10-K 1 c25109e10vk.htm FORM 10-K e10vk
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 2011
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
Securities Registered Pursuant to Section 12(b) of the Act:
     
Title of Each Class   Name of Each Exchange on Which Registered
Common Stock   New York Stock Exchange and Nasdaq Global Select Market
7-1/8% Senior Debentures due February 3, 2034   New York Stock Exchange
7% Senior Notes due September 30, 2050   New York Stock Exchange
Securities Registered Pursuant to Section 12(g) of the Act: None
Other securities for which reports are submitted pursuant to Section 15(d) of the Act:
9-7/8% Senior Notes due June 15, 2019
Indicate by check mark whether the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o
Indicate by check mark whether the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
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 o
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 o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definitions of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
             
Large Accelerated Filer þ   Accelerated Filer o   Non-Accelerated Filer o   Smaller Reporting Company o
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
State the aggregate market value of the voting and non -voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the Registrant’s most recently completed second fiscal quarter: $2.8 billion.
Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of the latest practicable date: 97,895,717 shares (excluding 14.9 million shares owned by subsidiaries) as of February 1, 2012.
 
Documents Incorporated by Reference:
Proxy Statement for 2012 Annual Meeting of Stockholders (portions of which are incorporated by reference into Part III hereof).
 
 

 

 


 

AMERICAN FINANCIAL GROUP, INC.
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 EX-101 PRESENTATION LINKBASE DOCUMENT
 EX-101 DEFINITION LINKBASE DOCUMENT

 

 


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FORWARD-LOOKING STATEMENTS
The disclosures in this Form 10-K contain certain forward-looking statements that are subject to numerous assumptions, risks or uncertainties. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Some of the forward-looking statements can be identified by the use of words such as “anticipates”, “believes”, “expects”, “projects”, “estimates”, “intends”, “plans”, “seeks”, “could”, “may”, “should”, “will” or the negative version of those words or other comparable terminology. Such forward-looking statements include statements relating to: expectations concerning market and other conditions and their effect on future premiums, revenues, earnings and investment activities; recoverability of asset values; expected losses and the adequacy of reserves for asbestos, environmental pollution and mass tort claims; rate changes; and improved loss experience.
Actual results and/or financial condition could differ materially from those contained in or implied by such forward-looking statements for a variety of reasons including but not limited to the following and those discussed in Item 1A — “Risk Factors.”
  changes in financial, political and economic conditions, including changes in interest and inflation rates, currency fluctuations and extended economic recessions or expansions in the U.S. and abroad;
  performance of securities markets;
  AFG’s ability to estimate accurately the likelihood, magnitude and timing of any losses in connection with investments in the non-agency residential mortgage market;
  new legislation or declines in credit quality or credit ratings that could have a material impact on the valuation of securities in AFG’s investment portfolio;
  the availability of capital;
  regulatory actions (including changes in statutory accounting rules);
  changes in the legal environment affecting AFG or its customers;
  tax law and accounting changes;
  levels of natural catastrophes and severe weather, terrorist activities (including any nuclear, biological, chemical or radiological events), incidents of war or losses resulting from civil unrest and other major losses;
  development of insurance loss reserves and establishment of other reserves, particularly with respect to amounts associated with asbestos and environmental claims;
  availability of reinsurance and ability of reinsurers to pay their obligations;
  the unpredictability of possible future litigation if certain settlements of current litigation do not become effective;
  trends in persistency, mortality and morbidity;
  competitive pressures, including those in the annuity bank distribution channels, the ability to obtain adequate rates and policy terms; and
  changes in AFG’s credit ratings or the financial strength ratings assigned by major ratings agencies to AFG’s operating subsidiaries.
The forward-looking statements herein are made only as of the date of this report. The Company assumes no obligation to publicly update any forward-looking statements.

 

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PART I
ITEM 1
Business
Introduction
American Financial Group, Inc. (“AFG”) is a holding company that, through subsidiaries, is engaged primarily in property and casualty insurance, focusing on specialized commercial products for businesses, and in the sale of traditional fixed and indexed annuities and a variety of supplemental insurance products, such as Medicare supplement. Its address is 301 East Fourth Street, Cincinnati, Ohio 45202; its phone number is (513) 579-2121. SEC filings, news releases, AFG’s Code of Ethics applicable to directors, officers and employees and other information may be accessed free of charge through AFG’s Internet site at: www.AFGinc.com. (Information on AFG’s Internet site is not part of this Form 10-K.)
Property and Casualty Insurance Operations
General
AFG’s specialty property and casualty insurance operations consist of approximately 30 niche insurance businesses offering a wide range of commercial coverages. These businesses report to a single senior executive and operate under a business model that allows local decision-making for underwriting, claims and policy servicing in each of the niche operations. These businesses are managed by experienced professionals in particular lines of business or customer groups and operate autonomously but with certain central controls and accountability. The decentralized approach allows each unit the autonomy necessary to respond to local and specialty market conditions while capitalizing on the efficiencies of centralized investment and administrative support functions. AFG’s property and casualty insurance operations employed approximately 5,200 persons as of December 31, 2011.
The primary objectives of AFG’s property and casualty insurance operations are to achieve solid underwriting profitability and provide excellent service to its policyholders and agents. Underwriting profitability is measured by the combined ratio, which is a sum of the ratios of losses, loss adjustment expenses (“LAE”), underwriting expenses and policyholder dividends to premiums. A combined ratio under 100% indicates an underwriting profit. The combined ratio does not reflect investment income, other income, or federal income taxes.
While many costs included in underwriting are readily determined (commissions, administrative expenses, and many of the losses on claims reported), the process of determining overall underwriting results is highly dependent upon the use of estimates in the case of losses incurred or expected but not yet reported or developed. Actuarial procedures and projections are used to obtain “point estimates” of ultimate losses. While the process is imprecise and develops amounts which are subject to change over time, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate.
AFG’s statutory combined ratio averaged 87.4% for the period 2009 to 2011 as compared to 102.7% for the property and casualty industry over the same period (Source: “A.M. Best’s U.S. Property/Casualty — Review & Preview” — February 2012 Edition). AFG believes that its specialty niche focus, product line diversification and underwriting discipline have contributed to the Company’s ability to consistently outperform the industry’s underwriting results. Management’s philosophy is to refrain from writing business that is not expected to produce an underwriting profit even if it is necessary to limit premium growth to do so.

 

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Financial data is reported in accordance with U.S. generally accepted accounting principles (“GAAP”) for shareholder and other investment purposes and reported on a statutory basis for insurance regulatory purposes. Major differences for statutory accounting include charging policy acquisition costs to expense as incurred rather than spreading the costs over the periods covered by the policies; reporting investment grade bonds and redeemable preferred stocks at amortized cost rather than fair value; netting of reinsurance recoverables and prepaid reinsurance premiums against the corresponding liabilities rather than reporting such items separately; and charging to surplus certain GAAP assets, such as furniture and fixtures and agents’ balances over 90 days old.
Unless indicated otherwise, the financial information presented for the property and casualty insurance operations herein is presented based on GAAP. Statutory information is provided for industry comparisons or where comparable GAAP information is not readily available.
Property and Casualty Results
Performance measures such as underwriting profit or loss and related combined ratios are often used by property and casualty insurers to help users of their financial statements better understand the company’s performance. See Note C — “Segments of Operations” to the financial statements for the reconciliation of AFG’s operating profit by significant business segment to the Statement of Earnings.
The following table shows the performance of AFG’s property and casualty insurance operations (dollars in millions):
                         
    2011     2010     2009  
 
                       
Gross written premiums
  $ 4,106     $ 3,589     $ 3,763  
Ceded reinsurance
    (1,336 )     (1,181 )     (1,452 )
 
                 
Net written premiums
  $ 2,770     $ 2,408     $ 2,311  
 
                 
 
                       
Net earned premiums
  $ 2,759     $ 2,550     $ 2,412  
Loss and LAE
    1,694       1,457       1,187  
Special asbestos and environmental (“A&E”) charge
    50              
Underwriting expenses
    835       797       808  
 
                 
Underwriting gain
  $ 180     $ 296     $ 417  
 
                 
 
                       
GAAP ratios:
                       
Loss and LAE ratio
    63.2 %     57.2 %     49.2 %
Underwriting expense ratio
    30.2       31.3       33.5  
 
                 
Combined ratio
    93.4 %     88.5 %     82.7 %
 
                 
 
                       
Statutory ratios:
                       
Loss and LAE ratio
    60.4 %     53.5 %     46.2 %
Underwriting expense ratio
    32.3       33.8       36.1  
 
                 
Combined ratio
    92.7 %     87.3 %     82.3 %
 
                 
 
                       
Industry statutory combined ratio (a)
                       
All lines
    107.5 %     101.0 %     99.5 %
Commercial lines
    108.2 %     102.7 %     103.0 %
     
(a)   Ratios are derived from “A.M. Best’s U.S. Property/Casualty — Review & Preview” (February 2012 Edition).
As with other property and casualty insurers, AFG’s operating results can be adversely affected by unpredictable catastrophe losses. Certain natural disasters (hurricanes, earthquakes, tornadoes, floods, etc.) and other incidents of major loss (explosions, civil disorder, terrorist events, fires, etc.) are classified as catastrophes by industry associations. Losses from these incidents are usually tracked separately from other business of insurers because of their sizable effects on overall operations. Total net losses to AFG’s insurance operations from catastrophes, primarily hailstorms, hurricanes and tornadoes, were $46 million in 2011, $49 million in 2010 and $18 million in 2009.
AFG generally seeks to reduce its exposure to catastrophes through individual risk selection, including minimizing coastal and known fault-line exposures, and the purchase of reinsurance. AFG’s exposure to a catastrophic earthquake or windstorm that industry models indicate could occur once in every 500 years (a “500-year event”) is expected to be less than 2.5% of AFG’s shareholders’ equity.

 

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Property and Casualty Insurance Products
AFG is focused on growth opportunities in what it believes to be more profitable specialty businesses where AFG personnel are experts in particular lines of business or customer groups. The following are examples of AFG’s specialty businesses:
     
Property and Transportation
   
 
   
Inland and Ocean Marine
  Provides coverage primarily for builders’ risk, contractors’ equipment, property, motor truck cargo, marine cargo, boat dealers, marina operators/dealers and excursion vessels.
 
   
Agricultural-related
  Provides federally reinsured multi-peril crop (allied lines) insurance covering most perils as well as crop-hail, equine mortality and other coverages for full-time operating farms/ranches and agribusiness operations on a nationwide basis.
 
   
Commercial Automobile
  Provides coverage for vehicles (such as buses and trucks) in a broad range of businesses including the moving and storage and transportation industries, and a specialized physical damage product for the trucking industry.
 
   
Specialty Casualty
   
 
   
Executive and Professional Liability
  Markets coverage for directors and officers of businesses and non-profit organizations; errors and omissions; and provides non-U.S. medical malpractice insurance.
 
   
Umbrella and Excess Liability
  Provides higher layer liability coverage in excess of primary layers.
 
   
Excess and Surplus
  Provides liability, umbrella and excess coverage for unique, volatile or hard to place risks, using rates and forms that generally do not have to be approved by state insurance regulators.
 
   
General Liability
  Provides coverage for contractor-related businesses, energy development and production risks, and environmental liability risks.
 
   
Targeted Programs
  Includes coverage (primarily liability and property) for social service agencies, leisure, entertainment and non-profit organizations, customized solutions for other targeted markets and alternative risk programs using agency captives.
 
   
Workers’ Compensation
  Provides coverage for prescribed benefits payable to employees who are injured on the job.
 
   
Specialty Financial
   
 
   
Fidelity and Surety
  Provides fidelity and crime coverage for government, mercantile and financial institutions and surety coverage for various types of contractors and public and private corporations.
 
   
Lease and Loan Services
  Provides coverage for insurance risk management programs for lending and leasing institutions, including equipment leasing and collateral and mortgage protection.

 

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Management believes specialization is the key element to the underwriting success of these business units. These specialty businesses are opportunistic and their premium volume will vary based on prevailing market conditions. AFG continually evaluates expansion in existing markets and opportunities in new specialty markets that meet its profitability objectives. For example, in July 2010, a majority-owned subsidiary of AFG acquired Vanliner Group, Inc. (“Vanliner”), a market leader in providing insurance for the moving and storage industry. Likewise, AFG will withdraw from markets that do not meet its profit objectives or business strategy, such as the withdrawal from certain program business in 2010 and 2011.
Premium Distribution
The following table shows the net written premiums by sub-segment for AFG’s property and casualty insurance operations for 2011 (net written premiums for 2007 are given to show changes over a four-year period)(dollars in millions):
                 
    2011     2007  
Property and transportation
  $ 1,436     $ 1,132  
Specialty casualty
    867       1,022  
Specialty financial
    398       488  
Other
    69       70  
 
           
 
  $ 2,770     $ 2,712  
 
           
The geographic distribution of statutory direct written premiums by AFG’s U.S.-based insurers in 2011 compared to 2007 is shown below. Amounts exclude business written under special arrangements on behalf of, and fully reinsured to, the purchasers of several divisions sold. Approximately 5% of AFG’s direct written premiums in 2011 were derived from non U.S.-based insurers, primarily Marketform, a majority-owned United Kingdom-based Lloyd’s insurer acquired in 2008.
                 
    2011     2007  
California
    12.0 %     14.7 %
Illinois
    8.0       6.1  
Texas
    6.8       8.0  
New York
    4.8       4.4  
Florida
    4.5       7.4  
Kansas
    4.1       3.2  
Iowa
    3.8       *  
Missouri
    3.2       2.1  
Indiana
    2.9       2.5  
South Dakota
    2.7       *  
Pennsylvania     2.6 %     2.4 %
Ohio     2.4       2.3  
Georgia     2.4       2.3  
Nebraska     2.3       2.0  
North Carolina     2.2       2.3  
North Dakota     2.2       *  
New Jersey     2.1       2.1  
Minnesota     2.1       *  
Oklahoma     2.0       2.7  
Other     26.9       35.5  
             
                 
      100.0 %     100.0 %
             
 
     
(*)   less than 2%, included in “Other”
Ratings
The following table shows independent ratings and 2011 net written premiums (in millions) of AFG’s major property and casualty insurance subsidiaries. Such ratings are generally based on concerns for policyholders and agents and are not directed toward the protection of investors. During 2010, AFG’s principal property and casualty insurance companies were upgraded by Standard & Poor’s (“S&P”) to A+. AFG believes that maintaining an S&P rating of at least “A-” is important to compete successfully in certain lines of business.
                 
    Ratings   Net Written  
Company   AM Best   S&P   Premiums  
Great American Pool(*)
  A   A+   $ 1,847  
National Interstate
  A   not rated     442  
Marketform Lloyd’s Syndicate
  A   A+     146  
Republic Indemnity
  A   A+     135  
Mid-Continent
  A   A+     127  
American Empire Surplus Lines
  A+   A+     35  
Other
            38  
 
             
 
          $ 2,770  
 
             
   
(*)   The Great American Pool represents Great American Insurance Company (“GAI”) and 10 subsidiaries.

 

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Reinsurance
Consistent with standard practice of most insurance companies, AFG reinsures a portion of its business with other insurance companies and assumes a relatively small amount of business from other insurers. AFG uses reinsurance for two primary purposes: (i) to provide higher limits of coverage than it would otherwise be willing to provide (i.e. large line capacity) and (ii) to protect its business by reducing the impact of catastrophes. The availability and cost of reinsurance are subject to prevailing market conditions, which may affect the volume and profitability of business that is written. AFG is subject to credit risk with respect to its reinsurers, as the ceding of risk to reinsurers does not relieve AFG of its liability to its insureds until claims are fully settled.
The commercial marketplace requires large policy limits ($25 million or more) in several of AFG’s lines of business, including certain executive and professional liability, umbrella and excess liability, and fidelity and surety coverages. Since these limits exceed management’s desired exposure to an individual risk, AFG generally enters into reinsurance agreements to reduce its net exposure under such policies to an acceptable level. Reinsurance continues to be available for this large line capacity exposure with satisfactory pricing and terms.
AFG has taken steps to limit its exposure to wind and earthquake losses by purchasing catastrophe reinsurance. In addition, AFG purchases catastrophe reinsurance for its workers’ compensation businesses. Although the cost of catastrophe reinsurance varies depending on exposure and the level of worldwide loss activity, AFG has been able to obtain reinsurance coverage in adequate amounts at acceptable rates due to management’s decision to limit overall exposure to catastrophe losses through individual risk selection (including minimizing coastal and known fault-line exposures) and the Company’s limited historical catastrophe losses.
In addition to the large line capacity and catastrophe reinsurance programs discussed above, AFG purchases reinsurance on a product-by-product basis. AFG regularly reviews the financial strength of its current and potential reinsurers. These reviews include consideration of credit ratings, available capital, claims paying history and expertise. This process periodically results in the transfer of risks to more financially secure reinsurers. Substantially all reinsurance is ceded to companies with investment grade or better S&P ratings or is secured by “funds withheld” or other collateral. Under “funds withheld” arrangements, AFG retains ceded premiums to fund ceded losses as they become due from the reinsurer. Recoverables from the following companies were individually between 5% and 11% of AFG’s total reinsurance recoverable (net of payables to reinsurers) at December 31, 2011: Everest Reinsurance Company, Munich Reinsurance America, Inc. and Swiss Reinsurance America Corporation. In addition, AFG has a reinsurance recoverable from Ohio Casualty Insurance Company of $212 million related to that company’s purchase of AFG’s commercial lines business in 1998.
Reinsurance is provided on one of two bases, facultative or treaty. Facultative reinsurance is generally provided on a risk by risk basis. Individual risks are ceded and assumed based on an offer and acceptance of risk by each party to the transaction. AFG purchases facultative reinsurance, both pro rata and excess of loss, depending on the risk and available reinsurance markets. Treaty reinsurance provides for risks meeting prescribed criteria to be automatically ceded and assumed according to contract provisions.
The following table presents (by type of coverage) the amount of each loss above the specified retention maximum generally covered by treaty reinsurance programs (in millions) as of January 1, 2012:
                 
    Retention     Reinsurance  
Coverage   Maximum     Coverage(a)  
California Workers’ Compensation
  $ 3     $ 147  
Other Workers’ Compensation
    2       48  
Commercial Umbrella
    4       46  
Property — General
    3       98  
Property — Catastrophe
    26       154  
     
(a)   Reinsurance covers substantial portions of losses in excess of retention. However, in general, losses resulting from terrorism are not covered.

 

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In addition to the coverage shown above, AFG reinsures a portion of its crop insurance business through the Federal Crop Insurance Corporation (“FCIC”). The FCIC offers both proportional (or “quota share”) and non-proportional coverages. The proportional coverage provides that a fixed percentage of risk is assumed by the FCIC. The non-proportional coverage allows AFG to select desired retention of risk on a state-by-state, county, crop or plan basis. AFG typically reinsures 15% to 25% of gross written premium with the FCIC. AFG also purchases quota share reinsurance in the private market. This quota share provides for a ceding commission to AFG and a profit sharing provision. During 2011, AFG reinsured 52.5% of premiums not reinsured by the FCIC in the private market and purchased stop loss protection coverage for the remaining portion of the business. AFG expects to utilize similar levels of reinsurance in 2012. In 2010 and 2009, AFG reinsured approximately 50% and 90%, respectively, of premiums not reinsured by the FCIC.
Included in the Balance Sheet caption “recoverables from reinsurers” were approximately $72 million on paid losses and LAE and $2.2 billion on unpaid losses and LAE at December 31, 2011. These amounts are net of allowances of approximately $26 million for doubtful collection of reinsurance recoverables. The collectibility of a reinsurance balance is based upon the financial condition of a reinsurer as well as individual claim considerations.
Reinsurance premiums ceded and assumed are presented in the following table (in millions):
                         
    2011     2010     2009  
Reinsurance ceded
  $ 1,336     $ 1,181     $ 1,452  
Reinsurance ceded, excluding crop
    652       727       680  
Reinsurance assumed — including involuntary pools and associations
    45       47       32  
Loss and Loss Adjustment Expense Reserves
The consolidated financial statements include the estimated liability for unpaid losses and LAE of AFG’s insurance subsidiaries. This liability represents estimates of the ultimate net cost of all unpaid losses and LAE and is determined by using case-basis evaluations, actuarial projections and management’s judgment. These estimates are subject to the effects of changes in claim amounts and frequency and are periodically reviewed and adjusted as additional information becomes known. In accordance with industry practices, such adjustments are reflected in current year operations. Generally, reserves for reinsurance assumed and involuntary pools and associations are reflected in AFG’s results at the amounts reported by those entities.

 

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The following table presents the development of AFG’s liability for losses and LAE, net of reinsurance, on a GAAP basis for the last ten years. The top line of the table shows the estimated liability (in millions) for unpaid losses and LAE recorded at the balance sheet date for the indicated years. The second line shows the re-estimated liability as of December 31, 2011. The remainder of the table presents intervening development as percentages of the initially estimated liability. The development results from additional information and experience in subsequent years, particularly with regard to A&E charges, settlements and reallocations as detailed below. The middle line shows a cumulative deficiency (redundancy), which represents the aggregate percentage increase (decrease) in the liability initially estimated. The lower portion of the table indicates the cumulative amounts paid as of successive periods as a percentage of the original loss reserve liability. For purposes of this table, reserves of businesses sold are considered paid at the date of sale. See Note O - “Insurance - Property and Casualty Insurance Reserves” to the financial statements for an analysis of changes in AFG’s estimated liability for losses and LAE, net and gross of reinsurance, over the past three years on a GAAP basis.
                                                                                         
    2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011  
Liability for unpaid losses and loss adjustment expenses:
                                                                                       
As originally estimated
  $ 3,338     $ 3,466     $ 2,901     $ 3,155     $ 3,619     $ 3,791     $ 3,868     $ 4,154     $ 3,899     $ 4,164     $ 4,282  
As re-estimated at December 31, 2011
  $ 4,306     $ 4,289     $ 3,444     $ 3,310     $ 3,332     $ 3,280     $ 3,268     $ 3,756     $ 3,673     $ 4,095       N/A  
 
                                                                                       
Liability re-estimated:
                                                                                       
One year later
    104.5 %     104.4 %     104.9 %     106.3 %     98.4 %     97.4 %     93.6 %     95.2 %     96.0 %     98.3 %        
Two years later
    110.0 %     109.7 %     114.0 %     106.1 %     98.8 %     92.3 %     89.7 %     91.6 %     94.2 %                
Three years later
    113.8 %     118.0 %     114.7 %     107.7 %     95.2 %     89.5 %     85.8 %     90.4 %                        
Four years later
    121.1 %     118.8 %     118.0 %     106.0 %     93.6 %     87.0 %     84.5 %                                
Five years later
    122.8 %     122.1 %     118.5 %     105.5 %     92.1 %     86.5 %                                        
Six years later
    126.5 %     123.0 %     118.8 %     104.4 %     92.1 %                                                
Seven years later
    127.7 %     123.6 %     117.9 %     104.9 %                                                        
Eight years later
    128.6 %     123.1 %     118.7 %                                                                
Nine years later
    128.2 %     123.7 %                                                                        
Ten years later
    129.0 %                                                                                
 
                                                                                       
Cumulative deficiency (redundancy) (a)
    29.0 %     23.7 %     18.7 %     4.9 %     (7.9 %)     (13.5 %)     (15.5 %)     (9.6 %)     (5.8 %)     (1.7 %)     N/A  
 
                                                                 
 
                                                                                       
Cumulative paid as of:
                                                                                       
One year later
    32.7 %     42.2 %     27.3 %     25.4 %     23.5 %     22.3 %     21.0 %     24.0 %     21.3 %     23.3 %        
Two years later
    61.3 %     60.9 %     46.4 %     40.8 %     37.5 %     34.8 %     32.9 %     37.2 %     35.9 %                
Three years later
    74.4 %     72.7 %     58.8 %     52.4 %     46.9 %     43.6 %     41.6 %     47.0 %                        
Four years later
    82.8 %     80.3 %     68.5 %     60.1 %     53.6 %     49.9 %     47.5 %                                
Five years later
    88.4 %     86.2 %     75.2 %     65.6 %     58.7 %     54.2 %                                        
Six years later
    93.4 %     90.7 %     80.1 %     70.5 %     62.1 %                                                
Seven years later
    97.0 %     94.2 %     84.4 %     73.8 %                                                        
Eight years later
    100.1 %     96.9 %     87.4 %                                                                
Nine years later
    102.7 %     99.1 %                                                                        
Ten years later
    104.8 %                                                                                
 
                                                                                       
 
 
(a)   Cumulative deficiency (redundancy):
 
Special A&E charges, settlements and reallocations
    9.4 %     8.2 %     9.8 %     9.1 %     2.9 %     2.8 %     1.6 %     1.2 %     1.3 %     1.2 %        
Other
    19.6 %     15.5 %     8.9 %     (4.2 %)     (10.8 %)     (16.3 %)     (17.1 %)     (10.8 %)     (7.1 %)     (2.9 %)        
 
                                                                 
Total
    29.0 %     23.7 %     18.7 %     4.9 %     (7.9 %)     (13.5 %)     (15.5 %)     (9.6 %)     (5.8 %)     (1.7 %)     N/A  
 
                                                                 
The following is a reconciliation of the net liability to the gross liability for unpaid losses and LAE.
                                                                                         
    2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011  
As originally estimated:
                                                                                       
Net liability shown above
  $ 3,338     $ 3,466     $ 2,901     $ 3,155     $ 3,619     $ 3,791     $ 3,868     $ 4,154     $ 3,899     $ 4,164     $ 4,282  
Add reinsurance recoverables
    1,525       1,804       2,059       2,234       2,243       2,309       2,300       2,610       2,513       2,249       2,238  
 
                                                                 
Gross liability
  $ 4,863     $ 5,270     $ 4,960     $ 5,389     $ 5,862     $ 6,100     $ 6,168     $ 6,764     $ 6,412     $ 6,413     $ 6,520  
 
                                                                 
As re-estimated at December 31, 2011:
                                                                                       
Net liability shown above
  $ 4,306     $ 4,289     $ 3,444     $ 3,310     $ 3,332     $ 3,280     $ 3,268     $ 3,756     $ 3,673     $ 4,095          
Add reinsurance recoverables
    2,516       2,626       2,750       2,544       2,323       2,141       1,933       2,281       1,983       2,007          
 
                                                                   
Gross liability
  $ 6,822     $ 6,915     $ 6,194     $ 5,854     $ 5,655     $ 5,421     $ 5,201     $ 6,037     $ 5,656     $ 6,102       N/A  
 
                                                                 
 
                                                                                       
Gross cumulative Deficiency (redundancy) (a)
    40.3 %     31.2 %     24.9 %     8.6 %     (3.5 %)     (11.1 %)     (15.7 %)     (10.7 %)     (11.8 %)     (4.8 %)     N/A  
 
                                                                 
 
                                                                                       
 
 
(a)   Gross cumulative deficiency (redundancy):
 
Special A&E charges, settlements and reallocations
    7.4 %     6.2 %     6.7 %     6.1 %     2.1 %     2.1 %     1.0 %     0.7 %     0.7 %     0.8 %        
Other
    32.9 %     25.0 %     18.2 %     2.5 %     (5.6 %)     (13.2 %)     (16.7 %)     (11.4 %)     (12.5 %)     (5.6 %)        
 
                                                                   
Total
    40.3 %     31.2 %     24.9 %     8.6 %     (3.5 %)     (11.1 %)     (15.7 %)     (10.7 %)     (11.8 %)     (4.8 %)     N/A  
 
                                                                 

 

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In evaluating the re-estimated liability and cumulative deficiency (redundancy), it should be noted that each percentage includes the effects of changes in amounts for prior periods. For example, AFG’s $50 million special A&E charge related to losses recorded in 2011, but incurred before 2001, is included in the re-estimated liability and cumulative deficiency (redundancy) percentage for each of the previous years shown. Conditions and trends that have affected development of the liability in the past may not necessarily exist in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
A significant portion of the adverse development in the tables is due to A&E exposures for which AFG has been held liable under general liability policies written prior to 1987, even though such coverage was not intended. Other factors affecting adverse development included changes in the legal environment, including more liberal coverage decisions and higher jury awards, higher legal fees, the general state of the economy and medical cost inflation.
The differences between the liability for losses and LAE reported in the annual statements filed with the state insurance departments in accordance with statutory accounting principles (“SAP”) and that reported in the accompanying consolidated financial statements in accordance with GAAP at December 31, 2011 are as follows (in millions):
         
Liability reported on a SAP basis, net of $157 million of retroactive reinsurance
  $ 3,749  
Reinsurance recoverables, net of allowance
    2,238  
Other, including reserves of foreign insurers
    533  
 
     
 
       
Liability reported on a GAAP basis
  $ 6,520  
 
     
Asbestos and Environmental (“A&E”) Reserves AFG’s property and casualty group, like many others in the industry, has A&E claims arising in most cases from general liability policies written more than twenty-five years ago. The establishment of reserves for such A&E claims presents unique and difficult challenges and is subject to uncertainties significantly greater than those presented by other types of claims. For a discussion of these uncertainties, see Item 7 — “Management’s Discussion and Analysis” “Uncertainties Asbestos and Environmentalrelated Insurance Reserves” and Note M “Contingencies” to the financial statements.
Management has conducted comprehensive studies of its asbestos and environmental reserves with the aid of outside actuarial and engineering firms and specialty outside counsel every two years with an in-depth internal review during the intervening years. Charges resulting from these studies and reviews are included in “Incurred losses and LAE” in the table below. The 2011 comprehensive study relied on a ground-up exposure analysis and considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development. As a result of the study, AFG recorded a $50 million special charge (net of reinsurance) in the second quarter of 2011 to increase the property and casualty group’s A&E reserves. During the course of the in-depth internal review in 2010, there were no newly identified emerging trends or issues that management believes significantly impacted the overall adequacy of AFG’s A&E reserves. Likewise, the 2009 comprehensive study resulted in only minor adjustments to A&E reserves. For a discussion of the A&E reserve strengthening, see “Management’s Discussion and Analysis” — “Results of Operations — Asbestos and Environmental Reserve Charges.”
The following table (in millions) is a progression of the property and casualty group’s A&E reserves.
                         
    2011     2010     2009  
 
                       
Reserves at beginning of year
  $ 342     $ 378     $ 399  
Incurred losses and LAE
    50       8       4  
Paid losses and LAE
    (30 )     (44 )     (25 )
 
                 
Reserves at end of year, net of reinsurance recoverable
    362       342       378  
 
                       
Reinsurance recoverable, net of allowance
    92       74       79  
 
                 
 
                       
Gross reserves at end of year
  $ 454     $ 416     $ 457  
 
                 

 

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Marketing
The property and casualty insurance group directs its sales efforts primarily through independent property and casualty insurance agents and brokers, although small portions are written through employee agents. Independent agents and brokers generally receive a commission on the sale of each policy. Some agents and brokers are eligible for a bonus commission based on the overall profitability of policies placed with AFG by the broker or agent in a particular year. The property and casualty insurance group writes insurance through several thousand agents and brokers.
Competition
AFG’s property and casualty insurance businesses compete with other individual insurers, state funds and insurance groups of varying sizes, some of which are mutual insurance companies possessing competitive advantages in that all their profits inure to their policyholders. See Item 1A - “Risk Factors.” They also compete with self-insurance plans, captive programs and risk retention groups. Due to the specialty nature of these coverages, competition is based primarily on service to policyholders and agents, specific characteristics of products offered and reputation for claims handling. Financial strength ratings, price, commissions and profit sharing terms are also important factors. Management believes that sophisticated data analysis for refinement of risk profiles, extensive specialized knowledge and loss prevention service have helped AFG compete successfully.
Annuity and Supplemental Insurance Operations
General
AFG’s annuity and supplemental insurance operations are conducted through Great American Financial Resources, Inc. (“GAFRI”). GAFRI’s primary insurance subsidiaries include Great American Life Insurance Company (“GALIC”), Annuity Investors Life Insurance Company (“AILIC”), United Teacher Associates Insurance Company (“UTA”) and Loyal American Life Insurance Company (“Loyal”). These companies market retirement products, primarily fixed and indexed annuities, and various forms of supplemental insurance such as Medicare supplement. All of these companies sell their products through independent producers. GAFRI and its subsidiaries employed approximately 800 persons at December 31, 2011.
Following is certain information concerning GAFRI’s largest subsidiaries (dollars in millions).
                             
        2011                
        Statutory     Policies     Ratings
Company   Principal Products   Premiums     In Force     AM Best   S&P
 
                           
GALIC
  Fixed and indexed annuities   $ 2,803       392,000     A   A+
AILIC
  Fixed and indexed annuities     301       137,000     A   A+
UTA
  Supplemental insurance     206       194,000     B++   not rated
Loyal
  Supplemental insurance     103       132,000     A-   not rated
AFG believes that the ratings assigned by independent insurance rating agencies are important because agents, potential policyholders and school districts often use a company’s rating as an initial screening device in considering annuity products. AFG believes that (i) a rating in the “A” category by A.M. Best is necessary to successfully market tax-deferred annuities to public education employees and other non-profit groups and (ii) a rating in the “A” category by at least one rating agency is necessary to successfully compete in other annuity markets. During 2010, AFG’s principal annuity subsidiaries were upgraded by S&P to A+ and its principal supplemental insurance subsidiaries were downgraded one notch by A.M. Best to A- and B++. Ratings are an important competitive factor; AFG believes that these entities can successfully compete in these markets with their respective ratings.

 

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Statutory premiums of AFG’s annuity and supplemental insurance companies over the last three years were as follows (in millions):
                         
    Premiums  
    2011     2010     2009  
 
Non-403(b) indexed annuities
  $ 1,549     $ 735     $ 402  
Non-403(b) fixed annuities
    239       430       294  
Bank fixed annuities
    971       737       314  
403(b) fixed and indexed annuities
    257       305       337  
Variable annuities
    70       73       87  
 
                 
Total annuities
    3,086       2,280       1,434  
Supplemental insurance
    384       402       390  
Life insurance
    35       39       44  
 
                 
Total
  $ 3,505     $ 2,721     $ 1,868  
 
                 
Annuities
AFG’s principal retirement products are Flexible Premium Deferred Annuities (“FPDAs”) and Single Premium Deferred Annuities (“SPDAs”). Annuities are long-term retirement saving instruments that benefit from income accruing on a tax-deferred basis. The issuer of the annuity collects premiums, credits interest or earnings on the policy and pays out a benefit upon death, surrender or annuitization. FPDAs are characterized by premium payments that are flexible in both amount and timing as determined by the policyholder and are generally made through payroll deductions. SPDAs are generally issued in exchange for a one-time lump-sum premium payment.
Annuity contracts are generally classified as either fixed rate (including indexed) or variable. With a traditional fixed rate annuity, AFG seeks to maintain a desired spread between the yield on its investment portfolio and the rate it credits. AFG accomplishes this by: (i) offering crediting rates that it has the option to change after any initial guarantee period (subject to minimum interest rate guarantees); (ii) designing annuity products that encourage persistency; and (iii) maintaining an appropriate matching of assets and liabilities.
An indexed annuity provides policyholders with the opportunity to receive a crediting rate tied, in part, to the performance of an existing market index (generally the S&P 500) while protecting against the related downside risk through a guarantee of principal (excluding surrender charges). AFG purchases call options designed to substantially offset the effect of the index participation in the liabilities associated with indexed annuities.
As an ancillary product to its traditional fixed rate and indexed annuities, AFG offers variable annuities. With a variable annuity, the earnings credited to the policy vary based on the investment results of the underlying investment options chosen by the policyholder, generally without any guarantee of principal except in the case of death of the insured. Premiums directed to the underlying investment options maintained in separate accounts are invested in funds managed by various independent investment managers. AFG earns a fee on amounts deposited into separate accounts. Subject to contractual provisions, policyholders may also choose to direct all or a portion of their premiums to various fixed rate options, in which case AFG earns a spread on amounts deposited.
Supplemental and Life Insurance Products
AFG offers a variety of supplemental insurance products primarily to individuals age 55 and older. Principal products include coverage for Medicare supplement, cancer and accidental injury. These products are sold primarily through independent agents, including a former captive career agency force that was sold by AFG in the fourth quarter of 2010. At December 31, 2011, AFG’s reserves related to Medicare supplement, cancer, accidental injury and similar products were $191 million, net of reinsurance recoverables.
AFG ceased new sales of long-term care insurance beginning in January 2010. Renewal premiums on approximately 60,000 policies will be accepted unless those policies lapse. At December 31, 2011, AFG’s long-term care insurance reserves were $490 million, net of reinsurance recoverables.

 

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Although AFG no longer actively markets new life insurance products, it continues to service and receive renewal premiums on its in-force block of approximately 211,000 policies and $21 billion gross ($5 billion net) of life insurance in force at December 31, 2011. At December 31, 2011, AFG’s life insurance reserves were $492 million, net of reinsurance recoverables.
Marketing
The majority of AFG’s FPDAs are sold in qualified markets under sections 403(b) and 457 of the Internal Revenue Code. In the 403(b) and 457 markets, schools, government agencies and certain other non-profit organizations may allow employees to save for retirement through contributions made on a before-tax basis. Federal income taxes are not payable on pretax contributions or earnings until amounts are withdrawn.
AFG sells its single premium non-403(b) fixed rate annuities, excluding bank production (discussed below), primarily through a network of approximately 100 national marketing organizations (“NMOs”) and managing general agents (“MGAs”) who, in turn, direct over 1,500 actively producing agents.
In 2011, AFG began selling its 403(b) fixed rate annuities directly through writing agents rather than through NMOs and MGAs as it had historically done. AFG believes that, by eliminating the costs associated with NMOs and MGAs in this market segment, it will be able to increase sales by offering higher crediting rates to policyholders and higher commissions to writing agents while still reducing its overall costs.
AFG also sells non-403(b) fixed rate annuities in banks through independent agents and brokers, as well as through direct relationships with certain financial institutions.
Premiums generated through AFG’s direct relationship with PNC Bank and through Regions Bank and BB&T by independent brokers were the largest individual sources of annuity premiums in 2011 and accounted for approximately 11%, 11% and 7%, respectively, of AFG’s overall annuity premiums in 2011.
AFG is licensed to sell its fixed annuity products in all states except New York; it is licensed to sell its variable products in all states except New York and Vermont. In 2011, the only states that accounted for 5% or more of AFG’s annuity premiums were Florida (11%), California (9%), Michigan (6%), Pennsylvania (5%) and Ohio (5%). At December 31, 2011, AFG had approximately 448,000 annuity policies in force.
Competition
AFG’s annuity and supplemental insurance businesses operate in highly competitive markets. They compete with other insurers and financial institutions based on many factors, including: (i) ratings; (ii) financial strength; (iii) reputation; (iv) service to policyholders and agents; (v) product design (including interest rates credited, index participation and premium rates charged); (vi) commissions; and (vii) number of school districts in which a company has approval to sell. Since most policies are marketed and distributed through independent agents, the insurance companies must also compete for agents.
No single insurer dominates the markets in which AFG’s annuity and supplemental insurance businesses compete. See Item 1A — “Risk Factors.” Competitors include (i) individual insurers and insurance groups, (ii) mutual funds and (iii) other financial institutions. In a broader sense, AFG’s annuity and supplemental insurance businesses compete for retirement savings with a variety of financial institutions offering a full range of financial services. In the bank annuity market, AFG’s annuities compete directly against competitors’ bank annuities, certificates of deposit and other investment alternatives at the point of sale.
Sales of annuities, including renewal premiums, are affected by many factors, including: (i) competitive annuity products and rates; (ii) the general level and volatility of interest rates, including the slope of the yield curve; (iii) the favorable tax treatment of annuities; (iv) commissions paid to agents; (v) services offered; (vi) ratings from independent insurance rating agencies; (vii) other alternative investments; (viii) performance and volatility of the equity markets; (ix) media coverage of annuities; (x) regulatory developments regarding suitability and the sales process; and (xi) general economic conditions.

 

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Other Operations
Through subsidiaries, AFG is engaged in a variety of other operations, including commercial real estate operations in Cincinnati (office buildings and The Cincinnatian Hotel), New Orleans (Le Pavillon Hotel), Whitefield, New Hampshire (Mountain View Grand Resort), Chesapeake Bay (Skipjack Cove Yachting Resort and Bay Bridge Marina), Charleston (Charleston Harbor Resort and Marina), Palm Beach (Sailfish Marina and Resort), Florida City, Florida (retail commercial development) and apartments in Louisville and Pittsburgh. These operations employed approximately 500 full-time employees at December 31, 2011.
Investment Portfolio
General
A summary of AFG’s fixed maturities and equity securities is shown in Note E to the financial statements. For additional information on AFG’s investments, see Item 7 — Management’s Discussion and Analysis — Investments.” Portfolio yields are shown below.
                         
    2011     2010     2009  
 
                       
Yield on Fixed Maturities (a):
                       
Excluding realized gains and losses
    5.7 %     6.2 %     6.9 %
Including realized gains and losses
    5.8 %     6.6 %     6.8 %
 
                       
Yield on Equity Securities (a):
                       
Excluding realized gains and losses
    4.8 %     5.0 %     5.0 %
Including realized gains and losses
    18.5 %     15.8 %     20.7 %
     
(a)   Based on amortized cost; excludes effects of changes in unrealized gains and losses. Realized losses include impairment charges.
The table below compares total returns, which include changes in fair value, on AFG’s fixed maturities and equity securities to comparable public indices. While there are no directly comparable indices to AFG’s portfolio, the two shown below are widely used benchmarks in the financial services industry. Both AFG’s performance and the indices include changes in unrealized gains and losses.
                         
    2011     2010     2009  
 
                       
Total return on AFG’s fixed maturities
    7.7 %     10.9 %     21.1 %
Barclays Capital U.S. Universal Bond Index
    7.4 %     7.2 %     8.6 %
 
                       
Total return on AFG’s equity securities
    6.9 %     17.4 %     48.0 %
Standard & Poor’s 500 Index
    2.1 %     15.1 %     26.5 %
Fixed Maturity Investments
AFG’s bond portfolio is invested primarily in taxable bonds. The following table shows AFG’s available for sale fixed maturities by Standard & Poor’s Corporation or comparable rating as of December 31, 2011 (dollars in millions).
                         
    Amortized     Fair Value  
S&P or comparable rating   Cost     Amount     %  
 
                       
AAA, AA, A
  $ 13,847     $ 14,820       68 %
BBB
    4,422       4,745       22  
 
                 
Total investment grade
    18,269       19,565       90  
 
                 
BB
    667       638       3  
B
    584       547       3  
CCC, CC, C
    720       723       3  
D
    322       334       2  
 
                 
Total non-investment grade
    2,293       2,242       11  
 
                 
Total
  $ 20,562     $ 21,807       100 %
 
                 

 

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At December 31, 2011, approximately 77% of AFG’s mortgage-backed securities (“MBS”), having a fair value of $6.8 billion, were rated investment grade (BBB or better) by major rating firms. The National Association of Insurance Commissioners (“NAIC”) has retained third-party investment management firms to assist in the determination of appropriate NAIC designations for MBS based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At December 31, 2011, 97% (based on statutory carrying value of $6.5 billion) of AFG’s MBS portfolio held by its insurance companies had an NAIC designation of 1 or 2 (the highest of the six designations).
Equity Investments
At December 31, 2011, AFG held common and perpetual preferred stocks with a fair value of $928 million, the largest of which was a $130 million common stock investment in Verisk Analytics, Inc. (“Verisk”), a provider of risk information for insurance companies. AFG recorded after-tax gains of $49 million in 2011, $17 million in 2010 and $49 million in 2009 on sales of a portion of its investment in Verisk.
Regulation
AFG’s insurance company subsidiaries are subject to regulation in the jurisdictions where they do business. In general, the insurance laws of the various states establish regulatory agencies with broad administrative powers governing, among other things, premium rates, solvency standards, licensing of insurers, agents and brokers, trade practices, forms of policies, maintenance of specified reserves and capital for the protection of policyholders, deposits of securities for the benefit of policyholders, investment activities and relationships between insurance subsidiaries and their parents and affiliates. Material transactions between insurance subsidiaries and their parents and affiliates generally must receive prior approval of the applicable insurance regulatory authorities and be disclosed. In addition, while differing from state to state, these regulations typically restrict the maximum amount of dividends that may be paid by an insurer to its shareholders in any twelve-month period without advance regulatory approval. Such limitations are generally based on net earnings or statutory surplus. Under applicable restrictions, the maximum amount of dividends available to AFG in 2012 from its insurance subsidiaries without seeking regulatory clearance is approximately $546 million.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), among other things, established a Federal Insurance Office (“FIO”) within the U.S. Treasury. Under this law, regulations will need to be created for the FIO to carry out its mandate to focus on systemic risk oversight. The FIO is required to gather information regarding the insurance industry and submit to Congress a plan to modernize and improve insurance regulation in the U.S. At this time, it is difficult to predict the extent to which the Dodd-Frank Act, or any resulting regulations, will impact AFG’s operations.
Marketform, AFG’s UK-based Lloyd’s insurer, is subject to regulation by the European Union’s executive body, the European Commission. In 2014, Marketform will be required to adopt new capital adequacy and risk management regulations known as Solvency II. Implementation is not expected to be material to AFG.
Most states have created insurance guaranty associations to provide for the payment of claims of insurance companies that become insolvent. Annual guaranty assessments for AFG’s insurance companies have not been material.

 

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ITEM 1A
Risk Factors
In addition to the other information set forth in this report, the following factors could materially affect AFG’s business, financial condition, cash flows or future results. Any one of these factors could cause AFG’s actual results to vary materially from recent results or from anticipated future results. The risks described below are not the only risks facing AFG. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect AFG’s business, financial condition and/or operating results.
Adverse developments in the financial markets and deterioration in global economic conditions could have a material adverse effect on AFG’s results of operations and financial condition.
The highly volatile debt and equity markets, lack of liquidity, widening credit spreads and the collapse of several financial institutions during 2008 and early 2009 resulted in significant realized and unrealized losses in AFG’s investment portfolio. Although domestic economic conditions and financial markets have improved, financial markets continue to be volatile and there is continued uncertainty with regards to the global economy, particularly in Europe. See Item 7A — “Quantitative and Qualitative Disclosures about Market Risk” — “European Debt Exposure.” At December 31, 2011, AFG’s net unrealized gain on fixed maturity investments was $1.2 billion consisting of gross gains of $1.5 billion and gross losses of $249 million. Although AFG intends to hold its investments with unrealized losses until they recover in value, its intent may change for a variety of reasons as discussed in Item 7 — “Management’s Discussion and Analysis” — “Investments.” A change in AFG’s ability or intent with regard to a security in an unrealized loss position would result in the recognition of a realized loss.
AFG’s investment performance could also be adversely impacted by the types of investments, industry groups and/or individual securities in which it invests. As of December 31, 2011, 87% of AFG’s investment portfolio was invested in fixed maturity securities. Certain risks are inherent in connection with fixed maturity securities including loss upon default and price volatility in reaction to changes in interest rates and general market factors. AFG’s equity securities, which represent 4% of its investment portfolio, are subject to market price volatility.
MBS represented about one-third of AFG’s fixed maturity securities at December 31, 2011. AFG’s MBS portfolio will continue to be impacted by general economic conditions, including unemployment levels, real estate values and other factors that could negatively affect the creditworthiness of borrowers. MBS in which the underlying collateral is subprime mortgages represented 3% of AFG’s total fixed maturity portfolio at December 31, 2011; MBS in which the underlying collateral is Alt-A mortgages (risk profile between prime and subprime) represented approximately 3%. See Item 7A — “Quantitative and Qualitative Disclosures About Market Risk” “Fixed Maturity Portfolio.”
AFG cannot predict whether and the extent to which industry sectors in which it maintains investments may suffer losses as a result of potential declines in commercial and economic activity, or how any such decline might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected.
Investment returns are an important part of AFG’s overall profitability. Accordingly, adverse fluctuations in the fixed income or equity markets could adversely impact AFG’s profitability, financial condition or cash flows.
In addition, should economic conditions deteriorate or remain weak, it could have a material adverse effect on AFG’s insureds and reinsurers. However, the impact that this would have on AFG’s business cannot be predicted.

 

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Intense competition could adversely affect AFG’s profitability.
The property and casualty group operates in a highly competitive industry that is affected by many factors that can cause significant fluctuations in its results of operations. The industry has historically been subject to pricing cycles characterized by periods of intense competition and lower premium rates (a “downcycle”) followed by periods of reduced competition, reduced underwriting capacity due to lower policyholders’ surplus and higher premium rates (an “upcycle”). The trend of AFG’s underwriting results typically follows that of the industry and a prolonged downcycle could adversely affect AFG’s results of operations.
AFG’s specialty insurance businesses compete with other individual insurers, state funds and insurance groups of varying sizes, some of which are mutual insurance companies possessing competitive advantages in that all their profits inure to their policyholders. In addition, certain foreign insurers can write business in the U.S. on a tax-advantaged basis and therefore hold a competitive advantage over AFG. AFG also competes with self-insurance plans, captive programs and risk retention groups. Peer companies and major competitors in some or all of AFG’s specialty lines include the following companies and/or their subsidiaries: ACE Ltd., American International Group Inc. (Chartis and Lexington Insurance), Arch Capital Group Ltd., Chubb Corp., Cincinnati Financial Corp., CNA Financial Corp., Liberty Mutual, Markel Corp., Munich Re Group (Midland), Hartford Financial Services Group, HCC Insurance Holdings, Inc., Ironshore Insurance Ltd., RLI Corp., The Travelers Companies Inc., Tokio Marine Holdings, Inc. (Philadelphia Consolidated), W.R. Berkley Corp., Wells Fargo Corp. (Rural Community Insurance), XL Group Plc, Fairfax Financial Holdings Limited (Zenith National) and Zurich Financial Services Group.
AFG’s annuity and supplemental insurance businesses compete with individual insurers and insurance groups, mutual funds and other financial institutions. Competitors include the following companies and/or their subsidiaries: ING Life Insurance and Annuity Company, Metropolitan Life Insurance Company, American International Group Inc., Western National Life Insurance Company, Life Insurance Company of the Southwest, Midland National Life Insurance Company, Allianz Life Insurance Company of North America, Aviva Life and Annuity Company, Mutual of Omaha Insurance Company and Bankers Life and Casualty Company. Bank annuity premiums represented approximately one-third of AFG’s annuity premiums in 2011 and have been a key driver in the growth of AFG’s annuity business over the last three years. Approximately 89% of AFG’s bank annuity premiums in 2011 were generated through three large banks. Although AFG has been able to add several new banks in 2010 and 2011, the failure to replace these banks if they significantly reduce sales of AFG annuitites could adversely impact AFG’s future profitability. In the bank annuity market, AFG competes directly against competitors’ bank annuities, certificates of deposit and other investment alternatives at the point of sale.
Competition is based on many factors, including service to policyholders and agents, product design, reputation for claims handling, ratings and financial strength. Price, commissions, fees, profit sharing terms, interest crediting rates, technology and distribution channels are also important factors. Some of AFG’s competitors have more capital and greater resources than AFG, and may offer a broader range of products and lower prices than AFG offers. If competition limits AFG’s ability to write new or renewal business at adequate rates, its results of operations will be adversely affected.
AFG’s revenues could be negatively affected if it is not able to attract and retain independent agents.
AFG’s reliance on the independent agency market makes it vulnerable to a reduction in the amount of business written by agents. Many of AFG’s competitors also rely significantly on the independent agency market. Accordingly, AFG must compete with other insurance carriers for independent agents’ business. Some of its competitors offer a wider variety of products, lower price for insurance coverage or higher commissions. Loss of a substantial portion of the business that AFG writes through independent agents could adversely affect AFG’s revenues and profitability.

 

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The inability to obtain reinsurance or to collect on ceded reinsurance could adversely impact AFG’s results.
AFG relies on the use of reinsurance to limit the amount of risk it retains. The following amounts of gross property and casualty premiums have been ceded to other insurers: 2011 — $1.3 billion (33%); 2010 — $1.2 billion (33%) and 2009 — $1.5 billion (39%). The availability and cost of reinsurance are subject to prevailing market conditions, which are beyond AFG’s control and which may affect AFG’s level of business and profitablility. AFG also reinsures the death benefits above certain retained amounts on its run-off life insurance business. AFG is also subject to credit risk with respect to its reinsurers, as AFG will remain liable to its insureds if any reinsurer is unable to meet its obligations under agreements covering the reinsurance ceded.
AFG is subject to comprehensive regulation, and its ability to earn profits may be restricted by these regulations.
As previously discussed under Item 1 — “Business” — “Regulation,” AFG is subject to comprehensive regulation by government agencies in the states and countries where its insurance company subsidiaries are domiciled and where these subsidiaries issue policies and handle claims. AFG must obtain prior approval for certain corporate actions. The regulations may limit AFG’s ability to obtain rate increases or take other actions designed to increase AFG’s profitability. Such regulation is primarily intended for the protection of policyholders rather than securityholders.
In July 2010, the Dodd-Frank Act was signed into law. Among other things, this law established the Federal Insurance Office within the U.S. Treasury and authorizes it to gather information regarding the insurance industry and submit to Congress a plan to modernize and improve insurance regulation in the U.S.
Existing insurance-related laws and regulations may become more restrictive in the future or new restrictive laws may be enacted; it is not possible to predict the potential effects of these laws and regulations. The costs of compliance or the failure to comply with existing or future regulations could harm AFG’s financial results and its reputation with customers.
The failure of AFG’s insurance subsidiaries to maintain a commercially acceptable financial strength rating would have a significant negative effect on their ability to compete successfully.
As discussed under Item 1 — “Business” — “Property and Casualty Insurance Operations” and Item 1 - “Business” — “Annuity and Supplemental Insurance Operations — General,” financial strength ratings are an important factor in establishing the competitive position of insurance companies and may be expected to have an effect on an insurance company’s sales. A downgrade out of the “A” category in AFG’s insurers’ claims-paying and financial strength ratings could significantly reduce AFG’s business volumes in certain lines of business, adversely impact AFG’s ability to access the capital markets and increase AFG’s borrowing costs.
The continued threat of terrorism and ongoing military and other actions, as well as civil unrest, may adversely affect AFG’s financial results.
The continued threat of terrorism, both within the United States and abroad, and the ongoing military and other actions and heightened security measures in response to these types of threats, as well as civil unrest, may cause significant volatility and declines in the equity markets in the United States, Europe and elsewhere, loss of life, property damage, additional disruptions to commerce and reduced economic activity. Actual terrorist attacks could cause losses from insurance claims related to AFG’s property and casualty and life insurance operations with adverse financial consequences. In addition, some of the assets in AFG’s investment portfolios may be adversely affected by declines in the capital markets and economic activity caused by the continued threat of terrorism, ongoing military and other action, heightened security measures and civil unrest.

 

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AFG may experience difficulties with technology or data security, which could have an adverse effect on its business or reputation.
AFG uses computer systems to store, retrieve, evaluate and utilize company and customer data and information. Systems failures or outages could compromise AFG’s ability to perform business functions in a timely manner, which could harm its ability to conduct business and hurt its relationships with business partners and customers. In the event of a disaster such as a natural catastrophe, an industrial accident, a blackout, a computer virus, a terrorist attack or war, AFG’s systems may be inaccessible to employees, customers or business partners for an extended period of time. Even if AFG’s employees are able to report to work, they may be unable to perform their duties for an extended period of time if the Company’s data or systems are disabled or destroyed.
Despite the implementation of security measures, these systems may also be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. Any compromise of security could have a material adverse effect on AFG’s business or reputation and could subject AFG to liability if confidential customer information is misappropriated from its computer systems.
AFG’s property and casualty reserves may be inadequate, which could significantly affect AFG’s financial results.
AFG’s property and casualty insurance subsidiaries record reserve liabilities for the estimated payment of losses and loss adjustment expenses for both reported and unreported claims. Due to the inherent uncertainty of estimating reserves, it has been necessary in the past, and will continue to be necessary in the future, to revise estimated liabilities as reflected in AFG’s reserves for claims and related expenses. The historic development of reserves for losses and loss adjustment expense may not necessarily reflect future trends in the development of these amounts. Accordingly, it is not appropriate to extrapolate future redundancies or deficiencies based on historical information. To the extent that reserves are inadequate and are strengthened, the amount of such increase is treated as a charge to earnings in the period in which the deficiency is recognized.
AFG’s results could be negatively impacted by severe weather conditions or other catastrophes.
AFG recorded catastrophe losses of $46 million in 2011 (primarily from tornadoes), $49 million in 2010 (primarily from hailstorms) and $18 million in 2009 (primarily from tornadoes). Catastrophes (some of which are seasonal) can be caused by natural events such as hurricanes, windstorms, tornadoes, floods, hailstorms, severe winter weather, earthquakes, explosions and fire, and by man-made events, such as terrorist attacks and riots. While not considered a catastrophe by industry standards, droughts could also have a significant adverse impact on AFG’s crop insurance results. The extent of losses from a catastrophe is a function of the amount of insured exposure in the area affected by the event and the severity of the event. In addition, certain catastrophes could result in both property and non-property claims from the same event. A severe catastrophe or a series of catastrophes could result in losses exceeding AFG’s reinsurance protection and may have a material adverse impact on its results of operations or financial condition.
Climate change and related regulation could adversely affect AFG’s property and casualty insurance operations.
While AFG does not believe that its operations are likely to be impacted by existing laws and regulations regarding climate change, it is possible that future regulation in this area could result in additional compliance costs and demands on management time.
To the extent that global climate change meaningfully alters weather and tidal patterns, or sea levels, it is possible that the AFG’s property and casualty insurance operations could experience an increase in claims, primarily in coastal areas and in AFG’s crop and agricultural businesses.

 

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Volatility in crop prices could negatively impact AFG’s financial results.
Weather conditions and the level of crop prices in the commodities market heavily impact AFG’s crop insurance business. These factors are inherently unpredictable and could result in significant volatility in the results of the crop insurance business from one year to the next. AFG’s crop results could also be negatively impacted by pests and disease.
Exposure to asbestos or environmental claims could materially adversely affect AFG’s results of operations and financial condition.
AFG has asbestos and environmental (“A&E”) exposures arising from its insurance operations and former railroad and manufacturing operations. A&E liabilities are especially difficult to estimate for many reasons, including the long delays between exposure and manifestation of any bodily injury or property damage, difficulty in identifying the source of the asbestos or environmental contamination, long reporting delays and difficulty in properly allocating liability for the asbestos or environmental damage. Claimants continue to assert new theories of recovery, and from time to time, there is proposed state and federal legislation regarding A&E liability, which would also affect AFG’s exposure. If AFG has not established adequate reserves to cover future claims, AFG’s results of operations and financial condition could be materially adversely affected.
Changes in interest rates could adversely impact the spread AFG earns on its annuity products.
The profitability of AFG’s annuity business is largely dependent on spread (the difference between what it earns on its investments and the crediting rate it pays on its annuity contracts). Most of AFG’s annuity products have guaranteed minimum crediting rates (ranging from 4% down to currently 1% on new business). During periods of falling interest rates, AFG may not be able to fully offset the decline in investment earnings with lower crediting rates. During periods of rising rates, there may be competitive pressure to increase crediting rates to avoid a decline in sales or increased surrenders, thus resulting in lower spreads. In addition, an increase in surrenders could require the sale of investments at a time when the prices of those assets are lower due to the increase in market rates, which may result in realized investment losses.
Variations from the actuarial assumptions used to establish certain assets and liabilities in AFG’s annuity and supplemental insurance business could negatively impact AFG’s reported financial results.
The earnings on certain products sold by AFG’s annuity and supplemental insurance business depend significantly upon the extent to which actual experience is consistent with the assumptions used in setting reserves and establishing and amortizing deferred policy acquisition costs (“DPAC”). These assumptions relate to investment yields (and spreads over fixed annuity crediting rates), mortality, surrenders, annuitizations, morbidity (frequency and severity of sickness), policy persistency (percentage of policies remaining in force), and, on some policies, the ability to obtain price increases. Developing such assumptions is complex and involves information obtained from company-specific and industry-wide data, as well as general economic information. These assumptions, and therefore AFG’s results of operations, could be negatively impacted by changes in any of the factors listed above. Although charges related to changes in these assumptions were immaterial in 2011, AFG recorded a $25 million pretax charge in 2010 due primarily to the impact of changes in assumptions related to future investment yields and annuitization and death benefits partially offset by the impact of lower expected expenses and crediting rates in the fixed annuity business.

 

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AFG’s ability to get price increases and appropriate investment yields on its closed block of long-term care policies may adversely affect AFG’s profitability.
AFG ceased writing new long-term care insurance policies in January 2010. Previous policies written are guaranteed renewable, but can be re-priced to reflect adverse experience, subject to regulatory approval. Inability to get needed regulatory approval may adversely impact AFG’s results of operations.
In addition, given the duration of the long-term care product, AFG may be unable to purchase appropriate assets with cash flows and durations necessary to match those of future claims in that business.
As a holding company, AFG is dependent on the operations of its insurance company subsidiaries to meet its obligations and pay future dividends.
AFG is a holding company and a legal entity separate and distinct from its insurance company subsidiaries. As a holding company without significant operations of its own, AFG’s principal sources of funds are dividends and other distributions from its insurance company subsidiaries. As discussed under “Regulation,” state insurance laws limit the ability of insurance companies to pay dividends or other distributions and require insurance companies to maintain specified levels of statutory capital and surplus. AFG’s rights to participate in any distribution of assets of its insurance company subsidiaries are subject to prior claims of policyholders and creditors (except to the extent that its rights, if any, as a creditor are recognized). Consequently, AFG’s ability to pay debts, expenses and cash dividends to its shareholders may be limited.
Adverse developments in the financial markets may limit AFG’s access to capital.
Financial markets in the U.S. and elsewhere experienced extreme volatility during the latter part of 2008 and early 2009. These circumstances exerted downward pressure on stock prices and limited access to the equity and debt markets for certain issuers, including AFG.
The three-year revolving credit facility under which AFG can borrow up to $500 million expires in August 2013. There is no assurance that this facility will be renewed. In addition, AFG’s access to funds through this facility is dependent on the ability of its banks to meet their funding commitments. There were no borrowings outstanding under this agreement during 2011.
If AFG cannot obtain adequate capital or sources of credit on favorable terms, or at all, its business, operating results and financial condition would be adversely affected.
AFG may be adversely impacted by a downgrade in the ratings of its debt securities.
AFG’s debt securities are rated by Standard & Poor’s and Moody’s independent corporate credit rating agencies. AFG’s senior indebtedness is currently rated BBB+ by Standard & Poor’s and Baa2 by Moody’s. Securities ratings are subject to revision or withdrawal at any time by the assigning rating organization. A security rating is not a recommendation to buy, sell or hold securities. An unfavorable change in either of these ratings could make it more expensive to access the capital markets and may increase the interest rate charged under AFG’s current multi-bank credit line.
AFG is a party to litigation which, if decided adversely, could impact its financial results.
AFG and its subsidiaries are named as defendants in a number of lawsuits. See Item 1 — “Business” — “Property and Casualty Insurance Operations — Asbestos and Environmental (“A&E”) Reserves,” Item 3 — “Legal Proceedings,” and Item 7 “Management’s Discussion and Analysis” — “Uncertainties.” Litigation, by its very nature, is unpredictable and the outcome of these cases is uncertain and could result in liabilities that may vary from amounts AFG has currently recorded and a material variance could have a material effect on AFG’s business, operations, profitability or financial condition.

 

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Certain shareholders exercise substantial control over AFG’s affairs, which may impede a change of control transaction.
Carl H. Lindner III and S. Craig Lindner are each Co-Chief Executive Officers and Directors of AFG. Carl H. Lindner III and S. Craig Lindner beneficially own 8.7% and 6.6%, respectively, of AFG’s outstanding Common Stock as of February 1, 2012. As a result, certain members of the Lindner family have the ability to exercise significant influence over AFG’s management, including over matters requiring shareholder approval.
The price of AFG Common Stock may fluctuate significantly, which may make it difficult for holders to resell common stock when they want or at a price they find attractive.
The price of AFG’s Common Stock, listed on the NYSE and Nasdaq Global Select Market, constantly changes. During 2011, AFG’s Common Stock traded at prices ranging between $29.45 and $37.50. AFG’s Common Stock price can fluctuate as a result of a variety of factors, many of which are beyond its control. These factors include but are not limited to:
  actual or anticipated variations in quarterly operating results;
  actual or anticipated changes in the dividends paid on AFG Common Stock;
  rating agency actions;
  recommendations by securities analysts;
  significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving AFG or its competitors;
  operating and stock price performance of other companies that investors deem comparable to AFG;
  news reports relating to trends, concerns and other issues in AFG’s lines of business;
  general economic conditions, including volatility in the financial markets; and
  geopolitical conditions such as acts or threats of terrorism or military conflicts.
ITEM 2
Properties
Subsidiaries of AFG own several buildings in downtown Cincinnati. AFG and its affiliates occupy about half of the aggregate 680,000 square feet of commercial and office space in these buildings.
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 2011, AFG consolidated operations from several leased and owned locations in downtown Cincinnati into a new office tower in that city subject to a 15-year lease. National Interstate occupies approximately 90% of the 177,000 square feet of office space on 17.5 acres of land that it owns in Richfield, Ohio. See Item 1 — “Business” — “Other Operations” for a discussion of AFG’s other commercial real estate operations.
ITEM 3
Legal Proceedings
AFG and its subsidiaries are involved in various litigation, most of which arose in the ordinary course of business, including litigation alleging bad faith in dealing with policyholders and challenging certain business practices of insurance subsidiaries. Except for the following, management believes that none of the litigation meets the threshold for disclosure under this Item.
AFG’s insurance company subsidiaries and its 100%-owned subsidiary, American Premier Underwriters (including its subsidiaries, “American Premier”), are parties to litigation and receive claims alleging injuries and damages from asbestos, environmental and other substances and workplace hazards and have established loss accruals for such potential liabilities; other than the A.P. Green Industries proceedings discussed below, none of such litigation or claims is individually material to AFG. The ultimate loss for these claims may vary materially from amounts currently recorded as the conditions surrounding resolution of these claims continue to change.

 

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American Premier is a party or named as a potentially responsible party in a number of proceedings and claims by regulatory agencies and private parties under various environmental protection laws, including the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), seeking to impose responsibility on American Premier for hazardous waste or discharge remediation costs at certain railroad sites formerly owned by its predecessor, Penn Central Transportation Company (“PCTC”), and at certain other sites where hazardous waste or discharge allegedly generated by PCTC’s railroad operations and American Premier’s former manufacturing operations is present. It is difficult to estimate American Premier’s liability for remediation costs at these sites for a number of reasons, including the number and financial resources of other potentially responsible parties involved at a given site, the varying availability of evidence by which to allocate responsibility among such parties, the wide range of costs for possible remediation alternatives, changing technology and the period of time over which these matters develop. Nevertheless, American Premier believes that its accruals for potential environmental liabilities are adequate to cover the probable amount of such liabilities, based on American Premier’s estimates of remediation costs and related expenses and its estimates of the portions of such costs that will be borne by other parties. Such estimates are based on information currently available to American Premier and are subject to future change as additional information becomes available.
As previously reported, Great American Insurance Company and certain other insurers were parties to declaratory judgment coverage litigation brought in 2001 in the United States District Court for the Southern District of Ohio (arising from claims alleging asbestos exposure resulted in bodily injury) under insurance policies issued during the 1970’s and 1980’s to Bigelow-Liptak Corporation and related companies, subsequently known as A.P. Green Industries, Inc. (“A.P. Green”).
A.P. Green sought to recover defense and indemnity expenses related to those claims from a number of insurers, including Great American.
In February 2002, A.P. Green filed petitions for bankruptcy under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Western District of Pennsylvania (In Re Global Industrial Technologies, Inc., et al, filed February 14, 2002) and subsequently (in 2002) commenced adversary proceedings in that Court against Great American Insurance Company and other companies to obtain an adjudication of the insured’s rights under the above-referenced insurance policies.
In 2003, Great American Insurance Company entered into an agreement, which was approved by the Bankruptcy Court, for the settlement of coverage litigation related to A.P. Green asbestos claims. The settlement of $123.5 million (Great American has the option to pay in cash or over time with 5.25% interest) has been fully accrued and allows up to 10% of the settlement to be paid in AFG Common Stock. The settlement agreement is conditioned upon confirmation of a plan of reorganization that includes an injunction prohibiting the assertion against Great American of any present or future asbestos personal injury claims under policies issued to A.P. Green and related companies.
During 2007, the Bankruptcy Court confirmed the A. P. Green Plan of Reorganization which includes the injunction required by Great American’s settlement agreement. Certain parties subsequently appealed the confirmation.
On May 3, 2011, in connection with the appeal of the 2007 bankruptcy court confirmation, the Third Circuit Court of Appeals issued an opinion holding that two non-settling insurers had standing to challenge the trust established to administer silica claims which had been approved as part of the plan of bankruptcy along with the trust established to administer asbestos claims. The court also vacated the order confirming the Plan of Reorganization and remanded the Plan to the bankruptcy court for further proceedings on this limited issue. While the bankruptcy court had previously concluded that the trust to administer silica claims was a valid and legitimate trust, the Third Circuit held that a fuller evidentiary hearing is required on remand. Management believes that resolution of this issue ultimately will not impact the Great American settlement.

 

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PART II
ITEM 5
Market for Registrant’s Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities
AFG Common Stock is listed and traded on the New York Stock Exchange and the Nasdaq Global Select Market under the symbol AFG. The information presented in the table below represents the high and low sales prices per share reported on the NYSE Composite Tape.
                                 
    2011     2010  
    High     Low     High     Low  
 
                               
First Quarter
  $ 35.21     $ 32.19     $ 28.64     $ 23.90  
Second Quarter
    36.19       33.94       30.25       25.40  
Third Quarter
    36.05       29.45       30.88       26.69  
Fourth Quarter
    37.50       29.66       32.75       30.04  
There were approximately 7,200 shareholders of record of AFG Common Stock at February 1, 2012. AFG declared and paid quarterly dividends of $.1625 per share in January, April and July 2011. In August 2011, AFG increased its quarterly dividend to $.175 and declared and paid its first dividend at that rate in October 2011. In 2010, AFG declared and paid quarterly dividends of $.1375 per share in January, April and July and $.1625 per share in October. The ability of AFG to pay dividends will be dependent upon, among other things, the availability of dividends and payments under intercompany tax allocation agreements from its insurance company subsidiaries.
Issuer Purchases of Equity Securities AFG repurchased shares of its common stock during 2011 as follows:
                                 
                    Total Number     Maximum Number  
                    of Shares     of Shares  
    Total             Purchased as     that May  
    Number     Average     Part of Publicly     Yet be Purchased  
    of Shares     Price Paid     Announced Plans     Under the Plans  
    Purchased     Per Share     or Programs     or Programs (a)  
 
                               
First Quarter
    2,457,721     $ 34.04       2,457,721       10,250,706  
 
                               
Second Quarter
    2,710,121     $ 34.79       2,710,121       7,540,585  
 
                               
Third Quarter
    2,635,444     $ 32.25       2,635,444       4,905,141  
 
                               
October
    152,700     $ 31.09       152,700       4,752,441  
 
                               
November
    727,000     $ 35.17       727,000       4,025,441  
 
                               
December
    598,400     $ 36.20       598,400       3,427,041  
     
(a)   Represents the remaining shares that may be repurchased under the Plans authorized by AFG’s Board of Directors in August 2010 and February 2011. In February 2012, AFG’s Board of Directors authorized the repurchase of five million additional shares.
In addition, AFG acquired 2,467 shares of its common stock (at $36.48 per share) in October 2011, 1,900 shares (at $35.73 per share) in November 2011, and 16,384 shares (at an average of $36.62 per share) in December 2011 in connection with its stock incentive plans.

 

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ITEM 6
Selected Financial Data
The following table sets forth certain data for the periods indicated (dollars in millions, except per share data).
                                         
    2011     2010     2009     2008     2007  
Earnings Statement Data (a):
                                       
Total Revenues
  $ 4,750     $ 4,497     $ 4,320     $ 4,293     $ 4,379  
Operating Earnings Before Income Taxes
    560       689       812       316       639  
Earnings from Continuing Operations
    320       423       530       200       413  
Discontinued Operations
                            2  
Less: Net Earnings (Loss) Attributable to Noncontrolling Interests
    (23 )     (56 )     11       4       32  
Net Earnings Attributable to Shareholders
    343       479       519       196       383  
 
                                       
Basic Earnings Per Common Share:
                                       
Earnings from Continuing Operations
  $ 3.39     $ 4.38     $ 4.49     $ 1.71     $ 3.24  
Discontinued Operations
                            .01  
Net Earnings Attributable to Shareholders
    3.39       4.38       4.49       1.71       3.25  
 
                                       
Diluted Earnings Per Common Share:
                                       
Earnings from Continuing Operations
  $ 3.33     $ 4.33     $ 4.45     $ 1.67     $ 3.09  
Discontinued Operations
                            .01  
Net Earnings Attributable to Shareholders
    3.33       4.33       4.45       1.67       3.10  
 
                                       
Cash Dividends Paid Per Share of Common Stock
  $ .6625     $ .575     $ .52     $ .50     $ .40  
 
                                       
Ratio of Earnings to Fixed Charges Including Annuity Benefits (b)
    1.95       2.41       2.58       1.63       2.40  
 
                                       
Balance Sheet Data (a):
                                       
Total Assets
  $ 36,042     $ 32,454     $ 27,683     $ 26,428     $ 25,808  
Long-term Debt
    934       952       828       1,030       937  
Shareholders’ Equity
    4,545       4,470       3,781       2,490       3,046  
     
(a)   New accounting guidance issued by the Financial Accounting Standards Board limits the types of costs incurred in issuing or renewing insurance contracts that can be deferred. AFG will adopt this guidance retrospectively on January 1, 2012. See Note A — “Accounting Policies — Recent Accounting Standards” to the financial statements for disclosures of the impact of adopting the guidance.
 
(b)   Fixed charges are computed on a “total enterprise” basis. For purposes of calculating the ratios, “earnings” have been computed by adding to pretax earnings the fixed charges and the noncontrolling interests in earnings of subsidiaries having fixed charges and the undistributed equity in losses of investees. Fixed charges include interest (including annuity benefits as indicated), amortization of debt premium/discount and expense, preferred dividend and distribution requirements of subsidiaries and a portion of rental expense deemed to be representative of the interest factor.
 
    The ratio of earnings to fixed charges excluding annuity benefits was 6.61, 9.09, 11.06, 4.75 and 8.49 for 2011, 2010, 2009, 2008 and 2007, respectively. Although the ratio of earnings to fixed charges excluding annuity benefits 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.

 

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ITEM 7
Management’s Discussion and Analysis
of Financial Condition and Results of Operations
INDEX TO MD&A
         
    Page  
    25  
         
    25  
         
    26  
         
    27  
         
    27  
         
    27  
         
    29  
         
    29  
         
    29  
         
    34  
         
Managed Investment Entities     44  
         
Results of Operations     46  
         
    46  
         
    46  
         
    52  
         
    53  
GENERAL
Following is a discussion and analysis of the financial statements and other statistical data that management believes will enhance the understanding of AFG’s financial condition and results of operations. This discussion should be read in conjunction with the financial statements beginning on page F-1.
As discussed in Note A — “Accounting Policies — Recent Accounting Standards,” certain historical amounts presented herein will be retrospectively restated in 2012 to reflect the adoption of new accounting guidance related to deferred policy acquisition costs (“DPAC”).
OVERVIEW
Financial Condition
AFG is organized as a holding company with almost all of its operations being conducted by subsidiaries. AFG, however, has continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, shareholder dividends, and taxes. Therefore, certain analyses are best done on a parent-only basis while others are best done on a total enterprise basis. In addition, because most of its businesses are financial in nature, AFG does not prepare its consolidated financial statements using a current-noncurrent format. Consequently, certain traditional ratios and financial analysis tests are not meaningful.
At December 31, 2011, AFG (parent) held approximately $456 million in cash and securities and had $500 million available under a bank line of credit expiring in August 2013.
Results of Operations
Through the operations of its subsidiaries, AFG is engaged primarily in property and casualty insurance, focusing on specialized commercial products for businesses and in the sale of traditional fixed and indexed annuities and a variety of supplemental insurance products such as Medicare supplement.
The property and casualty business is cyclical in nature with periods of high competition resulting in low premium rates, sometimes referred to as a “soft market” or “downcycle” followed by periods of reduced competition and higher premium rates, referred to as a “hard market” or “upcycle.” For the past several years, AFG’s property and casualty insurance operations have experienced soft market conditions.
AFG reported net earnings attributable to shareholders of $343 million ($3.33 per share diluted) in 2011 compared to $479 million ($4.33 per share diluted) in 2010.

 

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Improved operating results in the annuity and supplemental insurance group were more than offset by a second quarter 2011 special charge to strengthen reserves for asbestos and other environmental exposures, primarily within the property and casualty run-off operations, lower underwriting profit and lower investment income in the on-going property and casualty operations and a fourth quarter charge for a valuation allowance against deferred tax assets.
CRITICAL ACCOUNTING POLICIES
Significant accounting policies are summarized in Note A to the financial statements. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that can have a significant effect on amounts reported in the financial statements. As more information becomes known, these estimates and assumptions change and thus impact amounts reported in the future. The areas where management believes the degree of judgment required to determine amounts recorded in the financial statements make accounting policies critical are as follows:
    the establishment of insurance reserves, especially asbestos and environmental-related reserves,
    the recoverability of reinsurance,
    the recoverability of deferred acquisition costs,
    the establishment of asbestos and environmental reserves of former railroad and manufacturing operations, and
    the valuation of investments, including the determination of “other-than-temporary” impairments.
See “Liquidity and Capital Resources — Uncertainties” for a discussion of insurance reserves, recoverables from reinsurers, and contingencies related to American Premier’s former operations and “Liquidity and Capital Resources Investments” for a discussion of impairments on investments. Deferred policy acquisition costs (“DPAC”) and certain liabilities related to annuities and universal life insurance products are amortized in relation to the present value of expected gross profits on the policies. Assumptions considered in determining expected gross profits involve significant judgment and include management’s estimates of assumed interest rates and investment spreads, surrenders, annuitizations, renewal premiums and mortality. Should actual experience require management to change its assumptions (commonly referred to as “unlocking”), a charge or credit would be recorded to adjust DPAC or annuity liabilities to the levels they would have been if the new assumptions had been used from the inception date of each policy.
Reserves for future policy benefits related to AFG’s closed block of long-term care business are established (and related acquisition costs are amortized) over the life of the policies based on policy benefit assumptions as of the date of issuance, including investment yields, mortality, morbidity, persistency, and expenses. Once these assumptions are established for a given policy or group of policies, they are not changed over the life of the policy unless a loss recognition event (premium deficiency) occurs. Loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums, including reasonably expected rate increases, are not expected to cover the present value of future claims payments and related settlement and maintenance costs as well as unamortized acquisition costs. Adverse changes in any of the reserve assumptions in future periods could result in loss recognition and charges to earnings for AFG’s long-term care business.

 

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LIQUIDITY AND CAPITAL RESOURCES
Ratios AFG’s debt to total capital ratio on a consolidated basis is shown below (dollars in millions). Management intends to maintain the ratio of debt to capital at or below 25% and intends to maintain the capital of its significant insurance subsidiaries at or above levels currently indicated by rating agencies as appropriate for the current ratings.
                 
    December 31,  
    2011     2010  
Long-term debt
  $ 934     $ 952  
Total capital
    5,017       5,050  
Ratio of debt to total capital:
               
Including debt secured by real estate
    18.6 %     18.9 %
Excluding debt secured by real estate
    17.6 %     17.8 %
The ratio of debt to total capital is a non-GAAP measure that management believes is useful for investors, analysts and independent ratings agencies to evaluate AFG’s financial strength and liquidity and to provide insight into how AFG finances its operations. It is calculated by dividing AFG’s long-term debt by its total capital, which includes long-term debt, noncontrolling interests and shareholders’ equity (excluding unrealized gains (losses) related to fixed maturity investments and appropriated retained earnings related to managed investment entities).
AFG’s ratio of earnings to fixed charges, including annuity benefits as a fixed charge, was 1.95 for the year ended December 31, 2011. Excluding annuity benefits, this ratio was 6.61 for 2011. Although the ratio excluding annuity benefits is not required or encouraged to be disclosed under Securities and Exchange Commission rules, it is presented because interest credited to annuity policyholder accounts is not always considered a borrowing cost for an insurance company.
The NAIC’s model law for risk based capital (“RBC”) applies to both life and property and casualty companies. RBC formulas determine the amount of capital that an insurance company needs so that it has an acceptable expectation of not becoming financially impaired. At December 31, 2011, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements.
Parent and Subsidiary Liquidity
Parent Holding Company Liquidity Management believes AFG has sufficient resources to meet its liquidity requirements. If funds generated from operations, including dividends, tax payments and borrowings 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.
AFG can borrow up to $500 million under its revolving credit facility which expires in August 2013. There were no borrowings under this agreement, or any other parent company short-term borrowing arrangements, during 2011.
During 2011, AFG repurchased 9.3 million shares of its Common Stock for $315 million. During 2010, AFG issued $132 million of 7% Senior Notes due 2050 and repurchased 10.3 million shares of its Common Stock for $292 million. During 2009, AFG retired $136 million of 7-1/8% Senior Debentures at maturity, issued $350 million of 9-7/8% Senior Notes due 2019 and repurchased 3.3 million shares of its Common Stock for $81 million.
All debentures and notes issued by AFG (and AAG Holding Company, a GAFRI subsidiary) are rated investment grade by two 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.
Under tax allocation agreements with AFG, its 80%-owned U.S. subsidiaries generally pay taxes to (or recover taxes from) AFG based on each subsidiary’s contribution to amounts due under AFG’s consolidated tax return.

 

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Subsidiary Liquidity Great American Life Insurance Company (“GALIC”), a wholly-owned annuity and supplemental insurance subsidiary, is a member of the Federal Home Loan Bank of Cincinnati (“FHLB”). The FHLB makes advances and provides other banking services to member institutions, which provides the annuity and supplemental insurance operations with a substantial additional source of liquidity. In the fourth quarter of 2011, the FHLB advanced GALIC $240 million at interest rates ranging from .02% to .03% over LIBOR (average rate of .31% at December 31, 2011). These advances must be repaid within 5 to 7 years, but GALIC has the option to prepay all or a portion of the advances on a monthly basis. GALIC has invested the proceeds from the advances in fixed maturity securities for the purpose of earning a spread over the interest payments due to the FHLB.
National Interstate Corporation (“NATL”), a 52%-owned property and casualty insurance subsidiary, can borrow up to $75 million, subject to certain conditions, under an unsecured credit agreement expiring in December 2012. Amounts borrowed bear interest at rates ranging from .45% to .9% (currently .65%) over LIBOR based on NATL’s credit rating. There was $22 million outstanding under this agreement at December 31, 2011. The maximum outstanding balance under this agreement during 2011 was $22 million.
The liquidity requirements of AFG’s insurance subsidiaries relate primarily to the liabilities associated with their products as well as operating costs and expenses, payments of dividends and taxes to AFG and contributions of capital to their subsidiaries. Historically, cash flows from premiums and investment income have generally provided more than sufficient funds to meet these requirements without requiring a sale of investments or contributions from AFG. Funds received in excess of cash requirements are generally invested in additional marketable securities. In addition, the insurance subsidiaries generally hold a significant amount of highly liquid, short-term investments.
The excess cash flow of AFG’s property and casualty group allows it to extend the duration of its investment portfolio somewhat beyond that of its claim reserves.
In the annuity business, where profitability is largely dependent on earning a “spread” between invested assets and annuity liabilities, the duration of investments is generally maintained close to that of liabilities. In a rising interest rate environment, significant protection from withdrawals exists in the form of temporary and permanent surrender charges on AFG’s annuity products. With declining rates, AFG receives some protection (from spread compression) due to the ability to lower crediting rates, subject to contractually guaranteed minimum interest rates (“GMIRs”). AFG began selling new policies with GMIRs below 2% in 2003; almost all new business since late 2010 has been issued with a 1% GMIR. At December 31, 2011, the average crediting rate on AFG’s annuities was approximately 3.1%, while the average GMIR was approximately 2.5%. This margin provides AFG the flexibility to lower its crediting rates by up to 60 basis points on average in the future should market interest rates continue to remain low for a long period of time.
For statutory accounting purposes, equity securities of non-affiliates are generally carried at fair value. At December 31, 2011, AFG’s insurance companies owned publicly traded equity securities with a fair value of $895 million. In addition, GAI’s investment in NATL common stock had a fair value of $252 million and a statutory carrying value of $199 million at December 31, 2011. 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.
AFG believes its insurance subsidiaries maintain sufficient liquidity to pay claims and benefits and operating expenses. In addition, these subsidiaries have sufficient capital to meet commitments in the event of unforeseen events such as reserve deficiencies, inadequate premium rates or reinsurer insolvencies. Nonetheless, changes in statutory accounting rules, significant declines in the fair value of the insurance subsidiaries’ investment portfolios or significant ratings downgrades on these investments, could create a need for additional capital.

 

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Contractual Obligations The following table shows an estimate (based on historical patterns and expected trends) of payments to be made for insurance reserve liabilities, as well as scheduled payments for major contractual obligations (in millions).
                                         
            Within                     More than  
    Total     One Year     2-3 Years     4-5 Years     5 Years  
Annuity, life, accident and health liabilities (a)
  $ 17,147     $ 1,618     $ 3,230     $ 3,905     $ 8,394  
Property and casualty unpaid losses and loss adjustment expenses (b)
    6,520       1,700       1,800       1,100       1,920  
Long-term debt, including interest
    2,096       107       165       200       1,624  
Operating leases
    412       52       93       70       197  
 
                             
Total (c)
  $ 26,175     $ 3,477     $ 5,288     $ 5,275     $ 12,135  
 
                             
     
(a)   Reserve projections include anticipated cash benefit payments only. Projections do not include any impact for future earnings or additional premiums.
 
(b)   Dollar amounts and time periods are estimates based on historical net payment patterns applied to the gross reserves and do not represent actual contractual obligations. Based on the same assumptions, AFG projects reinsurance recoveries related to these reserves totaling $2.2 billion as follows: Within 1 year — $600 million; 2-3 years - $600 million; 4-5 years — $400 million; and thereafter — $638 million. Actual payments and their timing could differ significantly from these estimates.
 
(c)   AFG’s $74 million liability for unrecognized tax benefits (including $15 million in interest) as of December 31, 2011, is not included because the period of payment cannot be reliably estimated.
AFG has no material contractual purchase obligations or other long-term liabilities at December 31, 2011.
Off-Balance Sheet Arrangements See Note P — “Additional Information — Financial Instruments with Off-Balance Sheet Risk” to the financial statements.
Investments AFG attempts to optimize investment income while building the value of its portfolio, placing emphasis upon total long-term performance.
AFG’s investment portfolio at December 31, 2011, contained $21.8 billion in “Fixed maturities” classified as available for sale and $928 million in “Equity securities”, all carried at fair value with unrealized gains and losses included in a separate component of shareholders’ equity on an after-tax basis. In addition, $440 million in fixed maturities were classified as trading with changes in unrealized holding gains or losses included in investment income.
As detailed under “Net Unrealized Gain on Marketable Securities” in Note E to the financial statements, unrealized gains and losses on AFG’s fixed maturity and equity securities are included in Shareholders’ Equity after adjustments for related changes in DPAC and certain liabilities related to annuities, noncontrolling interests and deferred income taxes. DPAC applicable to annuity products is adjusted for the impact of unrealized gains or losses on investments as if these gains or losses had been realized, with corresponding increases or decreases (net of tax) included in accumulated other comprehensive income in AFG’s Balance Sheet.
Fixed income investment funds are generally invested in securities with intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions. At December 31, 2011, the average life of AFG’s fixed maturities was about six years.
Fair values for AFG’s portfolio are determined by AFG’s internal investment professionals using data from nationally recognized pricing services as well as non-binding broker quotes. Fair values of equity securities are generally based on closing prices obtained from the pricing services. For mortgage-backed securities (“MBS”), which comprise approximately 30% of AFG’s fixed maturities, prices for each security are generally obtained from both pricing services and broker quotes. For the remainder of AFG’s fixed maturity portfolio, approximately 93% are priced using pricing services and the balance is priced primarily using non-binding broker quotes. When prices obtained for the same security vary, AFG’s internal investment professionals select the price they believe is most indicative of an exit price.

 

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The pricing services use a variety of observable inputs to estimate fair value of fixed maturities that do not trade on a daily basis. Based upon information provided by the pricing services, these inputs include, but are not limited to, recent reported trades, benchmark yields, issuer spreads, bids or offers, reference data, and measures of volatility. Included in the pricing of MBS are estimates of the rate of future prepayments and defaults of principal over the remaining life of the underlying collateral. Due to the lack of transparency in the process that brokers use to develop prices, valuations that are based on brokers’ prices are classified as Level 3 in the GAAP hierarchy unless the price can be corroborated, for example, by comparison to similar securities priced using observable inputs.
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. Prices obtained from a broker or pricing service are adjusted only in cases where they are deemed not to be representative of an appropriate exit price (fewer than 1% of the securities).
In general, the fair value of AFG’s fixed maturity investments is inversely correlated to changes in interest rates. The following table demonstrates the sensitivity of such fair values to reasonably likely changes in interest rates by illustrating the estimated effect on AFG’s fixed maturity portfolio that an immediate increase of 100 basis points in the interest rate yield curve would have at December 31, 2011 (dollars in millions). Increases or decreases from the 100 basis points illustrated would be approximately proportional.
         
Fair value of fixed maturity portfolio
  $ 22,247  
Pretax impact on fair value of 100 bps increase in interest rates
  $ (1,046 )
Pretax impact as % of total fixed maturity portfolio
    (4.7 %)
Approximately 90% of the fixed maturities held by AFG at December 31, 2011, were rated “investment grade” (credit rating of AAA to BBB) by nationally recognized rating agencies. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and non-investment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return.
MBS are subject to significant prepayment risk due to the fact that, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as borrowers refinance higher rate mortgages to take advantage of lower rates. Although interest rates have been low for the last few years, a weak housing market and uncertain economic conditions have led to tighter lending standards, which have resulted in fewer buyers being able to refinance the mortgages underlying much of AFG’s non-agency RMBS portfolio.

 

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Summarized information for AFG’s MBS (including those classified as trading) at December 31, 2011, is shown (in millions) in the table below. Agency-backed securities are those issued by a U.S. government-backed agency; Alt-A mortgages are those with risk profiles between prime and subprime. The majority of the Alt-A securities and substantially all of the subprime securities are backed by fixed rate mortgages. The average life of the residential and commercial MBS is approximately 4 and 5 years, respectively.
                                         
                                    % Rated  
    Amortized             Fair Value as     Unrealized     Investment  
Collateral type   Cost     Fair Value     % of Cost     Gain (Loss)     Grade  
Residential:
                                       
Agency-backed
  $ 340     $ 354       104 %   $ 14       100 %
Non-agency prime
    2,058       2,112       103       54       68  
Alt-A
    787       739       94       (48 )     44  
Subprime
    686       653       95       (33 )     29  
Commercial
    2,665       2,877       108       212       100  
Other
    22       25       114       3       48  
 
                                 
 
  $ 6,558     $ 6,760       103 %   $ 202       77 %
 
                                 
The National Association of Insurance Commissioners (“NAIC”) assigns creditworthiness designations on a scale of 1 to 6 with 1 being the highest quality and 6 being the lowest quality. The NAIC retained a third-party investment management firm to assist in the determination of appropriate NAIC designations for mortgage-backed securities based not only on the probability of loss (which is the primary basis of ratings by the major ratings firms), but also on the severity of loss and statutory carrying value. At December 31, 2011, 97% (based on statutory carrying value of $6.5 billion) of AFG’s MBS securities had an NAIC designation of 1 or 2.
Municipal bonds represented approximately 18% of AFG’s fixed maturity portfolio at December 31, 2011. AFG’s municipal bond portfolio is high quality, with 99% of the securities rated investment grade at that date. The portfolio is well diversified across the states of issuance and individual issuers. At December 31, 2011, approximately 80% of the municipal bond portfolio was held in revenue bonds, with the remaining 20% held in general obligation bonds. State general obligation securities of California, Illinois, New Jersey and New York collectively represented only 2% of this portfolio.

 

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Summarized information for the unrealized gains and losses recorded in AFG’s Balance Sheet at December 31, 2011, is shown in the following table (dollars in millions). Approximately $133 million of available for sale “Fixed maturities” and $36 million of “Equity securities” had no unrealized gains or losses at December 31, 2011.
                 
    Securities     Securities  
    With     With  
    Unrealized     Unrealized  
    Gains     Losses  
Available for Sale Fixed Maturities
               
Fair value of securities
  $ 18,623     $ 3,051  
Amortized cost of securities
  $ 17,129     $ 3,300  
Gross unrealized gain (loss)
  $ 1,494     $ (249 )
Fair value as % of amortized cost
    109 %     92 %
Number of security positions
    3,763       846  
Number individually exceeding $2 million gain or loss
    146       11  
Concentration of gains (losses) by type or industry (exceeding 5% of unrealized):
               
Mortgage-backed securities
  $ 388     $ (186 )
Banks, savings and credit institutions
    85       (33 )
Gas and electric services
    172       (2 )
States and municipalities
    267       (3 )
Percentage rated investment grade
    94 %     62 %
 
               
Equity Securities
               
Fair value of securities
  $ 665     $ 227  
Cost of securities
  $ 453     $ 255  
Gross unrealized gain (loss)
  $ 212 (*)   $ (28 )
Fair value as % of cost
    147 %     89 %
Number of security positions
    131       83  
Number individually exceeding $2 million gain or loss
    12       4  
     
(*)   Includes $121 million on AFG’s investment in Verisk Analytics, Inc.
The table below sets forth the scheduled maturities of AFG’s available for sale fixed maturity securities at December 31, 2011, based on their fair values. Asset- backed securities and other securities with sinking funds are reported at average maturity. Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.
                 
    Securities     Securities  
    with     with  
    Unrealized     Unrealized  
Maturity   Gains     Losses  
One year or less
    3 %     1 %
After one year through five years
    26       19  
After five years through ten years
    35       15  
After ten years
    10       5  
 
           
 
    74       40  
Mortgage-backed securities (average life of approximately four years)
    26       60  
 
           
 
    100 %     100 %
 
           

 

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The table below (dollars in millions) summarizes the unrealized gains and losses on fixed maturity securities by dollar amount.
                         
                    Fair  
    Aggregate     Aggregate     Value as  
    Fair     Unrealized     % of Cost  
Fixed Maturities at December 31, 2011   Value     Gain (Loss)     Basis  
 
                       
Securities with unrealized gains:
                       
Exceeding $500,000 (841 issues)
  $ 10,121     $ 1,093       112 %
$500,000 or less (2,922 issues)
    8,502       401       105  
 
                   
 
  $ 18,623     $ 1,494       109 %
 
                   
 
                       
Securities with unrealized losses:
                       
Exceeding $500,000 (151 issues)
  $ 982     $ (164 )     86 %
$500,000 or less (695 issues)
    2,069       (85 )     96  
 
                   
 
  $ 3,051     $ (249 )     92 %
 
                   
The following table summarizes (dollars in millions) the unrealized loss for all securities with unrealized losses by issuer quality and length of time those securities have been in an unrealized loss position.
                         
                    Fair  
    Aggregate     Aggregate     Value as  
    Fair     Unrealized     % of Cost  
Securities with Unrealized Losses at December 31, 2011   Value     Loss     Basis  
 
                       
Investment grade fixed maturities with losses for:
                       
Less than one year (292 issues)
  $ 1,528     $ (52 )     97 %
One year or longer (129 issues)
    367       (41 )     90  
 
                   
 
  $ 1,895     $ (93 )     95 %
 
                   
 
                       
Non-investment grade fixed maturities with losses for:
                       
Less than one year (250 issues)
  $ 859     $ (58 )     94 %
One year or longer (175 issues)
    297       (98 )     75  
 
                   
 
  $ 1,156     $ (156 )     88 %
 
                   
 
                       
Common equity securities with losses for:
                       
Less than one year (61 issues)
  $ 169     $ (19 )     90 %
One year or longer (4 issues)
    4       (1 )     80  
 
                   
 
  $ 173     $ (20 )     90 %
 
                   
 
                       
Perpetual preferred equity securities with losses for:
                       
Less than one year (9 issues)
  $ 23     $ (1 )     96 %
One year or longer (9 issues)
    31       (7 )     82  
 
                   
 
  $ 54     $ (8 )     87 %
 
                   
When a decline in the value of a specific investment is considered to be “other-than-temporary,” a provision for impairment is charged to earnings (accounted for as a realized loss) and the cost basis of that investment is reduced by the amount of the charge. The determination of whether unrealized losses are “other-than-temporary” requires judgment based on subjective as well as objective factors. Factors considered and resources used by management include:
  a)   whether the unrealized loss is credit-driven or a result of changes in market interest rates,
  b)   the extent to which fair value is less than cost basis,
  c)   historical operating, balance sheet and cash flow data contained in issuer SEC filings and news releases,
  d)   near-term prospects for improvement in the issuer and/or its industry,
  e)   third party research and communications with industry specialists,
  f)   financial models and forecasts,
  g)   the continuity of dividend payments, maintenance of investment grade ratings and hybrid nature of certain investments,
  h)   discussions with issuer management, and
  i)   ability and intent to hold the investment for a period of time sufficient to allow for anticipated recovery in fair value.

 

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Based on its analysis of the factors listed above, management believes (i) AFG will recover its cost basis in the securities with unrealized losses and (ii) that AFG has the ability to hold the securities until they recover in value and had no intent to sell them at December 31, 2011. 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 Management’s Discussion and Analysis — “Results of Operations — Realized Gains (Losses) on Securities.”
Uncertainties As more fully explained in the following paragraphs, management believes that the areas posing the greatest risk of material loss are the adequacy of its insurance reserves and contingencies arising out of its former railroad and manufacturing operations.
Property and Casualty Insurance Reserves Estimating the liability for unpaid losses and loss adjustment expenses (“LAE”) is inherently judgmental and is influenced by factors that are subject to significant variation. Determining the liability is a complex process incorporating input from many areas of the Company including actuarial, underwriting, pricing, claims and operations management.
The estimates of liabilities 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 the accounting periods on direct business written (“case reserves”); (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of claims incurred but not reported or “IBNR” (including possible development on known claims); (d) estimates (based on experience) of expense for investigating and adjusting claims; and (e) the current state of law and coverage litigation.
The process used to determine the total reserve for liabilities involves estimating the ultimate incurred losses and LAE, adjusted for amounts already paid on the claims. The IBNR reserve is derived by first estimating the ultimate unpaid reserve liability and subtracting case reserves and LAE.
In determining management’s best estimate of the ultimate liability, management (including Company actuaries) considers items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, the nature and maturity of lines of insurance, general economic trends and the legal environment. In addition, historical trends adjusted for changes in underwriting standards, policy provisions, product mix and other factors are analyzed using actuarial reserve development techniques. Weighing all of the factors, the management team determines a single or “point” estimate that it records as its best estimate of the ultimate liabilities. Ranges of loss reserves are not developed by Company actuaries. This reserve analysis and review is completed each quarter and for every line of business.
Each quarterly review includes in-depth analysis of over 500 subdivisions of the business, employing multiple actuarial techniques. For each particular subdivision, actuaries use informed, professional judgment to adjust these techniques as necessary to respond to specific conditions in the data or within the business.
Some of the standard actuarial methods employed for the quarterly reserve analysis may include (but may not be limited to):
    Case Incurred Development Method
    Paid Development Method
    Projected Claim Count Times Projected Claim Severity
    Bornhuetter-Ferguson Method
    Incremental Paid LAE to Paid Loss Methods

 

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Management believes that each method has particular strengths and weaknesses and that no single estimation method is most accurate in all situations. When applied to a particular group of claims, the relative strengths and weaknesses of each method can change over time based on the facts and circumstances. Ultimately, the estimation methods chosen are those which management believes produce the most reliable indication for the particular liabilities under review.
The period of time from the occurrence of a loss through the settlement of the liability is referred to as the “tail”. Generally, the same actuarial methods are considered for both short-tail and long-tail lines of business because most of them work properly for both. The methods are designed to incorporate the effects of the differing length of time to settle particular claims. For short-tail lines, management tends to give more weight to the Case Incurred and Paid Development methods, although the various methods tend to produce similar results. For long-tail lines, more judgment is involved, and more weight may be given to the Bornhuetter-Ferguson method and the Projected Claim Count times Projected Claim Severity method. Liability claims for long-tail lines are more susceptible to litigation and can be significantly affected by changing contract interpretation and the legal environment. Therefore, the estimation of loss reserves for these classes is more complex and subject to a higher degree of variability.
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.
Supplementary statistical information is also reviewed to determine which methods are most appropriate to use or if adjustments are needed to particular methods. Such information includes:
    Open and closed claim counts
    Average case reserves and average incurred on open claims
    Closure rates and statistics related to closed and open claim percentages
    Average closed claim severity
    Ultimate claim severity
    Reported loss ratios
    Projected ultimate loss ratios
    Loss payment patterns
Within each line, results of individual methods are reviewed, supplementary statistical information is analyzed, and all data from underwriting, operating and claim management are considered in deriving management’s best estimate of the ultimate liability. This estimate may be the result of one method, or a weighted average of several methods, or a judgmental selection as the management team determines is appropriate.

 

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The following table shows (in millions) the breakdown of AFG’s property and casualty reserves between case reserves, IBNR reserves and LAE reserves (estimated amounts required to adjust, record and settle claims, other than the claim payments themselves).
                                 
    Gross Loss Reserves at December 31, 2011  
                            Total  
    Case     IBNR     LAE     Reserve  
Statutory Line of Business
                               
Other liability — occurrence
  $ 507     $ 1,268     $ 265     $ 2,040  
Workers’ compensation
    744       348       130       1,222  
Special property (fire, allied lines, inland marine, earthquake)
    527       30       25       582  
Other liability — claims made
    210       272       61       543  
Commercial auto/truck liability/medical
    162       253       87       502  
Commercial multi-peril
    142       92       88       322  
Other lines
    191       337       167       695  
 
                       
Total Statutory Reserves
    2,483       2,600       823       5,906  
 
                               
Adjustments for GAAP:
                               
Reserves of foreign operations
    285       270       7       562  
Deferred gains on retroactive reinsurance
          74             74  
Loss reserve discounting
    (20 )                 (20 )
Other
    (1 )     (1 )           (2 )
 
                       
 
                               
Total Adjustments for GAAP
    264       343       7       614  
 
                       
 
                               
Total GAAP Reserves
  $ 2,747     $ 2,943     $ 830     $ 6,520  
 
                       
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 8, 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, 2011, to be deficient (for three years) by as much as 19.6% and redundant (for seven years) by as much as 17.1% (excluding the effect of special charges for asbestos and environmental exposures). This development illustrates the historical impact caused by variability in factors considered in estimating insurance reserves.
Following is a discussion of certain critical variables affecting the estimation of loss reserves of the more significant long-tail lines of business (asbestos and environmental liabilities are separately discussed below). Many other variables may also impact ultimate claim costs.
An important assumption underlying reserve estimates is that the cost trends implicitly built into development patterns will continue into the future. However, future results could vary due to an unexpected change in the underlying cost trends. This unexpected change could arise from a variety of sources including a general increase in economic inflation, inflation from social programs, new medical technologies, or other factors such as those listed below in connection with AFG’s largest lines of business. It is not possible to isolate and measure the potential impact of just one of these variables, and future cost trends could be partially impacted by several such variables. However, it is reasonable to address the sensitivity of the reserves to potential impact from changes in these variables by measuring the effect of a possible overall 1% change in future cost trends that may be caused by one or more variables. Utilizing the effect of a 1% change in overall cost trends enables changes greater than 1% to be estimated by extrapolation. Each additional 1% change in the cost trend would increase the effect on net earnings by an amount slightly (about 4%) greater than the effect of the previous 1%. For example, if a 1% change in cost trends in a line of business would change net earnings by $20 million, a 2% change would change net earnings by approximately $41 million.

 

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The estimated cumulative impact that a 1% change in cost trends would have on net earnings is shown below (in millions).
         
    Effect of 1%  
    Change in  
Line of business   Cost Trends  
Other liability — occurrence
  $ 17  
Workers’ compensation
    23  
Other liability — claims made
    9  
Commercial auto/truck liability/medical
    6  
Commercial multi-peril
    4  
The judgments and uncertainties surrounding management’s reserve estimation process and the potential for reasonably possible variability in management’s most recent reserve estimates may also be viewed by looking at how recent historical estimates of reserves have developed. The following table shows (in millions) what the impact on AFG’s net earnings would be on the more significant lines of business if the December 31, 2011, reserves (net of reinsurance) developed at the same rate as the average development of the most recent five years.
                         
    5-yr. Average     Net Reserves(**)     Effect on Net  
    Development(*)     December 31, 2011     Earnings(**)  
 
                       
Other liability — occurrence
    (5.5 %)   $ 742     $ 41  
Workers’ compensation
    (.8 %)     838       7  
Other liability — claims made
    (5.9 %)     398       23  
Commercial auto/truck liability/ medical
    (2.6 %)     361       9  
Commercial multi-peril
    .9 %     192       (2 )
     
(*)   Unfavorable (favorable), net of tax effect.
 
(**)   Excludes asbestos and environmental liabilities.
The following discussion describes key assumptions and important variables that affect the estimate of the reserve for loss and loss adjustment expenses of the more significant lines of business and explains what caused them to change from assumptions used in the preceding period.
Other Liability — Occurrence
This long-tail line of business consists of coverages protecting the insured against legal liability resulting from negligence, carelessness, or a failure to act causing property damage or personal injury to others. Some of the important variables affecting estimation of loss reserves for other liability — occurrence include:
    Litigious climate
    Unpredictability of judicial decisions regarding coverage issues
    Magnitude of jury awards
    Outside counsel costs
    Timing of claims reporting
AFG recorded favorable development of $50 million in 2011, $108 million in 2010 and $55 million in 2009 related to its other liability-occurrence coverage where both the frequency and severity of claims were lower than previously projected.
While management applies the actuarial methods mentioned above, more judgment is involved in arriving at the final reserve to be held. For recent accident years, more weight is given to the Bornhuetter-Ferguson method.
Uncertainty has emerged regarding AFG’s potential exposure for claims arising from the use of Chinese drywall. The potential exposure arises from insured policyholders who may have been associated with the installation of Chinese drywall in residential construction. AFG continues to monitor judicial decisions and settlements in this evolving area and is evaluating the possible implications of recent events on its potential exposure. While the ultimate liability is uncertain, management believes that AFG’s reserves for claims arising from the use of Chinese drywall are adequate.

 

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Workers’ Compensation
This long-tail line of business provides coverage to employees who may be injured in the course of employment. Some of the important variables affecting estimation of loss reserves for workers’ compensation include:
    Legislative actions and regulatory interpretations
    Future medical cost inflation
    Economic conditions
    Timing of claims reporting
Approximately one-half of AFG’s workers’ compensation business is currently written in California. Major reforms passed by the California state legislature in 2003 and in 2004 reduced employer premiums and set treatment standards for injured workers in that state. AFG’s subsidiary that writes workers’ compensation business in California recorded favorable prior year loss development of $5 million in 2011, $11 million in 2010 and $20 million in 2009 due primarily to the business written in California prior to 2008.
For several years after the reforms, the impact on claim settlements was more favorable than originally anticipated for claims incurred in 2003 to 2007, resulting in favorable development through 2011. However, this trend has subsided and the favorable development has flattened for more recent years. In both California and countrywide, economic conditions over the last couple years have led to longer duration of claims resulting in higher claim severity.
Several methods (including development methods and those based on claim count and severity) are weighted together to produce indications of reserve need. Management continues to review the frequency, severity and loss and LAE ratios implied by the indications from the standard tests and considers the uncertainties of future costs in determining the appropriate reserve level.
Other Liability — Claims Made
This long-tail line of business consists mostly of directors’ and officers’ liability. Some of the important variables affecting estimation of loss reserves for other liability — claims made include:
    Litigious climate
    Economic conditions
    Variability of stock prices
    Magnitude of jury awards
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. Recent economic conditions have led to increased claims for small account business and not-for-profit organizations.
AFG recorded favorable prior year loss development of $66 million in 2011, $40 million in 2010 and $26 million in 2009 on its directors’ and officers’ liability business as claim severity was significantly less than expected for claims incurred prior to 2010. Claims incurred in 2010 have developed adversely as economic conditions have driven severity higher than originally anticipated. The legal professional liability business, which has been in run-off since 2008, had favorable development of $17 million in 2011, $18 million in 2010 and $14 million in 2009 after several years of modest adverse development; as this run-off liability has matured, the claim severity trends have stabilized.
While management applies the actuarial methods mentioned above, more judgment is involved in arriving at the final reserve to be held. The selection of methods vary by subdivision of the data within this line. Some businesses within this line use the Paid Development method while others use the Case Incurred Development method and the Bornhuetter-Ferguson method.

 

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Commercial Auto/Truck Liability/Medical
This line of business is a mix of coverage protecting the insured against legal liability for property damage or personal injury to others arising from the operation of commercial motor vehicles. The property damage liability exposure is usually short-tail with relatively quick reporting and settlement of claims. The bodily injury and medical payments exposures are longer-tailed; although the claim reporting is relatively quick, the final settlement can take longer to achieve.
Some of the important variables affecting estimation of loss reserves for commercial auto/truck liability/medical are similar to other liability — occurrence and include:
    Magnitude of jury awards
    Unpredictability of judicial decisions regarding coverage issues
    Litigious climate and trends
    Change in frequency of severe accidents
    Health care costs and utilization of medical services by injured parties
AFG recorded favorable prior year loss development of $8 million in 2011, $26 million in 2010 and $6 million in 2009 for this line of business as claim severity was lower than in prior assumptions.
Commercial Multi-Peril
This long-tail line of business consists of two or more coverages protecting the insured from various property and liability risk exposures. The commercial multi-peril line of business includes coverage similar to other liability — occurrence, so in general, variables affecting estimation of loss reserves for commercial multi-peril include those mentioned above for other liability — occurrence. In addition, this line includes reserves for a run-off book of homebuilders business covering contractors’ liability for construction defects. Variables important to estimating the liabilities for this coverage include:
    Changing legal/regulatory interpretations of coverage
    Statutes of limitations and statutes of repose in filing claims
    Changes in policy forms and endorsements
AFG recorded adverse prior year loss development of $13 million in 2011 and $19 million in 2010 after having favorable development of $2 million in 2009. The adverse development resulted from higher claim frequency and severity in a block of program business related to motel/hotel, apartments, restaurants, taverns and recreation. This adverse development more than offset favorable development in coverage for non-profit organizations of $6 million in 2011, $13 million in 2010 and $11 million in 2009 as claim severity was less than anticipated.
Reserves of Foreign Operations
Reserves of foreign operations relate primarily to the operations of Marketform Group, Limited, AFG’s 72%-owned United Kingdom-based Lloyd’s insurer. Historically, the largest line of business written by Marketform has been non-U.S. medical malpractice, which provides coverage for injuries and damages caused by medical care providers, including but not limited to, hospitals and their physicians. Although Marketform offers this product in approximately 30 countries, the majority of the business has been written in the United Kingdom, Australia and Italy.
Significant variables in estimating the loss reserves for the medical malpractice business include:
    Litigious environment
    Magnitude of court awards
    A slow moving judicial system including varying approaches to medical malpractice claims among courts in different regions of Italy
    Third party claims administration in Italy
    Trends in claim costs, including medical cost inflation and, in Italy, escalating tables used to establish damages for personal injury

 

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Marketform recorded adverse prior year reserve development of $44 million in 2011, $55 million in 2010 and $56 million in 2009 related primarily to its Italian public hospital medical malpractice business, which it ceased writing in 2008. The development resulted from significant issues related to third party administration of claims and a challenging legal environment in Italy. Management believes that current reserves, which represent its best estimate of future liabilities, are adequate. Nonetheless, it concluded that sufficient uncertainty exists with respect to Italian public hospital medical malpractice reserves to leave open the 2007 year of account, in accordance with Lloyd’s provisions until a larger percentage of claims have been paid and the ultimate liabilities can be estimated with greater certainty. Included in AFG’s liability for unpaid losses and loss adjustment expenses at December 31, 2011, are reserves of $126 million related to this business.
Traditional actuarial techniques are not applicable to the Italian public hospital medical malpractice business due to the significant changes in this account over time. Accordingly, more detailed methods are used, including claim count development times average severity, and uplifting case reserves to historical severity levels.
Recoverables from Reinsurers and Availability of Reinsurance AFG is subject to credit risk with respect to its reinsurers, as reinsurance contracts do not relieve AFG of its liability to policyholders. To mitigate this risk, substantially all reinsurance is ceded to companies with investment grade or better S&P ratings or is secured by “funds withheld” or other collateral.
The availability and cost of reinsurance are subject to prevailing market conditions, which are beyond AFG’s control and which may affect AFG’s level of business and profitability. Although the cost of certain reinsurance programs may increase, management believes that AFG will be able to maintain adequate reinsurance coverage at acceptable rates without a material adverse effect on AFG’s results of operations. AFG’s gross and net combined ratios are shown in the table below.
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 O “Insurance Reinsurance” and the gross loss development table under Item 1 “Business” “Property and Casualty Operations Loss and Loss Adjustment Expense Reserves.”
The following table illustrates the effect that purchasing reinsurance has had on AFG’s combined ratio over the last three years.
                         
    2011     2010     2009  
Before reinsurance (gross)
    88.5 %     85.2 %     86.0 %
Effect of reinsurance
    4.9       3.3       (3.3 )
 
                 
Actual (net of reinsurance)
    93.4 %     88.5 %     82.7 %
 
                 
Asbestos and Environmental-related (“A&E”) Insurance Reserves Asbestos and environmental reserves of the property and casualty group consisted of the following (in millions):
                 
    December 31,  
    2011     2010  
Asbestos
  $ 292     $ 276  
Environmental
    70       66  
 
           
A&E reserves, net of reinsurance recoverable
    362       342  
Reinsurance recoverable, net of allowance
    92       74  
 
           
Gross A&E reserves
  $ 454     $ 416  
 
           
Asbestos reserves include claims asserting alleged injuries and damages from exposure to asbestos. Environmental reserves include claims relating to polluted waste sites.

 

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Asbestos claims against manufacturers, distributors or installers of asbestos products were presented under the products liability section of their policies which typically had aggregate limits that capped an insurer’s liability. In recent years, a number of asbestos claims are being presented as “non-products” claims, such as those by installers of asbestos products and by property owners or operators who allegedly had asbestos on their property, under the premises or operations section of their policies. Unlike products exposures, these non-products exposures typically had no aggregate limits, creating potentially greater exposure for insurers. Further, in an effort to seek additional insurance coverage, some insureds with installation activities who have substantially eroded their products coverage are presenting new asbestos claims as non-products operations claims or attempting to reclassify previously settled products claims as non-products claims to restore a portion of previously exhausted products aggregate limits. AFG, along with other insurers, is and will be subject to such non-products claims. It is difficult to predict whether insureds will be successful in asserting claims under non-products coverage or whether AFG and other insurers will be successful in asserting additional defenses. Therefore, the future impact of such efforts is uncertain.
Approximately 59% of AFG’s net asbestos reserves relate to policies written directly by AFG subsidiaries. Claims from these policies generally are product oriented claims with only a limited amount of non-product exposures, and are dominated by small to mid-sized commercial entities that are mostly regional policyholders with few national target defendants. The remainder is assumed reinsurance business that includes exposures for the periods 1954 to 1983. The asbestos and environmental assumed claims are ceded by various insurance companies under reinsurance treaties. A majority of the individual assumed claims have exposures of less than $100,000 to AFG. Asbestos losses assumed include some of the industry known manufacturers, distributors and installers. Pollution losses include industry known insured names and sites.
Establishing reserves for A&E claims relating to policies and participations in reinsurance treaties and former operations is subject to uncertainties that are significantly greater than those presented by other types of claims. For this group of claims, traditional actuarial techniques that rely on historical loss development trends cannot be used and a range of reasonably possible losses cannot be estimated. Case reserves and expense reserves are established by the claims department as specific policies are identified. In addition to the case reserves established for known claims, management establishes additional reserves for claims not yet known or reported and for possible development on known claims. These additional reserves are management’s best estimate based on periodic comprehensive studies and internal reviews adjusted for payments and identifiable changes, supplemented by management’s review of industry information about such claims, with due consideration to individual claim situations.
Management believes that estimating the ultimate liability for asbestos claims presents a unique and difficult challenge to the insurance industry due to, among other things, inconsistent court decisions, an increase in bankruptcy filings as a result of asbestos-related liabilities, novel theories of coverage, and judicial interpretations that often expand theories of recovery and broaden the scope of coverage. The casualty insurance industry is engaged in extensive litigation over these coverage and liability issues as the volume and severity of claims against asbestos defendants continue to increase. Environmental claims likewise present challenges in prediction, due to uncertainty regarding the interpretation of insurance policies, complexities regarding multi-party involvements at sites, evolving clean up standards and protracted time periods required to assess the level of clean up required at contaminated sites.
Emerging trends, such as those named below, could impact AFG’s reserves and payments:
    There is a growing interest at the state level to attempt to legislatively address asbestos liabilities and the manner in which asbestos claims are resolved. These developments are fluid and could result in piecemeal state-by-state solutions.
    The manner by which bankruptcy courts are addressing asbestos liabilities is in flux.
    AFG’s insureds may make claims alleging significant non-products exposures.

 

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While management believes that AFG’s reserves for A&E claims are a reasonable estimate of ultimate liability for such claims, actual results may vary materially from the amounts currently recorded due to the difficulty in predicting the number of future claims, the impact of recent bankruptcy filings, and unresolved issues such as whether coverage exists, whether policies are subject to aggregate limits on coverage, how claims are to be allocated among triggered policies and implicated years, and whether claimants who exhibit no signs of illness will be successful in pursuing their claims. A 1% variation in loss cost trends, caused by any of the factors previously described, would change net income by approximately $17 million.
AFG tracks its A&E claims by policyholder. The following table shows, by type of claim, the number of policyholders that did not receive any payments in the calendar year separate from policyholders that did receive a payment. Policyholder counts represent policies written by AFG subsidiaries and do not include assumed reinsurance.
                         
    2011     2010     2009  
Number of policyholders with no payments:
                       
Asbestos
    113       122       71  
Environmental
    98       132       156  
 
                 
 
    211       254       227  
 
                       
Number of policyholders with payments:
                       
Asbestos
    58       54       110  
Environmental
    26       20       22  
 
                 
 
    84       74       132  
 
                 
 
                       
Total
    295       328       359  
 
                 
Amounts paid (net of amounts received from reinsurers) for asbestos and environmental claims, including loss adjustment expenses, were as follows (in millions):
                         
    2011     2010     2009  
Asbestos
  $ 13     $ 27     $ 11  
Environmental
    17       17       14  
 
                 
Total
  $ 30     $ 44     $ 25  
 
                 
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, 2011, AFG’s three year survival ratios were 17.4 times paid losses for the asbestos reserves and 11.0 times paid losses for the total A&E reserves. Excluding amounts associated with the settlements of asbestos-related coverage litigation for A.P. Green Industries (see Item 3 — “Legal Proceedings”) and another large claim, AFG’s three year survival ratios were 10.9 and 7.6 times paid losses for the asbestos reserves and total A&E reserves, respectively. Data published by Conning Research & Consulting in June 2012 indicate that industry survival ratios were 8.5 for asbestos reserves and 7.8 for total A&E reserves at December 31, 2010.
AFG has conducted comprehensive studies of its asbestos and environmental reserves with the aid of outside actuarial and engineering firms and specialty outside counsel every two years with an in-depth internal review during the intervening years.
In the second quarter of 2011, AFG completed a comprehensive study of its asbestos and environmental exposures relating to the run-off operations of its property and casualty group and its exposures related to former railroad and manufacturing operations and sites. The study relied on a ground-up exposure analysis. With respect to asbestos, it considered products and non-products exposures, paid claims history, the pattern of new claims, settlements and projected development. As a result of the study, AFG recorded a $50 million special charge (net of reinsurance) to increase the property and casualty group’s asbestos reserves by $28 million and its environmental reserves by $22 million. The property and casualty group’s asbestos reserves increase related primarily to exposures on business assumed from other insurers resulting from an increase in anticipated aggregate exposures in several large settlements involving several insurers in which AFG has a small proportional share. Some insurers have settled long-standing asbestos exposures with their insureds and are seeking payment from reinsurers. Asbestos reserves related to the property and casualty group’s direct

 

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asbestos exposures were increased to reflect higher frequency and severity of mesothelioma and other cancer claims as well as increased defense costs on many of these claims. These trends were partially offset by a decline in the number of claims without serious injury and fewer new claims that required payment being reported to AFG. The increase in the property and casualty group’s environmental reserves was attributed primarily to a small number of increases on specific environmental claims at several sites. During the second quarter of 2010, an in-depth internal review of AFG’s A&E exposures was completed by AFG’s internal A&E claims specialists and actuaries in consultation with external actuaries and specialty outside counsel. During the second quarter of 2009, AFG completed a comprehensive study of its A&E exposures with the assistance of outside actuarial and engineering firms and specialty outside counsel. The 2010 in-depth internal review and the 2009 comprehensive study resulted in only minor adjustments to the A&E reserves. See Management’s Discussion and Analysis — “Results of Operations — Asbestos and Environmental Reserve Charges” for the amount of A&E reserve strengthening recorded in 2011, 2010 and 2009.
Supplemental Insurance Reserves — Long-term Care AFG, as well as other companies selling long-term care products have relatively limited claims, lapse, and mortality experience over extended periods, making it difficult to predict future claims. Long-term care claims tend to be much higher in dollar amount and longer in duration than other health care products such as Medicare supplement. In addition, long-term care claims are incurred much later in the life of a policy than most other supplemental health products. These factors make it difficult to appropriately price this product and were instrumental in AFG’s decision to stop writing new policies beginning in January 2010. AFG’s long-term care products have level premiums and are guaranteed renewable. Premium rates can potentially be increased in reaction to adverse experience. However, any rate increases would require regulatory approval.
Reserves for future policy benefits under long-term care policies are established (and related acquisition costs are amortized) over the life of the policies based on policy benefit assumptions as of the date of issuance, including investment yields, mortality, morbidity, persistency, and expenses. Once these assumptions are established for a given policy or group of policies, they are not changed over the life of the policy unless a loss recognition event (premium deficiency) occurs. Loss recognition occurs when, based on current expectations as of the measurement date, existing contract liabilities plus the present value of future premiums, including reasonably expected rate increases, are not expected to cover the present value of future claims payments and related settlement and maintenance costs as well as unamortized acquisition costs. Based on loss recognition testing at December 31, 2011, AFG’s long-term care reserves plus the present value of future premiums exceeded claims costs and unamortized acquisition expenses by approximately $25 million. Adverse changes in any of the reserve assumptions in future periods could result in loss recognition for AFG’s long-term care business. For example, a 1% change in claims costs or a 0.1% change in investment yields in all future periods, excluding their effect on the Company’s ability to achieve future rate increases, would each impact the December 31, 2011, “excess” described above by approximately $10 million. Once the “excess” is reduced to zero, the impact of adverse changes in assumptions is recorded as a charge to earnings as either a reduction in unamortized acquisition costs or an increase to contract reserves, net of any reinsurance recoverable.
Contingencies related to Subsidiaries’ Former Operations The A&E studies and reviews discussed above encompassed reserves for various environmental and occupational injury and disease claims and other contingencies arising out of the railroad operations disposed of by American Premier’s predecessor and certain manufacturing operations disposed of by American Premier and its subsidiaries and by GAFRI. Charges resulting from the A&E studies and review were less than $10 million in 2011, 2010 and 2009. Liabilities for claims and contingencies arising from these former operations totaled $92 million at December 31, 2011. For a discussion of the uncertainties in determining the ultimate liability, see Note M “Contingencies” to the financial statements.

 

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MANAGED INVESTMENT ENTITIES
Beginning in 2010, accounting standards require AFG to consolidate its investments in collateralized loan obligation (“CLO”) entities that it manages and owns an interest in (in the form of debt). See Note A “Accounting Policies Managed Investment Entities” and Note H “Managed Investment Entities.” The effect of consolidating these entities is shown in the tables below (in millions). The “Before CLO Consolidation” columns include AFG’s investment and earnings in the CLOs on an unconsolidated basis.
CONDENSED CONSOLIDATING BALANCE SHEET
                                 
            Managed              
    Before CLO     Investment     Consol.     Consolidated  
    Consolidation     Entities     Entries     As Reported  
December 31, 2011
                               
Assets:
                               
Cash and other investments
  $ 25,675     $     $ (98 )(a)   $ 25,577  
Assets of managed investment entities
          3,058             3,058  
Other assets
    7,407                   7,407  
 
                       
Total assets
  $ 33,082     $ 3,058     $ (98 )   $ 36,042  
 
                       
 
                               
Liabilities:
                               
Unpaid losses, loss adjustment expenses and unearned premiums
  $ 8,004     $     $     $ 8,004  
Annuity, life, accident and health benefits and reserves
    17,147                   17,147  
Liabilities of managed investment entities
          2,885       (98 )(a)     2,787  
Long-term debt and other liabilities
    3,413                   3,413  
 
                       
Total liabilities
    28,564       2,885       (98 )     31,351  
 
                               
Shareholders’ Equity:
                               
Common Stock and Capital surplus
    1,219                   1,219  
Retained earnings:
                               
Appropriated — managed investment entities
          173             173  
Unappropriated
    2,596                   2,596  
Accumulated other comprehensive income
    557                   557  
 
                       
Total shareholders’equity
    4,372       173             4,545  
Noncontrolling interests
    146                   146  
 
                       
Total equity
    4,518       173             4,691  
 
                       
Total liabilities and equity
  $ 33,082     $ 3,058     $ (98 )   $ 36,042  
 
                       
 
                               
December 31, 2010
                               
Assets:
                               
Cash and other investments
  $ 22,687     $     $ (17 )(a)   $ 22,670  
Assets of managed investment entities
          2,537             2,537  
Other assets
    7,247                   7,247  
 
                       
Total assets
  $ 29,934     $ 2,537     $ (17 )   $ 32,454  
 
                       
 
                               
Liabilities:
                               
Unpaid losses, loss adjustment expenses and unearned premiums
  $ 7,947     $     $     $ 7,947  
Annuity, life, accident and health benefits and reserves
    14,555                   14,555  
Liabilities of managed investment entities
          2,340       (17 )(a)     2,323  
Long-term debt and other liabilities
    3,009                   3,009  
 
                       
Total liabilities
    25,511       2,340       (17 )     27,834  
 
                               
Shareholders’ Equity:
                               
Common Stock and Capital surplus
    1,271                   1,271  
Retained earnings:
                               
Appropriated — managed investment entities
          197             197  
Unappropriated
    2,523                   2,523  
Accumulated other comprehensive income
    479                   479  
 
                       
Total shareholders’ equity
    4,273       197             4,470  
Noncontrolling interests
    150                   150  
 
                       
Total equity
    4,423       197             4,620  
 
                       
Total liabilities and equity
  $ 29,934     $ 2,537     $ (17 )   $ 32,454  
 
                       
     
(a)   Elimination of the fair value of AFG’s investment in CLOs.

 

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CONDENSED CONSOLIDATING STATEMENT OF EARNINGS
                                 
            Managed              
    Before CLO     Investment     Consol.     Consolidated  
    Consolidation(a)     Entities     Entries     As Reported  
Year ended December 31, 2011
                               
Revenues:
                               
Insurance premiums
  $ 3,189     $     $     $ 3,189  
Investment income
    1,247             (6 )(b)     1,241  
Realized gains (losses) on securities
    76                   76  
Realized gains (losses) on subsidiaries
    (3 )                 (3 )
Income (loss) of managed investment entities:
                               
Investment income
          105             105  
Loss on change in fair value of assets/liabilities
          (29 )     (4 )(b)     (33 )
Other income
    194             (19 )(c)     175  
 
                       
Total revenues
    4,703       76       (29 )     4,750  
 
                               
Costs and Expenses:
                               
Insurance benefits and expenses
    3,671                   3,671  
Expenses of managed investment entities
          100       (29 )(b)(c)     71  
Interest on borrowed money and other expenses
    448                   448  
 
                       
Total costs and expenses
    4,119       100       (29 )     4,190  
 
                       
 
                               
Operating earnings before income taxes
    584       (24 )           560  
Provision for income taxes
    240                   240  
 
                       
Net earnings, including noncontrolling interests
    344       (24 )           320  
Less: Net earnings (loss) attributable to noncontrolling interests
    1             (24 )(d)     (23 )
 
                       
Net Earnings Attributable to Shareholders
  $ 343     $ (24 )   $ 24     $ 343  
 
                       
 
                               
Year ended December 31, 2010
                               
Revenues:
                               
Insurance premiums
  $ 3,001     $     $     $ 3,001  
Investment income
    1,208             (17 )(b)     1,191  
Realized gains (losses) on securities
    101                   101  
Realized gains(losses) on subsidiaries
    (13 )                 (13 )
Income (loss) of managed investment entities:
                               
Investment income
          93             93  
Loss on change in fair value of assets/liabilities
          (80 )     10 (b)     (70 )
Other income
    209             (15 )(c)     194  
 
                       
Total revenues
    4,506       13       (22 )     4,497  
 
                               
Costs and Expenses:
                               
Insurance benefits and expenses
    3,297                   3,297  
Expenses of managed investment entities
          77       (22 )(b)(c)     55  
Interest on borrowed money and other expenses
    456                   456  
 
                       
Total costs and expenses
    3,753       77       (22 )     3,808  
 
                       
 
                               
Operating earnings before income taxes
    753       (64 )           689  
Provision for income taxes
    266                   266  
 
                       
Net earnings, including noncontrolling interests
    487       (64 )           423  
Less: Net earnings (loss) attributable to noncontrolling interests
    8             (64 )(d)     (56 )
 
                       
Net Earnings Attributable to Shareholders
  $ 479     $ (64 )   $ 64     $ 479  
 
                       
     
(a)   Includes $6 million and $17 million in 2011 and 2010, respectively, in investment income representing the change in fair value of AFG’s CLO investments plus $19 million and $15 million in 2011 and 2010, respectively, in CLO management fees earned.
 
(b)   Elimination of the change in fair value of AFG’s investments in the CLOs, including $10 million and $7 million 2011 and 2010, respectively, in distributions recorded as interest expense by the CLOs.
 
(c)   Elimination of management fees earned by AFG.
 
(d)   Allocate losses of CLOs attributable to other debt holders to noncontrolling interests.

 

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RESULTS OF OPERATIONS — THREE YEARS ENDED DECEMBER 31, 2011
General AFG’s net earnings attributable to shareholders, determined in accordance with GAAP, include certain items that may not be indicative of its ongoing core operations. The following table identifies such items and reconciles net earnings attributable to shareholders to core net operating earnings, a non-GAAP financial measure that AFG believes is a useful tool for investors and analysts in analyzing ongoing operating trends (in millions, except per share amounts):
                         
    2011     2010     2009  
Core net operating earnings
  $ 364     $ 433     $ 493  
Realized gains (a)
    45       46       26  
Special asbestos and environmental (“A&E”) charge(a)
    (38 )            
Valuation allowance against deferred tax assets(b)
    (28 )            
 
                 
Net earnings attributable to shareholders
  $ 343     $ 479     $ 519  
 
                 
 
                       
Diluted per share amounts:
                       
Core net operating earnings
  $ 3.53     $ 3.92     $ 4.23  
Realized gains
    .45       .41       .22  
Special asbestos and environmental charge
    (.37 )            
Valuation allowance against deferred tax assets
    (.28 )            
 
                 
Net earnings attributable to shareholders
  $ 3.33     $ 4.33     $ 4.45  
 
                 
     
(a)   The tax effects of reconciling items are shown below (in millions):
                         
    2011     2010     2009  
Realized gains
  $ (27 )   $ (36 )   $ (8 )
Special A&E charge
    21              
In addition, realized gains are shown net of noncontrolling interests of ($1 million) in 2011, ($6 million) in 2010 and ($4 million) in 2009.
     
(b)   The valuation allowance is net of $6 million in noncontrolling interest.
Net earnings attributable to shareholders and core net earnings decreased in 2011 compared to 2010 due primarily to lower underwriting profit and lower investment income in the property and casualty insurance operations partially offset by increased earnings in the annuity and supplemental operations. Net earnings attributable to shareholders were also impacted by a second quarter 2011 special A&E charge and a fourth quarter 2011 charge for a valuation allowance against deferred tax assets.
Net earnings attributable to shareholders and core net operating earnings decreased in 2010 compared to 2009 due primarily to lower underwriting profit and lower investment income in the property and casualty insurance operations, partially offset by improved results in the annuity and supplemental insurance operations. Net earnings attributable to shareholders also benefited from higher realized gains in 2010 than in 2009.
Property and Casualty Insurance — Underwriting AFG reports its property and casualty insurance business in the following sub-segments: (i) Property and transportation, (ii) Specialty casualty and (iii) Specialty financial.
To understand the overall profitability of particular lines, the timing of claims payments and the related impact of investment income must be considered. Certain “short-tail” lines of business (primarily property coverages) generally have quick loss payouts, which reduce the time funds are held, thereby limiting investment income earned thereon. On the other hand, “long-tail” lines of business (primarily liability coverages and workers’ compensation) generally have payouts that are either structured over many years or take many years to settle, thereby significantly increasing investment income earned on related premiums received.
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% indicates an underwriting profit. The combined ratio does not reflect investment income, other income or federal income taxes.

 

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While AFG desires and seeks to earn an underwriting profit on all of its business, it is not always possible to do so. As a result, AFG attempts to expand in the most profitable areas and control growth or even reduce its involvement in the least profitable ones.
AFG’s combined ratio has been better than the industry average for twenty-four of the last twenty-six years. Management believes that AFG’s insurance operations have performed better than the industry as a result of its specialty niche focus, product line diversification, stringent underwriting discipline and alignment of compensation incentives.
Premiums and combined ratios for AFG’s property and casualty insurance operations were as follows (dollars in millions):
                         
    2011     2010     2009  
Gross Written Premiums
                       
Property and transportation
  $ 2,273     $ 1,778     $ 1,816  
Specialty casualty
    1,302       1,295       1,394  
Specialty financial
    529       514       557  
Other
    2       2       (4 )
 
                 
 
  $ 4,106     $ 3,589     $ 3,763  
 
                 
Net Written Premiums
                       
Property and transportation
  $ 1,436     $ 1,159     $ 872  
Specialty casualty
    867       864       923  
Specialty financial
    398       323       448  
Other
    69       62       68  
 
                 
 
  $ 2,770     $ 2,408     $ 2,311  
 
                 
Combined Ratios
                       
Property and transportation
    92.0 %     88.0 %     74.1 %
Specialty casualty
    95.5       94.6       93.2  
Specialty financial
    85.1       74.8       74.1  
Total Specialty
    91.6       88.0       82.4  
Aggregate (including discontinued lines)
    93.4 %     88.5 %     82.7 %
Gross and net written premiums increased in 2011 compared to 2010 due primarily to higher premiums in the Property and transportation segment, particularly the crop and transportation businesses. In addition, higher net written premiums in 2011 reflect the impact of a third quarter 2010 reinsurance transaction in the Specialty financial group. Overall renewal rate momentum in the Specialty insurance operations was positive during the fourth quarter of 2011.
The Specialty insurance operations generated an underwriting profit of $231 million in 2011, $77 million lower than in 2010. Lower favorable reserve development, poor results in a block of program business and lower profitability in the crop operations were partially offset by improved results in the excess and surplus businesses. Results for 2011 include $120 million (4.3 points on the combined ratio) of favorable reserve development compared to $170 million (6.7 points) in 2010. Catastrophe losses totaled $46 million (1.7 points) in 2011 compared to $49 million (1.9 points) in 2010.
Gross written premiums decreased 5% in 2010 compared to 2009 due primarily to competitive pressures and lower spring agricultural commodity prices. Premiums resulting from National Interstate’s third quarter acquisition of Vanliner, premium growth from Marketform and higher fall agricultural commodity prices partially offset these declines. The increase in net written premiums in 2010 compared to 2009 is a result of decreased cessions under the crop reinsurance agreement, partially offset by the decline in premiums resulting from the reinsurance transaction in the Specialty financial group. Excluding crop operations, gross and net written premiums decreased 2% and 5%, respectively, in 2010 compared to 2009. Average renewal rates in the Specialty insurance operations during 2010 were flat compared to the prior year.
The Specialty insurance operations generated an underwriting profit of $308 million in 2010, $116 million lower than in 2009. In addition to soft market conditions, the reduced profit in 2010 compared to 2009 reflects a $35 million decrease in favorable prior year reserve development and a $31 million increase in catastrophe losses. Results for 2010 include 6.7 points of favorable reserve development compared to 8.5 points in 2009 and 1.9 points of catastrophe losses compared to .7 points in 2009.

 

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Property and transportation gross and net written premiums increased in 2011 when compared to 2010 as a result of higher crop premiums resulting from higher spring agricultural commodity prices as well as additional premiums related to National Interstate’s acquisition of Vanliner in July 2010. This group reported an underwriting profit of $113 million, $27 million lower than in 2010. Lower underwriting profits in the crop, property and inland marine and transportation businesses were partially offset by lower catastrophe losses. Catastrophe losses for this group were $32 million (2.3 points) in 2011 compared to $39 million (3.3 points) in 2010.
Gross written premiums for 2010 declined from 2009 primarily as a result of lower spring commodity prices that had the effect of lowering AFG’s crop premium volume. These declines were partially offset by additional premiums from the Vanliner acquisition. AFG returned to historical levels of 50% cessions under its crop reinsurance agreement in 2010, compared to 90% in 2009, contributing to a substantial increase in this group’s net written premiums. Excluding crop, this group’s net written premiums for 2010 increased 9% from 2009, primarily as a result of the Vanliner acquisition. This group reported an underwriting profit of $140 million in 2010, $96 million lower than in 2009 due primarily to lower favorable reserve development and higher catastrophe losses. Results for 2010 include 2.3 points of favorable reserve development compared to 5.7 points in 2009 and 3.3 points of catastrophe losses in 2010 compared to minimal catastrophe losses in 2009.
Specialty casualty gross and net written premiums for 2011 were up slightly when compared to the 2010 period. Growth in the international operations and higher premiums in the excess and surplus and targeted markets operations more than offset the non-renewal of two major programs that did not meet return thresholds and a decision to exit the excess workers’ compensation business. This group reported an underwriting profit of $39 million in 2011, $8 million lower than the prior year. Improved results in the excess and surplus businesses were more than offset by underwriting losses in a block of program business and an $18 million decrease in favorable reserve development.
Gross and net written premiums decreased in 2010 compared to 2009 due primarily to competitive market conditions in the excess and surplus markets and California workers’ compensation businesses, as well as volume reductions resulting from decreased demand for general liability coverages in the homebuilders’ market. Growth in gross written premiums in the Marketform and environmental operations partially offset these declines. Increased retentions in the executive liability operations helped to offset decreases in net written premiums. This group reported an underwriting profit of $47 million in 2010, $16 million lower than in 2009. The decrease was primarily due to lower underwriting profits in the California workers’ compensation business and the general liability operations (primarily those that serve the homebuilders’ industry). These decreases were partially offset by improved results in the executive liability and excess and surplus operations.
Underwriting results for 2011, 2010 and 2009 include $44 million, $55 million and $56 million, respectively, in adverse reserve development related to Marketform, primarily its run-off Italian public hospital medical malpractice business.
Specialty financial net written premiums in 2011 were higher when compared to 2010 due primarily to the impact of a third quarter 2010 reinsurance transaction that involved the sale of unearned premiums related to the automotive lines of business. This group reported an underwriting profit of $61 million in 2011, $51 million lower than in 2010. Lower favorable reserve development, primarily in the run-off automobile residual value insurance (“RVI”) business, contributed to this decline.

 

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Gross written premiums decreased in 2010 compared to 2009, reflecting the decision to exit certain automotive lines of business in 2009. During the third quarter of 2010, AFG ceded the unearned premium related to these businesses in a reinsurance transaction, which resulted in a reduction of approximately $100 million in net written premiums. Specialty financial underwriting profit was $112 million in 2010 compared to $134 million in 2009. The lower underwriting profit in 2010 reflects $51 million less of favorable prior year reserve development in the RVI operations than was recorded in 2009.
Asbestos and Environmental Reserve Charges As previously discussed under “Uncertainties — Asbestos and Environmental-related (“A&E”) Insurance Reserves,” AFG has established property and casualty insurance reserves for claims related to environmental exposures and asbestos claims. AFG also has recorded liabilities for various environmental and occupational injury and disease claims arising out of former railroad and manufacturing operations. Total charges recorded to increase reserves (net of reinsurance recoverable) for A&E exposures of AFG’s property and casualty group (included in loss and loss adjustment expenses) and its former railroad and manufacturing operations (included in other operating and general expenses) were as follows (in millions):
                         
    2011     2010     2009  
Property and casualty group
  $ 50     $ 9     $ 4  
Former operations
    9       19       15  
Loss development As shown in Note O “Insurance — Property and Casualty Insurance Reserves,” AFG’s property and casualty operations recorded favorable loss development of $69 million in 2011, $158 million in 2010 and $198 million in 2009 related to prior accident years. Major areas of favorable (adverse) development were as follows (in millions):
                         
    2011     2010     2009  
Property and transportation
  $ 26     $ 27     $ 52  
Specialty casualty
    71       89       59  
Specialty financial
    10       48       105  
Other specialty
    13       6       (11 )
 
                 
Total Specialty
    120       170       205  
Other, primarily asbestos and environmental charges
    (51 )     (12 )     (7 )
 
                 
Aggregate (including discontinued lines)
  $ 69     $ 158     $ 198  
 
                 
Favorable reserve development in the Property and transportation group in 2011, 2010 and 2009 reflects lower than expected loss frequency in crop products. The favorable reserve development in this group also reflects lower severity in auto liability products in 2010 and lower than expected loss frequency in ocean marine products and lower severity in farm and crop losses in 2009.
Favorable reserve development in the Specialty casualty group in 2011 is due primarily to lower than expected claim severity in directors and officers liability, excess and surplus lines and the run-off legal professional liability business, partially offset by adverse development due to higher frequency and severity on run-off Italian public hospital medical malpractice liability products written by Marketform and a block of U.S.-based program (motel/hotel, restaurants, taverns and recreational) business. Favorable reserve development in the Specialty casualty group in 2010 is due to lower than expected severity on claims in general liability, directors and officers liability and the run-off legal professional liability business, partially offset by adverse development on run-off Italian medical malpractice liability products in Marketform. Favorable reserve development in the Specialty casualty group in 2009 reflects lower severity on claims in general liability and directors and officers liability as well as lower than expected frequency in a block of program (leisure camps, fairs and festivals, and sports and leisure) business, partially offset by adverse development on Marketform’s run-off Italian medical malpractice reserves.
Favorable reserve development in the Specialty financial group in 2011 is due to lower than expected frequency and severity in the surety, fidelity, crime and foreign credit businesses as economic conditions did not affect these lines as adversely as had been anticipated. Favorable reserve development in Specialty financial in 2010 and 2009 related to lower than expected frequency and severity in the run-off RVI operations due to favorable trends in used car sale prices and lower loss severity in AFG’s surety, fidelity and crime products.

 

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The 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.
Annuity and Supplemental Insurance Operations Operating earnings before income taxes (excluding realized gains (losses)) of the annuity and supplemental insurance segment increased $22 million (11%) to $224 million in 2011 due primarily to higher earnings in the fixed annuity and Medicare supplement businesses, partially offset by higher mortality in the run-off life operations, the impact of a decrease in the stock market on the variable annuity business and the impact of lower interest rates on the indexed annuity business. The 2010 results were $40 million (25%) higher than 2009 as expense savings and higher earnings in the fixed annuity and supplemental insurance operations were partially offset by lower earnings in the variable annuity operations.
Statutory Annuity Premiums The following table summarizes AFG’s annuity sales (statutory, in millions).
                         
    2011     2010     2009  
403(b) Fixed and Indexed Annuities:
                       
First Year
  $ 18     $ 34     $ 66  
Renewal
    164       168       144  
Single Sum
    75       103       127  
 
                 
Subtotal
    257       305       337  
 
                       
Non-403(b) Indexed Annuities
    1,549       735       402  
Non-403(b) Fixed Annuities
    239       430       294  
Bank Annuities
    971       737       314  
Variable Annuities
    70       73       87  
 
                 
Total Annuity Premiums
  $ 3,086     $ 2,280     $ 1,434  
 
                 
Bank annuities represent annuity premiums generated through banks by independent agents and brokers, as well as through direct relationships with certain financial institutions.
The increase in annuity premiums in 2011 and 2010 is attributable to increased sales of indexed annuities in the non-403(b) single premium market and higher sales through banks.
Increased sales of indexed annuities reflects the industry trend towards indexed annuities and away from traditional fixed annuities, as well as AFG’s introduction of new indexed products and features. The increase in “Bank Annuities” premiums in 2011 reflects the addition of several new banks.
Life, Accident and Health Premiums and Benefits The following table summarizes AFG’s life, accident and health premiums and benefits as shown in the Consolidated Statement of Earnings (in millions):
                         
    2011     2010     2009  
Premiums
                       
Supplemental insurance operations
                       
First Year
  $ 38     $ 63     $ 85  
Renewal
    367       361       330  
Life operations (in run-off)
    25       27       29  
 
                 
 
  $ 430     $ 451     $ 444  
 
                 
 
                       
Benefits
                       
Supplemental insurance operations
  $ 326     $ 330     $ 317  
Life operations (in run-off)
    43       38       44  
 
                 
 
  $ 369     $ 368     $ 361  
 
                 
In January 2010, AFG ceased new sales of long-term care insurance. Renewal premiums will be accepted unless those policies lapse.

 

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Investment Income Over the past couple of years, yields available in the financial markets on fixed maturity securities have generally declined, placing downward pressure on AFG’s investment portfolio yield. The $50 million increase in investment income in 2011 compared to 2010 reflects higher average invested assets, primarily related to growth in the annuity business, partially offset by lower yields on fixed maturity investments. The $9 million decrease in investment income in 2010 compared to 2009 reflects lower yields on fixed maturity investments partially offset by higher average invested assets. Investment income includes $27 million in 2011, $66 million in 2010 and $130 million in 2009 of interest income earned on interest-only and similar MBS, primarily non-agency interest-only securities with interest rates that float inversely with short-term rates.
Realized Gains (Losses) on Securities Net realized gains (losses) on securities consisted of the following (in millions):
                         
    2011     2010     2009  
 
                       
Realized gains (losses) before impairments:
                       
Disposals
  $ 156     $ 134     $ 115  
Change in the fair value of derivatives
    (24 )     43       154  
Adjustments to annuity deferred policy acquisition costs and related items
    (4 )     (14 )     (23 )
 
                 
 
                       
 
    128       163       246  
 
                 
Impairment charges:
                       
Securities
    (68 )     (86 )     (271 )
Adjustments to annuity deferred policy acquisition costs and related items
    16       24       68  
 
                 
 
    (52 )     (62 )     (203 )
 
                 
 
  $ 76     $ 101     $ 43  
 
                 
Realized gains on disposals include gains of approximately $76 million in 2011, $26 million in 2010 and $76 million in 2009 on sales of shares of Verisk Analytics, Inc.
The change in fair value of derivatives includes net losses of less than $1 million in 2011, net gains of $50 million in 2010 and $157 million in 2009 from the mark-to-market of MBS, primarily interest-only securities with interest rates that float inversely with short-term rates. See Note F — “Derivatives.”
Approximately $57 million, $79 million and $221 million of the impairment charges in 2011, 2010 and 2009, respectively, related to fixed maturity investments, primarily corporate bonds and MBS.
Realized Losses on Subsidiaries In the third quarter of 2010, AFG recorded an impairment charge of $22 million resulting from management’s decision to de-emphasize the sale of supplemental health insurance products through career agents, including the sale of a marketing subsidiary. Partially offsetting this loss was National Interstate’s $7 million gain on the acquisition of Vanliner in 2010. See Note I — “Goodwill and Other Intangibles” and Note B — “Acquisition.”
Other Income The $19 million decrease in other income in 2011 compared to 2010 reflects $16 million in income recorded in the third quarter of 2010 from the sale of real estate and the termination of leases by a tenant. When comparing other income for 2010 to 2009, this income was more than offset by a decline in income from AFG’s warranty business and lower fee income in certain other businesses.

 

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Annuity Benefits Annuity benefits reflect amounts accrued on annuity policyholders’ funds accumulated. On deferred annuities (annuities in the accumulation phase), interest is generally credited to policyholders’ accounts at their current stated interest rates. Furthermore, for “two-tier” deferred annuities (annuities under which a higher interest amount can be earned if a policy is annuitized rather than surrendered), additional reserves are accrued for (i) persistency and premium bonuses and (ii) excess benefits expected to be paid for future deaths and annuitizations. Changes in investment yields, crediting rates, actual surrender, death and annuitization experience or modifications in actuarial assumptions can affect these additional reserves and could result in charges (or credits) to earnings in the period the projections are modified.
In the fourth quarters of 2011, 2010 and 2009, AFG conducted its detailed review of actual results and future assumptions underlying its annuity operations. As a result of the reviews, AFG recorded expense reductions of $10 million in 2011 and $3 million in 2010 and a charge of $5 million in 2009 to annuity benefits related to changes in these assumptions. Excluding these items, annuity benefits increased $73 million in 2011 compared to 2010 and $17 million in 2010 compared to 2009 reflecting growth in the annuity business partially offset by lower average crediting rates. The impact of changes in interest rates and stock market performance on the fair value of derivatives related to the indexed annuity business also impacted the 2011 and 2010 results.
Annuity and Supplemental Insurance Acquisition Expenses Annuity and supplemental insurance acquisition expenses include amortization of annuity, supplemental insurance and life business DPAC as well as a portion of commissions on sales of insurance products. Annuity and supplemental insurance acquisition expenses also include amortization of the present value of future profits of businesses acquired (“PVFP”).
As a result of the 2011 and 2010 reviews of actual results and future assumptions discussed above in “Annuity Benefits,” AFG recorded write-offs of DPAC of $10 million in 2011 and $28 million in 2010 due primarily to the impact of changes in assumptions related to future investment yields, surrenders and annuitization and death benefits partially offset by the impact of lower expected expenses and crediting rates in the fixed annuity business. As a result of the 2009 review, AFG recorded an $8 million write-off of DPAC due primarily to the impact of changes in assumptions related to future investment yields on the fixed annuity business. Excluding these charges, insurance acquisition expenses remained unchanged in 2011 compared to 2010 and increased $24 million in 2010 compared to 2009 reflecting additional amortization due to growth in the annuity business.
The vast majority of this group’s DPAC asset relates to its annuity and life insurance lines of business. Unanticipated spread compression, decreases in the stock market, adverse mortality experience, and higher than expected lapse rates could lead to further write-offs of DPAC or PVFP in the future.
Interest Charges on Borrowed Money Interest expense increased $7 million (9%) in 2011 compared to 2010 and $11 million (16%) in 2010 compared to 2009 reflecting AFG’s issuance of $132 million of 7% Senior Notes in September 2010.
Other Operating and General Expenses The $85 million decrease in 2010 compared to 2009 reflects the 2009 sale of a small subsidiary, lower expenses in AFG’s warranty business due to the run-off of certain products, and lower expenses in the annuity and supplemental insurance operations.
Income Taxes See Note L “Income Taxes” to the financial statements for an analysis of items affecting AFG’s effective tax rate.

 

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Noncontrolling Interests The following table details net earnings (loss) in consolidated subsidiaries attributable to holders other than AFG (in millions):
                         
    2011     2010     2009  
National Interstate
  $ 15     $ 19     $ 21  
Marketform
    (15 )     (11 )     (10 )
Managed Investment Entities
    (24 )     (64 )      
Other
    1              
 
                 
 
  $ (23 )   $ (56 )   $ 11  
 
                 
Marketform’s losses reflect adverse reserve development in its run-off Italian public hospital medical malpractice business. As discussed in Notes A and H to the financial statements, the losses of Managed Investment Entities in 2011 and 2010 represent CLO losses that ultimately inure to holders of CLO debt other than AFG.
NEW ACCOUNTING STANDARDS
See Note A — Recent Accounting Standards for a discussion of new accounting standards to be adopted by AFG in 2012.
ITEM 7A
Quantitative and Qualitative Disclosures About Market Risk
Market risk represents the potential economic loss arising from adverse changes in the fair value of financial instruments. AFG’s exposures to market risk relate primarily to its investment portfolio and annuity contracts, which are exposed to interest rate risk and, to a lesser extent, equity price risk. To a much lesser extent, AFG’s long-term debt is also exposed to interest rate risk.
Fixed Maturity Portfolio The fair value of AFG’s fixed maturity portfolio is directly impacted by changes in market interest rates. AFG’s fixed maturity portfolio is comprised of primarily fixed rate investments with intermediate-term maturities. This practice is designed to allow flexibility in reacting to fluctuations of interest rates. The portfolios of AFG’s insurance operations are managed with an attempt to achieve an adequate risk-adjusted return while maintaining sufficient liquidity to meet policyholder obligations. AFG’s annuity and run-off life operations attempt to align the duration of their invested assets to the projected cash flows of policyholder liabilities.
Consistent with the discussion in Item 7 — “Management’s Discussion and Analysis” — “Investments,” the following table demonstrates the sensitivity of the fair value of AFG’s fixed maturity portfolio to reasonably likely changes in interest rates by illustrating the estimated effect on AFG’s fixed maturity portfolio that an immediate increase of 100 basis points in the interest rate yield curve would have at December 31 (based on the duration of the portfolio, dollars in millions). Increases or decreases from the 100 basis points illustrated would be approximately proportional.
                 
    2011     2010  
Fair value of fixed maturity portfolio
  $ 22,247     $ 19,721  
Pretax impact on fair value of 100 bps increase in interest rates
  $ (1,046 )   $ (868 )
Pretax impact as % of total fixed maturity portfolio
    (4.7 %)     (4.4 %)

 

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European Debt Exposure Certain European countries, including the so-called “peripheral countries” (Greece, Portugal, Ireland, Italy and Spain) have been experiencing varying degrees of financial stress over the past couple of years. There remains considerable uncertainty as to future developments in the European debt crisis and the impact on global financial markets. Market concerns over the direct and indirect exposure of European financial institutions to the peripheral countries have resulted in widening of credit spreads and increased costs of funding for some European financial institutions.
At December 31, 2011, AFG owned no sovereign debt issued by the peripheral countries. The total exposure of AFG’s fixed maturity portfolio to sovereign and non-sovereign (corporate industrial and financial institution) debt at December 31, 2011, is shown in the table below (in millions):
                         
                    Unrealized  
    Carrying     Fair     Gain  
    Value     Value     (Loss)  
European Industrials
                       
Eurozone (17 countries with euro as common currency)
  $ 293     $ 308     $ 15  
Non-Eurozone (primarily U.K., Switzerland and Sweden)
    404       445       41  
 
                 
Total European Industrials
  $ 697     $ 753     $ 56  
 
                 
 
                       
European Financials
                       
Eurozone (17 countries with euro as common currency)
  $ 135     $ 132     $ (3 )
Non-Eurozone (primarily U.K., Switzerland and Sweden)
    285       273       (12 )
 
                 
Total European Financials
  $ 420     $ 405     $ (15 )
 
                 
 
                       
European Sovereign Debt
                       
Eurozone (primarily France, Germany and Netherlands)
  $ 18     $ 18     $  
Non-Eurozone (primarily U.K. and Sweden)
    13       13        
 
                 
Total European Sovereign Debt
  $ 31     $ 31     $  
 
                 
 
                       
Total European Exposure
                       
Eurozone
  $ 446     $ 458     $ 12  
Non-Eurozone
    702       731       29  
 
                 
Total European Exposure
  $ 1,148     $ 1,189     $ 41  
 
                 
Annuity Contracts Substantially all of AFG’s fixed rate annuity contracts permit AFG to change crediting rates (subject to minimum interest rate guarantees as determined by applicable law) enabling management to react to changes in market interest rates. In late 2003, AFG began issuing products with guaranteed minimum crediting rates of less than 2% in states where required approvals have been received. The guaranteed minimum crediting rate on virtually all new product sales since 2010 is 1%. At December 31, 2011, approximately half of AFG’s annuity contracts were at, or within ten basis points of the guaranteed minimum crediting rate.
At December 31, 2011, the weighted-average stated crediting rate on the in-force block of AFG’s principal fixed annuity products was approximately 3.1%, and management estimates that the crediting rate on this in-force business will remain approximately 3.1% over the next five years. This rate reflects actuarial assumptions as to (i) expected investment spreads, (ii) deaths, (iii) annuitizations, (iv) surrenders and (v) renewal premiums. Actual experience and changes in actuarial assumptions may result in different effective crediting rates than those above. The current stated crediting rates (excluding bonus interest) on new sales of AFG’s fixed annuity products generally range from 1.0% to 2.0%.
Actuarial assumptions used to estimate DPAC and certain annuity liabilities, as well as AFG’s ability to maintain spread, could be impacted if a low interest rate environment continues for an extended period, or if increases in interest rates cause policyholder behavior to differ significantly from current expectations.

 

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Projected payments (in millions) in each of the subsequent five years and for all years thereafter on AFG’s fixed annuity liabilities at December 31 were as follows.
                                                                 
                                                            Fair  
    First     Second     Third     Fourth     Fifth     Thereafter     Total     Value(*)  
2011
  $ 1,373     $ 1,500     $ 1,495     $ 1,772     $ 1,941     $ 7,339     $ 15,420     $ 15,314  
2010
    1,248       1,309       1,418       1,381       1,602       5,947       12,905       12,233  
     
(*)   Fair value excludes life contingent annuities in the payout phase (carrying value of $201 million and $208 million at December 31, 2011 and 2010, respectively).
AFG’s indexed annuities represented approximately one-third of annuity benefits accumulated at December 31, 2011. These annuities provide policyholders with a crediting rate tied, in part, to the performance of an existing stock market index. AFG attempts to mitigate the risk in the index-based component of these products through the purchase of call options on the appropriate index. AFG’s strategy is designed so that an increase in the liabilities, due to an increase in the market index, will be generally offset by unrealized and realized gains on the call options purchased by AFG. Both the index-based component of the annuities and the related call options are considered derivatives and adjusted to fair value through current earnings as annuity benefits. Adjusting these derivatives to fair value increased (decreased) annuity benefits expense by $42 million in 2011, ($21 million) in 2010 and $3 million in 2009.
Long-Term Debt The following table shows scheduled principal payments (in millions) on fixed-rate long-term debt of AFG and its subsidiaries and related weighted average interest rates for each of the subsequent five years and for all years thereafter.
                                     
    December 31, 2011         December 31, 2010  
    Scheduled                 Scheduled        
    Principal                 Principal        
    Payments     Rate         Payments     Rate  
2012
  $ 1       5.9 %   2011   $ 9       10.2 %
2013
    2       5.9     2012     1       5.9  
2014
    2       5.9     2013     2       5.9  
2015
    14       5.7     2014     2       5.9  
2016
    45       6.1     2015     14       5.7  
Thereafter
    799       8.4     Thereafter     844       8.3  
 
                               
 
                                   
Total
  $ 863       7.9 %   Total   $ 872       8.2 %
 
                               
 
                                   
Fair Value
  $ 940             Fair Value   $ 941          
 
                               
No amounts were outstanding under AFG’s bank credit facility at December 31, 2011 or 2010.

 

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ITEM 8
Financial Statements and Supplementary Data
“Selected Quarterly Financial Data” has been included in Note N to the Consolidated Financial Statements.
ITEM 9A
Controls and Procedures
AFG’s management, with participation of its Co-Chief Executive Officers and its principal financial officer, has evaluated AFG’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15) as of the end of the period covered by this report. Based on that evaluation, AFG’s Co-CEOs and principal financial officer concluded that these controls and procedures are effective. There have been no changes in AFG’s internal control over financial reporting during the fourth fiscal quarter of 2011 that materially affected, or are reasonably likely to materially affect, AFG’s internal control over financial reporting. There have been no significant changes in AFG’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
AFG’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Securities Exchange Act Rules 13a-15(f). Under the supervision and with the participation of management, including AFG’s principal executive officers and principal financial officer, AFG conducted an evaluation of the effectiveness of internal control over financial reporting as of December 31, 2011, based on the criteria set forth in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission.
There are inherent limitations to the effectiveness of any system of internal controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective internal controls and procedures can only provide reasonable assurance of achieving their control objectives.
Based on AFG’s evaluation, management concluded that internal control over financial reporting was effective as of December 31, 2011. The attestation report of AFG’s independent registered public accounting firm on AFG’s internal control over financial reporting as of December 31, 2011, is set forth below.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Board of Directors and Shareholders
American Financial Group, Inc.
We have audited American Financial Group, Inc. and subsidiaries’ (the Company’s) internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, American Financial Group, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of American Financial Group, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated statements of earnings, changes in equity and cash flows for each of the three years in the period ended December 31, 2011, and our report dated February 28, 2012, expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Cincinnati, Ohio
February 28, 2012

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
American Financial Group, Inc.
We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries (the Company) as of December 31, 2011 and 2010, and the related consolidated statements of earnings, changes in equity and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Financial Group, Inc. and subsidiaries at December 31, 2011 and 2010, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Note A to the consolidated financial statements, in connection with implementing a new accounting standard, the Company changed its method of accounting for certain variable interest entities in 2010.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), American Financial Group, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2011, 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 28, 2012, expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Cincinnati, Ohio
February 28, 2012

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars In Millions)
                 
    December 31,  
    2011     2010  
Assets:
               
Cash and cash equivalents
  $ 1,324     $ 1,099  
Investments:
               
Fixed maturities, available for sale at fair value (amortized cost — $20,562 and $18,490)
    21,807       19,328  
Fixed maturities, trading at fair value
    440       393  
Equity securities, at fair value (cost — $744 and $458)
    928       690  
Mortgage loans
    401       468  
Policy loans
    252       264  
Real estate and other investments
    425       428  
 
           
Total cash and investments
    25,577       22,670  
 
               
Recoverables from reinsurers
    2,942       2,964  
Prepaid reinsurance premiums
    409       422  
Agents’ balances and premiums receivable
    565       535  
Deferred policy acquisition costs
    1,105       1,244  
Assets of managed investment entities
    3,058       2,537  
Other receivables
    895       674  
Variable annuity assets (separate accounts)
    548       616  
Other assets
    757       606  
Goodwill
    186       186  
 
           
 
               
Total assets
  $ 36,042     $ 32,454  
 
           
 
               
Liabilities and Equity:
               
Unpaid losses and loss adjustment expenses
  $ 6,520     $ 6,413  
Unearned premiums
    1,484       1,534  
Annuity benefits accumulated
    15,420       12,905  
Life, accident and health reserves
    1,727       1,650  
Payable to reinsurers
    475       320  
Liabilities of managed investment entities
    2,787       2,323  
Long-term debt
    934       952  
Variable annuity liabilities (separate accounts)
    548       616  
Other liabilities
    1,456       1,121  
 
           
Total liabilities
    31,351       27,834  
 
               
Shareholders’ equity:
               
Common Stock, no par value
               
— 200,000,000 shares authorized
               
— 97,846,402 and 105,168,366 shares outstanding
    98       105  
Capital surplus
    1,121       1,166  
Retained earnings:
               
Appropriated — managed investment entities
    173       197  
Unappropriated
    2,596       2,523  
Accumulated other comprehensive income, net of tax
    557       479  
 
           
Total shareholders’ equity
    4,545       4,470  
 
               
Noncontrolling interests
    146       150  
 
           
Total equity
    4,691       4,620  
 
           
 
               
Total liabilities and equity
  $ 36,042     $ 32,454  
 
           
See notes to consolidated financial statements.

 

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Table of Contents

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF EARNINGS
(In Millions, Except Per Share Data)
                         
    Year ended December 31,  
    2011     2010     2009  
Revenues:
                       
Property and casualty insurance premiums
  $ 2,759     $ 2,550     $ 2,412  
Life, accident and health premiums
    430       451       444  
Investment income
    1,241       1,191       1,200  
Realized gains (losses) on:
                       
Securities (*)
    76       101       43  
Subsidiaries
    (3 )     (13 )     (5 )
Income (loss) of managed investment entities:
                       
Investment income
    105       93        
Loss on change in fair value of assets/liabilities
    (33 )     (70 )      
Other income
    175       194       226  
 
                 
Total revenues
    4,750       4,497       4,320  
 
                       
Costs and Expenses:
                       
Property and casualty insurance:
                       
Losses and loss adjustment expenses
    1,744       1,457       1,187  
Commissions and other underwriting expenses
    835       797       808  
Annuity benefits
    510       444       435  
Life, accident and health benefits
    369       368       361  
Annuity and supplemental insurance acquisition expenses
    213       231       187  
Interest charges on borrowed money
    85       78       67  
Expenses of managed investment entities
    71       55        
Other operating and general expenses
    363       378       463  
 
                 
Total costs and expenses
    4,190       3,808       3,508  
 
                 
 
                       
Operating earnings before income taxes
    560       689       812  
Provision for income taxes
    240       266       282  
 
                 
 
                       
Net earnings, including noncontrolling interests
    320       423       530  
Less: Net earnings (loss) attributable to noncontrolling interests
    (23 )     (56 )     11  
 
                 
 
                       
Net Earnings Attributable to Shareholders
  $ 343     $ 479     $ 519  
 
                 
 
                       
Earnings Attributable to Shareholders per Common Share:
                       
Basic
  $ 3.39     $ 4.38     $ 4.49  
 
                 
Diluted
  $ 3.33     $ 4.33     $ 4.45  
 
                 
 
                       
Average number of Common Shares:
                       
Basic
    101.3       109.2       115.7  
Diluted
    102.9       110.5       116.8  
 
                       
Cash dividends per Common Share
  $ .6625     $ .575     $ .52  
 
     
(*)   Consists of the following:
                         
Realized gains before impairments
  $ 128     $ 163     $ 246  
 
                       
Losses on securities with impairment
    (31 )     (50 )     (373 )
Non-credit portion recognized in other comprehensive income (loss)
    (21 )     (12 )     170  
 
                 
Impairment charges recognized in earnings
    (52 )     (62 )     (203 )
 
                 
 
                       
Total realized gains on securities
  $ 76     $ 101     $ 43  
 
                 
See notes to consolidated financial statements.

 

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Table of Contents

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
(Dollars In Millions)
                                                                 
            Shareholders’ Equity              
            Common Stock                     Accum.             Noncon-        
    Common     and Capital     Retained Earnings     Other Comp             trolling     Total  
    Shares     Surplus     Appro.     Unappro.     Inc. (Loss)     Total     Interests     Equity  
Balance at December 31, 2008
    115,599,169     $ 1,351     $     $ 1,842     $ (703 )   $ 2,490     $ 112     $ 2,602  
 
                                                               
Cumulative effect of accounting change
                      17       (17 )                  
Net earnings
                      519             519       11       530  
Other comprehensive income (loss), net of tax:
                                                               
Change in unrealized gain (loss) on securities
                            866       866       6       872  
Change in foreign currency translation
                            18       18       1       19  
Change in unrealized pension and other postretirement benefits
                            (1 )     (1 )           (1 )
 
                                                         
Total comprehensive income (loss)
                                            1,402       18       1,420  
 
                                                               
Dividends on Common Stock
                      (60 )           (60 )           (60 )
Shares issued:
                                                               
Exercise of stock options
    1,026,891       18                         18             18  
Other benefit plans
    207,601       3                         3             3  
Dividend reinvestment plan
    20,847                                            
Stock-based compensation expense
          11                         11             11  
Shares acquired and retired
    (3,291,835 )     (39 )           (42 )           (81 )           (81 )
Shares exchanged — benefit plans
    (176,330 )     (2 )           (2 )           (4 )           (4 )
Noncontrolling interest of acquired business
                                        10       10  
Other
          2                         2       (2 )      
 
                                               
 
                                                               
Balance at December 31, 2009
    113,386,343       1,344             2,274       163       3,781       138       3,919  
 
                                                               
Cumulative effect of accounting change
                261       4       (4 )     261             261  
Net earnings
                      479             479       (56 )     423  
Other comprehensive income (loss), net of tax:
                                                               
Change in unrealized gain (loss) on securities
                            313       313       2       315  
Change in foreign currency translation
                            8       8             8  
 
                                                         
Total comprehensive income (loss)
                                            800       (54 )     746  
 
                                                               
Allocation of losses of managed investment entities
                (64 )                 (64 )     64        
Dividends on Common Stock
                      (64 )           (64 )           (64 )
Shares issued:
                                                               
Exercise of stock options
    1,547,526       31                         31             31  
Other benefit plans
    479,514       6                         6             6  
Dividend reinvestment plan
    17,028                                            
Stock-based compensation expense
          12                         12             12  
Shares acquired and retired
    (10,261,045 )     (122 )           (170 )           (292 )           (292 )
Shares exchanged — benefit plans
    (1,000 )                                          
Other
                            (1 )     (1 )     2       1  
 
                                               
 
                                                               
Balance at December 31, 2010
    105,168,366       1,271       197       2,523       479       4,470       150       4,620  
 
                                                               
Net earnings
                      343             343       (23 )     320  
Other comprehensive income (loss), net of tax:
                                                               
Change in unrealized gain (loss) on securities
                            80       80       5       85  
Change in foreign currency translation
                            (3 )     (3 )     1       (2 )
Change in unrealized pension and other postretirement benefits
                            1       1             1  
 
                                                         
Total comprehensive income (loss)
                                            421       (17 )     404  
Allocation of losses of managed investment entities
                (24 )                 (24 )     24        
Dividends on Common Stock
                      (68 )           (68 )           (68 )
Shares issued:
                                                               
Exercise of stock options
    1,576,664       38                         38             38  
Other benefit plans
    387,746       9                         9             9  
Dividend reinvestment plan
    15,763       1                         1             1  
Stock-based compensation expense
          14                         14             14  
Shares acquired and retired
    (9,281,386 )     (113 )           (202 )           (315 )           (315 )
Shares exchanged — benefit plans
    (20,751 )     (1 )                       (1 )           (1 )
Other
                                        (11 )     (11 )
 
                                               
 
                                                               
Balance at December 31, 2011
    97,846,402     $ 1,219     $ 173     $ 2,596     $ 557     $ 4,545     $ 146     $ 4,691  
 
                                               
See notes to consolidated financial statements.

 

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Table of Contents

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(In Millions)
                         
    Year ended December 31,  
    2011     2010     2009  
Operating Activities:
                       
Net earnings, including noncontrolling interests
  $ 320     $ 423     $ 530  
Adjustments:
                       
Depreciation and amortization
    192       214       198  
Annuity benefits
    510       444       435  
Realized gains on investing activities
    (74 )     (92 )     (34 )
Net purchases of trading securities
    (45 )     (11 )     (51 )
Deferred annuity and life policy acquisition costs
    (253 )     (211 )     (172 )
Change in:
                       
Reinsurance and other receivables
    (228 )     555       352  
Other assets
    (101 )     8       145  
Insurance claims and reserves
    134       (413 )     (421 )
Payable to reinsurers
    155       (150 )     (41 )
Other liabilities
    246       2       (17 )
Managed investment entities’ assets/liabilities
    (212 )     89        
Other operating activities, net
    23       6       (9 )
 
                 
Net cash provided by operating activities
    667       864       915  
 
                 
 
                       
Investing Activities:
                       
Purchases of:
                       
Fixed maturities
    (5,321 )     (4,979 )     (4,855 )
Equity securities
    (397 )     (223 )     (21 )
Mortgage loans
    (190 )     (159 )     (82 )
Real estate, property and equipment
    (86 )     (74 )     (62 )
Subsidiaries
          (128 )     (5 )
Proceeds from:
                       
Maturities and redemptions of fixed maturities
    1,974       2,081       1,934  
Repayments of mortgage loans
    269       71       11  
Sales of fixed maturities
    1,293       1,540       2,207  
Sales of equity securities
    198       49       127  
Sales of real estate, property and equipment
    3       4       1  
Sale of subsidiary
    9              
Managed investment entities:
                       
Purchases of investments
    (1,563 )     (1,008 )      
Proceeds from sales and redemptions of investments
    1,391       1,018        
Cash and cash equivalents of businesses acquired or sold, net
    (5 )     95       (23 )
Other investing activities, net
    (14 )     8       (15 )
 
                 
Net cash used in investing activities
    (2,439 )     (1,705 )     (783 )
 
                 
 
                       
Financing Activities:
                       
Annuity receipts
    3,326       2,282       1,434  
Annuity surrenders, benefits and withdrawals
    (1,321 )     (1,221 )     (1,273 )
Net transfers from (to) variable annuity assets
    39       7       (10 )
Additional long-term borrowings
    2       159       581  
Reductions of long-term debt
    (20 )     (39 )     (785 )
Issuances of managed investment entities’ liabilities
    394              
Retirement of managed investment entities’ liabilities
    (66 )     (45 )      
Issuances of Common Stock
    39       32       15  
Repurchases of Common Stock
    (315 )     (292 )     (81 )
Cash dividends paid on Common Stock
    (67 )     (63 )     (60 )
Other financing activities, net
    (14 )           (97 )
 
                 
Net cash provided by (used in) financing activities
    1,997       820       (276 )
 
                 
 
                       
Net Change in Cash and Cash Equivalents
    225       (21 )     (144 )
 
                       
Cash and cash equivalents at beginning of year
    1,099       1,120       1,264  
 
                 
 
                       
Cash and cash equivalents at end of year
  $ 1,324     $ 1,099     $ 1,120  
 
                 
See notes to consolidated financial statements.

 

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Table of Contents

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INDEX TO NOTES
     
A. Accounting Policies
   
 
   
B. Acquisition
   
 
   
C. Segments of Operations
   
 
   
D. Fair Value Measurements
   
 
   
E. Investments
   
 
   
F. Derivatives
   
 
   
G. Deferred Policy Acquisition Costs
   
 
   
H. Managed Investment Entities
   
 
   
I. Goodwill and Other Intangibles
   
 
   
J. Long-Term Debt
   
 
   
K. Shareholders’ Equity
   
 
   
L. Income Taxes
   
 
   
M. Contingencies
   
 
   
N. Quarterly Operating Results (Unaudited)
   
 
   
O. Insurance
   
 
   
P. Additional Information
   
 
   
Q. Condensed Consolidating Information
   
A.   Accounting Policies
Basis of Presentation 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. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. Events or transactions occurring subsequent to December 31, 2011, and prior to the filing of this Form 10-K, have been evaluated for potential recognition or disclosure herein.
The preparation of the financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) 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.
Recent Accounting Standards In October 2010, the FASB issued Accounting Standards Update (“ASU”) 2010-26 to address diversity in practice regarding which costs related to issuing or renewing insurance contracts qualify for deferral. To qualify for deferral, the guidance specifies that a cost must be directly related to the successful acquisition of an insurance contract. The guidance is effective on January 1, 2012, with retrospective application permitted, but not required. AFG will adopt the new standard retrospectively on that date. The impact of adoption on amounts reported herein is shown in the table below (in millions, except per share data):
                 
    December 31,  
    2011     2010  
Deferred policy acquisition costs
               
As reported
  $ 1,105     $ 1,244  
As adjusted
    901       1,031  
 
               
Net deferred tax liability (included in other liabilities)
               
As reported
  $ 203     $ 116  
As adjusted
    132       41  
 
               
Shareholders’ equity
               
As reported
  $ 4,545     $ 4,470  
As adjusted
    4,412       4,332  

 

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Table of Contents

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
                         
    December 31,  
    2011     2010     2009  
Net earnings attributable to shareholders
                       
As reported
  $ 343     $ 479     $ 519  
As adjusted
    342       482       521  
 
                       
Diluted earnings per Common Share
                       
As reported
  $ 3.33     $ 4.33     $ 4.45  
As adjusted
    3.32       4.36       4.46  
In May 2011, the FASB issued ASU 2011-04 which clarifies the application of existing fair value measurement and amends certain disclosure requirements. The guidance is to be applied prospectively for reporting periods beginning after December 15, 2011. Early adoption is not permitted. The impact of adoption is not expected to be material to AFG’s results of operations or financial position.
In June 2011, the FASB issued ASU 2011-05, which eliminates the option to report other comprehensive income in the statement of changes in equity. Instead, the guidance requires that all other comprehensive income (non-owner changes in shareholders’ equity) be presented either in a single continuous statement of comprehensive income, which would contain net income and other comprehensive income sections and replace the statement of earnings, or in a separate statement of other comprehensive income immediately following the statement of earnings. AFG intends to present other comprehensive income in a separate statement. The guidance is effective January 1, 2012, with retrospective application required. The guidance relates solely to the presentation of other comprehensive income and therefore does not change the measurement of net income, other comprehensive income or earnings per share. Accordingly, the adoption of this guidance will have 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. Except for the acquisition discussed in Note B — “Acquisition” and the impairment of goodwill discussed in Note I — “Goodwill and Other Intangibles,” AFG did not have any significant nonrecurring fair value measurements of nonfinancial assets and liabilities in 2011 or 2010.
New accounting guidance adopted by AFG on January 1, 2010, requires additional disclosures about transfers between levels in the hierarchy of fair value measurements. The guidance also clarifies existing disclosure requirements related to the level of disaggregation presented and inputs used in determining fair values. Additional detail relating to the roll-forward of Level 3 fair values was required in 2011.
Investments Fixed maturity and equity securities classified as “available for sale” are reported at fair value with unrealized gains and losses included in accumulated other comprehensive income (loss) 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.

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
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.
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)) and the cost basis of that investment is reduced.
In 2009, AFG adopted new accounting guidance relating to the recognition and presentation of other-than-temporary impairments. Under the guidance, 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 (loss)). 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. AFG adopted this guidance effective January 1, 2009, and recorded a cumulative effect adjustment of $17 million to reclassify the non-credit component of previously recognized impairments from retained earnings to accumulated other comprehensive income (loss). Additional disclosures required by this guidance are contained in Note E — “Investments.”
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. On October 1, 2011, AFG adopted ASU 2011-08, “Intangibles — Goodwill and Other,” which simplifies the annual goodwill impairment test by only requiring an entity to complete the test on a reporting unit if the entity determines that it is more likely than not that the reporting unit’s fair value is less than its carrying amount. The adoption of this guidance did not impact AFG’s results of operations or financial position.
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 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.

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
Certain annuity and supplemental insurance subsidiaries cede life insurance policies to a third party on a funds withheld basis whereby the subsidiaries retain the assets (securities) associated with the reinsurance contracts. Interest is credited to the reinsurer based on the actual investment performance of the retained assets. These reinsurance contracts are considered to contain embedded derivatives (that must be adjusted to fair value) because the yield on the payables is based on specific blocks of the ceding companies’ assets, rather than the overall creditworthiness of the ceding company. AFG determined that changes in the fair value of the underlying portfolios of fixed maturity securities is an appropriate measure of the value of the embedded derivative. The securities related to these transactions are classified as “trading.” The adjustment to fair value on the embedded derivatives offsets the investment income recorded on the adjustment to fair value of the related trading portfolios.
Deferred Policy Acquisition Costs (“DPAC”) Policy acquisition costs (principally commissions, premium taxes and other marketing and underwriting expenses) related to the production of new business are deferred. DPAC also includes capitalized costs associated with sales inducements offered to fixed annuity policyholders such as enhanced interest rates and premium and persistency bonuses. As discussed above under “Recent Accounting Standards,” AFG’s current accounting for DPAC will change effective in 2012 and amounts included herein will be adjusted retrospectively.
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, unamortized acquisition costs and policy maintenance 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 variable annuity policy charges, less death and annuitization benefits in excess of account balances and estimated future policy administration expenses. To the extent that realized gains and losses result in adjustments to the amortization of DPAC related to annuities, such adjustments are reflected as components of realized gains (losses).
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.
DPAC related to annuities is also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in unrealized gains (losses) on marketable securities, a component of accumulated other comprehensive income in AFG’s Balance Sheet.
DPAC includes the present value of future profits on business in force of annuity and supplemental 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.

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
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 are 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). Prior to adoption of guidance requiring the consolidation of VIEs beginning in 2010, the CLOs were not consolidated. Upon adoption of the guidance, the $261 million excess of fair value of the CLOs’ assets over the fair value of the liabilities was recorded in AFG’s Balance Sheet as appropriated retained earnings — managed investment entities, representing the cumulative effect of adopting the new guidance that ultimately will inure to the benefit of the CLO debt holders.
AFG has elected the fair value option for reporting on the CLO assets and liabilities to improve the transparency of financial reporting related to the CLOs. The net gain or loss from accounting for the CLO assets and liabilities at fair value subsequent to January 1, 2010, is separately presented in AFG’s Statement of Earnings. CLO earnings attributable to AFG’s shareholders represent the change in fair value of AFG’s investments in the CLOs and management fees earned. All other CLO earnings (losses) are not attributable to AFG’s shareholders and will ultimately inure to the benefit of the other CLO debt holders. As a result, such CLO earnings (losses) are included in net earnings (loss) attributable to noncontrolling interests in AFG’s Statement of Earnings and in appropriated retained earnings — managed investment entities in the Balance Sheet. As the CLOs approach maturity (2016 to 2022), 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.
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 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.

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
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 surrender charges are credited to other income.
For certain products, annuity benefits accumulated also includes reserves for accrued persistency and premium bonuses 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 variable annuity policy charges, and unearned revenues once they are recognized as income.
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. Claim reserves and liabilities established for accident and health claims are modified as necessary to reflect actual experience and developing trends.
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.
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.

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
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 records a liability for the inherent uncertainty in quantifying its income tax provisions. Related interest and penalties 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 Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding during the period. The calculation of diluted earnings per share includes the following adjustments to weighted average common shares related to stock-based compensation plans: 2011 — 1.6 million, 2010 — 1.3 million and 2009 — 1.1 million.
AFG’s weighted average diluted shares outstanding excludes the following anti-dilutive potential common shares related to stock compensation plans: 2011 — 2.3 million, 2010 — 3.5 million and 2009 — 5.7 million. Adjustments to net earnings attributable to shareholders in the calculation of diluted earnings per share were nominal in the 2011, 2010 and 2009 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.

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
B.   Acquisition
Vanliner Group, Inc. (“Vanliner”) In July 2010, National Interstate (“NATL”), a 52%-owned subsidiary of AFG, completed the acquisition of Vanliner, a market leader in providing insurance for the moving and storage industry for $114 million (including post-closing adjustments). The initial purchase price (funded primarily with cash on hand) was based on Vanliner’s estimated tangible book value at the date of closing and is subject to certain adjustments, including a four and one-half year balance sheet guarantee whereby both favorable and unfavorable developments related to the closing balance sheet inure to the seller, UniGroup, Inc. In accordance with accounting guidance, all assets acquired and liabilities assumed were recognized at their fair values as of the acquisition date. The purchase price allocation based on these fair values resulted in a gain on purchase of $7 million (included in realized gains on subsidiaries). Vanliner’s premiums associated with policies in force as of December 31, 2011 totaled approximately $93 million. Pro forma results of operations for AFG assuming the acquisition of Vanliner had taken place at the beginning of 2010 would not differ significantly from actual reported results.
C.   Segments of Operations
AFG manages its business as three segments: (i) property and casualty insurance, (ii) annuity and supplemental insurance and (iii) other, which includes holding company assets and costs, and the assets and operations 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 California workers’ compensation, and (iii) Specialty financial, which includes risk management insurance programs for lending and leasing institutions (including collateral and mortgage protection insurance), surety and fidelity products and trade credit insurance. AFG’s annuity and supplemental insurance business markets traditional fixed and indexed annuities and a variety of supplemental insurance products such as Medicare supplement.
AFG’s reportable segments and their components were determined based primarily upon similar economic characteristics, products and services.
Sales of property and casualty insurance outside of the United States represented 5% of AFG’s revenues in 2011, and 4% in both 2010 and 2009.

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
The following tables (in millions) show AFG’s assets, revenues and operating earnings before income taxes by significant business segment and sub-segment.
                         
    2011     2010     2009  
Assets
                       
Property and casualty insurance (a)
  $ 11,882     $ 11,609     $ 11,863  
Annuity and supplemental insurance
    20,451       17,766       15,476  
Other
    3,709       3,079       344  
 
                 
 
                       
Total assets
  $ 36,042     $ 32,454     $ 27,683  
 
                 
 
                       
Revenues
                       
Property and casualty insurance:
                       
Premiums earned:
                       
Specialty
                       
Property and transportation
  $ 1,412     $ 1,167     $ 909  
Specialty casualty
    872       873       917  
Specialty financial
    408       446       517  
Other
    67       64       69  
 
                 
Total premiums earned
    2,759       2,550       2,412  
Investment income
    296       341       414  
Realized gains (losses)
    97       88       123  
Other income
    65       64       106  
 
                 
Total property and casualty insurance
    3,217       3,043       3,055  
Annuity and supplemental insurance:
                       
Investment income
    944       856       784  
Life, accident and health premiums
    430       451       444  
Realized gains (losses)
    (23 )           (86 )
Other income
    104       110       114  
 
                 
Total annuity and supplemental insurance
    1,455       1,417       1,256  
Other
    78       37       9  
 
                 
 
                       
Total revenues
  $ 4,750     $ 4,497     $ 4,320  
 
                 
 
                       
Operating Earnings Before Income Taxes
                       
Property and casualty insurance:
                       
Underwriting:
                       
Specialty
                       
Property and transportation
  $ 113     $ 140     $ 236  
Specialty casualty
    39       47       63  
Specialty financial
    61       112       134  
Other
    18       9       (9 )
Other lines (b)
    (51 )     (12 )     (7 )
 
                 
Total underwriting
    180       296       417  
Investment and other income, net
    263       299       338  
Realized gains (losses)
    97       88       123  
 
                 
Total property and casualty insurance
    540       683       878  
Annuity and supplemental insurance:
                       
Operations
    224       202       162  
Realized gains (losses)
    (23 )           (86 )
 
                 
Total annuity and supplemental insurance
    201       202       76  
Other (c)
    (181 )     (196 )     (142 )
 
                 
 
                       
Total operating earnings before income taxes
  $ 560     $ 689     $ 812  
 
                 
     
(a)   Not allocable to sub-segments.
 
(b)   Includes a second quarter 2011 special charge of $50 million to increase asbestos and environmental reserves.
 
(c)   Includes holding company expenses, a second quarter 2011 special charge of $9 million to increase asbestos and environmental reserves and $24 million and $64 million in losses of managed investment entities attributable to noncontrolling interests for the years ended December 31, 2011 and 2010, respectively.

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
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. 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.

 

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AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
Assets and liabilities measured at fair value at December 31 are summarized below (in millions):
                                 
    Level 1     Level 2     Level 3     Total  
2011
                               
Assets:
                               
Available for sale (“AFS”) fixed maturities:
                               
U.S. Government and government agencies
  $ 248     $ 134     $     $ 382  
States, municipalities and political subdivisions
          3,794       83       3,877  
Foreign government
          254             254  
Residential MBS
          3,487       361       3,848  
Commercial MBS
          2,821       19       2,840  
All other corporate
    9       10,078       519       10,606  
 
                       
Total AFS fixed maturities
    257       20,568       982       21,807  
 
                               
Trading fixed maturities
          439       1       440  
Equity securities
    888       29       11       928  
Assets of managed investment entities (“MIE”)
    290       2,724       44       3,058  
Variable annuity assets (separate accounts) (a)
          548             548  
Other investments
          71             71  
 
                       
Total assets accounted for at fair value
  $ 1,435     $ 24,379     $ 1,038     $ 26,852  
 
                       
 
                               
Liabilities:
                               
Liabilities of managed investment entities
  $ 194     $     $ 2,593     $ 2,787  
Derivatives in annuity benefits accumulated
                395       395  
 
                       
Total liabilities accounted for at fair value
  $ 194     $     $ 2,988     $ 3,182  
 
                       
 
                               
2010
                               
Assets:
                               
Available for sale fixed maturities:
                               
U.S. Government and government agencies
  $ 251     $ 216     $     $ 467  
States, municipalities and political subdivisions
          2,919       20       2,939  
Foreign government
          278             278  
Residential MBS
          3,563       312       3,875  
Commercial MBS
          2,117       6       2,123  
All other corporate
    9       9,201       436       9,646  
 
                       
Total AFS fixed maturities
    260       18,294       774       19,328  
 
                               
Trading fixed maturities
          390       3       393  
Equity securities
    461       208       21       690  
Assets of managed investment entities
    96       2,393       48       2,537  
Variable annuity assets (separate accounts) (a)
          616             616  
Other investments
          98             98  
 
                       
Total assets accounted for at fair value
  $ 817     $ 21,999     $ 846     $ 23,662  
 
                       
 
                               
Liabilities:
                               
Liabilities of managed investment entities
  $ 65     $     $ 2,258     $ 2,323  
Derivatives in annuity benefits accumulated
                190       190  
 
                       
Total liabilities accounted for at fair value
  $ 65     $     $ 2,448     $ 2,513  
 
                       
     
(a)   Variable annuity liabilities equal the fair value of variable annuity assets.
During 2011 and 2010, there were no significant transfers between Level 1 and Level 2. Approximately 4% of the total assets measured at fair value on December 31, 2011, were Level 3 assets. Approximately 95% of these assets were priced using non-binding broker quotes. The fair values of the liabilities of managed investment entities were determined using non-binding broker quotes, which were reviewed by AFG’s investment professionals.

 

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Table of Contents

AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
Changes in balances of Level 3 financial assets and liabilities during 2011, 2010 and 2009 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                                  
                    Other                                  
    Balance at             comp.     Purchases             Transfer     Transfer     Balance at  
    December 31,     Net     income     and     Sales and     into     out of     December 31,  
    2010     income     (loss)     issuances     settlements     Level 3     Level 3     2011  
AFS fixed maturities:
                                                               
State and municipal
  $ 20     $     $ 4     $ 58       (4 )   $ 17     $ (12 )   $ 83  
Residential MBS
    312       3       (9 )     42       (38 )     127       (76 )     361  
Commercial MBS
    6       1             9             13       (10 )     19  
All other corporate
    436       2       15       236       (72 )     90       (188 )     519  
Trading fixed maturities
    3                                     (2 )     1  
Equity securities
    21             1       2       (2 )     2       (13 )     11  
Assets of MIE
    48       (8 )           32       (18 )     9       (19 )     44  
Liabilities of MIE (*)
    (2,258 )                 (401 )     66                   (2,593 )
Embedded derivatives
    (190 )     (29 )           (200 )     24                   (395 )
     
(*)   Total realized/unrealized loss included in net income includes losses of $3 million related to liabilities outstanding as of December 31, 2011. See Note H — “Managed Investment Entities.”
                                                                 
                    Total                          
                    realized/unrealized                          
                    gains (losses)                          
                    included in                          
            Consolidate             Other     Purchases,                    
    Balance at     Managed             comp.     sales,     Transfer     Transfer     Balance at  
    December 31,     Inv.     Net     income     issuances and     into     out of     December 31,  
    2009     Entities     income     (loss)     settlements     Level 3     Level 3     2010  
AFS fixed maturities:
                                                               
State and municipal
  $ 23     $     $     $ 1     $ (4 )   $ 17     $ (17 )   $ 20  
Residential MBS
    435             7       26       17       27       (200 )     312  
Commercial MBS
                            6                   6  
All other corporate
    311       (6 )     (10 )     10       100       118       (87 )     436  
Trading fixed maturities
    1                         4       2       (4 )     3  
Equity securities
    25                   (1 )                 (3 )     21  
Assets of MIE
          90       8             (16 )     26       (60 )