratio has been better than the industry average for twenty-one of the last twenty-two years and excluding AFG's special A&E charges, for all twenty-two years. Management believes that AFG's insurance operations have performed better than the industry as a result of product line diversification, stringent underwriting discipline, alignment of incentives, and, more recently, a specialty niche focus.
Gross and net written premiums for the specialty insurance operations increased 2% in 2007 compared to 2006. Premium growth within the Property and transportation and Specialty financial groups was offset by significant rate declines in the California workers' compensation business, softening market conditions within certain of the Specialty casualty group operations and the impact of the automobile residual value insurance ("RVI") business and earthquake-exposed excess property operations previously placed in run-off.
The specialty insurance operations generated an underwriting profit of $506 million in 2007, $184 million higher than in 2006. The 2007 combined ratio improved 6.2 points compared to 2006. These improvements were largely driven by a higher amount of favorable reserve development, primarily within the Specialty casualty group, higher earnings in the crop insurance business and lower losses from the RVI business in run-off. Specialty insurance results for 2007 include $152.8 million (5.7 points) of favorable reserve development compared to $59.5 million (2.3 points) in 2006.
The specialty insurance operations generated an underwriting profit of $322 million in 2006, $115 million higher than in 2005, reflecting premium growth, rate adequacy in most of the businesses, lower catastrophe losses, and the impact of favorable reserve development within the Specialty casualty, Property and transportation and California workers' compensation groups. The 2005 results include $59.7 million (2.5 points) of catastrophe losses.
Net written premiums for 2006 increased 14% over 2005 due primarily to growth in the property and inland marine and transportation operations and new premium volume from the 2005 acquisition of Farmers Crop Insurance Alliance. The growth in net written premiums was less than the gross written premium growth due to the effect of crop reinsurance programs. The 2006 underwriting results benefited from strong underwriting profits in the crop insurance division resulting from higher favorable reserve development and additional profits from the Farmers acquisition. This group's 2006 combined ratio was 82.3%, slightly better than its 2005 results, reflecting excellent profitability and continuing favorable reserve development in nearly all of the business lines and lower catastrophe losses. The 2006 underwriting results include 3.7 points of favorable reserve development and 2.0 points of catastrophe losses compared to 1.6 points of favorable development and 5.4 points of catastrophe losses in 2005.
Specialty casualty gross and net written premiums decreased in 2007 compared to 2006 primarily due to stronger competition in the excess and surplus lines and softening in the homebuilders market, which affected AFG's general liability coverages. The Specialty casualty group's 2007 underwriting profit of $209 million was 73% higher than in 2006. These results include $105.4 million (12.7 points) of favorable reserve development, coming largely from the general liability and excess and surplus operations, compared to $9.9 million (1.2 points) in 2006.
Net written premiums for 2006 increased 10% above the 2005 period reflecting premium growth principally in the financial institutions, lease and loan and surety and fidelity businesses. The group experienced disappointing results in 2006 resulting from losses within the run-off RVI business. These losses were primarily attributable to lower than expected proceeds from the sale (at auction) of certain luxury cars and sport utility vehicles. Excluding the effect of the RVI business, this group's combined ratio was 88.7%, as the group's other operations are generating solid underwriting profits.
At December 31, 2007, the property and casualty group's A&E reserves were $423 million, net of reinsurance recoverables. The survival ratio is a measure often used by industry analysts to compare A&E reserves strength among companies. This ratio is typically calculated by dividing reserves for A&E exposures by the three year average of paid losses, and therefore measures the number of years that it would take to pay off current reserves based on recent average payments. Because this ratio can be significantly impacted by a number of factors such as loss payout variability, caution should be exercised in attempting to determine reserve adequacy based simply on the survival ratio.
At December 31, 2007, AFG's three year survival ratios were 11.5 times paid losses for the asbestos reserves and 9.6 times paid losses for the total A&E reserves. These ratios compare favorably with A.M. Best's most recent report on A&E survival ratios (November 2007) which were 8.6 for asbestos and 7.9 for total industry A&E reserves. Excluding amounts associated with the settlements of asbestos related coverage litigation for A.P. Green Industries (see "Legal Proceedings") and another large claim, AFG's three year survival ratios were 10.5 and 8.6 times paid losses for the asbestos reserves and total A&E reserves, respectively.
In addition to the property and casualty group, the study encompassed reserves for asbestos and environmental exposures of the former railroad and manufacturing operations. As a result of the study, AFG recorded a second quarter 2007 charge of $43.0 million (included in other expenses) to increase the A&E reserves related to these former operations. The $19.0 million increase in asbestos reserves was the result of increasing estimates of the cost of mesothelioma claims partially offset by lower estimated overall claim counts. The $24.0 million increase in
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. The asbestos legal climate remains very difficult to predict. While some progress has been made in state asbestos tort reform and judicial rulings, that progress has been somewhat offset by increased claims costs, increased defense costs, the assertion of non-products theories and an expanding pool of plaintiffs and defendants.
The unfavorable development in Other specialty reflects adjustments to the deferred gain on the retroactive insurance transaction entered into in connection with the sale of a business in 1998, net of related amortization.
The 14% increase in statutory annuity premiums in 2007 reflects higher non-403(b) indexed annuity sales, partially offset by lower sales of traditional fixed annuities in AFG's non-403(b) line of business.
Statutory annuity premiums in 2006 were 62% higher than in 2005. Premiums in 2005 included approximately $100 million of traditional fixed annuity premiums received in January 2005 from policyholders of an unaffiliated company in rehabilitation who chose to transfer their funds to AFG. Excluding the $100 million, AFG's premiums in 2006 were 84% higher than in 2005, due primarily to higher fixed indexed-annuity sales and higher sales of traditional annuities in AFG's 403(b) segment.
Realized gains (losses) on sales of securities include provisions for other than temporary impairment of securities of $127.9 million in 2007, $25.7 million in 2006 and $16.1 million in 2005. Impairment charges include $64.2 million in 2007 to write down AFG's equity investment in National City Corporation to fair value and $10.3 million in 2006 to write down two equity security positions.
Realized gains for 2006 includes a $23.6 million pretax gain in the first quarter on the sale of AFG's interest in The Cincinnati Reds.
Income from real estate operations includes pretax gains of $44.6 million on the sale of New York real estate assets in 2006 and $57.0 million on the sales of coal reserves in 2005. Other income also includes net pretax gains on the sales of other real estate assets of $15.4 million in 2007, $23.2 million in 2006 and $12.0 million in 2005.
The $20.1 million decrease in other income in 2007 compared to 2006 reflects the gains on sale of real estate assets discussed above, partially offset by fee income generated from the reinsurance agreements entered into in connection with the Ceres acquisition in August 2006, higher policy charges related to growth in the annuity business and higher fee income in the property and casualty dealer services business.
Annuity benefits increased $27.8 million in 2007 compared to 2006, reflecting higher sales of fixed-indexed annuities. Annuity benefits for 2006 increased slightly compared to 2005 as the effect of internal growth and the acquisition of Old Standard Life fixed annuity business were offset by the effect of the fourth quarter 2005 "unlocking" charge discussed below, lower average effective crediting rates and the sale of GAPR.
See Note I - "Income Taxes" to the Financial Statements for an analysis of items affecting AFG's effective tax rate.
In 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which defines and establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 is effective January 1, 2008, for calendar year companies; implementation is not expected to have a material effect on AFG's balance sheet or earnings.
In December 2007, the FASB issued SFAS No. 141(R), "Business Combinations," which requires the recognition of assets acquired, liabilities assumed and any noncontrolling interests at fair value as of the acquisition date, and the immediate expense recognition of acquisition-related transaction and restructuring costs. SFAS No. 141(R)is to be applied prospectively to business combinations after January 1, 2009, except that adjustments to an acquired company's valuation allowance on deferred tax assets and tax contingency liability are to be recorded as a component of income tax expense for all business combinations, regardless of the consummation date.
"Selected Quarterly Financial Data" has been included in Note L to the
Based on AFG's evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2007.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Financial Group, Inc.'s internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2008, expressed an unqualified opinion thereon.
The consolidated financial statements include the accounts of American Financial Group, Inc. ("AFG") and its subsidiaries. Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements.
Certain AFG subsidiaries loan fixed maturity and equity securities to other institutions for short periods of time. The borrower is required to provide collateral on which AFG earns investment income, net of a fee to the lending agent. AFG records the collateral held (included in other assets) and the liability to return the collateral (included in other liabilities) in its Balance Sheet at fair value. The securities loaned remain a recorded asset on AFG's Balance Sheet.
Derivatives included in AFG's Balance Sheet are recorded at fair value and consist primarily of (i) the interest component of certain life reinsurance contracts (included in other liabilities), (ii) components of certain fixed maturity securities, (iii) interest rate swaps (included in debt), and (iv) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related call options (included in other investments) designed to be consistent with the characteristics of the liabilities and used to mitigate the risk embedded in those annuity products. Changes in the fair value of derivatives are included in current earnings.
Effective January 1, 2006, AFG implemented Statement of Financial Accounting Standards ("SFAS") No. 123(R), "Share-Based Payment" using the modified prospective method under which prior year amounts are not restated. Under SFAS No. 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 calculated "fair value" at the date of grant. Beginning in 2006, all share-based grants are recognized as compensation expense over the vesting period. AFG uses the Black-Scholes pricing model to measure the fair value of employee stock options.
Prior to the implementation of SFAS No. 123(R), AFG accounted for stock options and other stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under this method, no compensation expense for stock option grants was recognized because options were granted at exercise prices equal to the fair value of the shares at the dates of grant. See Note H - "Shareholders' Equity" for further information on stock options.
AFG provides retirement benefits to qualified employees of participating companies through the AFG Retirement and Savings Plan, a defined contribution plan. AFG makes all contributions to the retirement fund portion of the plan and matches a percentage of employee contributions to the savings fund. Company contributions are expensed in the year for which they are declared.
AFG's weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: 2007 - 1.4 million, 2006 - 1.6 million and 2005 - 2.6 million.
In August 2006, GAFRI acquired Ceres Group, Inc. ("Ceres") for $204.4 million in cash (plus approximately $8 million in direct transaction costs). In connection with the acquisition, Ceres reinsured 100% of its major medical business and 50% of its in-force senior business, which focuses primarily on sales of Medicare supplement and other supplemental insurance
products to the senior market. As a result of the reinsurance, Ceres has exited the major medical business. The reinsurance transactions enabled Ceres to pay approximately $80 million in return of capital distributions to GAFRI since the acquisition. At December 31, 2007, Ceres had an additional $20 million of excess capital available for future distributions.
In June 2006, GAFRI sold a resort hotel located on Cape Cod for $166 million. See Note J - "Discontinued Operations."
GAFRI completed the sale of its subsidiary, Great American Life Assurance Company of Puerto Rico ("GAPR"), for $37.5 million in cash in January 2006. GAFRI acquired GAPR in 1997 for approximately $50 million. During 2005, GAFRI received $100 million in dividends from GAPR and recorded a $3.4 million pretax loss on the anticipated sale (included in Other income).
An AFG majority-owned subsidiary, National Interstate Corporation ("NATL"), issued 3.4 million of its common shares in a February 2005 initial public offering. NATL used $15 million of the $40.4 million in proceeds to repay a loan to an AFG subsidiary and the balance for general corporate purposes. At December 31, 2007, AFG owned approximately 53% of NATL's common stock compared to 66% prior to the offering.
The following tables (in millions) show AFG's assets, revenues and operating earnings before income taxes by significant business segment and sub-segment.
(c) Includes charges of $44.2 million and $179.3 million in the second quarter
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, 2007 and 2006.
For the years ended December 31, 2007, 2006 and 2005, respectively, AFG has recorded charges (included in realized gains on securities) of $128 million, $26 million and $16 million for other than temporary impairments of securities. Gross gains and losses (excluding impairment writedowns and changes in the fair value of derivatives) on available for sale fixed maturity investment transactions included in the Statement of Cash Flows consisted of the following (in millions):
In addition to adjusting equity securities and fixed maturity securities classified as "available for sale" to fair value, SFAS 115 requires that certain other balance sheet amounts be adjusted to the extent that unrealized gains and losses from securities would result in adjustments had those gains or losses actually been realized. The following table shows the components of the unrealized gain (loss) on marketable securities, and its effect on various balance sheet captions (in millions).
Changes in the carrying value of goodwill during 2006 and 2007, by reporting segment, are presented in the following table (in millions):
The addition to goodwill in 2007 includes $22.3 million related to the acquisition of the minority interest in GAFRI and $14.4 million due to a refinement of the purchase price allocation for the Ceres acquisition. The addition to goodwill in 2006 reflects the acquisition of Ceres. GAFRI recorded a goodwill impairment charge of $4.2 million (included in "Other operating and general expenses") during the fourth quarter of 2006 related to an insurance agency subsidiary. A review for impairment was prompted by a decrease in estimated future earnings from this agency. Fair value of the agency was estimated using the present value of expected future cash flows.
As shown below (in millions), the majority of AFG's long-term debt is unsecured obligations of the holding company and its subsidiaries:
AFG and AAG Holding have a five-year revolving credit facility under which they can borrow a combined $500 million. Amounts borrowed bear interest at rates
AFG's Senior Convertible Notes were issued at a price of 37.153% of the principal amount due at maturity. Interest is payable semiannually at a rate of 4% of issue price per year through June 2008, after which interest at 4% annually will be accrued and added to the carrying value of the Notes. The Notes are redeemable at AFG's option at any time on or after June 2, 2008, at accreted value ranging from $371.53 per Note to $1,000 per Note at maturity. Holders may require AFG to purchase all or a portion of their Notes on five year anniversaries beginning in 2008, at the accreted value. Generally, holders may convert each Note into 17.2524 shares (or an aggregate of 8.8 million shares) of AFG Common Stock (at $21.53 per share currently) (i) if the average market price of AFG Common Stock to be received upon conversion exceeds 120% of the accreted value ($25.84 per share currently) for a specified period, (ii) if the credit rating of the Notes is significantly lowered, or (iii) if AFG calls the notes for redemption. Based upon the market price of AFG's Common Stock at December 31, 2007, of $28.88 per share, AFG's cost to redeem the Notes exceeds the accreted value by $64.7 million. Through 2007, AFG has delivered cash in lieu of Common Stock upon conversion of the Notes. For conversions beginning in 2008, AFG intends to continue to pay cash for the accreted value of the Notes, but may pay amounts in excess of accreted value in stock. Accordingly, shares issuable for amounts in excess of accreted value are included in AFG's calculation of diluted earnings per share for 2007.
During 2007, AFG repurchased 6.9 million shares of its Common Stock for approximately $199 million.
At December 31, 2007, there were 14.1 million shares of AFG Common Stock reserved for issuance under AFG's stock incentive plan. Options are granted with an exercise price equal to the market price of AFG Common Stock at the date of grant. Options generally become exercisable at the rate of 20% per year commencing one year after grant; those granted to non-employee directors of AFG are fully exercisable upon grant. Options expire ten years after the date of grant. Data for stock options issued under AFG's stock incentive plans is presented below:
AFG uses the Black-Scholes option pricing model to calculate the "fair value" of its option grants. Expected volatility is based on historical volatility over a period equal to the estimated term. AFG began using the SEC's simplified method of calculating expected term with its 2006 grants. The weighted average fair value of options granted during 2007, 2006 and 2005 was $9.70 per share, $6.68 per share and $6.44 per share, respectively, based on the following assumptions:
Total compensation expense related to stock incentive plans for 2007 and 2006 was $16.2 million (including $3.9 million in non-deductible stock awards) and $10.0 million, respectively. Related tax benefits totaled $3.4 million and $2.0 million, respectively. Included in these totals are $2.9 million in 2007 and $3.0 million in 2006 in compensation expense and $907,000 in 2007 and $472,000 in 2006 in tax benefits related to stock incentive plans of AFG subsidiaries. As of December 31, 2007, there was a total of $24.5 million of total unrecognized compensation expense related to nonvested stock options granted under AFG's plans. That cost is expected to be recognized over a weighted average of 3.5 years.
The following table illustrates the effect on net earnings (in millions) and earnings per share for the year ended 2005, had compensation cost been recognized and determined based on the "fair values" at grant dates consistent with the method used beginning in 2006.
Comprehensive income is defined as all changes in Shareholders' Equity except those arising from transactions with shareholders. Comprehensive income includes net income and other comprehensive income, which consists primarily of changes in net unrealized gains or losses on available for sale securities and foreign currency translation. The progression of the components of accumulated other comprehensive income (loss) follows (in millions):
The following is a reconciliation of income taxes at the statutory rate of 35% and income taxes as shown in the Statement of Earnings (in millions):
For income tax purposes, AFG and its subsidiaries had the following carryforwards available at December 31, 2007 (in millions):
Deferred income tax assets and liabilities reflect temporary differences between the carrying amounts of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. The significant components of deferred tax assets and liabilities included in other assets in the Balance Sheet at December 31, were as follows (in millions):
The gross deferred tax asset has been reduced by a valuation allowance including $50.1 million related to a portion of AFG's net operating loss carryforwards ("NOL") that is subject to the separate return limitation year ("SRLY") tax rules. A SRLY NOL can be used only by the entity that created it and only in years that the consolidated group has taxable income. The likelihood of realizing this asset will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period during which developments requiring an adjustment become known.
The total unrecognized tax benefits and related interest that, if recognized, would impact the effective tax rate is $42.9 million. This amount does not include tax and interest totaling $16.5 million paid to the IRS in 2005 and 2006 for which a suit for refund has been filed. AFG does not expect a decision before 2010. AFG's provision for income taxes for the year ended December 31, 2007, included approximately $2.3 million of interest (net of federal benefit) and a $2.0 million benefit due to a reduction of penalties. At December 31, 2007, AFG's liability for interest related to unrecognized tax benefits was $7.0 million (net of federal benefit); no penalties were accrued at that date.
In April 2007, AFG signed a settlement agreement with a municipality. As a result of this settlement, AFG reduced its liability for unrecognized income tax benefits, including interest and penalties, by $5.7 million ($3.7 million net of federal benefit).
are ongoing disputes. AFG does not expect any change in the amount of unrecognized tax benefits during the next 12 months to have a significant impact on its results of operations or its financial position.
Cash payments for income taxes, net of refunds, were $224.9 million, $213.6 million and $91.9 million for 2007, 2006 and 2005, respectively.
The insurance group's liability for asbestos and environmental reserves was $486 million at December 31, 2007; related recoverables from reinsurers (net of allowances for doubtful accounts) at that date were $64 million.
At December 31, 2007, GAFRI had a liability of approximately $12 million for environmental costs and certain other matters associated with the sales of its former manufacturing operations.
Results for the fourth quarter of 2007 include a pretax charge of $98.4 million to write down certain securities to fair value, including $64.2 million related to AFG's investment in National City Corporation. Results for the second quarter of 2007 include pretax charges of $87.2 million to strengthen reserves for asbestos and environmental exposures.
Results for the fourth quarter of 2006 include a $44.6 million pretax gain on the sale of certain New York City assets. Discontinued operations for the second quarter of 2006 includes a $25.8 million after tax gain from the sale of Chatham Bars Inn, a resort hotel.
Securities owned by insurance subsidiaries having a carrying value of approximately $1.2 billion at December 31, 2007, were on deposit as required by regulatory authorities.
The liability for losses and loss adjustment expenses ("LAE") for long-term scheduled payments under certain workers' compensation insurance has been discounted at about 6%, an approximation of long-term investment yields. As a result, the total liability for losses and loss adjustment expenses at December 31, 2007, has been reduced by $37 million.
$23 million in 2007, $2 million in 2006 and $18 million in 2005.
the vast majority of this business was written directly by AFG.
Total rental expense for various leases of office space and equipment was $37 million, $34 million and $31 million for 2007, 2006 and 2005, respectively.
Other operating and general expenses included charges for possible losses on agents' balances, other receivables and other assets in the following amounts: 2007 - $.2 million; 2006 - $.4 million; and 2005 - $11.1 million. Losses and loss adjustment expenses included charges for possible losses on reinsurance recoverables of $7.9 million in 2007, $12.8 million in 2006 and $.4 million in 2005. The aggregate allowance for all such losses amounted to approximately $47 million and $39 million at December 31, 2007 and 2006, respectively.
In connection with GAFRI's acquisition of its publicly held common stock in September 2007, AFG has guaranteed all of the outstanding debt of GAFRI and GAFRI's wholly-owned subsidiary, AAG Holding Company, Inc. In addition, GAFRI guarantees AAG Holding's public debt. The AFG and GAFRI guarantees are full and unconditional and joint and several. Condensed consolidating financial statements for AFG are as follows:
A. Selected Quarterly Financial Data is included in Note L to
(a) Includes amounts contributed to fund GAFRI's acquisition of its shares not
(c) Grossed up for prepaid reinsurance premiums of $390 and $394 at December 31, 2007 and 2006, respectively.