Fourth quarter 2017 net earnings attributable to AFG’s shareholders were $166 million ($1.84 per share, diluted) compared to $385 million ($4.33 per share, diluted) in the fourth quarter of 2016, reflecting:
Based on its analysis of the factors listed above, management believes AFG will recover its cost basis in the securities with unrealized losses and that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, 2017. Although AFG has the ability to continue holding its investments with unrealized losses, its intent to hold them may change due to deterioration in the issuers’ creditworthiness, decisions to lessen exposure to a particular issuer or industry, asset/liability management decisions, market movements, changes in views about appropriate asset allocation or the desire to offset taxable realized gains. Should AFG’s ability or intent change with regard to a particular security, a charge for impairment would likely be required. While it is not possible to accurately predict if or when a specific security will become impaired, charges for other-than-temporary impairment could be material to results of operations in future periods. Significant declines in the fair value of AFG’s investment portfolio could have a significant adverse effect on AFG’s liquidity. For information on AFG’s realized gains (losses) on securities, including charges for other-than-temporary impairment, see “Results of Operations - Consolidated Realized Gains (Losses) on Securities.”
Approximately $631 million of the $901 million in gross reserves of foreign operations relate to the operations of Neon Underwriting Limited, AFG’s wholly-owned United Kingdom-based Lloyd’s insurer. Neon writes bloodstock and livestock, cargo, cyber, financial lines, marine and energy liability, marine hull and war, mergers and acquisitions, personal accident and health, political and trade risk, professional indemnity, property and terrorism and political violence insurance.
The Specialty property and casualty insurance operations generated an underwriting profit of $156 million for the fourth quarter of 2017 compared to $110 million in the fourth quarter of 2016, an increase of $46 million (42%). The higher underwriting profit in the fourth quarter of 2017 reflects improved underwriting results in the Property and transportation and Specialty casualty sub-segments. Overall catastrophe losses were $8 million (0.6 points on the combined ratio) and related net reinstatement premiums paid were $4 million in the fourth quarter of 2017 compared to catastrophe losses of $12 million (1.1 points) in the fourth quarter of 2016. Losses related to third quarter catastrophes, specifically Hurricanes Harvey, Irma and Maria, and two earthquakes in Mexico, developed favorably by $25 million during the fourth quarter of 2017 across all property and casualty sub-segments.
development within Neon, most significantly the portion of the 2015 and prior years reinsurance to close transaction attributed to ongoing lines of business, and higher underwriting profit in the workers’ compensation and excess and surplus lines businesses. These improved results were partially offset by lower underwriting profits in the targeted markets operations. Catastrophe losses were $14 million (2.5 points on the combined ratio) and related net reinstatement premiums paid were $4 million for the fourth quarter of 2017 compared to catastrophe losses of $4 million (0.8 points) for the fourth quarter of 2016. Catastrophe losses for the fourth quarter of 2017 include the impact of the favorable reserve development on third quarter catastrophes discussed above.
AFG’s overall expense ratio increased 0.8 percentage points in the fourth quarter of 2017 as compared to the fourth quarter of 2016.
Interest credited - fixed for the fourth quarter of 2017 was $164 million compared to $148 million for the fourth quarter of 2016, an increase of $16 million (11%). The impact of growth in the annuity business was partially offset by lower interest crediting rates on new premiums as compared to the crediting rates on policyholder funds surrendered or withdrawn. The average interest rate credited to policyholders, calculated as interest credited divided by average fixed annuity benefits accumulated, decreased 0.02 percentage points to 2.00% in the fourth quarter of 2017 from 2.02% in the fourth quarter of 2016.
The net charge from unlocking annuity assumptions in the fourth quarter of 2017 reflects the unfavorable impacts of a decrease in projected net interest spreads on in-force business (due primarily to lower than previously anticipated reinvestment rates), a slight increase in projected expenses (due primarily to an increase in projected trailer commissions) and slightly higher projected option costs in the near term, substantially offset by the favorable impact of changes in projected policyholder annuitization and lapse behavior. Reinvestment rate assumptions are based primarily on 7-year and 10-year corporate bond yields. For the 2017 unlocking, AFG assumed a net reinvestment rate (net of default and expense assumptions) of 3.99% in 2018, grading up ratably to an ultimate net reinvestment rate of 5.55% in 2023 and beyond.
Run-off Long-Term Care and Life Segment - Results of Operations The following table details AFG’s earnings before income taxes from its run-off long-term care and life operations for the three months ended December 31, 2017 and 2016 (dollars in millions):
Summit, a workers’ compensation insurance subsidiary, collects fees from a small group of unaffiliated insurers for providing underwriting, policy administration and claims services. In addition, certain of AFG’s property and casualty businesses collect fees from customers for ancillary services such as workplace safety programs and premium financing. In the fourth quarter of 2017, AFG collected $20 million in fees for these services compared to $17 million in the fourth quarter of 2016. Management views this fee income, net of the $11 million in both the fourth quarter of 2017 and 2016, in expenses incurred to generate such fees, as a reduction in the cost of underwriting its property and casualty insurance policies. Consistent with internal management reporting, these fees and the related expenses are netted and recorded as a reduction of commissions and other underwriting expenses in AFG’s segmented results.
Specialty financial Commissions and other underwriting expenses as a percentage of net earned premiums decreased 2.9 percentage points in 2017 compared to 2016 reflecting lower profitability-based commissions paid to agents in the financial institutions business, including an $8 million commission expense reduction due to hurricane losses.
Net investment income in AFG’s property and casualty insurance operations was $362 million in 2017 compared to $350 million in 2016, an increase of $12 million (3%). Net investment income in AFG’s property and casualty operations was $350 million in 2016 compared to $319 million in 2015, an increase of $31 million (10%). In recent years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG’s investment portfolio yield. The average invested assets and overall yield earned on investments held by AFG’s property and casualty insurance operations are provided below (dollars in millions):
AFG’s net spread earned on fixed annuities increased 0.03 percentage points to 1.29% in 2016 from 1.26% in 2015 due primarily to the 0.04 percentage points increase in AFG’s net interest spread.
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses, excess benefits expected to be paid on future deaths and annuitizations (“EDAR”) and guaranteed withdrawal benefits. Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati. The following table is a progression of AFG’s annuity benefits accumulated liability for 2017, 2016 and 2015 (in millions):
The $4 million increase in core earnings before income taxes in 2017 compared to 2016 reflects the impact of improved life claims experience.
Holding Company, Other and Unallocated - Results of Operations AFG’s net GAAP pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $258 million in 2017 compared to $181 million in 2016, an increase of $77 million (43%). AFG’s net core pretax loss outside of its insurance operations (excluding realized gains and losses) totaled $183 million in 2017 compared to $176 million in 2016, an increase of $7 million (4%).
AFG wrote off unamortized debt issuance costs of $4 million related to the redemption of its $132 million outstanding 7% Senior Notes due 2050 at par value on September 30, 2015.
related unearned premiums. A premium deficiency is first recognized by charging any unamortized acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized acquisition costs, a liability is accrued for the excess deficiency and reported with unpaid losses and loss adjustment expenses.
Prior to the adoption of new guidance effective January 1, 2015, measuring both the CLO assets and CLO liabilities at separately determined fair values resulted in a difference between the carrying value of the CLO assets and the carrying value of the CLO liabilities that was not attributable to AFG’s ownership interest in the CLOs. This difference was recorded as “appropriated retained earnings - managed investment entities” in AFG’s Balance Sheet. In accordance with the guidance adopted in 2015, the amount reported as “appropriated retained earnings - managed investment entities” at December 31, 2014 was reclassified to “liabilities of managed investment entities” on January 1, 2015 as the cumulative effect of an accounting change.
AFG manages its business as four segments: (i) Property and casualty insurance, (ii) Annuity, (iii) Run-off long-term care and life and (iv) Other, which includes holding company assets and costs, and the assets and operations attributable to the noncontrolling interests of the managed investment entities.
Includes income of $32 million (before noncontrolling interest) from the sale of an apartment property in 2016 and $66 million (before noncontrolling interest) from the sales of a hotel and an apartment property in 2015.
As discussed in Note A - “Accounting Policies - Investments,” effective January 1, 2018, all equity securities currently classified as “available for sale” will be required to be carried at fair value through net earnings instead of AOCI.
Under the terms of the swaps, AFG receives fixed-rate interest payments in exchange for variable interest payments based on short-term LIBOR. The notional amounts of the interest rate swaps generally decline over each swap’s respective life (the swaps expire between August 2019 and June 2030) in anticipation of the expected decline in AFG’s portfolio of fixed maturity securities with floating interest rates based on short-term LIBOR. The total outstanding notional amount of AFG’s interest rate swaps increased to $1.58 billion at December 31, 2017 compared to $1.08 billion at December 31, 2016, reflecting three new swaps with an aggregate notional amount at issuance of $663 million entered into in 2017, partially offset by the scheduled amortization discussed above. The fair value of the effective portion of the interest rate swaps in an asset position and included in other assets was less than $1 million at December 31, 2017 and $1 million at December 31, 2016. The fair value of the effective portion of interest rate swaps in a liability position and included in other liabilities was $31 million at December 31, 2017 and $22 million at December 31, 2016. The net unrealized gain or loss on cash flow hedges is included in AOCI, net of DPAC and deferred taxes. Amounts reclassified from AOCI (before DPAC and taxes) to net investment income were $6 million in 2017, $7 million in 2016 and $6 million in 2015. There was no ineffectiveness recorded in net earnings during these periods. A collateral receivable supporting these swaps of $70 million at December 31, 2017 and $60 million at December 31, 2016 is included in other assets in AFG’s Balance Sheet.
AFG is the investment manager and its subsidiaries have investments ranging from 15.0% to 60.9% of the most subordinate debt tranche of fifteen collateralized loan obligation entities or “CLOs,” which are considered variable interest entities. AFG’s subsidiaries also own portions of the senior debt tranches of certain of these CLOs. Upon formation between 2004 and 2017, these entities issued securities in various senior and subordinate classes and invested the proceeds primarily in secured bank loans, which serve as collateral for the debt securities issued by each particular CLO. None of the collateral was purchased from AFG. AFG’s investments in the subordinate debt tranches of these entities receive residual income from the CLOs only after the CLOs pay expenses (including management fees to AFG) and interest on and returns of capital to senior levels of debt
AFG used the Black-Scholes option pricing model to calculate the fair value of its option grants issued during 2015 (no options were granted in 2016 or 2017). The expected dividend yield is based on AFG’s current dividend rate. To determine expected volatility, AFG considers its daily historical volatility as well as implied volatility on traded options. The expected term was estimated based on historical exercise patterns and post vesting cancellations. The risk-free rate for periods associated with the expected term is based upon the U.S. Treasury yield curve in effect on the grant date.
The net decrease in the provision for claims of prior years in 2017 reflects (i) lower than expected losses in the crop and equine businesses and lower than expected claim severity in the property and inland marine and transportation businesses (all within the Property and transportation sub-segment), (ii) favorable reserve development of $18 million on Neon’s exited lines, as well as additional favorable development on ongoing lines of business within Neon, recorded in connection with the reinsurance to close agreement entered into in December 2017 for the 2015 and prior years of account, lower than anticipated claim severity in the workers’ compensation businesses and lower than expected losses in the executive liability business (all within the Specialty casualty sub-segment) and (iii) lower than anticipated claim severity in the fidelity business and lower than expected claim frequency and severity in the surety business (both within the Specialty financial sub-segment). This favorable development was partially offset by (i) the $89 million special charge to increase asbestos and environmental reserves, (ii) higher than expected claim frequency and severity in the ocean marine business (within the Property and transportation sub-segment), (iii) higher than anticipated claim severity in the targeted markets and general liability businesses and higher than anticipated
Represents the cumulative percentage paid of incurred claims and allocated LAE (net of reinsurance, as estimated at December 31, 2017).