AFG-2013.6.30 10Q
______________________________________________________________________________________________________
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
|
| | |
For the Quarterly Period Ended June 30, 2013 | | Commission File No. 1-13653 |
AMERICAN FINANCIAL GROUP, INC.
|
| | |
Incorporated under the Laws of Ohio | | IRS Employer I.D. No. 31-1544320 |
301 East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes þ No ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company:
Large Accelerated Filer þ Accelerated Filer ¨ Non-Accelerated Filer ¨ Smaller Reporting Company ¨
Indicate by check mark whether the Registrant is a shell company. Yes ¨ No þ
As of August 1, 2013, there were 88,968,433 shares of the Registrant’s Common Stock outstanding, excluding 14.9 million shares owned by subsidiaries.
______________________________________________________________________________________________________
AMERICAN FINANCIAL GROUP, INC. 10-Q
TABLE OF CONTENTS
AMERICAN FINANCIAL GROUP, INC. 10-Q
PART I
ITEM I — FINANCIAL STATEMENTS
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (UNAUDITED)
(Dollars in Millions)
|
| | | | | | | |
| June 30, 2013 | | December 31, 2012 |
Assets: | | | |
Cash and cash equivalents | $ | 1,271 |
| | $ | 1,705 |
|
Investments: | | | |
Fixed maturities, available for sale at fair value (amortized cost — $23,740 and $22,083) | 25,035 |
| | 24,118 |
|
Fixed maturities, trading at fair value | 293 |
| | 321 |
|
Equity securities, at fair value (cost — $984 and $778) | 1,199 |
| | 939 |
|
Mortgage loans | 599 |
| | 607 |
|
Policy loans | 242 |
| | 228 |
|
Real estate and other investments | 623 |
| | 531 |
|
Total cash and investments | 29,262 |
| | 28,449 |
|
Recoverables from reinsurers | 3,044 |
| | 3,750 |
|
Prepaid reinsurance premiums | 520 |
| | 471 |
|
Agents’ balances and premiums receivable | 754 |
| | 636 |
|
Deferred policy acquisition costs | 818 |
| | 550 |
|
Assets of managed investment entities | 2,973 |
| | 3,225 |
|
Other receivables | 422 |
| | 539 |
|
Variable annuity assets (separate accounts) | 608 |
| | 580 |
|
Other assets | 828 |
| | 786 |
|
Goodwill | 185 |
| | 185 |
|
Total assets | $ | 39,414 |
| | $ | 39,171 |
|
| | | |
Liabilities and Equity: | | | |
Unpaid losses and loss adjustment expenses | $ | 6,098 |
| | $ | 6,845 |
|
Unearned premiums | 1,789 |
| | 1,651 |
|
Annuity benefits accumulated | 18,848 |
| | 17,609 |
|
Life, accident and health reserves | 2,017 |
| | 2,059 |
|
Payable to reinsurers | 367 |
| | 475 |
|
Liabilities of managed investment entities | 2,603 |
| | 2,892 |
|
Long-term debt | 949 |
| | 953 |
|
Variable annuity liabilities (separate accounts) | 608 |
| | 580 |
|
Other liabilities | 1,497 |
| | 1,359 |
|
Total liabilities | 34,776 |
| | 34,423 |
|
Shareholders’ equity: | | | |
Common Stock, no par value — 200,000,000 shares authorized — 88,820,940 and 88,979,303 shares outstanding | 89 |
| | 89 |
|
Capital surplus | 1,088 |
| | 1,063 |
|
Retained earnings: | | | |
Appropriated — managed investment entities | 33 |
| | 75 |
|
Unappropriated | 2,664 |
| | 2,520 |
|
Accumulated other comprehensive income, net of tax | 599 |
| | 831 |
|
Total shareholders’ equity | 4,473 |
| | 4,578 |
|
Noncontrolling interests | 165 |
| | 170 |
|
Total equity | 4,638 |
| | 4,748 |
|
Total liabilities and equity | $ | 39,414 |
| | $ | 39,171 |
|
AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF EARNINGS (UNAUDITED)
(In Millions, Except Per Share Data)
|
| | | | | | | | | | | | | | | |
| Three months ended June 30, | | Six months ended June 30, |
| 2013 | | 2012 | | 2013 | | 2012 |
Revenues: | | | | | | | |
Property and casualty insurance net earned premiums | $ | 709 |
| | $ | 640 |
| | $ | 1,396 |
| | $ | 1,243 |
|
Life, accident and health net earned premiums | 28 |
| | 105 |
| | 58 |
| | 210 |
|
Net investment income | 332 |
| | 329 |
| | 658 |
| | 646 |
|
Realized gains (losses) on: | | | | | | | |
Securities (*) | 41 |
| | 16 |
| | 98 |
| | 60 |
|
Subsidiaries | — |
| | (1 | ) | | — |
| | (1 | ) |
Income (loss) of managed investment entities: | | | | | | | |
Investment income | 32 |
| | 32 |
| | 66 |
| | 61 |
|
Loss on change in fair value of assets/liabilities | (28 | ) | | (21 | ) | | (36 | ) | | (50 | ) |
Other income | 25 |
| | 24 |
| | 47 |
| | 42 |
|
Total revenues | 1,139 |
| | 1,124 |
| | 2,287 |
| | 2,211 |
|
| | | | | | | |
Costs and Expenses: | | | | | | | |
Property and casualty insurance: | | | | | | | |
Losses and loss adjustment expenses | 430 |
| | 363 |
| | 823 |
| | 707 |
|
Commissions and other underwriting expenses | 260 |
| | 232 |
| | 511 |
| | 443 |
|
Annuity benefits | 120 |
| | 147 |
| | 254 |
| | 277 |
|
Life, accident and health benefits | 38 |
| | 82 |
| | 78 |
| | 172 |
|
Annuity and supplemental insurance acquisition expenses | 52 |
| | 47 |
| | 88 |
| | 92 |
|
Interest charges on borrowed money | 18 |
| | 19 |
| | 36 |
| | 38 |
|
Expenses of managed investment entities | 24 |
| | 20 |
| | 46 |
| | 39 |
|
Other expenses | 71 |
| | 78 |
| | 150 |
| | 161 |
|
Total costs and expenses | 1,013 |
| | 988 |
| | 1,986 |
| | 1,929 |
|
Earnings before income taxes | 126 |
| | 136 |
| | 301 |
| | 282 |
|
Provision for income taxes | 49 |
| | 52 |
| | 111 |
| | 110 |
|
Net earnings, including noncontrolling interests | 77 |
| | 84 |
| | 190 |
| | 172 |
|
Less: Net earnings (loss) attributable to noncontrolling interests | (33 | ) | | (15 | ) | | (40 | ) | | (40 | ) |
Net Earnings Attributable to Shareholders | $ | 110 |
| | $ | 99 |
| | $ | 230 |
| | $ | 212 |
|
| | | | | | | |
Earnings Attributable to Shareholders per Common Share: | | | | | | | |
Basic | $ | 1.23 |
| | $ | 1.02 |
| | $ | 2.57 |
| | $ | 2.18 |
|
Diluted | $ | 1.20 |
| | $ | 1.01 |
| | $ | 2.52 |
| | $ | 2.15 |
|
Average number of Common Shares: | | | | | | | |
Basic | 89.6 |
| | 96.4 |
| | 89.5 |
| | 97.0 |
|
Diluted | 91.5 |
| | 98.0 |
| | 91.3 |
| | 98.7 |
|
| | | | | | | |
Cash dividends per Common Share | $ | 0.195 |
| | $ | 0.175 |
| | $ | 0.39 |
| | $ | 0.35 |
|
________________________________________ | | | | | | | |
(*) Consists of the following: | | | | | | | |
Realized gains before impairments | $ | 42 |
| | $ | 23 |
| | $ | 99 |
| | $ | 71 |
|
| | | | | | | |
Losses on securities with impairment | (1 | ) | | (7 | ) | | (1 | ) | | (12 | ) |
Non-credit portion recognized in other comprehensive income (loss) | — |
| | — |
| | — |
| | 1 |
|
Impairment charges recognized in earnings | (1 | ) | | (7 | ) | | (1 | ) | | (11 | ) |
Total realized gains on securities | $ | 41 |
| | $ | 16 |
| | $ | 98 |
| | $ | 60 |
|
AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (UNAUDITED)
(In Millions)
|
| | | | | | | | | | | | | | | |
| Three months ended June 30, | | Six months ended June 30, |
| 2013 | | 2012 | | 2013 | | 2012 |
Net earnings, including noncontrolling interests | $ | 77 |
| | $ | 84 |
| | $ | 190 |
| | $ | 172 |
|
Other comprehensive income (loss), net of tax: | | | | | | | |
Net unrealized gains (losses) on securities: | | | | | | | |
Unrealized holding gains (losses) on securities arising during the period | (245 | ) | | 78 |
| | (166 | ) | | 236 |
|
Reclassification adjustment for realized gains included in net earnings | (27 | ) | | (12 | ) | | (63 | ) | | (40 | ) |
Total net unrealized gains (losses) on securities | (272 | ) | | 66 |
| | (229 | ) | | 196 |
|
Foreign currency translation adjustments | (5 | ) | | (8 | ) | | (9 | ) | | (1 | ) |
Pension and other postretirement plans adjustments | — |
| | — |
| | — |
| | 1 |
|
Other comprehensive income (loss), net of tax | (277 | ) | | 58 |
| | (238 | ) | | 196 |
|
Total comprehensive income (loss), net of tax | (200 | ) | | 142 |
| | (48 | ) | | 368 |
|
Less: Comprehensive income (loss) attributable to noncontrolling interests | (40 | ) | | (16 | ) | | (46 | ) | | (37 | ) |
Comprehensive income (loss) attributable to shareholders | $ | (160 | ) | | $ | 158 |
| | $ | (2 | ) | | $ | 405 |
|
AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED)
(Dollars in Millions)
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Shareholders’ Equity | | | | |
Common | | Common Stock and Capital | | Retained Earnings | | Accumulated Other Comp | | | | Noncon- trolling | | Total |
Shares | | Surplus | | Approp. | | Unapprop. | | Inc. (Loss) | | Total | | Interests | | Equity |
Balance at December 31, 2012 | 88,979,303 |
| | $ | 1,152 |
| | $ | 75 |
| | $ | 2,520 |
| | $ | 831 |
| | $ | 4,578 |
| | $ | 170 |
| | $ | 4,748 |
|
Net earnings | — |
| | — |
| | — |
| | 230 |
| | — |
| | 230 |
| | (40 | ) | | 190 |
|
Other comprehensive income | — |
| | — |
| | — |
| | — |
| | (232 | ) | | (232 | ) | | (6 | ) | | (238 | ) |
Allocation of losses of managed investment entities | — |
| | — |
| | (42 | ) | | — |
| | — |
| | (42 | ) | | 42 |
| | — |
|
Dividends on Common Stock | — |
| | — |
| | — |
| | (34 | ) | | — |
| | (34 | ) | | — |
| | (34 | ) |
Shares issued: | | | | | | | | | | | | | | | |
Exercise of stock options | 943,697 |
| | 30 |
| | — |
| | — |
| | — |
| | 30 |
| | — |
| | 30 |
|
Other benefit plans | 368,051 |
| | 6 |
| | — |
| | — |
| | — |
| | 6 |
| | — |
| | 6 |
|
Dividend reinvestment plan | 7,398 |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
|
Stock-based compensation expense | — |
| | 8 |
| | — |
| | — |
| | — |
| | 8 |
| | — |
| | 8 |
|
Shares acquired and retired | (1,448,156 | ) | | (19 | ) | | — |
| | (51 | ) | | — |
| | (70 | ) | | — |
| | (70 | ) |
Shares exchanged — benefit plans | (29,353 | ) | | — |
| | — |
| | (1 | ) | | — |
| | (1 | ) | | — |
| | (1 | ) |
Other | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (1 | ) | | (1 | ) |
Balance at June 30, 2013 | 88,820,940 |
| | $ | 1,177 |
| | $ | 33 |
| | $ | 2,664 |
| | $ | 599 |
| | $ | 4,473 |
| | $ | 165 |
| | $ | 4,638 |
|
| | | | | | | | | | | | | | | |
Balance at December 31, 2011 | 97,846,402 |
| | $ | 1,219 |
| | $ | 173 |
| | $ | 2,439 |
| | $ | 580 |
| | $ | 4,411 |
| | $ | 146 |
| | $ | 4,557 |
|
Net earnings | — |
| | — |
| | — |
| | 212 |
| | — |
| | 212 |
| | (40 | ) | | 172 |
|
Other comprehensive income | — |
| | — |
| | — |
| | — |
| | 193 |
| | 193 |
| | 3 |
| | 196 |
|
Allocation of losses of managed investment entities | — |
| | — |
| | (46 | ) | | — |
| | — |
| | (46 | ) | | 46 |
| | — |
|
Dividends on Common Stock | — |
| | — |
| | — |
| | (33 | ) | | — |
| | (33 | ) | | — |
| | (33 | ) |
Shares issued: | | | | | | | | | | |
| | | |
|
Exercise of stock options | 814,394 |
| | 21 |
| | — |
| | — |
| | — |
| | 21 |
| | — |
| | 21 |
|
Other benefit plans | 276,195 |
| | 5 |
| | — |
| | — |
| | — |
| | 5 |
| | — |
| | 5 |
|
Dividend reinvestment plan | 7,711 |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
|
Stock-based compensation expense | — |
| | 12 |
| | — |
| | — |
| | — |
| | 12 |
| | — |
| | 12 |
|
Shares acquired and retired | (3,985,470 | ) | | (50 | ) | | — |
| | (103 | ) | | — |
| | (153 | ) | | — |
| | (153 | ) |
Other | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | (2 | ) | | (2 | ) |
Balance at June 30, 2012 | 94,959,232 |
| | $ | 1,207 |
| | $ | 127 |
| | $ | 2,515 |
| | $ | 773 |
| | $ | 4,622 |
| | $ | 153 |
| | $ | 4,775 |
|
AMERICAN FINANCIAL GROUP, INC. 10-Q
AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED)
(In Millions) |
| | | | | | | |
| Six months ended June 30, |
| 2013 | | 2012 |
Operating Activities: | | | |
Net earnings, including noncontrolling interests | $ | 190 |
| | $ | 172 |
|
Adjustments: | | | |
Depreciation and amortization | 78 |
| | 83 |
|
Annuity benefits | 254 |
| | 277 |
|
Realized gains on investing activities | (105 | ) | | (57 | ) |
Net sales of trading securities | 24 |
| | 5 |
|
Deferred annuity and life policy acquisition costs | (83 | ) | | (129 | ) |
Change in: | | | |
Reinsurance and other receivables | 659 |
| | 212 |
|
Other assets | (41 | ) | | 50 |
|
Insurance claims and reserves | (617 | ) | | (167 | ) |
Payable to reinsurers | (108 | ) | | (79 | ) |
Other liabilities | 45 |
| | (179 | ) |
Managed investment entities’ assets/liabilities | (115 | ) | | 40 |
|
Other operating activities, net | 15 |
| | (2 | ) |
Net cash provided by operating activities | 196 |
| | 226 |
|
| | | |
Investing Activities: | | | |
Purchases of: | | | |
Fixed maturities | (3,009 | ) | | (1,976 | ) |
Equity securities | (274 | ) | | (194 | ) |
Mortgage loans | (73 | ) | | (97 | ) |
Real estate, property and equipment | (38 | ) | | (52 | ) |
Proceeds from: | | | |
Maturities and redemptions of fixed maturities | 1,456 |
| | 993 |
|
Repayments of mortgage loans | 82 |
| | 6 |
|
Sales of fixed maturities | 139 |
| | 239 |
|
Sales of equity securities | 142 |
| | 107 |
|
Managed investment entities: | | | |
Purchases of investments | (829 | ) | | (925 | ) |
Proceeds from sales and redemptions of investments | 1,215 |
| | 1,106 |
|
Other investing activities, net | (3 | ) | | (33 | ) |
Net cash used in investing activities | (1,192 | ) | | (826 | ) |
| | | |
Financing Activities: | | | |
Annuity receipts | 1,685 |
| | 1,710 |
|
Annuity surrenders, benefits and withdrawals | (749 | ) | | (696 | ) |
Net transfers from variable annuity assets | 12 |
| | 9 |
|
Additional long-term borrowings | — |
| | 223 |
|
Reductions of long-term debt | (4 | ) | | (6 | ) |
Issuances of managed investment entities’ liabilities | 652 |
| | 359 |
|
Retirement of managed investment entities’ liabilities | (960 | ) | | (633 | ) |
Issuances of Common Stock | 31 |
| | 22 |
|
Repurchases of Common Stock | (70 | ) | | (153 | ) |
Cash dividends paid on Common Stock | (34 | ) | | (33 | ) |
Other financing activities, net | (1 | ) | | (3 | ) |
Net cash provided by financing activities | 562 |
| | 799 |
|
Net Change in Cash and Cash Equivalents | (434 | ) | | 199 |
|
Cash and cash equivalents at beginning of period | 1,705 |
| | 1,324 |
|
Cash and cash equivalents at end of period | $ | 1,271 |
| | $ | 1,523 |
|
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|
| | | | | |
INDEX TO NOTES |
| | | | | |
A. | Accounting Policies | | H. | Managed Investment Entities | |
B. | Sale of Subsidiaries | | I. | Goodwill and Other Intangibles | |
C. | Segments of Operations | | J. | Long-Term Debt | |
D. | Fair Value Measurements | | K. | Shareholders’ Equity | |
E. | Investments | | L. | Income Taxes | |
F. | Derivatives | | M. | Contingencies | |
G. | Deferred Policy Acquisition Costs | | | | |
| | | | | |
A. Accounting Policies
Basis of Presentation The accompanying consolidated financial statements for American Financial Group, Inc. (“AFG”) and its subsidiaries are unaudited; however, management believes that all adjustments (consisting only of normal recurring accruals unless otherwise disclosed herein) necessary for fair presentation have been made. The results of operations for interim periods are not necessarily indicative of results to be expected for the year. The financial statements have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include all information and footnotes necessary to be in conformity with U.S. generally accepted accounting principles.
Certain reclassifications have been made to prior periods to conform to the current year’s presentation, primarily the reclassification of investment expenses and real estate income and expenses to net investment income. All significant intercompany balances and transactions have been eliminated. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to June 30, 2013, and prior to the filing date of this Form 10-Q, have been evaluated for potential recognition or disclosure herein.
The preparation of the financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates.
Accounting Standards Adopted in 2013 Effective January 1, 2013, AFG prospectively adopted Accounting Standards Update (“ASU”) 2013-02, which requires companies to disclose, in a single location within the financial statements or footnotes, reclassifications out of accumulated other comprehensive income (“AOCI”) separately for each component of other comprehensive income. For significant reclassifications, the disclosure is required to include the respective line items in net earnings affected by the reclassification. Disclosures required by the guidance are included in Note K — “Shareholders’ Equity.” This new disclosure requirement had no impact on AFG’s results of operations or financial position.
Fair Value Measurements Accounting standards define fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. The standards establish a hierarchy of valuation techniques based on whether the assumptions that market participants would use in pricing the asset or liability (“inputs”) are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect AFG’s assumptions about the assumptions market participants would use in pricing the asset or liability. AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in the first six months of 2013 or 2012.
Investments Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in AOCI in AFG’s Balance Sheet. Fixed maturity and equity securities classified as “trading” are reported at fair value with changes in unrealized holding gains or losses during the period included in investment income. Mortgage and policy loans are carried primarily at the aggregate unpaid balance.
Premiums and discounts on fixed maturity securities are amortized using the interest method; mortgage-backed securities (“MBS”) are amortized over a period based on estimated future principal payments, including prepayments. Prepayment assumptions are reviewed periodically and adjusted to reflect actual prepayments and changes in expectations.
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
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.
Derivatives Derivatives included in AFG’s Balance Sheet are recorded at fair value and consist primarily of (i) components of certain fixed maturity securities (primarily interest-only MBS) and (ii) the equity-based component of certain annuity products (included in annuity benefits accumulated) and related 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 earnings.
Goodwill Goodwill represents the excess of cost of subsidiaries over AFG’s equity in their underlying net assets. Goodwill is not amortized, but is subject to an impairment test at least annually. An entity is not required to complete the quantitative annual goodwill impairment test on a reporting unit if the entity elects to perform a qualitative analysis and determines that it is more likely than not that the reporting unit’s fair value exceeds its carrying amount.
Reinsurance Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. AFG’s property and casualty insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on paid and unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid or due to reinsurers applicable to the unexpired terms of policies in force. Payable to reinsurers includes ceded premiums due to reinsurers as well as ceded premiums retained by AFG’s property and casualty insurance subsidiaries under contracts to fund ceded losses as they become due. AFG’s insurance subsidiaries also assume reinsurance from other companies. Earnings on reinsurance assumed is recognized based on information received from ceding companies.
A subsidiary cedes life insurance policies to a third party on a funds withheld basis whereby the subsidiary retains the assets (securities) associated with the reinsurance contract. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. This reinsurance contract is considered to contain an embedded derivative (that must be adjusted to fair value) because the yield on the payable is based on a specific block of the ceding company’s assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolio of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to this contract are classified as “trading.” The adjustment to fair value on the embedded derivative offsets the investment income recorded on the adjustment to fair value of the related trading portfolio.
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.
For the property and casualty companies, DPAC is limited based upon recoverability without any consideration for anticipated investment income and is charged against income ratably over the terms of the related policies. A premium deficiency is recognized if the sum of expected claims costs, claims adjustment expenses and unamortized acquisition costs exceed the 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.
DPAC related to annuities is deferred to the extent deemed recoverable and amortized, with interest, in relation to the present value of actual and expected gross profits on the policies. Expected gross profits consist principally of estimated future investment margin (estimated future net investment income less interest credited on policyholder funds) and surrender, mortality, and other life and annuity policy charges, less death, annuitization and guaranteed withdrawal benefits in excess of account balances and estimated future policy administration expenses. To the extent that realized gains and losses result in
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains (losses) on securities.
DPAC related to traditional life and health insurance is amortized over the expected premium paying period of the related policies, in proportion to the ratio of annual premium revenues to total anticipated premium revenues. See Note A, “Accounting Policies — Life, Accident and Health Reserves” for details on the impact of loss recognition on the accounting for traditional life and health insurance contracts.
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.
DPAC and certain other balance sheet amounts related to annuity, long-term care and life businesses are also adjusted, net of tax, for the change in expense that would have been recorded if the unrealized gains (losses) from securities had actually been realized. These adjustments are included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.
Managed Investment Entities A company is considered the primary beneficiary of, and therefore must consolidate, a variable interest entity (“VIE”) based primarily on its ability to direct the activities of the VIE that most significantly impact that entity’s economic performance and the obligation to absorb losses of, or receive benefits from, the entity that could potentially be significant to the VIE.
AFG manages, and has investments in, collateralized loan obligations (“CLOs”) that are VIEs (see Note H — “Managed Investment Entities”). Both the management fees (payment of which is subordinate to other obligations of the CLOs) and the investments in the CLOs are considered variable interests. AFG has determined that it is the primary beneficiary of the CLOs because (i) its role as asset manager gives it the power to direct the activities that most significantly impact the economic performance of the CLOs and (ii) it has exposure to CLO losses (through its investments in the CLO debt tranches) and the right to receive benefits (through its subordinated management fees and returns on its investments), both of which could potentially be significant to the CLOs.
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). 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 excess of fair value of the CLOs’ assets over the fair value of the liabilities is recorded in AFG’s Balance Sheet as appropriated retained earnings — managed investment entities, representing amounts that ultimately will inure to the benefit of the CLO debt holders.
The net gain or loss from accounting for the CLO assets and liabilities at fair value 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 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 2025), 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.
At June 30, 2013, assets and liabilities of managed investment entities included $96 million in assets and $66 million in liabilities of a temporary warehousing entity that was established in connection with the formation of a new CLO that is expected to close in the second half of 2013. Upon closing, all warehoused assets are expected to be transferred to the new CLO and the liabilities will be repaid. At December 31, 2012, assets and liabilities of managed investment entities included $107 million in assets and $87 million in liabilities of a temporary warehousing entity that was established in connection with the formation of a new CLO. All warehoused assets were transferred to that new CLO and the liabilities were repaid when the CLO formation was completed and the CLO issued securities in April 2013.
Unpaid Losses and Loss Adjustment Expenses The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
the accounting period on direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses (including possible development on known claims) based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims; and (e) the current state of the law and coverage litigation. Establishing reserves for asbestos, environmental and other mass tort claims involves considerably more judgment than other types of claims due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage.
Loss reserve liabilities are subject to the impact of changes in claim amounts and frequency and other factors. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Despite the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
Annuity Benefits Accumulated Annuity receipts and benefit payments are recorded as increases or decreases in annuity benefits accumulated rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for policy charges are credited to other income.
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.
Annuity benefits accumulated also includes amounts advanced from the Federal Home Loan Bank of Cincinnati.
Unearned Revenue Certain upfront policy charges on annuities are deferred as unearned revenue (included in other liabilities) and recognized in net earnings using the same assumptions and estimated gross profits used to amortize DPAC.
Life, Accident and Health Reserves Liabilities for future policy benefits under traditional life, accident and health policies are computed using the net level premium method. Computations are based on the original projections of investment yields, mortality, morbidity and surrenders and include provisions for unfavorable deviations unless a loss recognition event (premium deficiency) occurs. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.
For long-duration contracts (such as traditional life and long-term care policies), 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 (excluding overhead) as well as unamortized acquisition costs. If a block of business is determined to be in loss recognition, a charge is recorded in earnings in an amount equal to the excess of the present value of expected future claims costs and unamortized acquisition costs over existing reserves plus the present value of expected future premiums (with no provision for adverse deviation). The charge is recorded first to reduce unamortized acquisition costs and then as an additional reserve (if unamortized acquisition costs have been reduced to zero).
In addition, reserves for traditional life and long-term care policies are subject to adjustment for loss recognition charges that would have been recorded if the unrealized gains from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of AOCI in AFG’s Balance Sheet.
Variable Annuity Assets and Liabilities Separate accounts related to variable annuities represent the fair value of deposits invested in underlying investment funds on which AFG earns a fee. Investment funds are selected and may be changed only by the policyholder, who retains all investment risk.
AFG’s variable annuity contracts contain a guaranteed minimum death benefit (“GMDB”) to be paid if the policyholder dies before the annuity payout period commences. In periods of declining equity markets, the GMDB may exceed the value of the policyholder’s account. A GMDB liability is established for future excess death benefits using assumptions together with a range of reasonably possible scenarios for investment fund performance that are consistent with DPAC capitalization and amortization assumptions.
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
Premium Recognition Property and casualty premiums are earned generally over the terms of the policies on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. On reinsurance assumed from other insurance companies or written through various underwriting organizations, unearned premiums are based on information received from such companies and organizations. For traditional life, accident and health products, premiums are recognized as revenue when legally collectible from policyholders. For interest-sensitive life and universal life products, premiums are recorded in a policyholder account, which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses.
Noncontrolling Interests For Balance Sheet purposes, noncontrolling interests represents the interests of shareholders other than AFG in consolidated entities. In the Statement of Earnings, net earnings and losses attributable to noncontrolling interests represents such shareholders’ interest in the earnings and losses of those entities.
Income Taxes Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. A valuation allowance is established to reduce total deferred tax assets to an amount that will more likely than not be realized.
AFG recognizes the tax benefits of uncertain tax positions only when the position is more likely than not to be sustained under examination by the appropriate taxing authority. Interest and penalties on AFG’s reserve for uncertain tax positions are recognized as a component of tax expense.
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.
Benefit Plans AFG provides retirement benefits to qualified employees of participating companies through the AFG 401(k) Retirement and Savings Plan, a defined contribution plan. AFG makes all contributions to the retirement fund portion of the plan and matches a percentage of employee contributions to the savings fund. Company contributions are expensed in the year for which they are declared. AFG and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFG also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period employees earn such benefits.
Earnings Per Share Although basic earnings per share only considers shares of common stock outstanding during the period, the calculation of diluted earnings per share includes adjustments to weighted average common shares related to stock-based compensation plans: second quarter of 2013 and 2012 — 1.9 million and 1.6 million; first six months of 2013 and 2012 — 1.8 million and 1.7 million, respectively.
AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: second quarter of 2013 and 2012 — 1.3 million and 2.1 million; first six months of 2013 and 2012 — 1.4 million and 1.8 million, respectively. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2013 and 2012 periods.
Statement of Cash Flows For cash flow purposes, “investing activities” are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. “Financing activities” include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, benefits and withdrawals are also reflected as financing activities. All other activities are considered “operating.” Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements.
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
B. Sale of Subsidiaries
Medicare Supplement and Critical Illness Segment In August 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 sold are not reported as discontinued operations. Summarized Statement of Earnings information for the Medicare supplement and critical illness segment for the second quarter and first six months of 2012 is shown below (in millions): |
| | | | | | | | |
| | Three months ended | | Six months ended |
| | June 30, 2012 | | June 30, 2012 |
Total revenues | | $ | 79 |
| | $ | 159 |
|
Total costs and expenses | | 67 |
| | 141 |
|
Earnings before income taxes | | $ | 12 |
| | $ | 18 |
|
C. Segments of Operations
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 (sold in August 2012) and (v) Other, which includes holding company costs, and the operations attributable to the noncontrolling interests of the managed investment entities.
AFG reports its property and casualty insurance business in the following Specialty sub-segments: (i) Property and transportation, which includes physical damage and liability coverage for buses, trucks and recreational vehicles, inland and ocean marine, agricultural-related products and other property coverages, (ii) Specialty casualty, which includes primarily 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 leasing and financing institutions (including collateral and lender-placed mortgage property insurance), surety and fidelity products and trade credit insurance. AFG’s annuity business markets traditional fixed and fixed-indexed annuities in the retail, financial institutions and education markets. AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
The following tables (in millions) show AFG’s revenues and earnings before income taxes by segment and sub-segment.
|
| | | | | | | | | | | | | | | |
| Three months ended June 30, | | Six months ended June 30, |
| 2013 | | 2012 | | 2013 | | 2012 |
Revenues | | | | | | | |
Property and casualty insurance: | | | | | | | |
Premiums earned: | | | | | | | |
Specialty | | | | | | | |
Property and transportation | $ | 301 |
| | $ | 290 |
| | $ | 594 |
| | $ | 553 |
|
Specialty casualty | 277 |
| | 236 |
| | 536 |
| | 456 |
|
Specialty financial | 113 |
| | 98 |
| | 229 |
| | 201 |
|
Other specialty | 18 |
| | 16 |
| | 37 |
| | 33 |
|
Total premiums earned | 709 |
| | 640 |
| | 1,396 |
| | 1,243 |
|
Net investment income | 65 |
| | 69 |
| | 131 |
| | 139 |
|
Other income | 6 |
| | 8 |
| | 9 |
| | 11 |
|
Total property and casualty insurance | 780 |
| | 717 |
| | 1,536 |
| | 1,393 |
|
Annuity: | | | | | | | |
Net investment income | 257 |
| | 245 |
| | 505 |
| | 473 |
|
Other income | 15 |
| | 12 |
| | 29 |
| | 25 |
|
Total annuity | 272 |
| | 257 |
| | 534 |
| | 498 |
|
Run-off long-term care and life | 47 |
| | 49 |
| | 97 |
| | 96 |
|
Medicare supplement and critical illness (a) | — |
| | 79 |
| | — |
| | 159 |
|
Other | (1 | ) | | 7 |
| | 22 |
| | 6 |
|
Total revenues before realized gains | 1,098 |
| | 1,109 |
| | 2,189 |
| | 2,152 |
|
Realized gains on securities | 41 |
| | 16 |
| | 98 |
| | 60 |
|
Realized losses on subsidiaries | — |
| | (1 | ) | | — |
| | (1 | ) |
Total revenues | $ | 1,139 |
| | $ | 1,124 |
| | $ | 2,287 |
| | $ | 2,211 |
|
|
| | | | | | | | | | | | | | | |
Earnings Before Income Taxes | | | | | | | |
Property and casualty insurance: | | | | | | | |
Underwriting: | | | | | | | |
Specialty | | | | | | | |
Property and transportation | $ | (31 | ) | | $ | 6 |
| | $ | (21 | ) | | $ | 33 |
|
Specialty casualty | 32 |
| | 33 |
| | 51 |
| | 37 |
|
Specialty financial | 15 |
| | 11 |
| | 28 |
| | 27 |
|
Other specialty | 5 |
| | 2 |
| | 11 |
| | 3 |
|
Other lines, primarily A&E charges | (2 | ) | | (7 | ) | | (7 | ) | | (7 | ) |
Total underwriting | 19 |
| | 45 |
| | 62 |
| | 93 |
|
Investment and other income, net | 60 |
| | 60 |
| | 116 |
| | 115 |
|
Total property and casualty insurance | 79 |
| | 105 |
| | 178 |
| | 208 |
|
Annuity (b) | 77 |
| | 59 |
| | 153 |
| | 119 |
|
Run-off long-term care and life | (2 | ) | | 5 |
| | (3 | ) | | 6 |
|
Medicare supplement and critical illness (a) | — |
| | 12 |
| | — |
| | 18 |
|
Other (c) | (69 | ) | | (60 | ) | | (125 | ) | | (128 | ) |
Total earnings before realized gains and income taxes | 85 |
| | 121 |
| | 203 |
| | 223 |
|
Realized gains on securities | 41 |
| | 16 |
| | 98 |
| | 60 |
|
Realized losses on subsidiaries | — |
| | (1 | ) | | — |
| | (1 | ) |
Total earnings before income taxes | $ | 126 |
| | $ | 136 |
| | $ | 301 |
| | $ | 282 |
|
| |
(b) | Includes a $5 million charge in the second quarter of 2013 to cover expected assessments from state guaranty funds related to the insolvency and liquidation of an unaffiliated life insurance company. |
| |
(c) | Includes holding company expenses and losses of managed investment entities attributable to noncontrolling interest of $31 million and $18 million for the second quarter and $42 million and $46 million for the first six months of 2013 and 2012, respectively. |
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
D. Fair Value Measurements
Accounting standards for measuring fair value are based on inputs used in estimating fair value. The three levels of the hierarchy are as follows:
Level 1 — Quoted prices for identical assets or liabilities in active markets (markets in which transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis). AFG’s Level 1 financial instruments consist primarily of publicly traded equity securities and highly liquid government bonds for which quoted market prices in active markets are available and short-term investments of managed investment entities.
Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar assets or liabilities in inactive markets (markets in which there are few transactions, the prices are not current, price quotations vary substantially over time or among market makers, or in which little information is released publicly); and valuations based on other significant inputs that are observable in active markets. AFG’s Level 2 financial instruments include separate account assets, corporate and municipal fixed maturity securities, mortgage-backed securities (“MBS”) and investments of managed investment entities priced using observable inputs. Level 2 inputs include benchmark yields, reported trades, corroborated broker/dealer quotes, issuer spreads and benchmark securities. When non-binding broker quotes can be corroborated by comparison to similar securities priced using observable inputs, they are classified as Level 2.
Level 3 — Valuations derived from market valuation techniques generally consistent with those used to estimate the fair values of Level 2 financial instruments in which one or more significant inputs are unobservable or when the market for a security exhibits significantly less liquidity relative to markets supporting Level 2 fair value measurements. The unobservable inputs may include management’s own assumptions about the assumptions market participants would use based on the best information available in the circumstances. AFG’s Level 3 is comprised of financial instruments, including liabilities of managed investment entities, whose fair value is estimated based on non-binding broker quotes or internally developed using significant inputs not based on, or corroborated by, observable market information.
AFG’s management is responsible for the valuation process and uses data from outside sources (including nationally recognized pricing services and broker/dealers) in establishing fair value. AFG’s internal investment professionals are a group of approximately 20 analysts whose primary responsibility is to manage AFG’s investment portfolio. These professionals monitor individual investments as well as overall industries and are active in the financial markets on a daily basis. The group is led by AFG’s chief investment officer, who reports directly to one of AFG’s Co-CEOs. Valuation techniques utilized by pricing services and prices obtained from external sources are reviewed by AFG’s internal investment professionals who are familiar with the securities being priced and the markets in which they trade to ensure the fair value determination is representative of an exit price. To validate the appropriateness of the prices obtained, these investment managers consider widely published indices (as benchmarks), recent trades, changes in interest rates, general economic conditions and the credit quality of the specific issuers. In addition, the Company communicates directly with the pricing service regarding the methods and assumptions used in pricing, including verifying, on a test basis, the inputs used by the service to value specific securities.
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
Assets and liabilities measured and carried at fair value in the financial statements are summarized below (in millions):
|
| | | | | | | | | | | | | | | |
| Level 1 | | Level 2 | | Level 3 | | Total |
June 30, 2013 | | | | | | | |
Assets: | | | | | | | |
Available for sale (“AFS”) fixed maturities: | | | | | | | |
U.S. Government and government agencies | $ | 163 |
| | $ | 129 |
| | $ | 20 |
| | $ | 312 |
|
States, municipalities and political subdivisions | — |
| | 4,753 |
| | 63 |
| | 4,816 |
|
Foreign government | — |
| | 242 |
| | — |
| | 242 |
|
Residential MBS | — |
| | 3,824 |
| | 329 |
| | 4,153 |
|
Commercial MBS | — |
| | 2,818 |
| | 28 |
| | 2,846 |
|
Asset-backed securities (“ABS”) | — |
| | 2,054 |
| | 180 |
| | 2,234 |
|
Corporate and other | 15 |
| | 10,122 |
| | 295 |
| | 10,432 |
|
Total AFS fixed maturities | 178 |
| | 23,942 |
| | 915 |
| | 25,035 |
|
Trading fixed maturities | — |
| | 293 |
| | — |
| | 293 |
|
Equity securities | 953 |
| | 168 |
| | 78 |
| | 1,199 |
|
Assets of managed investment entities (“MIE”) | 335 |
| | 2,607 |
| | 31 |
| | 2,973 |
|
Variable annuity assets (separate accounts) (a) | — |
| | 608 |
| | — |
| | 608 |
|
Other investments | — |
| | 187 |
| | — |
| | 187 |
|
Total assets accounted for at fair value | $ | 1,466 |
| | $ | 27,805 |
| | $ | 1,024 |
| | $ | 30,295 |
|
Liabilities: | | | | | | | |
Liabilities of managed investment entities | $ | 121 |
| | $ | — |
| | $ | 2,482 |
| | $ | 2,603 |
|
Derivatives in annuity benefits accumulated | — |
| | — |
| | 577 |
| | 577 |
|
Other liabilities — derivatives | — |
| | 12 |
| | — |
| | 12 |
|
Total liabilities accounted for at fair value | $ | 121 |
| | $ | 12 |
| | $ | 3,059 |
| | $ | 3,192 |
|
| | | | | | | |
December 31, 2012 | | | | | | | |
Assets: | | | | | | | |
Available for sale fixed maturities: | | | | | | | |
U.S. Government and government agencies | $ | 227 |
| | $ | 141 |
| | $ | 20 |
| | $ | 388 |
|
States, municipalities and political subdivisions | — |
| | 4,410 |
| | 58 |
| | 4,468 |
|
Foreign government | — |
| | 260 |
| | — |
| | 260 |
|
Residential MBS | — |
| | 3,833 |
| | 371 |
| | 4,204 |
|
Commercial MBS | — |
| | 2,896 |
| | 22 |
| | 2,918 |
|
Asset-backed securities | — |
| | 1,387 |
| | 253 |
| | 1,640 |
|
Corporate and other | 5 |
| | 9,999 |
| | 236 |
| | 10,240 |
|
Total AFS fixed maturities | 232 |
| | 22,926 |
| | 960 |
| | 24,118 |
|
Trading fixed maturities | — |
| | 321 |
| | — |
| | 321 |
|
Equity securities | 781 |
| | 121 |
| | 37 |
| | 939 |
|
Assets of managed investment entities | 256 |
| | 2,929 |
| | 40 |
| | 3,225 |
|
Variable annuity assets (separate accounts) (a) | — |
| | 580 |
| | — |
| | 580 |
|
Other investments | — |
| | 133 |
| | — |
| | 133 |
|
Total assets accounted for at fair value | $ | 1,269 |
| | $ | 27,010 |
| | $ | 1,037 |
| | $ | 29,316 |
|
Liabilities: | | | | | | | |
Liabilities of managed investment entities | $ | 147 |
| | $ | — |
| | $ | 2,745 |
| | $ | 2,892 |
|
Derivatives in annuity benefits accumulated | — |
| | — |
| | 465 |
| | 465 |
|
Other liabilities — derivatives | — |
| | 17 |
| | — |
| | 17 |
|
Total liabilities accounted for at fair value | $ | 147 |
| | $ | 17 |
| | $ | 3,210 |
| | $ | 3,374 |
|
(a) Variable annuity liabilities equal the fair value of variable annuity assets.
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
During the first six months of 2013 (all in the second quarter), five preferred stocks with an aggregate fair value of $11 million were transferred from Level 2 to Level 1 due to increases in trade frequency, resulting in trade data sufficient to warrant classification in Level 1. During the first six months of 2013, there were no transfers from Level 1 to Level 2. During the first six months of 2012 (all in the first quarter), six preferred stocks with an aggregate fair value of $35 million were transferred from Level 1 to Level 2 due to decreases in trade frequency, resulting in lack of available trade data sufficient to warrant classification in Level 1. During the first six months 2012, there were no transfers from Level 2 to Level 1. Approximately 3% of the total assets carried at fair value on June 30, 2013, were Level 3 assets. Approximately 82% of the Level 3 assets were priced using non-binding broker quotes, for which there is a lack of transparency as to the inputs used to determine fair value. Details as to the quantitative inputs are neither provided by the brokers nor otherwise reasonably obtainable by AFG. Since internally developed Level 3 asset fair values represent less than one-half of 1% of the total assets measured at fair value and less than 3% of AFG’s shareholders’ equity, changes in unobservable inputs used to determine internally developed fair values would not have a material impact on AFG’s financial position.
The fair values of the liabilities of managed investment entities were determined using primarily non-binding broker quotes, which were reviewed by AFG’s investment professionals. AFG’s investment professionals are familiar with the cash flow models used by the brokers to determine the fair value of these liabilities and review the broker quotes based on their knowledge of the CLO market and the market for the underlying assets. Their review includes consideration of expected reinvestment, default and recovery rates on the assets supporting the CLO liabilities, as well as surveying general CLO liability fair values and analysis provided by third parties.
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 $577 million at June 30, 2013. The following table presents information about the unobservable inputs used by management in determining fair value of these embedded derivatives. See Note F — “Derivatives.”
|
| | |
Unobservable Input | | Range |
Adjustment for insurance subsidiary’s credit risk | | 0.50% – 2.00% over the risk free rate |
Risk margin for uncertainty in cash flows | | 0.4% reduction in the discount rate |
Surrenders | | 4% – 20% of indexed account value |
Partial surrenders | | 2% – 5% of indexed account value |
Annuitizations | | 1% – 2% of indexed account value |
Deaths | | 1% – 2.5% of indexed account value |
Budgeted option costs | | 2.5% – 4.0% of indexed account value |
The range of adjustments for insurance subsidiary’s credit risk reflects credit spread variations across the yield curve. The range of projected surrender rates reflects the specific surrender charges and other features of AFG’s individual fixed-indexed annuity products with an expected range of 5% to 12% in the majority of future calendar years (4% — 20% over all periods). Increasing the budgeted option cost or risk margin for uncertainty in cash flows assumptions in the table above would increase the fair value of the fixed-indexed annuity embedded derivatives, while increasing any of the other unobservable inputs in the table above would decrease the fair value of the embedded derivatives.
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
Changes in balances of Level 3 financial assets and liabilities carried at fair value during the second quarter and first six months of 2013 and 2012 are presented below (in millions). The transfers into and out of Level 3 were due to changes in the availability of market observable inputs. All transfers are reflected in the table at fair value as of the end of the reporting period.
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Total realized/unrealized gains (losses) included in | | | | | | | | | | |
Balance at March 31, 2013 | | Net income | | Other comprehensive income (loss) | | Purchases and issuances | | Sales and settlements | | Transfer into Level 3 | | Transfer out of Level 3 | | Balance at June 30, 2013 |
AFS fixed maturities: | | | | | | | | | | | | | | | |
U.S. government agency | $ | 20 |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | 20 |
|
State and municipal | 54 |
| | — |
| | (1 | ) | | 10 |
| | — |
| | — |
| | — |
| | 63 |
|
Residential MBS | 354 |
| | 2 |
| | (7 | ) | | — |
| | (17 | ) | | 9 |
| | (12 | ) | | 329 |
|
Commercial MBS | 30 |
| | (2 | ) | | — |
| | — |
| | — |
| | — |
| | — |
| | 28 |
|
Asset-backed securities | 245 |
| | 2 |
| | (2 | ) | | — |
| | (39 | ) | | — |
| | (26 | ) | | 180 |
|
Corporate and other | 244 |
| | — |
| | (10 | ) | | 44 |
| | (4 | ) | | 25 |
| | (4 | ) | | 295 |
|
Equity securities | 49 |
| | — |
| | (1 | ) | | 39 |
| | — |
| | — |
| | (9 | ) | | 78 |
|
Assets of MIE | 30 |
| | 1 |
| | — |
| | 6 |
| | (6 | ) | | — |
| | — |
| | 31 |
|
Liabilities of MIE (*) | (2,501 | ) | | (14 | ) | | — |
| | (406 | ) | | 439 |
| | — |
| | — |
| | (2,482 | ) |
Embedded derivatives | (555 | ) | | 3 |
| | — |
| | (32 | ) | | 7 |
| | — |
| | — |
| | (577 | ) |
| |
(*) | Total realized/unrealized loss included in net income includes losses of $9 million related to liabilities outstanding as of June 30, 2013. See Note H — “Managed Investment Entities.” |
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Total realized/unrealized gains (losses) included in | | | | | | | | | | |
Balance at March 31, 2012 | | Net income | | Other comprehensive income (loss) | | Purchases and issuances | | Sales and settlements | | Transfer into Level 3 | | Transfer out of Level 3 | | Balance at June 30, 2012 |
AFS fixed maturities: | | | | | | | | | | | | | | | |
State and municipal | $ | 72 |
| | $ | — |
| | $ | 1 |
| | $ | 9 |
| | $ | — |
| | $ | 5 |
| | $ | (1 | ) | | $ | 86 |
|
Residential MBS | 314 |
| | 1 |
| | — |
| | 63 |
| | (7 | ) | | 21 |
| | (72 | ) | | 320 |
|
Commercial MBS | 20 |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | 20 |
|
Asset-backed securities | 239 |
| | 4 |
| | — |
| | 10 |
| | (9 | ) | | 3 |
| | (7 | ) | | 240 |
|
Corporate and other | 276 |
| | 1 |
| | 8 |
| | 41 |
| | (13 | ) | | 4 |
| | — |
| | 317 |
|
Trading fixed maturities | 1 |
| | — |
| | — |
| | — |
| | — |
| | — |
| | — |
| | 1 |
|
Equity securities | 24 |
| | — |
| | — |
| | 17 |
| | — |
| | — |
| | — |
| | 41 |
|
Assets of MIE | 64 |
| | — |
| | — |
| | 1 |
| | (9 | ) | | — |
| | (2 | ) | | 54 |
|
Liabilities of MIE (*) | (2,554 | ) | | (19 | ) | | — |
| | — |
| | 144 |
| | — |
| | — |
| | (2,429 | ) |
Embedded derivatives | (437 | ) | | 3 |
| | — |
| | (16 | ) | | 6 |
| | — |
| | — |
| | (444 | ) |
| |
(*) | Total realized/unrealized loss included in net income includes losses of $14 million related to liabilities outstanding as of June 30, 2012. See Note H — “Managed Investment Entities.” |
AMERICAN FINANCIAL GROUP, INC. 10-Q
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Total realized/unrealized gains (losses) included in | | | | | | | | | | |
Balance at December 31, 2012 | | Net income | | Other comprehensive income (loss) | | Purchases and issuances | | Sales and settlements | | Transfer into Level 3 | | Transfer out of Level 3 | | Balance at June 30, 2013 |
AFS fixed maturities: | | | | | | | | | | | | | | | |
U.S. government agency | $ | 20 |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | — |
| | $ | 20 |
|
State and municipal | 58 |
| | — |
| | (1 | ) | | 10 |
| | — |
| | — |
| | (4 | ) | | 63 |
|
Residential MBS | 371 |
| | 4 |
| | (1 | ) | | 6 |
| | (29 | ) | | 25 |
| | (47 | ) | | 329 |
|
Commercial MBS | 22 |
| | (1 | ) | | — |
| | — |
| | — |
| | 7 |
| | — |
| | 28 |
|
Asset-backed securities | 253 |
| | 3 |
| | (2 | ) | | 12 |
| | (45 | ) | | — |
| | (41 | ) | | 180 |
|
Corporate and other | 236 |
| | — |
| | (10 | ) | | 55 |
| | (6 | ) | | 24 |
| | (4 | ) | | 295 |
|
Equity securities | 37 |
| | — |
| | 2 |
| | 48 |
| | — |
| | — |
| | (9 | ) | | 78 |
|
Assets of MIE | 40 |
| | (3 | ) | | — |
| | 6 |
| | (6 | ) | | — |
| | (6 | ) | | 31 |
|
Liabilities of MIE (*) | (2,745 | ) | | (39 | ) | | — |
| | (406 | ) | | 689 |
| | — |
| | 19 |
| | (2,482 | ) |
Embedded derivatives | (465 | ) | | (77 | ) | | — |
| | (49 | ) | | 14 |
| | — |
| | — |
| | (577 | ) |
| |
(*) | Total realized/unrealized loss included in net income includes losses of $24 million related to liabilities outstanding as of June 30, 2013. See Note H — “Managed Investment Entities.” |
|
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Total realized/unrealized gains (losses) included in | | | | | | | | | | |
Balance at December 31, 2011 | | Net income | | Other comprehensive income (loss) | | Purchases and issuances | | Sales and settlements | | Transfer into Level 3 | | Transfer out of Level 3 | | Balance at June 30, 2012 |
AFS fixed maturities: | | | | | | | | | | | | | |