-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, CCeKoMZJgo9T38+DwdjLzBUzzJ9/umqdZHG6D+JjqlbGMW0nRrDVp9dHWbIW3ctW E6Gq0QnSwGA0NoYGSuOw9g== 0000933537-97-000026.txt : 19971030 0000933537-97-000026.hdr.sgml : 19971030 ACCESSION NUMBER: 0000933537-97-000026 CONFORMED SUBMISSION TYPE: 10-K405/A PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19971029 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: AMERICAN FINANCIAL GROUP INC /OH/ CENTRAL INDEX KEY: 0000933537 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 311422526 STATE OF INCORPORATION: OH FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405/A SEC ACT: SEC FILE NUMBER: 001-11453 FILM NUMBER: 97702516 BUSINESS ADDRESS: STREET 1: ONE E FOURTH ST STREET 2: SUITE 919 CITY: CINCINNATI STATE: OH ZIP: 45202 BUSINESS PHONE: 5135796600 MAIL ADDRESS: STREET 1: ONE EAST FOURTH STREET STREET 2: SUITE 919 CITY: CINCINNATI STATE: OH ZIP: 45202 FORMER COMPANY: FORMER CONFORMED NAME: AMERICAN PREMIER GROUP INC DATE OF NAME CHANGE: 19941208 10-K405/A 1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K/A Amendment No. 2 to Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Fiscal Year Ended Commission File December 31, 1996 No. 1-11453 AMERICAN FINANCIAL GROUP, INC. Incorporated under IRS Employer I.D. the Laws of Ohio No. 31-1422526 One East Fourth Street, Cincinnati, Ohio 45202 (513) 579-2121 PART I ITEM 1 Business Introduction American Financial Group, Inc. ("AFG") was incorporated as an Ohio corporation in 1994. Its address is One East Fourth Street, Cincinnati, Ohio 45202; its phone number is (513) 579-2121. AFG is a holding company which, through its subsidiaries, is engaged primarily in specialty and multi-line property and casualty insurance businesses and in the sale of tax-deferred annuities. AFG's property and casualty operations originated in 1872 and are the seventeenth largest property and casualty group in the United States based on 1995 statutory net premiums written of $3.1 billion. AFG was formed for the purpose of acquiring American Financial Corporation ("AFC") and American Premier Underwriters, Inc. ("APU" or "American Premier") in merger transactions completed in April 1995 (the "Mergers"). For financial reporting purposes, because the former shareholders of AFC owned more than 50% of AFG following the Mergers, the financial statements of AFG for periods prior to the Mergers are those of AFC. The operations of APU are included in AFG's financial statements from the effective date of the Mergers. At December 31, 1996, Carl H. Lindner, members of his immediate family and trusts for their benefit (collectively the "Lindner Family") beneficially owned approximately 43% of AFG's outstanding voting common stock. General Generally, companies have been included in AFG's consolidated financial statements when the ownership of voting securities has exceeded 50%; for investments below that level but above 20%, AFG has accounted for the investments as investees. (See Note F to AFG's financial statements.) The following table shows AFG's percentage ownership of voting securities of its significant affiliates over the past several years: Voting Ownership at December 31, 1996 1995 1994 1993 1992 American Financial Corporation 76% 79% n/a n/a n/a American Premier Underwriters 100% 100% 42% 41% 51% Great American Insurance Group 100% 100% 100% 100% 100% American Annuity Group 81% 81% 80% 80% 82% American Financial Enterprises 83% 83% 83% 83% 83% Chiquita Brands International 43% 44% 46% 46% 46% Citicasters (a) 38% 37% 20% 40% General Cable - - (b) 45% 45% (a) Sold in September 1996. (b) Sold in June 1994. The following summarizes the more significant changes in ownership percentages shown in the above table. American Financial Corporation For financial reporting purposes, AFC is the predecessor to AFG. In April 1995, AFC became a subsidiary of AFG as a result of the Mergers. Holders of AFC Series F and G Preferred Stock were granted voting rights equal to approximately 21% of the total voting power of AFC shareholders immediately prior to the Mergers. American Premier Underwriters In 1993, American Financial Enterprises, Inc. ("AFEI") sold 4.5 million shares of American Premier common stock in a secondary public offering. In April 1995, APU became a subsidiary of AFG as a result of the Mergers. 1 Citicasters In December 1993, Great American Communications Company ("GACC") completed a prepackaged plan of reorganization. In the restructuring, AFC's previous holdings of GACC stock and debt were exchanged for 20% of the new common stock. GACC changed its name to Citicasters to reflect the nature of its business. In June 1994, AFEI purchased approximately 10% of Citicasters common stock. In the second half of 1994, Citicasters repurchased and retired approximately 21% of its common stock. In September 1996, the investments in Citicasters were sold to an unaffiliated company. General Cable In 1994, AFC sold its investment in General Cable to an unaffiliated company. Property and Casualty Insurance Operations AFG manages and operates its property and casualty business in three major business segments: Nonstandard Automobile Insurance, Specialty Lines and Commercial and Personal Lines. Each segment is comprised of multiple business units which operate autonomously but with strong central financial controls and full accountability. Decentralized control allows each unit the autonomy necessary to respond to local and specialty market conditions while capitalizing on the efficiencies of centralized investment, actuarial, financial and legal support functions. AFG's property and casualty insurance operations employ approximately 7,800 persons. Unless indicated otherwise, the financial information presented for the property and casualty insurance operations is presented based on generally accepted accounting principles ("GAAP") and includes the insurance operations of AFC and American Premier for all periods. The following table shows the size (in millions), segment and A.M. Best rating of AFG's major property and casualty insurance subsidiaries. 1996 Net Written Premiums Commercial NSA A.M. Best and Personal Specialty Group Rating Great American $660 $636 $ - A Republic Indemnity - 222 - A Mid-Continent - 90 - A American Empire Surplus Lines - 28 - A+ Atlanta Casualty - - 391 A Windsor - - 323 A Infinity - - 232 A Leader National - - 63 A- Transport - - 106 A Other - 17 20 $660 $993 $1,135 The primary objective of the property and casualty insurance operations is to achieve underwriting profitability. Underwriting profitability is measured by the combined ratio which is a sum of the ratios of underwriting losses, loss adjustment expenses ("LAE"), underwriting expenses and policyholder dividends to premiums. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, other income or federal income taxes. 2 Management's focus on underwriting performance has resulted in a statutory combined ratio averaging 101.2% for the period 1992 to 1996, as compared to 108.8% for the property and casualty industry over the same period (Source: "Best's Review - Property/Casualty" - January 1997 Edition). 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. For 1996, net written premiums were nearly $2.8 billion compared to $3.1 billion in 1995. The decrease reflects the effect of significant rate increases initiated by the nonstandard auto group, the continuing competitive pricing environment in the California workers' compensation market as well as the casualty markets, withdrawal from an unprofitable pool at the end of 1995 and reduced writings of homeowners' insurance in certain states. The following table shows (in millions) certain information of AFG's property and casualty insurance operations. While financial data is reported on a statutory basis for insurance regulatory purposes, it is reported in accordance with GAAP for shareholder and other investment purposes. In general, statutory accounting results in lower capital surplus and net earnings than result from application of GAAP. Major differences include charging policy acquisition costs to expense as incurred rather than spreading the costs over the periods covered by the policies; recording bonds and redeemable preferred stocks primarily at amortized cost; netting of reinsurance recoverables and prepaid reinsurance premiums against the corresponding liability; requiring additional loss reserves; and charging to surplus certain assets, such as furniture and fixtures and agents' balances over 90 days old. 1996 1995 1994 Statutory Basis Premiums Earned $2,821 $3,006 $2,915 Admitted Assets 6,603 6,753 6,398 Unearned Premiums 1,104 1,160 1,093 Loss and LAE Reserves 3,397 3,394 3,275 Capital and Surplus 1,659 1,595 1,586 GAAP Basis Premiums Earned $2,845 $3,031 $2,945 Total Assets 8,623 9,002 8,617 Unearned Premiums 1,248 1,294 1,213 Loss and LAE Reserves 4,124 4,097 4,021 Shareholder's Equity 2,695 2,893 2,615 3 The following table shows the performance of AFG's property and casualty insurance operations in various categories (dollars in millions): 1996 1995 1994 Net written premiums $2,788 $3,092 $3,124 Net earned premiums $2,845 $3,031 $2,945 Loss and LAE 2,132 2,265 2,077 Underwriting expenses 780 792 770 Policyholder dividends 14 8 84 Underwriting profit (loss) ($ 81) ($ 34) $ 14 GAAP ratios: Loss and LAE ratio 75.0% 74.8% 70.5% Underwriting expense ratio 27.4 26.1 26.1 Policyholder dividend ratio .5 .3 2.8 Combined ratio (a) 102.9% 101.2% 99.4% Statutory ratios: Loss and LAE ratio 74.8% 74.8% 71.0% Underwriting expense ratio 27.2 25.9 26.3 Policyholder dividend ratio .4 1.7 3.6 Combined ratio (a) 102.4% 102.4% 100.9% Industry statutory combined ratio (b) 107.0% 106.5% 108.5% (a) The 1996 combined ratios include an increase of 2.8 percentage points attributable to the strengthening of insurance reserves relating to asbestos and other environmental matters ("A&E"). (b) Ratios are derived from "Best's Review - Property/Casualty" (January 1997 Edition). Nonstandard Automobile Insurance General. The Nonstandard Automobile Insurance segment ("NSA Group") underwrites private passenger automobile liability and physical damage insurance policies for "nonstandard" risks. Nonstandard insureds are those individuals who are unable to obtain insurance through standard market carriers due to factors such as age, record of prior accidents, driving violations, particular occupation or type of vehicle. Premium rates for nonstandard risks are generally higher than for standard risks. Total private passenger automobile insurance premiums written by insurance carriers in the United States in 1996 have been estimated by A.M. Best to be approximately $110 billion. Because it can be viewed as a residual market, the size of the nonstandard private passenger automobile insurance market changes with the insurance environment and grows when standard coverage becomes more restrictive. When this occurs, the criteria which differentiate standard from nonstandard insurance risks change. The size of the voluntary nonstandard market is also affected by rate levels adopted by state administered involuntary plans. According to A.M. Best, the voluntary nonstandard market has accounted for about 15% of total private passenger automobile insurance premiums written in recent years. The NSA Group's implementation of significant rate increases during the last couple years and competitive pressures in the nonstandard automobile insurance industry served to curtail the trend of annual premium growth it had experienced previously. These rate increases contributed to an improvement, however, in underwriting profitability for 1996. 4 The NSA Group writes business in 42 states and holds licenses to write policies in 48 states and the District of Columbia. The U.S. geographic distribution of the NSA Group's statutory direct written premiums in 1996 compared to 1992, was as follows: 1996 1992 1996 1992 Florida 12.1% 20.1% Mississippi 3.2% 3.3% Pennsylvania 10.1 * Oklahoma 3.1 2.9 Texas 9.4 2.2 Missouri 3.0 2.2 Georgia 8.9 13.7 New York 3.0 * California 8.0 8.4 Arizona 2.5 5.9 Connecticut 5.8 3.5 Washington 2.4 * Indiana 3.3 3.6 Alabama 2.1 4.2 Tennessee 3.2 4.7 Other 19.9 25.3 100.0% 100.0% _____________ * less than 2% In addition, the NSA Group writes approximately 4% of its net premiums annually in the United Kingdom. Management believes that the NSA Group's underwriting success has been due, in part, to the refinement of various risk profiles, thereby dividing the consumer market into more defined segments which can be underwritten or priced properly. The NSA Group also generally writes policies of short duration which allow more frequent rating evaluations of individual risks, providing management greater flexibility in the ongoing assessment of the business. In addition, the NSA Group has implemented cost control measures both in the underwriting and claims handling areas. The following table shows the performance of AFG's NSA Group insurance operations in various categories (dollars in millions): 1996 1995 1994 Net written premiums $1,135 $1,277 $1,186 Net earned premiums $1,183 $1,246 $1,097 Loss and LAE 904 1,036 833 Underwriting expenses 278 273 265 Underwriting profit (loss) $ 1 ($ 63) ($ 1) GAAP ratios: Loss and LAE ratio 76.4% 83.2% 75.9% Underwriting expense ratio 23.5 22.0 24.1 Combined ratio 99.9% 105.2% 100.0% Statutory ratios: Loss and LAE ratio 75.8% 83.1% 76.0% Underwriting expense ratio 22.5 21.6 23.9 Combined ratio 98.3% 104.7% 99.9% Industry statutory combined ratio (a) 101.0% 101.3% 101.3% (a) Represents the private passenger automobile industry statutory combined ratio derived from "Best's Review - Property/Casualty" (January 1997 Edition). Although AFG believes that there is no reliable regularly published combined ratio data for the nonstandard automobile insurance industry, AFG believes that such a combined ratio would be lower than the private passenger automobile industry average shown above. 5 Marketing. Each of the principal units in the NSA Group is responsible for its own marketing, sales, underwriting and claims processing. Sales efforts are directed primarily toward independent agents. These units each write policies through several thousand independent agents. The NSA Group had approximately 900,000 policies in force at December 31, 1996, just under 90% of which had policy limits of $50,000 or less per occurrence. Most NSA Group policies are written for policy periods of six months or less, with some as short as one month. Competition. A large number of national, regional and local insurers write nonstandard private passenger automobile insurance coverage. Insurers in this market generally compete on the basis of price (including differentiation on liability limits, variety of coverages offered and deductibles), geographic availability and ease of enrollment and, to a lesser extent, reputation for claims handling, financial stability and customer service. NSA Group management believes that sophisticated data analysis for refinement of risk profiles has helped the NSA Group to compete successfully. The NSA Group attempts to provide selected pricing for a wider spectrum of risks and with a greater variety of payment options, deductibles and limits of liability than are offered by many of its competitors. Specialty Lines General. The Specialty Lines segment emphasizes the writing of specialized insurance coverage where AFG personnel are experts in particular lines of business or customer groups. Examples include California workers' compensation, executive liability, ocean and inland marine, agricultural-related coverages (allied lines), non-profit liability, umbrella and excess and surplus lines. The Specialty Lines workers' compensation operations write coverage for prescribed benefits payable to employees (principally in California) who are injured on the job. The executive and professional liability divisions market liability coverage for corporate directors and officers and attorneys. Ocean and inland marine businesses provide coverage primarily for marine cargo, boat dealers, marina operators/dealers, excursion vessels, builder's risk, contractor's equipment, excess property and transportation cargo. The agricultural-related businesses provide multi-peril crop insurance covering weather and disease perils as well as coverage for full-time operating farms/ranches and agribusiness operations on a nationwide basis through independent agents who specialize in the rural market. The non-profit liability business provides property, general/professional liability, automobile, trustee liability, umbrella and crime coverage for a wide range of non-profit organizations. These operations also provide excess and surplus commercial property and casualty insurance in a variety of industries. Specialization is the key element to the underwriting success of these business units. Each unit has independent management with significant operating autonomy to oversee the important operational functions of its business such as underwriting, pricing, marketing, policy processing and claims service. These specialty lines are opportunistic and their premium volume will vary based on current market conditions. AFG continually evaluates expansion in existing markets and opportunities in new specialty markets. The U.S. geographic distribution of the Specialty Lines statutory direct written premiums in 1996 compared to 1992, was as follows: 1996 1992 1996 1992 California 30.4% 47.4% Florida 3.5% * Texas 7.3 2.7 New Jersey 2.8 2.6% New York 5.2 5.7 Ohio 2.1 2.1 Massachusetts 5.1 2.8 Pennsylvania 2.0 2.1 Illinois 4.0 3.4 Other 33.9 25.3 Oklahoma 3.7 5.9 100.0% 100.0% _____________ * less than 2% 6 The following table sets forth a distribution of statutory net written premiums for AFG's Specialty Lines by NAIC annual statement line for 1996 compared to 1992: 1996 1992 Workers' compensation 26.0% 47.2% Other liability 23.4 15.7 Commercial multi-peril 10.1 3.1 Inland marine 9.2 5.8 Auto liability 8.3 8.7 Allied lines 5.7 4.2 Ocean marine 4.6 4.6 Surety 3.8 3.0 Auto physical damage 2.5 2.2 Other 6.4 5.5 100.0% 100.0% The following table shows the performance of AFG's Specialty Lines insurance operations in various categories (dollars in millions): 1996 1995 1994 Net written premiums $993 $1,097 $1,250 Net earned premiums $976 $1,085 $1,185 Loss and LAE 527 730 785 Underwriting expenses 295 302 291 Policyholder dividends - (3) 76 Underwriting profit $154 $ 56 $ 33 GAAP ratios: Loss and LAE ratio 53.9% 67.2% 66.2% Underwriting expense ratio 30.2 27.9 24.6 Policyholder dividend ratio - (.3) 6.4 Combined ratio (a) 84.1% 94.8% 97.2% Statutory ratios: Loss and LAE ratio 54.1% 67.5% 66.7% Underwriting expense ratio 30.3 28.1 25.2 Policyholder dividend ratio .5 4.2 8.5 Combined ratio (a) 84.9% 99.8% 100.4% Industry statutory combined ratio (b) 111.0% 109.9% 107.9% (a) The 1996 combined ratios reflect a reduction of 4.1 percentage points attributable to a reallocation of loss reserves in connection with the strengthening of A&E reserves. (b) Represents the commercial industry statutory combined ratio derived from "Best's Review - Property/Casualty" (January 1997 Edition). Marketing. The Specialty Lines operations direct their sales efforts primarily toward independent property and casualty insurance agents and brokers. These businesses write insurance through several thousand agents and brokers and have nearly 275,000 policies in force. Competition. These businesses compete with other insurers as well as the California State Fund in the California workers' compensation insurance market. Because of 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. Price, commissions and profit sharing terms are also important factors. Competitors include individual insurers 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. Management believes that sophisticated data analysis for refinement of risk profiles, extensive specialized knowledge and loss prevention service have helped AFG's specialty lines compete successfully. 7 Commercial and Personal Lines General. Major commercial lines of business are workers' compensation, commercial multi-peril, umbrella (including primary and excess layers) and general liability insurance. The workers' compensation business has experienced solid growth and profitability due to improved rate structures and favorable trends in medical care costs and the success of its Drug-Free Workplace program. AFG's Drug-Free Workplace program for workers' compensation customers assists insureds in setting up drug testing programs (as permitted by law), drug and alcohol education programs and work safety programs. At December 31, 1996, there were more than 850 insureds in 20 states with such programs producing approximately $67 million in annual net written premiums. Commercial business is written in 26 states where management believes adequate rates can be obtained and where assigned risk costs are not excessive. AFG's approach focuses on specific customer groups, such as fine restaurants, light manufacturers, hotels/motels, workers' compensation safety groups and insureds with large umbrella coverages. The approach also emphasizes site visits at prospective customers to ensure underwriter familiarity with risk factors relating to each insured and to avoid those risks which have unacceptable frequency or severity exposures. Personal lines business consists primarily of standard private passenger automobile and homeowners' insurance and is currently being marketed in 25 states. AFG's approach is to develop tailored rates for its personal automobile customers based on a variety of factors, including the driving record of the insureds. The approach to homeowners business is to limit exposure in locations which are likely to be unprofitable and those which have significant catastrophic potential (such as windstorms, earthquakes and hurricanes). The U.S. geographic distribution of the Commercial and Personal Lines statutory direct written premiums in 1996 compared to 1992, was as follows: 1996 1992 1996 1992 Connecticut 13.6% 12.1% Ohio 3.6% 4.5% New York 12.0 8.1 Florida 2.9 3.9 New Jersey 11.5 7.4 Massachusetts 2.8 * North Carolina 11.0 10.3 Illinois 2.2 2.9 Pennsylvania 7.0 4.5 California * 7.1 Texas 3.9 2.7 Oregon * 2.5 Michigan 3.8 2.9 Washington * 2.4 Maryland 3.7 3.5 Other 22.0 25.2 100.0% 100.0% _____________ * less than 2% The following table sets forth a distribution of statutory net written premiums for AFG's Commercial and Personal Lines by NAIC annual statement line for 1996 compared to 1992: 1996 1992 Auto liability 26.5% 28.2% Workers' compensation 21.1 12.7 Commercial multi-peril 17.2 20.8 Auto physical damage 12.9 13.4 Homeowners 9.9 11.0 Other liability 7.6 8.9 Other 4.8 5.0 100.0% 100.0% 8 The following table shows the performance of AFG's Commercial and Personal Lines insurance operations in various categories (dollars in millions): 1996 1995 1994 Net written premiums $ 660 $ 717 $ 683 Net earned premiums $ 685 $ 698 $ 656 Loss and LAE 538 468 430 Underwriting expenses 206 214 211 Policyholder dividends 14 11 8 Underwriting profit (loss) ($ 73) $ 5 $ 7 GAAP ratios: Loss and LAE ratio 78.5% 66.9% 65.5% Underwriting expense ratio 30.0 30.6 32.2 Policyholder dividend ratio 2.1 1.6 1.2 Combined ratio (a) 110.6% 99.1% 98.9% Statutory ratios: Loss and LAE ratio 78.8% 67.2% 67.0% Underwriting expense ratio 30.4 29.9 32.4 Policyholder dividend ratio 1.0 .6 1.0 Combined ratio (a) 110.2% 97.7% 100.4% Industry statutory combined ratio (b) 107.0% 106.5% 108.5% (a) The 1996 combined ratios include 3.9 percentage points (GAAP) and 3.8 percentage points (statutory) due to losses from Hurricane Fran. (b) Ratios are derived from "Best's Review - Property/Casualty" (January 1997 Edition). Marketing. The Commercial and Personal Lines business units direct their sales efforts primarily toward independent agents and brokers. These businesses write insurance through more than 5,000 agents and have approximately 425,000 policies in force. Competition. These businesses compete with other insurers, primarily on the basis of price (including differentiation on policy limits, coverages offered and deductibles), agent commissions and profit sharing terms. Customer service, loss prevention and reputation for claims handling are also important factors. Competitors include individual insurers 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. Management believes that sophisticated data analysis for refinement of risk profiles, disciplined underwriting practices and aggressive loss prevention procedures have enabled these businesses to compete successfully on the basis of price without negatively affecting underwriting profitability. Reinsurance Consistent with standard practice of most insurance companies, AFG reinsures a portion of its business with other reinsurance companies and assumes a relatively small amount of business from other insurers. Ceding reinsurance permits diversification of risks and limits the maximum loss arising from large or unusually hazardous risks or catastrophic events. AFG's insurance companies enter into separate reinsurance programs due to their differing exposures. 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. 9 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. Treaty reinsurance provides for risks meeting prescribed criteria to be automatically ceded and assumed according to contract provisions. In order to limit the maximum loss arising out of any one occurrence, AFG's insurance companies reinsure a portion of their exposure under treaty and facultative reinsurance programs. 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): Retention Reinsurance Coverage Maximum Coverage(a) California Workers' Compensation $ 1.5 $148.5 Other Workers' Compensation 1.0 49.0 Commercial Umbrella 1.0 49.0 Other Casualty 5.0 15.0 Property - General 5.0 25.0(b) Property - Catastrophe 20.0 130.0 (a) Reinsurance covers substantial portions of losses in excess of retention. (b) Beginning in 1997, AFG will cede 80% of its homeowners insurance coverage through a reinsurance agreement. AFG purchases facultative reinsurance providing coverage on a risk by risk basis, both pro rata and excess of loss, depending on the risk and available reinsurance markets. Due in part to the limited exposure on individual policies, the NSA Group is not materially involved in reinsuring risks with third party insurance companies. Included in the balance sheet caption "recoverables from reinsurers and prepaid reinsurance premiums" were $79 million on paid losses and LAE and $720 million on unpaid losses and LAE at December 31, 1996. The collectibility of a reinsurance balance is based upon the financial condition of a reinsurer as well as individual claim considerations. Market conditions over the past few years have forced many reinsurers into financial difficulties or liquidation proceedings. At December 31, 1996, AFG's insurance subsidiaries had allowances of approximately $79 million for doubtful collection of reinsurance recoverables, substantially all related to unpaid losses. AFG regularly monitors the financial strength of its reinsurers. This process periodically results in the transfer of risks to more financially secure reinsurers. Substantially all reinsurance is ceded to reinsurers having more than $100 million in capital and A.M. Best ratings of A- or better. AFG's major reinsurers include American Re-Insurance Company, Employers Reinsurance Corporation, NAC Reinsurance Corporation, Mitsui Marine and Fire Insurance Company and General Reinsurance Corporation. These five companies assume approximately one-third of AFG's ceded reinsurance. Premiums written for reinsurance ceded and assumed are presented in the following table (in millions): 1996 1995 1994 Reinsurance ceded $518 $482 $422 Reinsurance assumed - including involuntary pools and associations 58 98 119 10 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 and actuarial projections. 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. Future costs of claims are projected based on historical trends adjusted for changes in underwriting standards, policy provisions, product mix and other factors. Estimating the liability for unpaid losses and LAE is inherently judgmental and is influenced by factors which are subject to significant variation. Through the use of analytical reserve development techniques, management monitors items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, general economic trends and the legal environment. Although management believes that the reserves currently established reflect a reasonable and sufficient estimate of the ultimate cost of all losses and claims, actual development may vary materially. AFG recognizes underwriting profit only when realization is reasonably determinable and assured. In certain specialty lines, where experience is limited or where there is potential for volatile results, AFG holds reasonable "incurred but not reported" reserves and does not recognize underwriting profit until the accident years mature. Generally, reserves for reinsurance and involuntary pools and associations are reflected in AFG's results at the amounts reported by those entities. Unless otherwise indicated, the following discussion of insurance reserves includes the reserves of American Premier's subsidiaries for only those periods following the Mergers. See Note O to the Financial Statements for an analysis of changes in AFG's estimated liability for losses and LAE, net of reinsurance (and grossed up), over the past three years on a GAAP basis. 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, excluding reserves of American Premier subsidiaries prior to the Mergers. 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, 1996. The remainder of the table presents development as percentages of the estimated liability. The development results from additional information and experience in subsequent years. 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. 1986 1987 1988 1989 1990 Liability for unpaid losses and loss adjustment expenses: As originally estimated $1,843 $2,024 $2,209 $2,246 $2,137 As re-estimated at December 31, 1996 2,459 2,423 2,472 2,462 2,280 Liability re-estimated (*): One year later 102.7% 102.5% 99.8% 100.4% 98.6% Two years later 107.3% 103.6% 100.0% 99.3% 97.7% Three years later 109.7% 103.1% 99.7% 98.4% 97.4% Four years later 110.8% 102.5% 98.7% 98.2% 99.2% Five years later 111.8% 102.6% 99.1% 101.1% 98.4% Six years later 112.7% 103.5% 103.0% 101.1% 106.7% Seven years later 115.3% 109.4% 103.0% 109.6% Eight years later 122.1% 109.8% 111.9% Nine years later 122.5% 119.7% Ten years later 133.4% Cumulative deficiency (redundancy) 33.4% 19.7% 11.9% 9.6% 6.7% Cumulative paid as of: One year later 33.0% 29.2% 29.4% 32.3% 26.1% Two years later 52.5% 49.0% 48.6% 48.2% 43.2% Three years later 67.7% 63.5% 59.8% 59.2% 55.3% Four years later 79.3% 72.2% 67.9% 67.6% 64.8% Five years later 86.4% 78.5% 74.0% 74.3% 70.4% Six years later 91.9% 83.6% 79.5% 78.1% 74.9% Seven years later 96.1% 87.7% 82.4% 81.7% Eight years later 100.0% 90.3% 85.7% Nine years later 102.7% 93.3% Ten years later 105.7% 1991 1992 1993 1994 1995 1996 Liability for unpaid losses and loss adjustment expenses: As originally estimated $2,129 $2,123 $2,113 $2,187 $3,393 $3,404 As re-estimated at December 31, 1996 2,199 2,134 2,058 2,170 3,345 N/A Liability re-estimated (*): One year later 99.3% 100.0% 98.1% 95.1% 98.6% Two years later 98.8% 98.2% 92.7% 99.2% Three years later 98.0% 93.5% 97.4% Four years later 95.8% 100.5% Five years later 103.3% Six years later Seven years later Eight years later Nine years later Ten years later Cumulative deficiency (redundancy) 3.3% .5% (2.6%) (.8%) (1.4%) N/A Cumulative paid as of: One year later 26.4% 26.7% 25.2% 26.5% 33.0% Two years later 43.0% 43.7% 40.1% 42.4% Three years later 55.4% 53.6% 50.8% Four years later 62.6% 61.0% Five years later 68.1% Six years later Seven years later Eight years later Nine years later Ten years later (*) Reflects significant A&E charges and reallocations in 1994 and 1996 for prior years losses. The following is a reconciliation of the net liability to the gross liability for unpaid losses and LAE. 1993 1994 1995 1996 As originally estimated: Net liability shown above $2,113 $2,187 $3,393 $3,404 Add reinsurance recoverables 611 730 704 720 Gross liability $2,724 $2,917 $4,097 $4,124 As re-estimated at December 31, 1996: Net liability shown above $2,058 $2,170 $3,345 Add reinsurance recoverables 553 637 726 Gross liability $2,611 $2,807 $4,071 N/A Gross cumulative deficiency (redundancy) (4.1%) (3.8%) (.6%) N/A 11 The following table presents certain data from the table above, adjusted to include reserves of American Premier's subsidiaries for periods subsequent to their entry into the insurance business in 1989 and prior to the Mergers in 1995.
1989 1990 1991 1992 1993 1994 Liability for unpaid losses and loss adjustment expenses: As originally estimated $2,616 $2,739 $2,793 $2,886 $3,029 $3,267 As re-estimated at December 31, 1996 2,776 2,818 2,801 2,779 2,835 3,146 Cumulative deficiency (redundancy) 6.1% 2.9% .3% (3.7%) (6.4%) (3.7%) Reconciliation of gross liability to net liability: As originally estimated: Net liability shown above $3,029 $3,267 Add reinsurance recoverables 656 781 Gross liability $3,685 $4,048 As re-estimated at December 31, 1996: Net liability shown above $2,835 $3,146 Add reinsurance recoverables 574 691 Gross liability $3,409 $3,837 Gross cumulative deficiency (redundancy) (7.5%) (5.2%)
These tables do not present accident or policy year development data. Furthermore, 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 $80 million charge for asbestos and environmental claims related to losses recorded in 1996, but incurred before 1986 is included in the re-estimated liability and cumulative deficiency (redundancy) percentage for each of the 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. The adverse development in the tables is due primarily to asbestos and environmental exposures for which AFC has been held liable under general liability policies written years ago where environmental coverage was not intended. Other factors affecting development included higher than projected inflation on medical, hospitalization, material, repair and replacement costs. Additionally, changes in the legal environment have influenced the development patterns over the past ten years. Two significant changes in the early to mid-1980s were the trend towards an adverse litigious climate and the change from contributory to comparative negligence. The adverse litigious climate was evidenced by an increase in lawsuits and damage awards, changes in judicial interpretation of legal liability and of the scope of policy coverage, and a lengthening of time it takes to settle cases. Under comparative negligence rules, a plaintiff's negligence is no longer a bar to recovery. Instead, if the plaintiff's negligence is 50% or less of the cause of the injury, the plaintiff can recover damages, but in an amount reduced by the portion of damage attributable to the plaintiff's own negligence. Recent years have seen a moderation of inflation and the enactment of legislation intended to limit the patterns of the previous years. 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, 1996, are as follows (in millions): Liability reported on a SAP basis $3,397 Additional discounting of GAAP reserves in excess of the statutory limitation for SAP reserves (23) Reserves of foreign operations 31 Estimated salvage and subrogation recoveries based on a cash basis for SAP and on an accrual basis for GAAP (1) Reinsurance recoverables 720 Liability reported on a GAAP basis $4,124 12 Asbestos and Environmental Reserves ("A&E"). The insurance industry typically includes only claims relating to polluted waste sites and asbestos in defining environmental exposures. AFG extends this definition to include claims relating to breast implants, repetitive stress on keyboards, DES (a drug used in pregnancies years ago alleged to cause cancer and birth defects) and other latent injuries. Establishing reserves for A&E claims is subject to uncertainties that are greater than those presented by other types of claims. Factors contributing to those uncertainties include a lack of sufficiently detailed historical data, long reporting delays, uncertainty as to the number and identity of insureds with potential exposure, unresolved legal issues regarding policy coverage, and the extent and timing of any such contractual liability. Courts have reached different and sometimes inconsistent conclusions as to when a loss is deemed to have occurred, what policies provide coverage, what claims are covered, whether there is an insured obligation to defend, how policy limits are determined and other policy provisions. Management believes these issues are not likely to be resolved in the near future. Prior to the fourth quarter of 1994, AFG maintained reserves only on its reported A&E claims; reserves for claims incurred but not reported ("IBNR") were not allocated to A&E claims. Following completion of a detailed analysis in that quarter, AFG allocated a specific portion of its IBNR reserves to A&E claims. Significant industrywide information concerning A&E reserves first became broadly available in mid-1996 following the publication of new data relating to that subject in the 1995 Annual Statements of insurance companies. During 1995 and 1996, a number of insurers recorded large reserve increases for A&E exposures. By the end of 1995, the industry's one-year survival ratio (reserves divided by average annual paid losses) had increased from a multiple of six times in the early 1990's to more than nine times. The following table compares AFG's three-year survival ratio for A&E claims with that of the industry. December 31, Survival Ratio: 1996 1995 1994 AFG 10.5 6.5 7.0 Industry(a) 8.2 9.4 7.9 (a) Source: "BestWeek - Property and Casualty Supplement" (September 15, 1997 Edition.) Industry actions and statistics in 1995 caused AFG to re-evaluate its position in relation to its peers as part of the continuing process of obtaining additional information and revising accounting estimates. This process led management to conclude that the A&E reserves should be increased sufficiently to bring AFG's three-year survival ratio in line with those of the top 50 companies. In the third quarter of 1996, AFG strengthened its A&E reserve to approximately 10.5 times average annual paid losses based upon these revised industry standards for reserving such claims. AFG recorded a non-cash, pretax charge of $80 million and reallocated $40 million in reserves from its Specialty Operations. Based on known facts, current law, and current industry practices, management believes that its reserves for such claims are appropriate. The following table (in millions) is a progression of reserves for A&E exposures for which AFG has been held liable under general liability policies written years ago where environmental coverage was not intended and, in many cases, was specifically excluded. 1996 1995(*) 1994(*) Reserves at beginning of year $225.7 $224.9 $143.5 Incurred losses and LAE 149.0 35.2 113.6 Paid losses and LAE (31.3) (34.4) (32.2) Reserves at end of year, net of reinsurance recoverable 343.4 225.7 224.9 Reinsurance recoverable 162.7 164.2 162.0 Gross reserves at end of year $506.1 $389.9 $386.9 (*) Amounts have been increased by $6.1 million in 1995 and $5.1 million in 1994 to reflect certain items previously classified as non-A&E. Since the mid-1980's, AFG has also written certain environmental coverages (asbestos abatement and underground storage tank liability) in which the premium charged is intended to provide coverage for the specific environmental exposures inherent in these policies. The business has been profitable since its inception. To date, approximately $180 million of premiums has been written, $20 million in losses and LAE has been paid and reserves for unpaid losses and LAE aggregated $41 million at December 31, 1996 (not included in the above table). 13 Annuity and Life Operations General. AFG's annuity operations are conducted through American Annuity Group ("AAG"), a holding company whose primary subsidiary is Great American Life Insurance Company ("GALIC") which it acquired from GAI on December 31, 1992. GALIC sells (i) flexible premium and single premium annuities in the qualified (not-for-profit) market and (ii) single premium annuities in the non-qualified market. AAG and its subsidiaries employ approximately 1,000 persons. The following table (in millions) presents financial information concerning GALIC. 1996 1995 1994 Statutory Basis Total Assets $5,752 $5,414 $5,057 Insurance Reserves: Annuities $5,298 $4,974 $4,655 Life 22 22 21 Accident and Health - - 1 $5,320 $4,996 $4,677 Capital and Surplus $ 285 $ 273 $ 256 Asset Valuation Reserve (a) 91 90 80 Interest Maintenance Reserve (a) 25 32 28 Annuity Receipts: Flexible Premium: First Year $ 35 $ 42 $ 39 Renewal 182 196 208 217 238 247 Single Premium 319 219 196 Total Annuity Receipts $ 536 $ 457 $ 443 GAAP Basis Total Assets $5,934 $5,608 $5,044 Annuity Benefits Accumulated 5,205 4,917 4,596 Stockholder's Equity 658 623 449 (a) Allocation of surplus. Annuity Products. Annuities are long-term retirement savings plans that benefit from interest accruing on a tax-deferred basis. Employees of qualified not-for-profit organizations are eligible to save for retirement through contributions made on a before-tax basis. Contributions are made at the discretion of the participants through payroll deductions or through tax-free "rollovers" of funds. Federal income taxes are not payable on contributions or earnings until amounts are withdrawn. GALIC's principal products are Flexible Premium Deferred Annuities ("FPDAs") and Single Premium Deferred Annuities ("SPDAs"). FPDAs are characterized by premium payments that are flexible in both amount and timing as determined by the policyholder. SPDAs are issued in exchange for a one-time lump- sum premium payment. Annuity contracts are generally classified as either fixed rate or variable. With a fixed rate annuity, the interest crediting rate is initially set by the issuer and thereafter may be changed from time to time by the issuer based on market conditions, subject to any guaranteed minimum interest crediting rates in the policy. With a variable annuity, the value of the policy is tied to an underlying securities portfolio or underlying mutual funds. The majority of annuities issued by GALIC have been fixed rate annuities. In the third quarter of 1996, GALIC began marketing a new type of annuity that offers the traditional features of a fixed annuity (guaranteed minimum annual interest rate on a portion of the premium received and a guaranteed minimum surrender value) with the opportunity to participate, in part, in 14 increases in the S&P 500 Index over a selected term (generally a minimum of six years). A GALIC subsidiary began marketing variable annuities in the fourth quarter of 1995. 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. Policyholders may also choose to direct all or a portion of their premiums to various fixed rate options. For these annuity products, all premiums directed to the variable options are placed in funds managed by third party investment advisers. At December 31, 1996, substantially all of GALIC's annuity policyholder benefit reserves consisted of fixed rate annuities which offered a minimum interest rate guarantee of 3% or 4%. The majority of GALIC's fixed rate annuity policies permit GALIC to change the crediting rate at any time (subject to the minimum guaranteed interest rate). In determining the frequency and extent of changes in the crediting rate, GALIC takes into account the economic environment and the relative competitive position of its products. GALIC seeks to maintain a desired spread between the yield on its investment portfolio and the rate it credits to its policies. GALIC accomplishes this by (i) offering crediting rates which it has the option to change, (ii) designing annuity products that encourage persistency and (iii) maintaining an appropriate matching of assets and liabilities. GALIC designs its products with certain surrender charges and front-end fees to discourage policyholders from surrendering or withdrawing funds during the first five to ten years after issuance of a policy. Partly due to these features, GALIC's annuity surrenders have averaged approximately 7% of statutory reserves over the past five years. Marketing. GALIC markets its FPDAs principally to employees of educational institutions in the kindergarten through high school segment. In 1996, written premiums from this market segment represented the majority of GALIC's total tax-qualified premiums. GALIC distributes its annuity products through over 75 managing general agents ("MGAs") who, in turn, direct approximately 1,000 actively producing independent agents. GALIC has developed its business on the basis of its relationships with MGAs and independent agents primarily through a consistent marketing approach and responsive service. GALIC is licensed to sell its products in all states (except New York) and in the District of Columbia. The following table reflects the geographical distribution of GALIC's annuity premiums in 1996 compared to 1992. 1996 1992 1996 1992 California 29.8% 20.2% North Carolina 3.0% 3.2% Washington 7.0 * Minnesota 2.8 * Texas 6.6 2.8 Connecticut 2.7 6.3 Florida 5.1 10.2 Indiana 2.3 * Massachusetts 4.8 8.1 Arizona 2.1 * Ohio 4.8 5.1 Illinois * 3.8 Michigan 3.5 9.9 Rhode Island * 2.6 Iowa 3.4 * New Hampshire * 2.3 New Jersey 3.1 6.2 Other 19.0 19.3 100.0% 100.0% _____________ * less than 2% Sales of annuities are affected by many factors, including: (i) competitive annuity products and rates; (ii) the general level of interest rates; (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; and (viii) general economic conditions. At December 31, 1996, GALIC had approximately 250,000 annuity policies in force, nearly all of which were individual contracts. 15 American Memorial Life Insurance. Acquired in November 1995, American Memorial (formerly Prairie States Life Insurance Company) offers a variety of life insurance and annuity products to finance pre-arranged funerals. American Memorial markets its products through funeral home operators in addition to a captive general agency force. At year-end 1996, American Memorial had relationships with approximately 2,200 funeral homes nationwide. In 1996, American Memorial collected $97 million in life and annuity premiums. At December 31, 1996, American Memorial had total statutory assets of approximately $412 million, reserves for future policy benefits of approximately $371 million, and capital and surplus of approximately $27 million. Loyal American Life Insurance. Acquired in November 1995, Loyal offers a variety of supplemental life and health insurance products through payroll deduction plans and credit unions. Loyal's products are marketed with the endorsement or consent of the employer or the credit union management. In 1996, Loyal collected $41 million in life and accident and health premiums. At December 31, 1996, Loyal had total statutory assets of approximately $255 million, reserves for future policy benefits of approximately $202 million, and capital and surplus of approximately $37 million. Independent Ratings. AAG's principal insurance subsidiaries are currently rated by A.M. Best and Duff & Phelps as follows: A.M. Best Duff & Phelps GALIC A (Excellent) AA- (Very high claims paying ability) American Memorial B+ (Very Good) AA- (Very high claims paying ability) Loyal A- (Excellent) AA- (Very high claims paying ability) AAG believes that the ratings assigned by independent insurance rating agencies are important because potential policyholders often use a company's rating as an initial screening device in considering annuity products. AAG also believes that the majority of purchasers of tax-deferred annuities would not be willing to purchase annuities from an issuer that had a rating below certain levels. In addition, some school districts, hospitals and banks do not allow insurers with a rating below certain levels to sell annuity products through their institutions. AAG believes that a rating in the "A" category by at least one rating agency is necessary for GALIC to successfully market tax-deferred annuities to public education employees and other not-for-profit groups. American Memorial and Loyal compete in markets other than the sale of tax-deferred annuities. While ratings are an important competitive factor in their markets, AAG believes that American Memorial and Loyal can successfully compete in these markets with their respective ratings. Although management of AAG believes that its insurance companies' ratings are very stable, those companies' operations could be materially adversely affected by a downgrade in ratings. Competition. AAG's insurance companies 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; (v) product design (including interest rates credited); (vi) commissions; and (vii) service to agents. Since policies are marketed and distributed primarily through independent agents, the insurance companies must also compete for agents. Management believes that consistently targeting the same market and emphasizing service to agents and policyholders provides a competitive advantage. More than 150 insurance companies offer tax-deferred annuities. No single insurer dominates the marketplace. Competitors include (i) individual insurers and insurance groups, (ii) mutual funds and (iii) other financial institutions of varying sizes. In a broader sense, AAG's insurance companies compete for retirement savings with a variety of financial institutions offering a full range of financial services. Financial institutions have demonstrated a growing interest in marketing investment and savings products 16 other than traditional deposit accounts. In addition, recent judicial and regulatory decisions have expanded powers of financial institutions in this regard. It is too early to predict what impact, if any, these developments will have on AAG's insurance companies. Other Companies AFEI is a holding company with assets consisting primarily of investments in the common stock of AFG and American Annuity. Millennium Dynamics, Inc. ("MDI") was formed in 1995 by Great American to market software tools developed internally to solve the inability of certain of its information systems to properly interpret dates for the year 2000 and beyond. MDI licenses its Vantage YR2000 conversion toolset through its own sales force in the U.S. and through independent software distributors around the world. MDI also offers project management and contract programming services to its customers. Through subsidiaries, AFC is engaged in a variety of other businesses, including The Golf Center at Kings Island (golf and tennis facility) in the Greater Cincinnati area; commercial real estate operations in Cincinnati (office buildings and The Cincinnatian Hotel), Louisiana (Le Pavillon Hotel), Massachusetts (Chatham Bars Inn), Texas (Driskill Hotel) and apartments in Florida, Kentucky, Louisiana, Minnesota, Oklahoma, Pennsylvania, Texas and Wisconsin. These operations employ approximately 700 full-time employees. In March 1996, American Premier sold its interest in an independent pipeline common carrier of refined petroleum products for approximately $60 million in cash, net of transaction costs. Investment Portfolio General. A breakdown of AFG's December 31, 1996, investment portfolio by business segment follows (excluding investment in equity securities of investee corporations) (in millions). Total Carrying Value Market P&C Annuity Other Total Value Cash and short-term investments $ 190 $ 84 $174 $ 448 $ 448 Bonds and redeemable preferred stocks 4,165 5,689 132 9,986 10,023 Other stocks, options and warrants 196 51 81 328 328 Loans receivable 122 436 11 569 569(a) Real estate and other investments 140 40 28 208 208(a) $4,813 $6,300 $426 $11,539 $11,576 (a) Carrying value used since market values are not readily available. 17 The following tables present the percentage distribution and yields of AFG's investment portfolio (excluding investment in equity securities of investee corporations) as reflected in its financial statements. 1996 1995 1994 1993 1992 Cash and Short-term Investments 3.9% 4.9% 2.2% 2.3% 9.3% Bonds and Redeemable Preferred Stocks: U.S. Government and Agencies 4.1 3.7 4.0 2.8 5.7 State and Municipal 1.0 .7 .8 .8 .6 Public Utilities 8.2 9.7 9.1 9.3 8.5 Mortgage-Backed Securities 22.2 20.7 21.8 24.7 22.9 Corporate and Other 49.3 46.8 48.6 42.0 33.9 Redeemable Preferred Stocks 0.5 1.0 1.4 1.3 .8 85.3 82.6 85.7 80.9 72.4 Net Unrealized Gains (Losses) on Bonds and Redeemable Preferred Stocks held Available for Sale 1.1 2.7 (1.0) 1.8 .8 86.4 85.3 84.7 82.7 73.2 Other Stocks, Options and Warrants 2.8 2.3 2.7 4.6 2.6 Loans Receivable 4.9 5.6 8.4 8.5 12.9 Real Estate and Other Investments 2.0 1.9 2.0 1.9 2.0 100.0% 100.0% 100.0% 100.0% 100.0% Yield on Fixed Income Securities: Excluding realized gains and losses 7.9% 7.9% 8.1% 8.0% 8.8% Including realized gains and losses 7.7% 8.8% 8.1% 8.7% 9.8% Yield on Stocks: Excluding realized gains and losses 5.8% 3.9% 5.1% 4.4% 6.4% Including realized gains and losses 15.1% 8.4% 35.4% 16.9% 15.5% Yield on Investments (*): Excluding realized gains and losses 7.8% 7.9% 8.1% 7.9% 8.7% Including realized gains and losses 7.8% 8.8% 8.8% 9.0% 10.0% (*)Excludes "Real Estate and Other Investments". Fixed Maturity Investments. Unlike many insurance groups which have portfolios that are invested heavily in tax-exempt bonds, AFG's bond portfolio is invested primarily in taxable bonds. The NAIC assigns quality ratings which range from Class 1 (highest quality) to Class 6 (lowest quality). The following table shows AFG's bonds and redeemable preferred stocks, by NAIC designation (and comparable Standard & Poor's Corporation rating) as of December 31, 1996 (dollars in millions): NAIC Amortized Market Value Rating Comparable S&P Rating Cost Amount % 1 AAA, AA, A $6,844.1 $ 6,944.8 69% 2 BBB 2,380.2 2,423.9 24 Total investment grade 9,224.3 9,368.7 93 3 BB 341.7 344.9 4 4 B 280.6 296.7 3 5 CCC, CC, C 7.1 9.9 * 6 D - 2.5 * Total non-investment grade 629.4 654.0 7 Total $9,853.7 $10,022.7 100% _______________ (*) Less than 1% Risks inherent in connection with fixed income securities include loss upon default and market price volatility. Factors which can affect the market price of securities include: creditworthiness, changes in interest rates, the number of market makers and investors and defaults by major issuers of securities. 18 AFG's primary investment objective for bonds and redeemable preferred stocks is to earn interest and dividend income rather than to realize capital gains. AFG invests in bonds and redeemable preferred stocks that have primarily short-term and intermediate-term maturities. This practice allows flexibility in reacting to fluctuations of interest rates. Equity Investments. AFG's equity investment practice permits concentration of attention on a relatively limited number of companies. Some of the equity investments, because of their size, may not be as readily marketable as the typical small investment position. Alternatively, a large equity position may be attractive to persons seeking to control or influence the policies of a company and AFG's concentration in a relatively small number of companies may permit it to identify investments with above average potential to increase in value. Chiquita At December 31, 1996, AFG owned 24 million shares of Chiquita common stock representing 43% of its outstanding shares. The carrying value and market value of AFG's investment in Chiquita were approximately $200 million and $306 million, respectively, at December 31, 1996. Chiquita is a leading international marketer, producer and distributor of bananas and other quality fresh and processed food products. In addition to bananas, these products include other tropical fruit and fresh produce; fruit and vegetable juices and beverages; processed fruits and vegetables; salads; and edible oil-based consumer products. Citicasters In September 1996, AFG sold its investment in Citicasters to Jacor Communications for approximately $220 million in cash plus warrants to purchase Jacor common stock. Citicasters owned radio and television stations in major markets throughout the country. General Cable In 1994, AFC sold its investment in General Cable common stock to an unaffiliated company for $27.6 million in cash. General Cable was formed in 1992 to hold American Premier's wire and cable and heavy equipment manufacturing businesses. 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 be disclosed and prior approval of the applicable insurance regulatory authorities generally is required for any such transaction which may be deemed to be material or extraordinary. 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 1997 from its insurance subsidiaries without seeking regulatory clearance is approximately $253 million. Changes in state insurance laws and regulations have the potential to materially affect the revenues and expenses of the insurance operations. The Company is unable to predict whether or when laws or regulations may be adopted or enacted in such states or what the impact of such developments would be on the future operations and revenues of its insurance businesses in such states. Prior to 1995, minimum premium rates for California workers' compensation insurance were determined by the California Commissioner based in part upon recommendations of the Workers' Compensation Insurance Rating Bureau of 19 California. In July 1993, California enacted legislation (the "Reform Legislation") effecting an immediate overall 7% reduction in workers' compensation insurance premium rates and replaced the workers' compensation insurance minimum rate law, effective January 1, 1995, with a procedure permitting insurers to use any rate within 30 days after its filing with the California Commissioner unless the rate is disapproved by the California Commissioner. Between December 1, 1993 and January 1, 1995, when the "open rating" policy went into effect, the California Commissioner ordered additional rate decreases totaling more than 25%. Most states have created insurance guarantee associations to provide for the payment of claims of insurance companies that become insolvent. Annual assessments for AFG's insurance companies have not been material. In addition, many states have created "assigned risk" plans or similar arrangements to provide state mandated minimum levels of automobile liability coverage to drivers whose driving records or other relevant characteristics make it difficult for them to obtain insurance otherwise. Automobile insurers in those states are required to provide such coverage to a proportionate number of those drivers applying as assigned risks. Premium rates for assigned risk business are established by the regulators of the particular state plan and are frequently inadequate in relation to the risks insured, resulting in underwriting losses. Assigned risks accounted for approximately one-half of one percent of AFG's net written premiums in 1996. The NAIC is an organization which is comprised of the chief insurance regulator for each of the 50 states and the District of Columbia. In 1990, the NAIC began an accreditation program to ensure that states have adequate procedures in place for effective insurance regulation, especially with respect to financial solvency. The accreditation program requires that a state meet specific minimum standards in over 15 regulatory areas to be considered for accreditation. The accreditation program is an ongoing process and once accredited, a state must enact any new or modified standards approved by the NAIC within two years following adoption. As of December 31, 1996, the District of Columbia and 48 states were accredited including states which regulate AFG's largest insurance subsidiaries. The NAIC model law for Risk Based Capital applies to both life and property and casualty companies. The risk-based capital formulas determine the amount of capital that an insurance company needs to ensure that it has an acceptably low expectation of becoming financially impaired. The model law provides for increasing levels of regulatory intervention as the ratio of an insurer's total adjusted capital and surplus decreases relative to its risk-based capital, culminating with mandatory control of the operations of the insurer by the domiciliary insurance department at the so-called "mandatory control level". The risk-based capital formulas became effective in 1993 for life companies and in 1995 for property and casualty companies. At December 31, 1996, the capital ratios of all AFG insurance companies substantially exceeded the risk-based capital requirements. In September 1996, the NAIC adopted a model investment law. The law will not be a requirement of the NAIC accreditation standards. However, each state may adopt all, any part, or none of the model investment law to regulate the investment policies of their insurance companies. At this time, it is not possible to determine the impact, if any, this will have on AFG's insurance subsidiaries. 20 ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 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 to the financial statements, financial statements for periods prior to the Mergers are those of AFC. The operations of American Premier are included in AFG's financial statements from the date of acquisition. LIQUIDITY AND CAPITAL RESOURCES Ratios From the date of the Mergers to the end of 1996, approximately $1.1 billion of AFC and American Premier debt was retired or replaced with lower cost debt, resulting in a net reduction of aggregate debt by approximately 75%. Consequently, AFG's debt to total capital ratio at the parent holding company level improved from nearly 60% at the date of the Mergers to approximately 15% at December 31, 1996. These debt reductions and replacements will also reduce AFG's interest expense by over $100 million annually. AFG's ratio of earnings to fixed charges on a total enterprise basis was 4.22, 2.60 and 1.69 for the years ended December 31, 1996, 1995 and 1994, respectively. Assuming the Mergers and related transactions occurred at the beginning of each period, these ratios would have been 2.93 for 1995 and 2.07 for 1994. The National Association of Insurance Commissioners' 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 to ensure that it has an acceptable expectation of not becoming financially impaired. At December 31, 1996, the capital ratios of all AFG insurance companies substantially exceeded the RBC requirements (the lowest capital ratio of any AFG subsidiary was 2.8 times its authorized control level RBC; weighted average of all AFG subsidiaries was 5.0 times). Sources of Funds AFG and its subsidiaries, AFC and American Premier, are organized as holding companies with almost all of their operations being conducted by subsidiaries. These parent corporations, however, have continuing cash needs for administrative expenses, the payment of principal and interest on borrowings, and shareholder dividends. AFG, AFC and American Premier rely primarily on dividends and tax payments from their subsidiaries for funds to meet their obligations. Management believes AFG has sufficient resources to meet the liquidity requirements of AFG, AFC and American Premier through operations in the short-term and long-term future. If funds generated from operations, including dividends from subsidiaries, are insufficient to meet fixed charges in any period, these companies would be required to generate cash through borrowings, sales of securities or other assets, or similar transactions. Prior to the Mergers, American Premier had substantial cash and short-term investments at the parent company level. Subsequent to the Mergers, AFC and two of its subsidiaries entered into separate credit agreements with American Premier. Funds borrowed from American Premier under these agreements were used for debt retirements, capital contributions to subsidiaries, and other corporate purposes. In addition, AFG and American Premier entered into a reciprocal credit agreement under which these companies make funds available to each other for general corporate purposes. 25 In December 1996, American Premier paid a dividend to AFG in the form of a $675 million note receivable from AFC under its credit agreement plus $18.7 million of related accrued interest. AFG then contributed $450 million of the note (without accrued interest) to the capital of AFC. At the close of business on December 31, 1996, AFG contributed to AFC 81% of the common stock of American Premier. In September and October of 1996, three nationally recognized rating agencies issued or upgraded ratings on AFC, American Premier and AAG public debentures. All of the AFC and AAG senior debentures are now rated investment grade; the APU and AAG subordinated debentures are rated investment grade by two of the agencies. Generally, the upgrades reflect the expectation that AFG's consolidated debt to total capital will remain conservative and that coverage ratios will benefit from higher subsidiary earnings and a lower level of fixed charges at AFG's subsidiaries. Bank credit lines at several subsidiary holding companies provide ample liquidity and can be used to obtain funds for the operating subsidiaries or, if necessary, for the parent companies, AFC, American Premier and ultimately AFG. Agreements with the banks generally run for three to seven years and are renewed before maturity. While it is highly unlikely that all such amounts would ever be borrowed at one time, a maximum of $510 million is available under these bank facilities, $45 million of which was borrowed at December 31, 1996. In the past, funds have been borrowed under certain of these bank facilities and used for working capital, capital infusions into subsidiaries, and to retire other issues of short-term or high-rate debt. Also, AFG believes it may be prudent and advisable to borrow up to $200 million of bank debt in the normal course in order to retire public or privately held fixed rate obligations over the next year or two. In October 1996, a wholly-owned trust subsidiary of AFG issued four million units of 9-1/8% Trust Originated Preferred Securities ("TOPrS") for $100 million in cash. The Trust then purchased $100 million of newly issued AFG 9-1/8% Subordinated Debentures due 2026, which, along with related interest and principal payments received, will be the only assets of the Trust. AFG used the proceeds to retire outstanding debt and preferred stock of subsidiaries and for general corporate purposes. In addition, in November 1996, a wholly-owned trust subsidiary of AAG issued $75 million of similar TOPrS. AAG used $50 million of the proceeds to retire bank debt and the remainder for general corporate purposes. Two nationally recognized rating agencies gave both TOPrS investment grade ratings. In March 1997, AAG raised an additional $75 million from a private offering of preferred securities similar to the TOPrS. In February 1997, AFG filed a shelf registration statement for the future issuance of up to an aggregate of $500 million in common stock, debt or trust securities, with no more than $200 million of any one security being issued. The filing provides AFG with greater flexibility to access the capital markets from time to time as market and other conditions permit. Dividend payments from subsidiaries have been very important to the liquidity and cash flow of the individual holding companies in the past. However, the reliance on such dividend payments has been lessened by the combination of (i) strong capital at AFG's insurance subsidiaries (and the related decreased likelihood of a need for investment in those companies), (ii) the reductions of debt at the holding companies (and the related decrease in ongoing cash needs for interest and principal payments), (iii) AFG's ability to obtain financing in capital markets, as well as (iv) the sales of Citicasters and Buckeye Management Company ("Buckeye"). 26 For statutory accounting purposes, equity securities are generally carried at market value. At December 31, 1996, AFG's insurance companies owned publicly traded equity securities with a market value of $1.3 billion, including equity securities of AFG affiliates (including subsidiaries) of $1.0 billion. Since significant amounts of these are concentrated in a relatively small number of companies, decreases in the 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 the market prices could have a favorable impact on the group's dividend-paying capability. AFC and American Premier have each filed consolidated tax returns. Under tax allocation agreements with AFC, its 80%-owned U.S. subsidiaries generally compute tax provisions as if filing separate returns based on book taxable income computed in accordance with generally accepted accounting principles. American Premier has tax allocation agreements with its U.S. insurance subsidiaries whereby such subsidiaries compute tax provisions based on taxable income in accordance with statutory accounting principles. In each case, the resulting provision (or credit) is currently payable to (or receivable from) AFC or American Premier. American Premier's federal income tax loss carryforward was available to offset taxable income and, as a result, American Premier's obligation to pay federal income tax for 1996 was substantially eliminated. Beginning with the 1997 federal tax return, American Premier will join AFC's consolidated return. Uncertainties Two lawsuits were filed in 1994 against American Premier by USX Corporation ("USX") and a former USX subsidiary. The lawsuits seek contribution from American Premier for all or a portion of a $600 million final antitrust judgment entered against a USX subsidiary in 1994. The lawsuits argue that USX's liability for that judgment is attributable to the alleged activities of American Premier's predecessor in an unlawful antitrust conspiracy among certain railroad companies. American Premier and its outside counsel believe that American Premier has substantial defenses and should not suffer a material loss as a result of this litigation. Great American's liability for unpaid losses and loss adjustment expenses includes amounts for various liability coverages related to environmental and hazardous product claims. The insurance industry typically includes only claims relating to polluted waste sites and asbestos in defining environmental exposures, whereas Great American extends this definition to include claims relating to breast implants, repetitive stress on keyboards, DES (a drug used in pregnancies years ago alleged to cause cancer and birth defects), and other latent injuries. At December 31, 1996, Great American had recorded $343 million (net of reinsurance recoverables of $163 million) for environmental pollution and hazardous products claims on policies written many years ago where, in most cases, coverage was never intended. Due to inconsistent court decisions on many coverage issues and the difficulty in determining standards acceptable for cleaning up pollution sites, significant uncertainties exist which are not likely to be resolved in the near future. AFG's subsidiaries are parties in a number of proceedings relating to former operations. See Note M to the financial statements. While the results of all such uncertainties cannot be predicted, based upon its knowledge of the facts, circumstances and applicable laws, management believes that sufficient reserves have been provided. 27 Investments Approximately 70% of AFG's consolidated assets are invested in marketable securities. A diverse portfolio of bonds and redeemable preferred stocks accounts for 95% of these securities. AFG attempts to optimize investment income while building the value of its portfolio, placing emphasis upon long-term performance. AFG's goal is to maximize return on an ongoing basis rather than focusing on short-term performance. Fixed income investment funds are generally invested in securities with short-term and intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions. At December 31, 1996, the average life of AFG's bonds and redeemable preferred stocks was just over 6 years. Approximately 93% of the bonds and redeemable preferred stocks held by AFG were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies at December 31, 1996. 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. Investments in mortgage-backed securities ("MBSs") represented approximately one-fourth of AFG's bonds and redeemable preferred stocks at December 31, 1996. AFG invests primarily in MBSs which have a reduced risk of prepayment. Interest only (I/Os), principal only (P/Os) and other "high risk" MBSs represented approximately two percent of AFG's total mortgage-backed securities portfolio. In addition, the majority of MBSs held by AFG were purchased at a discount. Management believes that the structure and discounted nature of the MBSs will minimize the effect of prepayments on earnings over the anticipated life of the MBS portfolio. More than 90% of AFG's MBSs are rated "AAA" with substantially all being of investment grade quality. The majority are collateralized by GNMA, FNMA and FHLMC single-family residential pass-through certificates. The market in which these securities trade is highly liquid. Aside from interest rate risk, AFG does not believe a material risk (relative to earnings or liquidity) is inherent in holding such investments. Because most income of the property and casualty insurance subsidiaries has been sheltered from income taxes through 1996, non-taxable municipal bonds represent only a small portion (approximately 1%) of the portfolio. AFG's equity securities are concentrated in a relatively limited number of major positions. This approach allows management to more closely monitor the companies and industries in which they operate. The realization of capital gains, primarily through sales of equity securities, was an integral part of AFG's investment program. Individual securities are sold creating gains or losses as market opportunities exist. Pretax capital gains recognized upon disposition of securities, including investees, during the past five years have been: 1996 - $166 million; 1995 - $84 million; 1994 - $50 million; 1993 - $165 million and 1992 - $104 million. At December 31, 1996, the net unrealized gain on AFG's bonds and redeemable preferred stocks was $169 million; the net unrealized gain on equity securities was $185 million. 28 RESULTS OF OPERATIONS - THREE YEARS ENDED DECEMBER 31, 1996 General As previously noted, financial statements for periods prior to the April 1995 Mergers are those of AFC. The operations of American Premier are included in AFG's financial statements from the date of acquisition. AFC had accounted for American Premier as an investee from the second quarter of 1993 through the first quarter of 1995. Accordingly, current year income statement components are not comparable to prior years. Pretax earnings before extraordinary items were $353 million in 1996, $247 million in 1995 and $44 million in 1994. Results for 1996 include $203 million in pretax gains primarily on the sales of Citicasters and Buckeye, reduced by a charge of $80 million resulting from a decision to strengthen insurance reserves relating to asbestos and other environmental matters ("A&E"). In addition to the earnings contribution resulting from the Mergers, results for 1995 include $84 million in pretax gains on the sale of securities. Results for 1994 include AFC's share ($28 million) of American Premier's loss on the sale of General Cable securities, Great American's $19 million charge relating to a rate rollback liability in California and a $35 million charge related to payments under AFC's Book Value Incentive Plan. Property and Casualty Insurance - Underwriting AFG manages and operates its property and casualty business as three major sectors. The nonstandard automobile insurance companies (the "NSA Group") insure risks not typically accepted for standard automobile coverage because of the applicant's driving record, type of vehicle, age or other criteria. The specialty lines are a diversified group of over twenty-five business lines that offer a wide variety of specialty insurance products. Some of the more significant areas are California workers' compensation, executive liability, inland and ocean marine, U.S.-based operations of Japanese companies, agricultural-related coverages, excess and surplus lines and fidelity and surety bonds. The commercial and personal lines provide coverages in commercial multi-peril, workers' compensation, umbrella and commercial automobile, standard private passenger automobile and homeowners insurance. To understand the overall profitability of particular lines, timing of claims payments and the related impact of investment income must be considered. Certain "short-tail" lines of business (primarily property coverages) 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) 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 underwriting losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, other income or federal income taxes. For certain lines of business and products where the credibility of the range of loss projections is less certain (primarily the various specialty lines listed above), management believes that it is prudent and appropriate to use conservative assumptions until such time as the data, experience and projections have more credibility, as evidenced by data volume, consistency and maturity of the data. While this practice mitigates the risk of adverse development on this business, it does not eliminate it. 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. 29 Comparisons made in the following discussion of AFG's insurance operations include American Premier's insurance operations even though they were not consolidated in the financial statements prior to the Mergers. Net written premiums and combined ratios for AFG's property and casualty insurance subsidiaries were as follows (dollars in millions): 1996 1995 1994 Net Written Premiums (GAAP) NSA Group $1,135 $1,277 $1,186 Specialty Operations 993 1,097 1,250 Commercial and Personal Operations 660 717 683 Other Lines - 1 5 $2,788 $3,092 $3,124 Combined Ratios (GAAP) NSA Group 99.9% 105.2% 100.0% Specialty Operations 84.1 94.8 97.2 Commercial and Personal Operations 110.6 99.1 98.9 Aggregate (including A&E and other lines) 102.9 101.2 99.4 Operating results for 1996 were adversely impacted by two unusual items: (i) higher than normal catastrophe losses including approximately $30 million in losses due to Hurricane Fran and (ii) the strengthening of A&E reserves (exposures for which AFG may be liable under general liability policies written years ago). A standard insurance measure used in analyzing the adequacy of A&E reserves is the "survival ratio" (reserves divided by three-year average annual paid losses). Due in part to the greater uncertainties inherent in estimating A&E claims, management evaluates its survival ratio in relation to those published for the industry. Based primarily on industry survival ratios published in mid-1996, AFG increased A&E reserves of its discontinued insurance lines by $120 million by recording a third quarter, non-cash pretax charge of $80 million and reallocating $40 million or approximately 2% of reserves from its Specialty Operations. Reserves for unpaid losses and loss adjustment expenses of the Specialty Lines were approximately $2.1 billion, $2.2 billion and $1.5 billion at December 31, 1996, 1995 and 1994, respectively. Following a detailed analysis of overall reserves, the reallocation was made based on available data, experience and projections. A&E reserves at December 31, 1996, were approximately $343 million, an amount equal to approximately 10.5 times the preceding three years' average claim payments. In 1996, underwriting results of AFG's insurance operations significantly outperformed the industry average for the eleventh consecutive year. AFG's insurance operations have been able to exceed the industry's results by focusing on highly specialized niche products, supplemented by commercial lines coverages and personal automobile products. NSA Group The NSA Group has implemented premium rate increases in various states over the last three years. The higher rate levels along with competitive pressures in the nonstandard automobile insurance industry resulted in an 11% decline in net written premiums in 1996 and adversely impacted premium growth during 1995. These rate increases contributed to an improvement, however, in the combined ratio for 1996. The increase in the combined ratio for 1995 was due primarily to inadequate rate levels in certain markets and weather- related losses (principally from hailstorms in Texas) which more than offset a reduction in underwriting expenses due largely to cost control measures. Specialty Operations Net written premiums for the specialty operations declined 9% and 12% during 1996 and 1995, respectively, due primarily to a decrease in the California workers' compensation business in both years and withdrawal from an unprofitable pool at the end of 1995, partially offset by increases in other specialty niche lines. The decline in California workers' compensation premiums reflects (i) extremely competitive pricing in the marketplace as a result of the repeal of the California workers' compensation minimum rate law effective January 1, 1995 and (ii) the impact of mandatory premium rate reductions which took effect a year earlier. Excluding the impact of the decreases in the California workers' compensation business and the withdrawal from the voluntary pool, specialty net written premiums increased $16 million (2%) in 1996. The increase is due in part to increases in specialized coverages for fidelity and surety bonds, executive liability, animal mortality and collateral protection exposures. 30 The improvement in the combined ratio of the Specialty Lines for 1996 includes 4.1 percentage points attributable to a reallocation of loss reserves in connection with the strengthening of A&E reserves. Further improvement is attributable to (i) improved results in certain niche businesses, (ii) reductions in loss, loss adjustment expense and policyholder dividend reserves prompted by the fundamental changes in the California workers' compensation market and actuarial evaluations, and (iii) losses in 1995 from participation in the voluntary pool. The combined ratio of the specialty operations in 1995 reflects improved results experienced in the crop hail and farm lines as well as coverages of U.S. operations of Japanese companies. The 1995 combined ratio also includes losses resulting from participation in a voluntary pool from which AFG withdrew. Commercial and Personal Operations Net written premiums for the commercial and personal operations decreased 8% in 1996. The decrease is due primarily to significant reductions in homeowners coverages in certain states as well as competitive pricing conditions in the commercial casualty market, partially offset by increases in writings of workers' compensation coverages. The profitability of the commercial and personal operations declined in 1996 due primarily to deterioration in personal lines operations as well as weather-related losses, including losses from Hurricane Fran. Net written premiums increased 5% in 1995 due primarily to increased writing of workers' compensation and commercial umbrella insurance. The profitability of both of these lines improved in 1995. These profitable results were offset by unfavorable results in the personal lines operations from weather-related losses, start-up costs related to a direct-to- consumer operation and deteriorating automobile loss experience. Investment Income Changes in investment income reflect fluctuations in market rates and changes in average invested assets. 1996 compared to 1995 Investment income increased $96 million (13%) from 1995; adjusting for the effects of the Mergers retroactively to January 1, 1995, investment income increased $55 million (7%) from 1995 due primarily to an increase in the average amount of investments held. 1995 compared to 1994 AFC's investment income increased $50 million (9%) from 1994 due to an increase in the average amount of investments held. For the period following the Mergers, investment income includes $117 million attributable to American Premier. Investee Corporations Equity in net earnings of investee corporations (companies in which AFG owns a significant portion of the voting stock) represents AFG's proportionate share of the investees' earnings and losses. 1996 compared to 1995 AFG's equity in net earnings of investee corporations decreased $32 million compared to 1995. Chiquita reported a decrease in operating income in 1996 of $92 million. Chiquita recorded writedowns and costs of $70 million resulting from (i) industry-wide flooding in Costa Rica, Guatemala and Honduras, (ii) certain strategic undertakings designed to achieve further long-term reductions in the delivered product cost of Chiquita bananas and (iii) certain claims relating to prior European Union quota restructuring actions. Aside from the effects described above, operating income from remaining core operations improved in 1996 primarily as a result of lower delivered product cost for bananas. This improvement in core operating results substantially offset the elimination of earnings from Chiquita's Costa Rican edible oils operations which were sold in December 1995. 1995 compared to 1994 AFG's equity in net earnings of investee corporations increased $32 million in 1995. Chiquita reported a $105 million improvement in operating income primarily due to net gains from the sale of non-core assets, higher banana prices outside the European Union, the favorable effect of foreign exchange rates on European sales, and earnings improvements from other food products. 31 Gains on Sales of Investees The gains on sales of investees in 1996 represent pretax gains, before $6.5 million of minority interest, on the sale of Citicasters common stock. The gains on sales of investees in 1994 represent pretax gains on the sale of General Cable common stock. Gains on Sales of Subsidiaries The gains on sales of subsidiaries in 1996 include a pretax gain of $33.9 million on the sale of Buckeye and the settlement of litigation related to a subsidiary sold in 1993. Annuity Benefits For GAAP financial reporting purposes, annuity receipts are accounted for as interest-bearing deposits ("annuity benefits accumulated") rather than as revenues. Under these contracts, policyholders' funds are credited with interest on a tax-deferred basis until withdrawn by the policyholder. Annuity benefits represent primarily interest related to annuity policyholders' funds held. The rate at which GALIC credits interest on annuity policyholders' funds is subject to change based on management's judgment of market conditions. Annuity receipts totaled approximately $570 million in 1996, $460 million in 1995 and $440 million in 1994. Annuity receipts have increased over the last few years due to sales of newly introduced single premium products and, in 1995, the development of new distribution channels. Annuity benefits increased $17 million (7%) in 1996 and $13 million (5%) in 1995 primarily due to an increase in average annuity benefits accumulated. Interest on Borrowed Money Changes in interest expense result from fluctuations in market rates as well as changes in borrowings. AFG has generally financed its borrowings on a long-term basis which has resulted in higher current costs. 1996 compared to 1995 Interest expense for 1996 was $76.1 million and interest expense for 1995, adjusted to reflect the effect of the Mergers retroactively to January 1, 1995, was $116.3 million. The $40 million (35%) decrease reflects significant debt retirements during both 1995 and 1996. 1995 compared to 1994 Excluding $29 million attributable to American Premier, interest expense decreased by $22 million (19%) due primarily to repayments of borrowings by AFC and certain subsidiaries and the AFC debt exchange in 1994. Other Operating and General Expenses Operating and general expenses in 1994 included a charge of $18 million for allowance for bad debts and a charge of $19 million for a California insurance reform measure. Income Taxes See Note K to the Financial Statements for an analysis of items affecting AFG's effective tax rate. 32 ITEM 8 Financial Statements and Supplementary Data Page Report of Independent Auditors F-1 Consolidated Balance Sheet: December 31, 1996 and 1995 F-2 Consolidated Statement of Earnings: Years ended December 31, 1996, 1995 and 1994 F-3 Consolidated Statement of Cash Flows: Years ended December 31, 1996, 1995 and 1994 F-4 Notes to Consolidated Financial Statements F-5 "Selected Quarterly Financial Data" has been included in Note N to the Consolidated Financial Statements. 33 REPORT OF INDEPENDENT AUDITORS Board of Directors American Financial Group, Inc. We have audited the accompanying consolidated balance sheets of American Financial Group, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of earnings and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the Index at Item 14(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 generally accepted auditing standards. 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 consolidated 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, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with 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. ERNST & YOUNG LLP Cincinnati, Ohio March 25, 1997 F-1 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars In Thousands) December 31, 1996 1995 Assets Cash and short-term investments $ 448,296 $ 544,408 Investments: Bonds and redeemable preferred stocks: Held to maturity - at amortized cost (market - $3,528,100 and $3,729,300) 3,491,126 3,588,943 Available for sale - at market (amortized cost - $6,362,597 and $5,648,060) 6,494,597 5,949,260 Other stocks - principally at market (cost - $142,364 and $136,944) 327,664 252,244 Investment in investee corporations 199,651 306,545 Loans receivable 568,765 631,408 Real estate and other investments 208,765 220,135 Total investments 11,290,568 10,948,535 Recoverables from reinsurers and prepaid reinsurance premiums 942,450 923,080 Agents' balances and premiums receivable 609,403 703,274 Deferred acquisition costs 452,041 419,919 Other receivables 272,595 270,263 Deferred tax asset 137,284 200,392 Assets held in separate accounts 247,579 238,524 Prepaid expenses, deferred charges and other assets 372,321 391,339 Cost in excess of net assets acquired 278,581 314,136 $15,051,118 $14,953,870 Liabilities and Capital Unpaid losses and loss adjustment expenses $ 4,123,701 $ 4,096,703 Unearned premiums 1,247,806 1,294,054 Annuity benefits accumulated 5,365,612 5,051,959 Life, accident and health reserves 575,380 538,274 Long-term debt: Direct obligations of AFG Parent Company - - Obligations of AFG subsidiaries: American Financial Corporation (parent only) 172,809 311,202 American Premier Underwriters (parent only) 166,695 337,334 American Annuity Group 114,900 167,734 Other subsidiaries 63,515 65,793 Liabilities related to separate accounts 247,579 238,524 Accounts payable, accrued expenses and other liabilities 924,244 1,097,766 Total liabilities 13,002,241 13,199,343 Minority interest 494,440 314,390 Shareholders' Equity: Common Stock, $1 par value - 200,000,000 shares authorized - 61,071,626 and 60,139,303 shares outstanding 61,072 60,139 Capital surplus 745,649 741,355 Retained earnings 559,716 387,143 Net unrealized gain on marketable securities, net of deferred income taxes 188,000 251,500 Total shareholders' equity 1,554,437 1,440,137 $15,051,118 $14,953,870 See notes to consolidated financial statements. F-2 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS (In Thousands, Except Per Share Data)
Year ended December 31, 1996 1995 1994 Income: Property and casualty insurance premiums $2,844,512 $2,648,703 $1,378,628 Life, accident and health premiums 103,552 15,691 2,231 Investment income 846,428 750,640 582,931 Realized gains (losses) on sales of securities (3,470) 84,028 48,342 Equity in net earnings (losses) of investee corporations (16,955) 15,237 (16,573) Gains on sales of investee corporations 169,138 335 1,694 Gains on sales of subsidiaries 36,837 - - Other income 135,355 114,975 107,051 4,115,397 3,629,609 2,104,304 Costs and Expenses: Property and casualty insurance: Losses and loss adjustment expense 2,131,421 1,977,395 986,996 Commissions and other underwriting expenses 793,800 707,340 428,590 Annuity benefits 271,821 254,650 241,811 Life, accident and health benefits 92,315 13,202 1,524 Interest charges on borrowed money 76,052 122,568 115,162 Minority interest expense 47,821 33,264 8,903 Book Value Incentive Plan - - 34,740 Other operating and general expenses 348,923 274,271 243,010 3,762,153 3,382,690 2,060,736 Earnings before income taxes and extraordinary items 353,244 246,919 43,568 Provision for income taxes 91,277 56,489 24,650 Earnings before extraordinary items 261,967 190,430 18,918 Extraordinary items - gain (loss) on prepayment of debt (28,667) 817 (16,818) Net Earnings $ 233,300 $ 191,247 $ 2,100 Preferred dividend requirement of predecessor company - 6,349 25,709 Net earnings (loss) available to Common Shares $ 233,300 $ 184,898 ($ 23,609) Earnings (loss) per Common Share: Before extraordinary items $4.31 $3.87 ($.24) Extraordinary items (.47) .01 (.59) Net earnings (loss) $3.84 $3.88 ($.83) Average number of Common Shares 60,801 47,620 28,324
See notes to consolidated financial statements. F-3 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands)
Year ended December 31, 1996 1995 1994 Operating Activities: Net earnings $ 233,300 $ 191,247 $ 2,100 Adjustments: Extraordinary items 28,667 (817) 16,818 Depreciation and amortization 79,425 47,760 30,729 Annuity benefits 271,821 254,650 241,811 Equity in net (earnings) losses of investee corporations 16,955 (15,237) 16,573 Changes in reserves on assets 5,656 2,302 17,094 Realized gains on investing activities (198,676) (84,995) (59,609) Decrease (increase) in reinsurance and other receivables 96,387 23,192 (223,113) Decrease (increase) in other assets 23,541 (11,503) (96,596) Increase in insurance claims and reserves 9,171 137,180 345,542 Increase (decrease) in other liabilities (212,720) (247,938) 67,799 Increase in minority interest 18,206 7,877 6,773 Dividends from investees 4,799 9,568 21,567 Other, net (3,552) (673) (1,488) 372,980 312,613 386,000 Investing Activities: Purchases of and additional investments in: Fixed maturity investments (2,128,553) (2,378,427) (1,726,318) Equity securities (10,528) (1,034) (7,315) Investees and subsidiaries - (68,591) (29,306) Real estate, property and equipment (38,035) (42,579) (27,185) Maturities and redemptions of fixed maturity investments 617,272 309,581 420,945 Sales of: Fixed maturity investments 881,114 2,310,837 694,947 Equity securities 53,195 17,379 127,181 Investees and subsidiaries 284,277 - 27,621 Real estate, property and equipment 7,981 27,759 6,151 Cash and short-term investments of acquired (former) subsidiaries (4,589) 392,100 - Decrease (increase) in other investments 315 (11,466) (5,571) (337,551) 555,559 (518,850) Financing Activities: Annuity receipts 573,741 457,525 442,703 Annuity payments (517,881) (412,854) (321,038) Additional long-term borrowings 288,775 337,076 244,311 Reductions of long-term debt (582,288) (1,061,187) (193,481) Issuances of common stock 26,296 211,557 - Repurchases of common stock (8,563) (17) - Issuances of trust originated preferred securities 168,876 - - Issuance of subsidiary preferred stock 16,800 - - Repurchases of subsidiary preferred stock (36,912) - (6,738) Cash dividends paid (60,385) (27,199) (29,522) (131,541) (495,099) 136,235 Net Increase (Decrease) in Cash and Short-term Investments (96,112) 373,073 3,385 Cash and short-term investments at beginning of period 544,408 171,335 167,950 Cash and short-term investments at end of period $ 448,296 $ 544,408 $ 171,335
See notes to consolidated financial statements. F-4 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS INDEX TO NOTES A. Mergers I. Minority Interest B. Accounting Policies J. Capital Stock C. Acquisitions and Sales of Subsidiaries K. Income Taxes and Investees L. Extraordinary Items D. Segments of Operations M. Commitments and Contingencies E. Investments N. Quarterly Operating Results F. Investment in Investee Corporations O. Insurance G. Cost in Excess of Net Assets Acquired P. Additional Information H. Long-Term Debt Q. Subsequent Event A. Mergers American Financial Group, Inc. ("AFG") was formed in December 1994 for the purpose of acquiring American Financial Corporation ("AFC") and American Premier Underwriters, Inc. ("American Premier"). In Mergers completed on April 3, 1995, AFG issued 71.4 million shares of its Common Stock in exchange for all of the outstanding common stock of AFC and American Premier. AFC received 18.7 million shares of AFG for its investment in American Premier. These shares are accounted for herein as retired. For financial reporting purposes, because the former shareholders of AFC owned more than 50% of AFG following the Mergers, the Mergers were accounted for as a reverse acquisition whereby AFC was deemed to have acquired American Premier. Financial statements for periods prior to the Mergers are those of AFC. The operations of American Premier are included in AFG's financial statements from the date of the Mergers. The valuation of American Premier's net assets was determined based on the fair market value of the AFG shares issued to shareholders other than AFC and was allocated to American Premier's assets and liabilities based on their fair values at the date of acquisition. The following unaudited pro forma data is presented as if the Mergers occurred on January 1, 1994 (in millions, except per share data). 1995 1994 Revenues $4,049 $3,832 Earnings before Extraordinary Items 216 59 Extraordinary Items 1 (17) Net Earnings 217 42 Earnings Per Share $ 4.04 $ .79 B. Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of AFG and its subsidiaries. Mergers and changes in ownership levels of subsidiaries and investees have resulted in certain differences in the financial statements and have affected comparability between years. Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. All acquisitions have been treated as purchases. The results of operations of companies since their formation or acquisition are included in the consolidated financial statements. The preparation of the financial statements in conformity with generally accepted accounting principles 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. F-5 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AFG's ownership of subsidiaries and significant investees with publicly traded common shares at December 31, was as follows: 1996 1995 1994 American Annuity Group, Inc. ("AAG") 81% 81% 80% American Financial Enterprises, Inc. ("AFEI") 83% 83% 83% American Premier Underwriters, Inc. (a) (a) 42% Chiquita Brands International, Inc. 43% 44% 46% Citicasters Inc. (b) 38% 37% (a) Became a 100%-owned subsidiary on April 3, 1995. (b) Sold in September 1996. Investments Debt securities are classified as "held to maturity" and reported at amortized cost if AFG has the positive intent and ability to hold them to maturity. Debt and equity securities are classified as "available for sale" and reported at fair value with unrealized gains and losses reported as a separate component of shareholders' equity if the securities are not classified as held to maturity or bought and held principally for selling in the near term. Only in certain limited circumstances, such as significant issuer credit deterioration or if required by insurance or other regulators, may a company change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. Premiums and discounts on mortgage-backed securities are amortized over their expected average lives using the interest method. Gains or losses on sales of securities are recognized at the time of disposition with the amount of gain or loss determined on the specific identification basis. 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 and the carrying value of that investment is reduced. Short-term investments are carried at cost; loans receivable are stated primarily at the aggregate unpaid balance. Investment in Investee Corporations Investments in securities of 20%- to 50%-owned companies are carried at cost, adjusted for AFG's proportionate share of their undistributed earnings or losses. Investments in less than 20%-owned companies are accounted for by the equity method when, in the opinion of management, AFG can exercise significant influence over operating and financial policies of the investee. Cost in Excess of Net Assets Acquired The excess of cost of subsidiaries and investees over AFG's equity in the underlying net assets ("goodwill") is being amortized over 40 years. The excess of AFG's equity in the net assets of other subsidiaries and investees over its cost of acquiring these companies ("negative goodwill") is allocated to AFG's basis in these companies' fixed assets, goodwill and other long-term assets and is amortized on a 10- to 40-year basis. Insurance As discussed under "Reinsurance" below, unpaid losses and loss adjustment expenses and unearned premiums have not been reduced for reinsurance recoverable. Reinsurance In the normal course of business, AFG's insurance subsidiaries cede reinsurance to other companies to diversify risk and limit maximum loss arising from large claims. To the extent that any reinsuring companies are unable to meet obligations under the agreements covering reinsurance ceded, AFG's insurance subsidiaries would remain liable. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsurance policies. AFG's insurance subsidiaries report as assets (a) the F-6 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED estimated reinsurance recoverable on 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. AFG's insurance subsidiaries also assume reinsurance from other companies. Income on reinsurance assumed is recognized based on reports received from ceding reinsurers. Deferred Acquisition Costs Policy acquisition costs (principally commissions, premium taxes and other underwriting expenses) related to the production of new business are deferred ("DPAC"). For the property and casualty companies, the deferral of acquisition costs is limited based upon their recoverability without any consideration for anticipated investment income. DPAC is charged against income ratably over the terms of the related policies. For the annuity companies, DPAC is amortized, with interest, in relation to the present value of expected gross profits on the policies. 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 the direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses 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. These liabilities are subject to the impact of changes in claim amounts and frequency and other factors. In spite of the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate. 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. 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. Life, Accident and Health Reserves Liabilities for future policy benefits under traditional ordinary life, accident and health policies are computed using a net level premium method. Computations are based on anticipated investment yield (primarily 7%), mortality, morbidity and surrenders and include provisions for unfavorable deviations. Reserves are modified as necessary to reflect actual experience and developing trends. Assets Held In and Liabilities Related to Separate Accounts Investment annuity deposits and related liabilities represent primarily deposits maintained by several banks under a previously offered tax-deferred annuity program. AAG receives an annual fee from each bank for sponsoring the program; if depositors elect to purchase an annuity from AAG, funds are transferred to AAG. Premium Recognition Property and casualty premiums are earned 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 reports 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. F-7 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Policyholder Dividends Dividends payable to policyholders are included in "Accounts payable, accrued expenses and other liabilities" and represent estimates of amounts payable on participating policies which share in favorable underwriting results. The estimate is accrued during the period in which the related premium is earned. Changes in estimates are included in income in the period determined. Policyholder dividends do not become legal liabilities unless and until declared by the boards of directors of the insurance companies. Income Taxes AFC and American Premier have each filed consolidated federal income tax returns which include all 80%-owned U.S. subsidiaries, except for certain life insurance subsidiaries and their subsidiaries. Because voting rights aggregating 21% were extended to holders of AFC Series F and G Preferred Stock in connection with the Mergers, AFC filed a separate consolidated return for 1995 and will again for 1996. AFG (parent) is included in American Premier's consolidated return for those years. At the close of business on December 31, 1996, AFG contributed 81% of the common stock of American Premier to AFC. Accordingly, AFC and American Premier will file a consolidated return for 1997 and AFG (parent) will file a separate return. 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. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized. Benefit Plans AFG provides retirement benefits to qualified employees of participating companies through contributory and noncontributory defined contribution plans. Contributions to benefit plans are charged against earnings in the year for which they are declared. Both AFC and American Premier had contributory employee savings plans and noncontributory Employee Stock Ownership Retirement Plans ("ESORP"). Under one of the savings plans, American Premier matched a specified portion of employee contributions. Under the ESORP plans, contributions are invested in securities of AFG and affiliates for the benefit of their employees. In 1997, these ESORP plans were combined into a new plan. 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 the employees qualify for such benefits. Under AFG's stock option plan, options are granted to officers, directors and key employees at exercise prices equal to the fair value of the shares at the dates of grant. No compensation expense is recognized for stock option grants. In connection with the Mergers, full vesting was granted to holders of units under AFC's Book Value Incentive Plan and the plan was terminated. Cash payments, which were made in April 1995 to holders of the units, were accrued at December 31, 1994. Minority Interest For balance sheet purposes, minority interest represents the interests of noncontrolling shareholders in AFG subsidiaries, including AFC preferred stock and trust originated preferred securities ("TOPrS") issued by trust subsidiaries of AFG. For income statement purposes, minority interest expense represents those shareholders' interest in the earnings of AFG subsidiaries as well as AFC preferred dividends following the Mergers and accrued distributions on the TOPrS. Earnings Per Share Earnings per share are calculated on the basis of the weighted average number of shares of common stock outstanding during the period and the dilutive effect, if material, of assumed conversion of common stock options. The weighted average number of shares used for periods prior to April 1995, is based upon the 28.3 million shares issued in exchange for AFC shares in the Mergers discussed in Note A. F-8 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED 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. Fair Value of Financial Instruments Methods and assumptions used in estimating fair values are described in Note P to the financial statements. These fair values represent point-in-time estimates of value that might not be particularly relevant in predicting AFG's future earnings or cash flows. C. Acquisitions and Sales of Subsidiaries and Investees Citicasters In September 1996, AFG sold its investment in Citicasters to Jacor Communications for approximately $220 million in cash plus warrants to purchase Jacor common stock. AFG realized a pretax gain of approximately $169 million, before minority interest of $6.5 million, on the sale. In 1994, AFEI purchased approximately 10% of Citicasters common stock from an unaffiliated company for $23.9 million in cash. Buckeye In March 1996, AFG sold Buckeye Management Company to Buckeye's management (including an AFG director who resigned in March 1996) and employees for $60 million in cash, net of transaction costs. AFG recognized a $33.9 million pretax gain on the sale. In connection with the sale, the AFG director converted his AFG convertible preferred stock into 446,799 shares of AFG Common Stock and sold such shares in the open market. General Cable In 1994, AFC sold its investment in General Cable common stock to an unaffiliated company for $27.6 million in cash. AFC realized a $1.7 million pretax gain on the sale (excluding its share of American Premier's loss on its sale of General Cable securities). D. Segments of Operations AFG operates its property and casualty insurance business in three major segments: nonstandard automobile, specialty lines, and commercial and personal lines. AFG's annuity and life business primarily sells tax-deferred annuities to employees of primary and secondary educational institutions and hospitals. These insurance businesses operate throughout the United States. In addition, AFG has owned significant portions of the voting equity securities of certain companies (investee corporations - see Note F). F-9 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The following tables (in thousands) show AFG's assets, revenues and operating profit (loss) by significant business segment. Capital expenditures, depreciation and amortization are not significant. Operating profit (loss) represents total revenues less operating expenses. Goodwill and its amortization have been allocated to the various segments to which they apply. General corporate assets and expenses have not been identified or allocated by segment.
1996 1995 1994 Assets Property and casualty insurance (a) $ 7,116,088 $ 7,443,115 $ 4,576,591 Annuities and life 7,009,127 6,600,377 5,078,928 Other 726,252 603,833 104,495 14,851,467 14,647,325 9,760,014 Investment in investee corporations 199,651 306,545 832,637 $15,051,118 $14,953,870 $10,592,651 Revenues (b) Property and casualty insurance: Premiums earned: Nonstandard automobile $ 1,183,098 $ 954,210 $ 24,974 Specialty lines 976,150 995,528 698,365 Commercial and personal lines 684,776 697,512 648,222 Other lines 488 1,453 7,067 2,844,512 2,648,703 1,378,628 Investment and other income 500,897 465,998 314,731 3,345,409 3,114,701 1,693,359 Annuities and life (c) 585,079 444,082 379,534 Other 201,864 55,589 47,984 4,132,352 3,614,372 2,120,877 Equity in net earnings (losses) of investee corporations (16,955) 15,237 (16,573) $ 4,115,397 $ 3,629,609 $ 2,104,304 Operating Profit (Loss) Property and casualty insurance: Underwriting: Nonstandard automobile $ 1,015 ($ 60,316) ($ 3,080) Specialty lines 154,329 50,690 (12,598) Commercial and personal lines (72,513) 5,315 7,087 Other lines (d) (163,540) (31,721) (24,914) (80,709) (36,032) (33,505) Investment and other income 392,250 370,579 199,292 311,541 334,547 165,787 Annuities and life 77,119 79,579 58,748 Other (e) (18,461) (182,444) (164,394) 370,199 231,682 60,141 Equity in net earnings (losses) of investee corporations (16,955) 15,237 (16,573) $ 353,244 $ 246,919 $ 43,568
(a) Not allocable to segments. (b) Revenues include sales of products and services as well as other income earned by the respective segments. (c) Represents primarily investment income. (d) Represents primarily losses related to asbestos and other environmental matters ("A&E"). (e) Includes holding company expenses. F-10 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED E. Investments Bonds, redeemable preferred stocks and other stocks at December 31, consisted of the following (in millions):
1996 Held to Maturity Available for Sale Amortized Market Gross Unrealized Amortized Market Gross Unrealized Cost Value Gains Losses Cost Value Gains Losses Bonds and redeemable preferred stocks: United States Government and government agencies and authorities $ - $ - $ - $ - $ 472.2 $ 475.7 $ 7.3 ($ 3.8) States, municipalities and political subdivisions 80.0 79.9 1.1 (1.2) 39.6 39.7 .5 (.4) Foreign government 8.5 9.0 .5 - 94.5 94.3 .8 (1.0) Public utilities 501.4 501.4 6.4 (6.4) 443.8 453.6 13.1 (3.3) Mortgage-backed securities 935.9 949.0 18.8 (5.7) 1,626.3 1,637.9 28.1 (16.5) All other corporate 1,965.3 1,988.8 34.8 (11.3) 3,624.4 3,733.0 122.2 (13.6) Redeemable preferred stocks - - - - 61.8 60.4 1.5 (2.9) $3,491.1 $3,528.1 $61.6 ($24.6) $6,362.6 $6,494.6 $173.5 ($41.5) Other stocks $ 142.4 $ 327.7 $191.6 ($ 6.3)
1995 Held to Maturity Available for Sale Amortized Market Gross Unrealized Amortized Market Gross Unrealized Cost Value Gains Losses Cost Value Gains Losses Bonds and redeemable preferred stocks: United States Government and government agencies and authorities $ - $ - $ - $ - $ 413.9 $ 431.3 $ 17.5 ($ .1) States, municipalities and political subdivisions 55.0 56.6 1.7 (.1) 20.6 20.3 .3 (.6) Foreign government 13.1 12.8 1.0 (1.3) 87.5 89.9 2.4 - Public utilities 528.8 545.3 17.7 (1.2) 561.3 591.0 32.3 (2.6) Mortgage-backed securities 945.7 980.3 35.3 (.7) 1,373.2 1,407.8 40.7 (6.1) All other corporate 2,042.1 2,129.8 87.8 (.1) 3,087.1 3,304.3 219.8 (2.6) Redeemable preferred stocks 4.2 4.5 .3 - 104.5 104.7 1.9 (1.7) $3,588.9 $3,729.3 $143.8 ($ 3.4) $5,648.1 $5,949.3 $314.9 ($13.7) Other stocks $ 136.9 $ 252.2 $115.9 ($ .6)
The table below sets forth the scheduled maturities of bonds and redeemable preferred stocks based on carrying value as of December 31, 1996. Data based on market value is generally the same. Mortgage-backed securities had an average life of approximately 7.5 years at December 31, 1996. Held to Available Maturity Maturity for Sale One year or less 6% 2% After one year through five years 27 17 After five years through ten years 36 41 After ten years 4 15 73 75 Mortgage-backed securities 27 25 100% 100% F-11 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Certain risks are inherent in connection with fixed maturity securities, including loss upon default, price volatility in reaction to changes in interest rates, and general market factors and risks associated with reinvestment of proceeds due to prepayments or redemptions in a period of declining interest rates. Realized gains (losses) and changes in unrealized appreciation (depreciation) on fixed maturity and equity security investments are summarized as follows (in thousands): Fixed Equity Tax Maturities Securities Effects Total 1996 Realized ($ 16,545) $13,075 $ 8,199 $ 4,729 Change in Unrealized (272,583) 70,000 70,904 (131,679) 1995 Realized 77,963 6,065 (13,915) 70,113 Change in Unrealized 810,690 43,700 (288,001) 566,389 1994 Realized (1,107) 49,449 30 48,372 Change in Unrealized (673,001) (60,500) 256,725 (476,776) Transactions in fixed maturity investments included in the Statement of Cash Flows consisted of the following (in millions): Maturities and Gross Gross Purchases Redemptions Sales Gains Losses 1996 Held to Maturity $ 202.8 $332.5 $ 9.3 $ 2.4 ($ 1.2) Available for Sale 1,925.8 284.8 871.8 29.6 (47.3) Total $2,128.6 $617.3 $ 881.1 $32.0 ($48.5) 1995 Held to Maturity $ 774.8 $176.3 $ 12.9 $ 1.9 ($ 2.3) Available for Sale 1,603.6 133.3 2,297.9 88.0 (9.6) Total $2,378.4 $309.6 $2,310.8 $89.9 ($11.9) 1994 Held to Maturity $1,090.0 $216.0 $ 8.0 $ 3.3 ($ 2.5) Available for Sale 636.3 204.9 686.9 9.4 (11.3) Total $1,726.3 $420.9 $ 694.9 $12.7 ($13.8) Securities classified as "held to maturity" having an amortized cost of $9.5 million, $14.7 million and $8.7 million were sold for a loss of $159,000, $1.8 million and $712,000 in 1996, 1995 and 1994, respectively, due to significant deterioration in the issuers' creditworthiness. F-12 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED F. Investment in Investee Corporations The companies in the following table are subject to the rules and regulations of the SEC. The market value of the investments was approximately $306 million and $509 million at December 31, 1996 and 1995, respectively. AFG's investment (and common stock ownership percentage) and equity in net earnings and losses of investees are stated below (dollars in thousands):
Investment (Ownership %) Equity in Net Earnings (Losses) 12/31/96 12/31/95 1996 1995 1994 Chiquita (a) $199,651 (43%) $232,466 (44%) ($18,415) $ 3,628 ($26,670) Citicasters (b) - 74,079 (38%) 1,460 4,702 8,950 American Premier(c) - - - 6,907 1,147 $199,651 $306,545 ($16,955) $15,237 ($16,573)
(a) Equity in net earnings (losses) excludes AFG's share of extraordinary losses. (b) Sold in September 1996. (c) Became a 100%-owned subsidiary on April 3, 1995. Chiquita is a leading international marketer, producer and distributor of bananas and other quality fresh and processed food products. Citicasters owned and operated radio and television stations in major markets throughout the country. Summarized financial information for Chiquita at December 31, is shown below (in millions). See "Investee Corporations" in Management's Discussion and Analysis. Chiquita Brands International, Inc. 1996 1995 1994 Current Assets $ 844 $ 877 Non-current Assets 1,623 1,747 Current Liabilities 464 510 Non-current Liabilities 1,279 1,442 Shareholders' Equity 724 672 Net Sales of Continuing Operations $2,435 $2,566 $2,506 Operating Income 84 176 71 Income (Loss) from Continuing Operations (28) 28 (84) Discontinued Operations - (11) 35 Extraordinary Loss from Debt Refinancings (23) (8) (23) Net Income (Loss) (51) 9 (72) G. Cost in Excess of Net Assets Acquired At December 31, 1996 and 1995, accumulated amortization of the excess of cost over net assets of purchased subsidiaries amounted to approximately $121 million and $110 million, respectively. Amortization expense was $10.8 million in 1996, $9.2 million in 1995 and $6.1 million in 1994. F-13 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED H. Long-Term Debt Long-term debt consisted of the following at December 31, (in thousands): 1996 1995 American Financial Corporation (Parent Company): 9-3/4% Debentures due April 2004, less discount of $1,146 and $1,249 (imputed rate - 9.8%) $164,368 $302,510 Other 8,441 8,692 $172,809 $311,202 American Premier Underwriters, Inc. (Parent Company): 9-3/4% Subordinated Notes due August 1999, including premium of $1,912 and $4,403 (imputed rate - 8.8%) $ 93,604 $161,531 10-5/8% Subordinated Notes due April 2000, including premium of $2,629 and $7,210 (imputed rate - 8.8%) 54,595 120,222 10-7/8% Subordinated Notes due May 2011, including premium of $1,642 and $5,082 (imputed rate - 9.6%) 18,496 55,581 $166,695 $337,334 American Annuity Group, Inc.: Notes payable under bank line due September 1999 $ 44,700 $ 20,500 9-1/2% Senior Notes due August 2001 40,845 41,490 11-1/8% Senior Subordinated Notes due February 2003 24,080 101,443 Other 5,275 4,301 $114,900 $167,734 Other Subsidiaries: Notes payable secured by real estate $ 52,543 $ 53,066 Other 10,972 12,727 $ 63,515 $ 65,793 At December 31, 1996, sinking fund and other scheduled principal payments on debt for the subsequent five years were as follows (in thousands): American AFC Premier (Parent) (Parent) Other Total 1997 $5,616 $ - $ 2,533 $ 8,149 1998 - - 2,846 2,846 1999 - 91,692 47,137 138,829 2000 - 51,966 8,735 60,701 2001 - - 42,304 42,304 Debentures purchased in excess of scheduled payments may be applied to satisfy any sinking fund requirement. The scheduled principal payments shown above assume that debentures purchased are applied to the earliest scheduled retirements. F-14 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Great American Holding Corporation ("GAHC"), a wholly-owned subsidiary of AFC, and Pennsylvania Company ("Pennco"), a wholly-owned subsidiary of American Premier, have revolving loan agreements with groups of banks under which they can borrow up to $300 million and $75 million, respectively. Borrowings bear interest at floating rates based on prime or LIBOR and are collateralized by certain stock of operating subsidiaries. Each facility is guaranteed by the respective immediate parent company. At December 31, 1996 and 1995, there were no outstanding borrowings under either of these credit lines. AAG and AFEI have revolving credit agreements with banks under which they can borrow up to $115 million and $20 million, respectively. Borrowings bear interest at floating rates based on prime or LIBOR and are collateralized. At December 31, 1996 and 1995, the weighted average interest rate on amounts borrowed under AAG's bank credit lines was 6.7% and 6.8%, respectively. At December 31, 1996 and 1995, there were no outstanding borrowings under the AFEI credit line. During 1995, AFC redeemed $279 million of its various debentures, repaid $187 million of GAHC's bank debt, and redeemed $200 million of GAHC's Notes. Also during 1995, AFC sold an aggregate of $100 million of its 9-3/4% debentures due in 2004 for cash. During 1996, AFC repurchased $138.2 million of its 9-3/4% debentures for $147.9 million in cash. As the result of the Mergers and a subsequent ratings downgrade, holders of American Premier's Notes had the right to "put" their Notes to American Premier at face amount. Approximately $44 million of the Notes were tendered under the put right in 1995. In addition, American Premier repurchased $136 million of the Notes during 1995 for $142.7 million in cash. In a December 1996 tender offer, American Premier retired $95.3 million of its Notes for $105.6 million. In addition, American Premier repurchased $64.8 million of its Notes for $71.6 million in cash during 1996. During 1995, AAG repurchased $4.9 million of its Notes for $5.0 million in cash. During 1996, AAG repurchased $78 million of its Notes for $84.2 million in cash. Cash interest payments of $75 million, $137 million and $115 million were made on long-term debt in 1996, 1995 and 1994, respectively. F-15 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED I. Minority Interest Included in minority interest in AFG's balance sheet are TOPrS and AFC's preferred stock. Trust Originated Preferred Securities In October 1996, a wholly-owned subsidiary trust of AFG issued 4 million units of 9-1/8% TOPrS for $100 million cash. The Trust then purchased $100 million of newly issued AFG 9-1/8% Subordinated Debentures due 2026, which, along with related interest and principal payments received, will be the only assets of the Trust. Holders of the TOPrS are entitled to quarterly cash distributions of $.57 per unit; payment dates and amounts for the TOPrS correspond to those on the Subordinated Debentures. The TOPrS are mandatorily redeemable upon maturity or redemption of the Subordinated Debentures. The Subordinated Debentures are redeemable by AFG on or after October 22, 2001. AFG effectively provides an unconditional guarantee of the Trust's obligations under the TOPrS. In November 1996, a wholly-owned subsidiary trust of AAG issued $75 million of similar TOPrS. The related 9-1/4% Subordinated Debentures of the AAG subsidiary are due in 2026 and are redeemable on or after November 7, 2001. AFC Preferred Stock At December 31, 1996, AFC's Preferred Stock was voting, cumulative, and consisted of the following: Series F, $1 par value; $20.00 liquidating value per share; annual dividends per share $1.80; nonredeemable after 1996; 11,900,725 and 13,744,754 shares (stated value $145.4 million and $167.9 million) outstanding at December 31, 1996 and 1995, respectively. Series G, $1 par value; annual dividends per share $1.05; redeemable at $10.50 per share; 1,964,158 and 364,158 shares (stated value $17.4 million and $600,000) outstanding at December 31, 1996 and 1995, respectively. In December 1996, AFC redeemed 1.6 million shares of its Series F Preferred Stock for $31.9 million and, in October, AFC purchased 250,000 shares of Series F from AFC's ESORP for $5.0 million. In December 1996, AFC issued 1.6 million shares of its Series G Preferred Stock to AFC's ESORP for $16.8 million. During 1995 and 1994, AFC retired issues of its mandatorily redeemable preferred stock for an aggregate of $2.9 million and $6.6 million, respectively. J. Capital Stock In connection with the Mergers discussed in Note A, AFG issued 51.3 million shares (net of 18.7 million shares held by AFC and its subsidiaries, which are shown herein as retired) of Common Stock on April 3, 1995. During 1995, AFG sold 7.4 million newly issued shares of its Common Stock for an aggregate of $202.8 million cash in connection with (i) exercises of Stock Options, (ii) issuances under AFG's new Dividend Reinvestment Plan and its Employee Stock Purchase Plan, and (iii) sales to the AFC ESORP and in a public offering. At December 31, 1996, there were 61,071,626 shares of AFG Common Stock outstanding, including 1,371,802 shares held by American Premier for distribution to certain creditors and other claimants pursuant to a plan of reorganization relating to American Premier's predecessor. AFG is authorized to issue 12.5 million shares of Voting Preferred Stock and 12.5 million shares of Nonvoting Preferred Stock, each without par value. At December 31, 1995, AFG had 212,698 shares of convertible F-16 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED preferred stock outstanding with a stated value of $469,000 (included in Capital Surplus, net of related notes receivable). These shares were converted into 446,799 shares of AFG Common Stock in March 1996. A progression of AFG's Shareholders' Equity is as follows (dollars in thousands):
Common Stock Common and Capital Retained Shares(*) Surplus Earnings Unrealized Balance at December 31, 1993 18,971,217 $904 $210,846 $156,900 Net earnings - - 2,100 - Change in unrealized - - - (153,400) Purchase of Preferred Stock - - (56) - Dividends on: Preferred Stock - - (25,728) - Common Stock - - (3,794) - Decrease in capital subject to put option - - 7,225 - Transfer from capital subject to put option - - 32,502 - Balance at December 31, 1994 18,971,217 904 223,095 3,500 Dividends on AFC Preferred Stock - - (191) - Exercise of AFC stock options 762,500 8,721 - - Restatement of AFC equity in terms of AFG Common Stock 8,590,159 - - - Shares issued in Mergers to holders of APU Common Stock 24,376,667 588,492 - - Net earnings - - 191,247 - Change in unrealized - - - 248,000 Dividends on Common Stock - - (27,008) - Shares issued: Exercise of stock options 883,974 18,875 - - Dividend reinvestment plan 200,381 5,859 - - Employee stock purchase plan 32,972 918 - - Public offering 4,600,000 127,180 - - Sale to AFC ESORP 1,703,000 50,004 - - Employee gift shares 19,050 494 - - Shares repurchased (617) (17) - - Change in foreign currency translation - 64 - - Balance at December 31, 1995 60,139,303 801,494 387,143 251,500 Net earnings - - 233,300 - Change in unrealized - - - (63,500) Dividends on Common Stock - - (60,727) - Shares issued: Exercise of stock options 664,639 14,837 - - Dividend reinvestment plan 10,491 342 - - Employee stock purchase plan 81,041 2,551 - - Employee stock bonus 4,300 131 - - Directors fees paid in common shares 1,299 46 - - Conversion of Preferred Stock 446,799 8,908 - - Shares repurchased (276,246) (8,563) - - Retirement of AFC Preferred Stock - (14,388) - - Change in foreign currency translation - 1,363 - - Balance at December 31, 1996 61,071,626 $806,721 $559,716 $188,000
(*) Prior to the Mergers, Carl H. Lindner and certain members of the Lindner family owned all of the outstanding common stock of AFC. Stock Options At December 31, 1996, there were 5.4 million shares of AFG Common Stock reserved for issuance under AFG's Stock Option Plan. Under the Stock Option Plan, the exercise price of each option equals the market price of AFG Common Stock at the date of grant. Options become exercisable at the rate of 20% per year commencing one year after grant; those granted to non-employee directors of AFG are generally fully exercisable upon grant. All options expire ten years after the date of grant. No compensation cost has been recognized for stock option grants. Had compensation cost been determined for stock option awards based on the fair values at grant dates consistent with the method prescribed by Statement of Financial Accounting Standards No. 123, AFG's net income and earnings per share would not have been materially different from amounts reported. For Statement No. 123 purposes, calculations were determined using the Black-Scholes option pricing model and the following assumptions: dividend yield of 2%; expected volatility of 20%; risk-free interest rate of 6.2%; and expected life of 7.5 years. F-17 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Data for AFG's Stock Option Plan is presented below: 1996 1995 Average Average Exercise Exercise Shares Price Shares Price Outstanding at beginning of year 3,939,986 $25.72 2,931,948 $22.88 Granted 75,000 $32.47 2,142,681 $27.81 Exercised (664,639) $22.33 (883,974) $21.35 Forfeited (18,400) $30.06 (250,669) $25.79 Outstanding at end of year 3,331,947 $26.53 3,939,986 $25.72 Options exercisable at year-end 1,379,182 $24.60 1,395,175 $22.55 The following table summarizes information about stock options outstanding at December 31, 1996: Options Outstanding Options Exercisable Average Average Average Exercise Range of Remaining Exercise Shares Price Exercise Prices Life Shares Price 211,419 $18.57 $17.24 - $20.00 4.0 years 211,419 $18.57 1,368,791 $23.80 $20.01 - $25.00 6.7 720,245 $23.63 343,637 $27.28 $25.01 - $30.00 7.0 174,218 $27.38 1,408,100 $30.19 $30.01 - $34.31 9.0 273,300 $30.08 3,331,947 $26.53 7.5 1,379,182 $24.60 K. Income Taxes The following is a reconciliation of income taxes at the statutory rate of 35% and income taxes as shown in the Statement of Earnings (in thousands): 1996 1995 1994 Earnings before income taxes and extraordinary items $353,244 $246,919 $43,568 Extraordinary items before income taxes (35,670) 536 (17,192) Adjusted earnings before income taxes $317,574 $247,455 $26,376 Income taxes at statutory rate $111,151 $ 86,609 $ 9,232 Effect of: Losses (utilized) not utilized (43,302) (40,292) 19,267 Dividends received deduction (7,450) (7,823) (8,528) Minority interest 15,112 11,673 2,998 Amortization of intangibles 3,065 3,015 1,987 Tax exempt interest (597) (897) (689) Foreign income taxes 3,474 359 6 State income taxes 4,140 81 149 Other (1,319) 3,483 (146) Total provision 84,274 56,208 24,276 Amounts applicable to extraordinary items 7,003 281 374 Provision for income taxes as shown on the Statement of Earnings $ 91,277 $ 56,489 $24,650 Adjusted earnings before income taxes consisted of the following (in thousands): 1996 1995 1994 Subject to tax in: United States $331,842 $250,423 $28,422 Foreign jurisdictions (14,268) (2,968) (2,046) $317,574 $247,455 $26,376 F-18 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The total income tax provision consists of (in thousands): 1996 1995 1994 Current taxes (credits): Federal $22,450 $38,512 $21,028 Foreign (1,735) (1,213) - State 6,369 124 226 Deferred taxes: Federal 56,869 18,233 3,012 Foreign 321 552 10 $84,274 $56,208 $24,276 For income tax purposes, certain members of the AFC consolidated tax group, including American Premier as of December 31, 1996, had the following carryforwards available at December 31, 1996 (in millions): Expiring Amount { 1997 - 2001 $ 20 Operating Loss{ 2002 - 2006 126 { 2007 - 2011 93 Capital Loss 1997 - 1999 195 Other - Tax Credits 23 Deferred income tax assets and liabilities reflect temporary differences between the carrying amounts of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. The significant components of deferred tax assets and liabilities for AFG's tax groups included in the Balance Sheet at December 31, were as follows (in millions): 1996 1995 AFC American AFC Tax Tax Premier Group (*) Group Tax Group Deferred tax assets: Net operating loss carryforwards $ 83.7 $ 93.8 $166.5 Capital loss carryforwards 68.2 - 108.7 Insurance claims and reserves 289.8 195.9 102.9 Other, net 142.2 41.2 91.3 583.9 330.9 469.4 Valuation allowance for deferred tax assets (131.9) (91.9) (214.0) 452.0 239.0 255.4 Deferred tax liabilities: Deferred acquisition costs (124.9) (89.8) (31.2) Investment securities (189.8) (210.8) (23.8) (314.7) (300.6) (55.0) Net deferred tax asset (liability) $137.3 ($ 61.6) $200.4 (*) Includes American Premier The gross deferred tax asset has been reduced by a valuation allowance based on an analysis of the likelihood of realization. Factors considered in assessing the need for a valuation allowance include: (i) recent tax returns, which show neither a history of large amounts of taxable income nor cumulative losses in recent years, (ii) opportunities to generate taxable income from sales of appreciated assets, and (iii) the likelihood of generating larger amounts of taxable income in the future. The likelihood of realizing this asset will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period in which the developments on which they are based become known. The aggregate valuation allowance decreased by $174 million in 1996 due primarily to the expiration of American Premier's loss carryforwards. Cash payments for income taxes, net of refunds, were $40.2 million, $14.8 million and $30.0 million for 1996, 1995 and 1994, respectively. F-19 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED L. Extraordinary Items Extraordinary items represent AFG's proportionate share of gains and losses related to debt retirements by the following companies. Amounts shown are net of minority interest and income tax benefits (in thousands): 1996 1995 1994 Subsidiaries: AFC (parent) ($ 9,672) ($1,713) ($ 6,454) APU (parent) (3,254) 6,137 - AAG (7,159) (201) (1,328) GAHC - (611) - Other 57 - - Investee: Chiquita (8,639) (2,795) (9,036) ($28,667) $ 817 ($16,818) M. Commitments and Contingencies Loss accruals have been recorded 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, Penn Central Transportation Company ("PCTC"), prior to its bankruptcy reorganization in 1978. Any ultimate liability arising therefrom in excess of previously established loss accruals would normally be attributable to pre-reorganization events and circumstances and accounted for as a reduction in capital surplus. However, under purchase accounting in connection with the Mergers, any such excess liability will be charged to earnings in AFG's financial statements. American Premier's liability for environmental claims ($50.1 million at December 31, 1996) consists of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs at certain railroad sites formerly owned by PCTC and certain other sites where hazardous waste was allegedly generated by PCTC's railroad operation. It is difficult to estimate remediation costs for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. American Premier's liability is based on information currently available and is subject to change as additional information becomes available. American Premier's liability for occupational injury and disease claims of $70.1 million (included in other liabilities) at December 31, 1996, includes pending and expected claims by former employees of PCTC for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the railroad workplace. Anticipated recoveries of $54.1 million on these liabilities are included in other assets. Recorded amounts are based on the accumulation of estimates of reported and unreported claims and related expenses and estimates of probable recoveries from insurance carriers. AFG has accrued approximately $41 million at December 31, 1996, for environmental costs and certain other matters associated with the sales of former operations. In management's opinion, the outcome of the items discussed under "Uncertainties" in Management's Discussion and Analysis and the above claims and contingencies will not, individually or in the aggregate, have a material adverse effect on AFG's financial condition or results of operations. F-20 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED N. Quarterly Operating Results (Unaudited) The operations of certain of AFG's business segments are seasonal in nature. While insurance premiums are recognized on a relatively level basis, claim losses related to adverse weather (snow, hail, hurricanes, tornadoes, etc.) may be seasonal. Quarterly results necessarily rely heavily on estimates. These estimates and certain other factors, such as the nature of investees' operations and discretionary sales of assets, cause the quarterly results not to be necessarily indicative of results for longer periods of time. See Notes A and C for changes in ownership of companies whose revenues are included in the consolidated operating results and for the effects of gains on sales of subsidiaries and investees in individual quarters. The following are quarterly results of consolidated operations for the two years ended December 31, 1996 (in millions, except per share amounts).
1st 2nd 3rd 4th Total Quarter Quarter Quarter Quarter Year 1996 Revenues $1,030.9 $1,032.8 $1,163.5 $888.2 $4,115.4 Earnings before extraordinary items 81.2 58.3 121.6 .9 262.0 Extraordinary items (7.6) (9.9) (8.4) (2.8) (28.7) Net earnings (loss) 73.6 48.4 113.2 (1.9) 233.3 Earnings per common share: Before extraordinary items $1.35 $.96 $2.00 $.02 $4.31 Extraordinary items (.13) (.16) (.14) (.05) (.47) Net earnings (loss) 1.22 .80 1.86 (.03) 3.84 Average number of Common Shares 60.3 60.9 61.0 61.0 60.8 1995 Revenues $553.6 $1,006.6 $1,002.7 $1,066.7 $3,629.6 Earnings before extraordinary items 29.8 33.0 51.0 76.6 190.4 Extraordinary items - .5 2.0 (1.7) .8 Net earnings 29.8 33.5 53.0 74.9 191.2 Earnings per common share: Before extraordinary items $.83 $.63 $.95 $1.36 $3.87 Extraordinary items - .01 .04 (.03) .01 Net earnings .83 .64 .99 1.33 3.88 Average number of Common Shares 28.3 52.7 53.4 56.1 47.6
Quarterly earnings per share do not add to year-to-date amounts due to changes in shares outstanding. In the third quarter of 1996, AFG increased A&E reserves by recording a non-cash pretax charge of $80 million. Realized gains (losses) on sales of securities amounted to (in millions):
1st 2nd 3rd 4th Total Quarter Quarter Quarter Quarter Year 1996 $18.7 $2.7 $ 3.2 ($28.1) ($ 3.5) 1995 3.5 7.9 23.6 49.0 84.0
F-21 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED O. Insurance Securities owned by insurance subsidiaries having a carrying value of approximately $1.5 billion at December 31, 1996, were on deposit as required by regulatory authorities. GAI recorded a charge of $19 million (included in "Other operating and general expenses") in 1994 in response to the California court decision upholding an insurance reform measure passed by California voters which led to rate rollbacks for most lines of property and casualty insurance. Several proposals have been made in recent years to change the federal income tax system. Some proposals included changes in the method of treating investment income and tax deferred income. To the extent a new tax law reduces or eliminates the tax deferred status of AFG's annuity products, that segment could be materially affected. Insurance Reserves The liability for losses and loss adjustment expenses for certain long-term scheduled payments under workers' compensation, auto liability and other liability insurance has been discounted at rates ranging from 4% to 8%. As a result, the total liability for losses and loss adjustment expenses at December 31, 1996, has been reduced by $64 million. The following table provides an analysis of changes in the liability for losses and loss adjustment expenses, net of reinsurance (and grossed up), over the past three years on a GAAP basis (in millions): 1996 1995 1994 Balance at beginning of period $3,393 $2,187 $2,113 Reserves of American Premier at date of the Mergers - 1,090 - Provision for losses and loss adjustment expenses occurring in the current year 2,179 2,116 1,027 Net decrease in provision for claims occurring in prior years (48) (139) (40) 2,131 1,977 987 Payments for losses and loss adjustment expenses occurring during: Current year (999) (987) (381) Prior years (1,121) (874) (532) (2,120) (1,861) (913) Balance at end of period $3,404 $3,393 $2,187 Add back reinsurance recoverables 720 704 730 Unpaid losses and loss adjustment expenses included in Balance Sheet, gross of reinsurance $4,124 $4,097 $2,917 F-22 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Net Investment Income The following table shows (in millions) investment income earned and investment expenses incurred by AFG's insurance companies. 1996 1995 1994 Insurance group investment income: Fixed maturities $817.8 $727.3 $560.6 Equity securities 8.2 5.3 8.3 Other 13.5 7.9 6.7 839.5 740.5 575.6 Insurance group investment expenses (*) (38.5) (33.8) (32.0) $801.0 $706.7 $543.6 (*) Included primarily in "Other operating and general expenses" in the Statement of Earnings. Statutory Information AFG's insurance subsidiaries are required to file financial statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Net earnings and policyholders' surplus on a statutory basis for the insurance subsidiaries were as follows (in millions): Policyholders' Net Earnings Surplus 1996 1995 1994 1996 1995 Property and casualty companies $276 $200 $63 $1,659 $1,595 Life insurance companies 67 76 54 287 273 Reinsurance In the normal course of business, AFG's insurance subsidiaries assume and cede reinsurance with other insurance companies. The following table shows (in millions) (i) amounts deducted from property and casualty premiums in connection with reinsurance ceded, (ii) amounts included in income for reinsurance assumed and (iii) reinsurance recoveries deducted from losses and loss adjustment expenses. 1996 1995 1994 Reinsurance ceded to: Non-affiliates $518 $476 $402 Affiliates - 33 161 Reinsurance assumed - including involuntary pools and associations 58 93 83 Reinsurance recoveries 306 304 429 P. Additional Information Total rental expense for various leases of office space, data processing equipment and railroad rolling stock was $34 million, $35 million and $22 million for 1996, 1995 and 1994, respectively. Sublease rental income related to these leases totaled $6.1 million in 1996, $6.2 million in 1995 and $6.4 million in 1994. Future minimum rentals, related principally to office space and railroad rolling stock, required under operating leases having initial or remaining noncancelable lease terms in excess of one year at December 31, 1996, were as follows: 1997 - $39 million, 1998 - $32 million, 1999 - $24 million, 2000 - $15 million, 2001 - $11 million, and $18 million thereafter. At December 31, 1996, minimum sublease rentals to be received through the expiration of the leases aggregated $21 million. Other operating and general expenses included charges for possible losses on agents' balances, reinsurance recoverables and other receivables in the following amounts: 1996 - $0, 1995 - $0 and 1994 - $18 million. The aggregate allowance for such losses amounted to approximately $123 million and $127 million at December 31, 1996 and 1995, respectively. F-23 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Summary Financial Information of AFC and American Premier Summarized consolidated financial information for AFC and American Premier is as follows (in millions):
AFC American Premier 1996 1995 1994 1996 1995 1994 Cash and Investments $11,691 $11,391 $1,947 $2,091 Other Assets 3,308 3,460 1,322 1,949 Insurance Claims and Reserves 11,312 10,981 1,452 1,684 Debt 518 882 169 330 Shareholders' Equity 1,277 1,248 1,045 1,552 Revenues $ 4,114 $ 3,628 $2,104 $1,674 $1,736 $1,759 Income from Continuing Operations 248 195 19 250 67 1 Discontinued Operations - - - - - (1) Extraordinary Item - (Loss) Gain on Prepayment of Debt (26) 2 (17) (12) (5) - Net Income 222 197 2 238 62 -
American Premier's 1996 net income included $49 million in gains from the sales of securities, real estate and other assets to AFC. These gains were eliminated in AFC's and AFG's consolidated financial statements. American Premier's 1994 results included a $75.8 million loss on the sale of securities of General Cable. Fair Value of Financial Instruments The following table presents (in millions) the carrying value and estimated fair value of AFG's financial instruments at December 31. 1996 1995 Carrying Fair Carrying Fair Value Value Value Value Assets: Bonds and redeemable preferred stocks $9,986 $10,023 $9,538 $9,679 Other stocks 328 328 252 252 Investment in investee corporations 200 306 307 509 Liabilities: Annuity benefits accumulated $5,366 $ 5,180 $5,052 $4,887 Long-term debt: AFC (parent company) 173 188 311 325 APU (parent company) 167 174 337 344 Other subsidiaries 178 183 234 243 Minority Interest: TOPrS $ 175 $ 179 $ - $ - AFC preferred stock 163 264 168 272 Shareholders' Equity $1,554 $ 2,305 $1,440 $1,842 When available, fair values are based on prices quoted in the most active market for each security. If quoted prices are not available, fair value is estimated based on present values, discounted cash flows, fair value of comparable securities, or similar methods. The fair value of the liability for annuities in the payout phase is assumed to be the present value of the anticipated cash flows, discounted at current interest rates. Fair value of annuities in the accumulation phase is assumed to be the policyholders' cash surrender amount. F-24 AMERICAN FINANCIAL GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Financial Instruments with Off-Balance-Sheet Risk On occasion, AFG and its subsidiaries have entered into financial instrument transactions which may present off-balance-sheet risks of both a credit and market risk nature. These transactions include commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. At December 31, 1996, AFG and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling $16 million. Restrictions on Transfer of Funds and Assets of Subsidiaries Payments of dividends, loans and advances by AFG's subsidiaries are subject to various state laws, federal regulations and debt covenants which limit the amount of dividends, loans and advances that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFG in 1997 from its insurance subsidiaries without seeking regulatory clearance is approximately $225 million. Total "restrictions" on intercompany transfers from AFG's subsidiaries cannot be quantified due to the discretionary nature of the restrictions. Benefit Plans AFG expensed $16.3 million in 1996, $16.5 million in 1995 and $6.2 million in 1994 for contributions to its ESORP and employee savings plans. Transactions With Affiliates In 1995, a subsidiary of AFC sold a house to its Chairman for its appraised value of $1.8 million. Q. Subsequent Event (Unaudited) In February 1997, AFEI and AFG announced that they are jointly examining the feasibility of a transaction whereby all 2.3 million shares of AFEI common stock not owned by AFG would be exchanged on a one-for-one basis for AFG Common Stock. AFEI and AFG intend that the transaction be structured so that it is tax-free to AFEI shareholders. The transaction would be subject to the approval of AFEI's shareholders other than AFG and other customary approvals. F-25 Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Amendment to be signed on its behalf by the undersigned, duly authorized. American Financial Group, Inc. BY: FRED J. RUNK Fred J. Runk Senior Vice President and Treasurer Dated: October 29, 1997 -----END PRIVACY-ENHANCED MESSAGE-----