- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Fiscal Year Ended Commission File
December 31, 2002 No. 1-7361
AMERICAN FINANCIAL CORPORATION
Incorporated under IRS Employer I.D.
the Laws of Ohio No. 31-0624874
One East Fourth Street, Cincinnati, Ohio 45202
(513) 579-2121
Securities Registered Pursuant to Section 12(b) of the Act:
Name of Each Exchange
Title of Each Class on which Registered
------------------- ---------------------
Series J Voting Cumulative Preferred Stock Archipelago Exchange
Securities Registered Pursuant to Section 12(g) of the Act: None
Other securities for which reports are submitted pursuant to Section 15(d) of
the Act: None
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and need not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer.
Yes No X
The aggregate market value of the Registrant's Preferred Stock as of the
Registrant's most recently completed second fiscal quarter (June 30, 2002) was
approximately $57.7 million (based upon nonaffiliate holdings of 2,886,161
shares and a market price of $20.00 per share).
As of March 1, 2003, there were 10,593,000 shares of the Registrant's
Common Stock outstanding, all of which were owned by American Financial Group,
Inc. At that date there were 2,886,161 shares of Series J Voting Preferred Stock
outstanding (all of which were owned by non-affiliates).
-------------
Documents Incorporated by Reference: None
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AMERICAN FINANCIAL CORPORATION
INDEX TO ANNUAL REPORT
ON FORM 10-K
Page
----
Part I
Item 1 - Business:
Introduction 1
Property and Casualty Insurance Operations 2
Annuity and Life Operations 15
Other Companies 19
Investment Portfolio 19
Foreign Operations 20
Regulation 20
Item 2 - Properties 21
Item 3 - Legal Proceedings 22
Item 4 - Submission of Matters to a Vote of Security Holders (a)
Part II
Item 5 - Market for Registrant's Common Equity and Related
Stockholder Matters 24
Item 6 - Selected Financial Data 25
Item 7 - Management's Discussion and Analysis of Financial
Condition and Results of Operations 26
Item 7A - Quantitative and Qualitative Disclosures About
Market Risk 43
Item 8 - Financial Statements and Supplementary Data 43
Item 9 - Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure (a)
Part III
Item 10 - Directors and Executive Officers of the Registrant 43
Item 11 - Executive Compensation 43
Item 12 - Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters 43
Item 13 - Certain Relationships and Related Transactions 43
Item 14 - Controls and Procedures 43
Part IV
Item 15 - Exhibits, Financial Statement Schedules and
Reports on Form 8-K S-1
(a) The response to this Item is "none".
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AMERICAN FINANCIAL CORPORATION
FORWARD-LOOKING STATEMENTS
This Form 10-K, chiefly in Items 1, 3, 5, 7 and 8, contains certain
forward-looking statements that are subject to numerous assumptions, risks or
uncertainties. The Private Securities Litigation Reform Act of 1995 provides a
safe harbor for forward-looking statements. Some of the forward-looking
statements can be identified by the use of forward-looking words such as
"anticipates", "believes", "expects", "estimates", "intends", "plans", "seeks",
"could", "may", "should", "will" or the negative version of those words or other
comparable terminology. Examples of such forward-looking statements include
statements relating to: expectations concerning market and other conditions and
their effect on future premiums, revenues, earnings and investment activities;
recoverability of asset values; expected losses and the adequacy of reserves for
asbestos, environmental pollution and mass tort claims; rate increases, improved
loss experience and expected expense savings resulting from recent initiatives.
Actual results could differ materially from those contained in or implied by
such forward-looking statements for a variety of factors including:
o changes in economic conditions, including interest rates, performance
of securities markets, and the availability of capital;
o regulatory actions;
o changes in legal environment;
o tax law changes;
o levels of natural catastrophes, terrorist events, incidents of war and
other major losses;
o the ultimate amount of liabilities associated with certain asbestos and
environmental-related claims;
o the unpredictability of possible future litigation if certain
settlements do not become effective;
o adequacy of insurance reserves;
o trends in mortality and morbidity;
o availability of reinsurance and ability of reinsurers to pay their
obligations;
o competitive pressures, including the ability to obtain rate increases; and
o changes in debt and claims paying ratings.
The forward-looking statements herein are made only as of the date of this
report. The Company assumes no obligation to publicly update any forward-looking
statements.
PART I
ITEM 1
BUSINESS
--------
Please refer to "Forward-Looking Statements" following the Index in front of
this Form 10-K.
INTRODUCTION
American Financial Corporation ("AFC") is a holding company which, through
subsidiaries, is engaged primarily in property and casualty insurance, focusing
on specialized commercial products for businesses, and in the sale of retirement
annuities, life, and supplemental health insurance products. AFC was
incorporated as an Ohio corporation in 1955. Its insurance subsidiaries have
been operating as far back as the 1800's. Its address is One East Fourth Street,
Cincinnati, Ohio 45202; its phone number is (513) 579-2121. At December 31,
2002, all of the outstanding Common Stock of AFC was owned by American Financial
Group, Inc. ("AFG").
Over the years, AFC has owned, operated, and invested in businesses in a
variety of industries and geographic areas, culminating in today's group of
insurance companies. Generally, AFC's interests have been in the following
areas: insurance, savings and loan, leasing, banking, real estate,
communications/ entertainment and food distribution. A small number of
opportunistic investments have been made in troubled and other undervalued
assets.
RECENT TRANSACTIONS
Infinity Property and Casualty Corporation ("Infinity") was incorporated
in September 2002 as a wholly-owned subsidiary of AFC. On December 31, 2002, AFC
transferred to Infinity the following subsidiaries: Atlanta Casualty Company,
Infinity Insurance Company, Leader Insurance Company and Windsor Insurance
Company. In exchange, AFC received all of the issued and outstanding shares of
Infinity common stock and a $55 million 10-year promissory note. In addition,
effective January 1, 2003, Great American Insurance Company ("GAI"), an AFC
subsidiary, transferred to Infinity its personal insurance business written
through independent agents. In 2002, 2001 and 2000, these businesses represented
28%, 35% and 46%, respectively, of AFC's property and casualty group's net
written premiums. In a February 2003 public offering, AFC sold 61% (12.5 million
shares) of Infinity for net proceeds of approximately $186 million, realizing a
pretax loss of approximately $40 million. In January 2003, GAI entered into an
agreement to sell its direct-to-consumer auto business.
In March 2001, GAI sold its Japanese property and casualty division to
Mitsui Marine & Fire Insurance Company of America for $22 million in cash. At
the same time, a reinsurance agreement under which GAI ceded a portion of its
pool of insurance to Mitsui was terminated. The Japanese division generated net
written premiums of approximately $60 million per year to GAI while GAI ceded
approximately $45 million per year to Mitsui.
In connection with the sale of the Japanese division, GAI continues to
write certain business for, and fully reinsures it to, Mitsui. When GAI sold its
commercial lines division in 1998, it had a similar arrangement which lasted
through early 2001. Such business does not appear in the net written premiums or
net earned premiums information herein.
In September 2000, AFC sold Stonewall Insurance Company for approximately
$31 million. Stonewall was a non-operating property and casualty subsidiary
engaged primarily in the run-off of approximately $170 million in asbestos and
environmental liabilities associated with policies written through 1991.
The businesses discussed above are included in the tables and financial
statements herein through their respective disposal dates.
1
PROPERTY AND CASUALTY INSURANCE OPERATIONS
AFC's property and casualty group has been engaged primarily in specialty
and private passenger automobile insurance businesses which have been managed as
two major business groups: Specialty and Personal. Each group has reported to an
individual senior executive and is comprised of multiple business units which
operate autonomously but with certain strong central 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 and administrative support functions.
Approximately 40% of the 7,100 people employed by AFC's property and casualty
insurance operations at December 31, 2002 work for the businesses transferred to
Infinity.
The property and casualty group operates in a highly competitive industry
that is affected by many factors which can cause significant fluctuations in its
results of operations. The industry has historically been subject to pricing
cycles characterized by periods of intense competition and lower premium rates
(a "downcycle") followed by periods of reduced competition, reduced underwriting
capacity due to lower policyholders' surplus and higher premium rates (an
"upcycle"). After being in an extended downcycle for over a decade, the property
and casualty insurance industry is experiencing significant market firming and
price increases in certain specialty markets and in the private passenger
automobile market.
The primary objective of AFC's property and casualty insurance operations
is to achieve solid underwriting profitability while providing excellent service
to its policyholders. 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.
While many costs included in underwriting may be readily determined
(commissions, administrative expenses, many of the losses on claims reported),
the process of determining overall underwriting results is also highly dependent
upon the use of estimates in the case of losses incurred or expected but not yet
reported or developed. Actuarial procedures and projections are used to obtain
"best estimates" which are then included in the overall results. While the
process is imprecise and develops amounts which are subject to change over time,
AFC's projections, excluding asbestos and environmental ("A&E") claims, have
been close to the developed ultimate results, as can be seen in the "reserve
development triangles" on page 13.
AFC's property and casualty group, like many others in the industry, has
A&E claims arising in most cases from general liability policies written in
years before 1987. The establishment of reserves for such A&E claims presents
unique and difficult challenges and is subject to uncertainties significantly
greater than those presented by other types of claims.
In February 2003, GAI entered into an agreement for the settlement of
asbestos-related coverage litigation from insurance policies issued in the
1970's and 1980's. Management believes that the $123.5 million settlement (GAI
has the option to pay in cash or over time with 5.25% interest) with parties
related to and known as A.P. Green Industries, Inc. will enhance financial
certainty and provide resolution to litigation that represents AFC's largest
known asbestos-related claim and the only such claim that management believes to
be material. For a discussion of uncertainties related to A&E claims, see
Management's Discussion and Analysis - "Asbestos and Environmental-related
Reserves."
Management's focus on underwriting performance has resulted in a statutory
combined ratio averaging 107.2% for the period 1998 to 2002 (or 104.4% excluding
special charges in 2002, 2001 and 1998 related to asbestos and other
environmental matters), as compared to 109.1% for the property and casualty
industry over the same period (Source: "Best's Review/Preview -
Property/Casualty" - January 2003 Edition). AFC believes that its product line
diversification and underwriting discipline have
2
contributed to the Company's ability to consistently outperform the industry's
underwriting results. Management's philosophy is to refrain from writing
business that is not expected to produce an underwriting profit even if it is
necessary to limit premium growth to do so.
Generally, while financial data is reported on a statutory basis for
insurance regulatory purposes, it is reported in accordance with generally
accepted accounting principles ("GAAP") for shareholder and other investment
purposes. In general, statutory accounting results in lower capital and surplus
and lower 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; reporting
investment-grade bonds and redeemable preferred stocks 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.
Unless indicated otherwise, the financial information presented for the
property and casualty insurance operations herein is presented based on GAAP.
The following table shows (in millions) certain information of AFC's
property and casualty insurance operations.
2002 2001 2000
---- ---- ----
Statutory Basis
---------------
Premiums Earned $ 2,372 $ 2,566 $2,484
Admitted Assets 7,233 6,736 6,472
Unearned Premiums 1,168 1,158 1,154
Loss and LAE Reserves (net) 3,607 3,539 3,445
Capital and Surplus 1,742 1,669 1,763
GAAP Basis
----------
Premiums Earned $ 2,403 $ 2,594 $2,495
Total Assets 10,927 10,007 9,458
Unearned Premiums 1,848 1,641 1,414
Loss and LAE Reserves (gross)(*) 5,204 4,778 4,516
Shareholder's Equity 3,241 3,288 3,360
(*) GAAP loss and LAE reserves net of reinsurance recoverable were $3.4
billion at December 31, 2002, $3.3 billion at December 31, 2001, and
$3.2 billion at December 31, 2000.
3
The following table shows the segment, independent ratings, and size (in
millions) of AFC's major property and casualty insurance subsidiaries. AFC
continues to focus on growth opportunities in what it believes to be more
profitable specialty businesses.
Net Written Premiums
----------------------------
Company (Ratings - AM Best/S&P) Personal Specialty
--------------------------------------------------- -------- ---------
Great American Pool(a): A A
Written through independent agents $ 80(b) $ 929
Written directly with customers 108(c) -
Mid-Continent A A 19 215
Republic Indemnity A- A 2 219
National Interstate A- - - 92
American Empire Surplus Lines A A - 116
Infinity Property and Casualty:
Infinity A A 233(b) -
Windsor A A 145(b) -
Atlanta Casualty A A 142(b) -
Leader A A 93(b) -
Other 14 6
---- ------
$836 $1,577
==== ======
(a) The Great American Pool represents approximately 15 subsidiaries.
(b) Business transferred to Infinity Property and Casualty Corporation
except for $6 million in assigned risk business retained by GAI. In
February 2003, AFC sold 61% of Infinity in a public offering.
(c) The direct-to-consumer business which GAI agreed to sell in 2003
produced $79 million of the 2002 premiums.
4
The following table shows the performance of AFC's property and casualty
insurance operations (dollars in millions):
2002 2001 2000
---- ---- ----
Gross written premiums (a) $3,935 $3,520 $3,231
Ceded reinsurance (a) (1,521) (938) (593)
------ ------ ------
Net written premiums $2,414 $2,582(b) $2,638
====== ====== ======
Net earned premiums $2,403 $2,594 $2,495
Loss and LAE 1,785 1,980 1,962
Asbestos litigation settlement 30 - -
Special A&E charge - 100 -
Underwriting expenses 606 737 732
Policyholder dividends 8 5 3
------ ------ ------
Underwriting loss ($ 26) ($ 228) ($ 202)
====== ====== ======
GAAP ratios:
Loss and LAE ratio 75.5% 80.2% 78.6%
Underwriting expense ratio 25.3 28.4 29.3
Policyholder dividend ratio .3 .2 .1
------ ------ ------
Combined ratio (c) 101.1% 108.8% 108.0%
====== ====== ======
Statutory ratios:
Loss and LAE ratio 76.4% 81.1% 80.1%
Underwriting expense ratio 25.0 28.3 28.4
Policyholder dividend ratio .2 .3 .3
------ ------ ------
Combined ratio (c) 101.6% 109.7% 108.8%
====== ====== ======
Industry statutory combined ratio (d) 105.7% 116.0% 110.1%
(a) Excludes the following premiums that were written on behalf of, and
fully reinsured to, the purchasers of the Commercial lines and
Japanese divisions: 2002 - $173 million; 2001 - $143 million; and
2000 - $213 million.
(b) Before a reduction of $29.7 million for unearned premium transfer
related to the sale of the Japanese division.
(c) The 2002 combined ratios include 1.2 percentage points (GAAP) and
1.3 points (statutory) related to the A.P. Green asbestos
litigation settlement. The 2001 combined ratios include 3.9
percentage points for the third quarter strengthening of insurance
reserves relating to A&E matters and 1 percentage point
attributable to the attack on the World Trade Center. The 2000
combined ratios include 1.4 percentage points for reserve
strengthening in AFC's California workers' compensation business.
(d) Ratios are derived from "Best's Review/Preview - Property/Casualty"
(January 2003 Edition).
As with other property and casualty insurers, AFC's operating results can
be adversely affected by unpredictable catastrophe losses. Certain natural
disasters (hurricanes, tornadoes, floods, forest fires, etc.) and other
incidents of major loss (explosions, civil disorder, fires, etc.) are classified
as catastrophes by industry associations. Losses from these incidents are
usually tracked separately from other business of insurers because of their
sizable effects on overall operations. AFC generally seeks to reduce its
exposure to such events through individual risk selection and the purchase of
reinsurance. Total net losses to AFC's insurance operations from catastrophes
were $7 million in 2002; $42 million in 2001 and $8 million in 2000. These
amounts are included in the tables herein. AFC's catastrophe losses in 2001
included $25 million related to the terrorist attack on the World Trade Center.
The Terrorism Risk Insurance Act of 2002 ("TRIA") is to be in effect until
the end of 2005 and establishes a temporary Terrorism Risk Insurance Program
which requires commercial insurers to offer virtually all policyholders coverage
for certain "acts of terrorism" as defined by TRIA. This federal legislation
provides that coverage may not materially differ from the terms, amounts, and
other coverage limitations applicable to losses arising from occurrences other
than terrorism. The federal government provides some stop loss insurance to
insurers after an act has
5
been certified by the government as an act of terrorism and after an insurer has
paid losses in excess of a deductible. The deductible progresses from 7% to 15%
of direct earned premium in each of the three program years. TRIA supersedes
state insurance law to the extent that such law is inconsistent with its terms.
For 2003, AFC would have to sustain losses in excess of $128 million to be
eligible for the reinsurance under TRIA. AFC believes that it is unlikely that
its losses in the event of a terrorist act would be so significant as to exceed
the deductible necessary to participate in the federal reinsurance. AFC
generally seeks to limit its exposure to catastrophe losses including those
arising from terrorist acts. AFC is complying with the obligations of TRIA to
offer coverage but continues to review its business with consideration of the
price it charges for such coverage, as well as through management of individual
risk selection.
SPECIALTY
GENERAL The Specialty group emphasizes the writing of specialized
insurance coverage where AFC personnel are experts in particular lines of
business or customer groups. The following are examples of such specialty
businesses:
Inland and Ocean Marine Provides coverage primarily for marine cargo,
boat dealers, marina operators/dealers, excursion
vessels, builder's risk, contractor's equipment,
excess property and motor truck cargo.
Workers' Compensation Writes coverage for prescribed benefits
payable to employees (principally in California)
who are injured on the job.
Agricultural-related Provides federally reinsured multi-peril crop
(allied lines) insurance covering most perils
as well as crop hail, equine mortality and
other coverages for full-time operating
farms/ranches and agribusiness operations on a
nationwide basis.
Executive and Professional Markets coverage for attorneys, architects and
Liability engineers, and for directors and officers of
businesses and not-for-profit organizations.
Fidelity and Surety Bonds Provides surety coverage for various types of
contractors and public and private corporations
and fidelity and crime coverage for
government, mercantile and financial institutions.
Collateral Protection Provides coverage for insurance risk management
programs for lending and leasing institutions.
Umbrella and Excess Provides higher layer liability coverage in
Liability excess of primary layers.
Excess and Surplus Specially designed insurance products offered
to those that can't find coverage in standard
markets.
Commercial Automobile Markets customized insurance programs for public
transportation operations (such as busses and
limousines), and a specialized physical damage
product for the trucking industry.
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 businesses are opportunistic and their premium volume will vary based
on prevailing market conditions. AFC continually evaluates expansion in existing
markets and opportunities in new specialty markets that meet its profitability
objectives.
6
The U.S. geographic distribution of the Specialty group's statutory direct
written premiums in 2002 (excluding business written on behalf of, and fully
reinsured to, the purchaser of the Japanese division) compared to 1998 is shown
below.
2002 1998 2002 1998
---- ---- ---- ----
California 21.4% 22.1% Pennsylvania 2.7% 2.6%
Texas 9.9 7.1 New Jersey 2.6 3.8
New York 5.7 6.6 Michigan 2.1 2.4
Florida 5.5 4.1 Missouri 2.0 *
Illinois 4.3 3.7 Massachusetts * 4.8
Georgia 3.0 2.2 North Carolina * 3.0
Ohio 2.9 2.3 Connecticut * 2.2
Oklahoma 2.8 3.0 Other 35.1 30.1
----- -----
100.0% 100.0%
===== =====
----------------
(*) less than 2%
The following table sets forth a distribution of statutory net written premiums
for AFC's Specialty group by NAIC annual statement line for 2002 compared to
1998.
2002 1998
---- ----
Other liability 30.1% 19.7%
Workers' compensation 16.2 23.5
Auto liability 8.7 9.0
Commercial multi-peril 8.6 10.7
Inland marine 7.2 10.1
Fidelity and surety 5.8 4.5
Collateral protection 5.3 *
Auto physical damage 4.8 4.5
Ocean marine 3.7 3.2
Product Liability 2.7 *
Allied lines 2.5 4.7
Aircraft * 4.0
Other 4.4 6.1
----- -----
100.0% 100.0%
===== =====
----------------
(*) less than 2%
7
The following table shows the performance of AFC's Specialty group
insurance operations (dollars in millions):
2002 2001 2000
---- ---- ----
Gross written premiums (a) $2,713 $2,236 $1,889
Ceded reinsurance (a) (1,136) (694) (565)
------ ------ ------
Net written premiums $1,577 $1,542(b) $1,324
====== ====== ======
Net earned premiums $1,497 $1,409 $1,223
Loss and LAE 1,009 997 902
Underwriting expenses 455 430 413
Policyholder dividends 8 5 3
------ ------ ------
Underwriting profit (loss) $ 25 ($ 23) ($ 95)
====== ====== ======
GAAP ratios:
Loss and LAE ratio 67.5% 70.7% 73.8%
Underwriting expense ratio 30.4 30.6 33.8
Policyholder dividend ratio .5 .4 .3
------ ------ ------
Combined ratio (c) 98.4% 101.7% 107.9%
====== ====== ======
Statutory ratios:
Loss and LAE ratio 68.7% 73.6% 76.5%
Underwriting expense ratio 31.1 30.5 31.4
Policyholder dividend ratio .3 .5 .5
------ ------ ------
Combined ratio (c) 100.1% 104.6% 108.4%
====== ====== ======
Industry statutory combined ratio (d) 103.4% 117.1% 108.2%
(a) Excludes the following premiums that were written on behalf of, and
fully reinsured to, the purchasers of the Commercial lines and
Japanese divisions: 2002 - $173 million; 2001 - $143 million; and
2000 - $213 million.
(b) Before a reduction of $29.7 million for unearned premium transfer
related to the sale of the Japanese division.
(c) The 2001 combined ratios include 1.8 percentage points attributable
to the attack on the World Trade Center. The 2000 combined ratios
include 2.9 percentage points for reserve strengthening in AFC's
California workers' compensation business. Because the combined
ratio is calculated based on premiums, the impact of these two
items is greater for the Specialty segment alone than it is for the
overall company.
(d) Represents the commercial industry statutory combined ratio derived
from "Best's Review/Preview - Property/Casualty" (January 2003
Edition).
MARKETING The Specialty group operations direct their sales efforts
primarily through independent property and casualty insurance agents and
brokers, although portions are written through employee agents. These businesses
write insurance through several thousand agents and brokers and have
approximately 440,000 policies in force.
COMPETITION These businesses compete with other individual insurers,
state funds and insurance groups of varying sizes, some of which are mutual
insurance companies possessing competitive advantages in that all their profits
inure to their policyholders. They also compete with self-insurance plans,
captive programs and risk retention groups. 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. Management believes that sophisticated data analysis for refinement of
risk profiles, extensive specialized knowledge and loss prevention service have
helped AFC's Specialty group compete successfully.
8
PERSONAL
GENERAL The Personal group wrote primarily private passenger automobile
liability and physical damage insurance, and to a lesser extent, homeowners'
insurance. In February 2003, AFC sold 61% of Infinity Property and Casualty
Corporation in a public offering. The businesses sold in the Infinity
transaction represented 82% of the Personal group's 2002 net written premiums.
In January 2003, GAI entered into an agreement to sell its direct-to-consumer
auto business. As a result of these transactions, AFC's future interest in
personal lines insurance will be limited to two subsidiaries that generated less
than $35 million in net written premiums in 2002, certain direct-to-consumer
business in run-off that had approximately $28 million in net written premiums
in 2002 and its 39% continuing interest in Infinity.
Historically, the majority of the Personal group's auto premiums was from
sales in the nonstandard market covering drivers 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. The
Personal group's approach to its auto business was to develop tailored rates for
its personal automobile customers based on a variety of factors, including the
driving record of the insureds, the number of and type of vehicles covered,
credit history, and other factors. Management believes this approach enabled the
Personal group to rate each risk appropriately and provided a means to serve a
broad spectrum of customers.
The Personal group's approach to homeowners business was to limit exposure
in locations which have significant catastrophic potential (such as windstorms,
earthquakes and hurricanes). Since 1997, the Personal group ceded the majority
of its homeowners' business through reinsurance agreements; in 2002, it ceded
80% of this business.
The Personal group held licenses to write policies in all states and the
District of Columbia. The U.S. geographic distribution of the Personal group's
statutory direct written premiums in 2002 compared to 1998, was as follows:
2002 1998 2002 1998
---- ---- ---- ----
California 28.7% 14.8% New Jersey 2.8% 3.3%
New York 10.0 6.2 Oklahoma 2.2 *
Florida 10.0 9.4 South Carolina 2.0 *
Connecticut 8.3 10.0 North Carolina * 2.8
Pennsylvania 7.2 5.5 Arizona * 2.6
Georgia 6.0 10.1 Missouri * 2.0
Texas 4.0 5.0 Other 18.8 28.3
----- -----
100.0% 100.0%
===== =====
(*) less than 2%
The Personal group's underwriting strategy was to sell its products
through independent agents in the states that management believed offer the
greatest opportunity for profitable growth based on market size and legal and
regulatory environments. Management was focused on obtaining adequate rates to
achieve underwriting profitability and was willing to forego volume to meet its
profit objectives. Since April 1, 2001, the Personal group ceded 90% of the
automobile physical damage business written by certain subsidiaries under
reinsurance agreements.
9
The following table shows the performance of AFC's Personal group
insurance operations (dollars in millions):
2002 2001 2000
---- ---- ----
Gross written premiums $1,221 $1,284 $1,339
Ceded reinsurance (385) (244) (28)
------ ------ ------
Net written premiums $ 836 $1,040 $1,311
====== ====== ======
Net earned premiums $ 905 $1,183 $1,270
Loss and LAE 753 970 1,061
Underwriting expenses (a) 151 306 317
------ ------ ------
Underwriting profit (loss) $ 1 ($ 93) ($ 108)
====== ====== ======
GAAP ratios:
Loss and LAE ratio 83.1% 82.1% 83.6%
Underwriting expense ratio (a) 16.7 25.8 25.0
------ ------ ------
Combined ratio 99.8% 107.9% 108.6%
====== ====== ======
Statutory ratios:
Loss and LAE ratio 83.4% 82.3% 83.9%
Underwriting expense ratio (a) 13.3 25.0 25.2
------ ------ ------
Combined ratio 96.7% 107.3% 109.1%
====== ====== ======
Industry statutory combined ratio (b) 105.6% 111.6% 110.3%
(a) The Personal group recorded commissions of $159 million in 2002 and
$47 million in 2001 on business ceded to reinsurers. Commissions on
ceded business are recorded as a reduction of underwriting
expenses.
(b) Represents the personal lines industry statutory combined ratio
derived from "Best's Review/Preview - Property/Casualty" (January
2003 Edition).
The Personal group had approximately 790,000 auto policies in force at
December 31, 2002, over 75% of which had policy limits of $50,000 or less per
occurrence.
10
REINSURANCE
Consistent with standard practice of most insurance companies, AFC
reinsures a portion of its business with other insurance 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. The availability and cost
of reinsurance are subject to prevailing market conditions which may affect the
volume and profitability of business that is written. AFC is subject to credit
risk with respect to its reinsurers, as the ceding of risk to reinsurers
generally does not relieve AFC of its liability to its insureds until claims are
fully settled.
AFC 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. AFC
further minimizes the credit risk of certain ceding arrangements, including the
90% automobile physical damage quota share, by entering into the contracts on a
"funds withheld" basis. Under "funds withheld" arrangements, AFC retains ceded
premiums, in exchange for a fee, to fund ceded losses as they become due from
the reinsurer. As an alternative method to reduce credit risk, AFC has, on
occasion, required reinsurers to secure financial guarantees or establish lines
of credit to support recoverables under reinsurance agreements. Excluding Mitsui
and Ohio Casualty (discussed below), approximately half of AFC's total
reinsurance recoverable (net of funds withheld) at December 31, 2002, was with
the following companies: American Re-Insurance Company, Swiss Reinsurance
America Corporation, General Reinsurance Corporation, X.L. Reinsurance America,
Inc., Converium Reinsurance North America, Inc., Employers Reinsurance
Corporation, Inter-Ocean Reinsurance (Ireland) Ltd., Continental Casualty
Company, Everest Reinsurance Company, Transatlantic Reinsurance Company,
Hartford Fire Insurance Company, Berkley Insurance Company and Folksamerica
Reinsurance Company. At December 31, 2002, less than 1% of AFC's reinsurance
recoverable balance was with companies affiliated with reinsurer Gerling Global
Re., a European reinsurer which has been the subject of recent news articles.
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. 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 $ 1.0 $99.0
Other Workers' Compensation 2.0 48.0
Commercial Umbrella 3.6 46.4
Other Casualty 5.0 25.0
Property - General 2.0 28.0 (b)
Property - Catastrophe 10.0 65.0
(a) Reinsurance covers substantial portions of losses in excess of
retention. However, in general, losses resulting from terrorism are
not covered.
(b) Since 1997, AFC has ceded at least 80% of its homeowners insurance
coverage through reinsurance agreements. Since April 1, 2001, AFC
has ceded 90% of the automobile physical damage business written by
certain subsidiaries. In July 2002, AFC added certain specialty
businesses to the 90% reinsurance agreement.
AFC also 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.
11
Included in the balance sheet caption "recoverables from reinsurers and
prepaid reinsurance premiums" were approximately $226 million on paid losses and
LAE and $1.8 billion on unpaid losses and LAE at December 31, 2002. The
collectibility of a reinsurance balance is based upon the financial condition of
a reinsurer as well as individual claim considerations. At December 31, 2002,
AFC's insurance subsidiaries had allowances of approximately $38 million for
doubtful collection of reinsurance recoverables.
Premiums written for reinsurance ceded and assumed are presented in the
following table (in millions):
2002 2001 2000
---- ---- ----
Reinsurance ceded $1,693 $1,114 $803
Reinsurance assumed - including
involuntary pools and associations 80 94 76
In connection with the sales of the Japanese division to Mitsui in 2001
and the Commercial lines division to Ohio Casualty in 1998, Great American
agreed to issue and renew policies related to the businesses transferred until
each purchaser received the required approvals and licensing to begin writing
business on their own behalf. Under these agreements, which last for a few
years, Great American cedes 100% of these premiums to the respective purchaser.
In 2002, 2001, and 2000, premiums of $173 million, $143 million, and $213
million, respectively, were ceded under these agreements.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The consolidated financial statements include the estimated liability for
unpaid losses and LAE of AFC'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.
Generally, reserves for reinsurance and involuntary pools and associations
are reflected in AFC's results at the amounts reported by those entities.
12
The following discussion of insurance reserves includes the reserves of
American Premier's subsidiaries for only those periods following its acquisition
in 1995. See Note N to the Financial Statements for an analysis of changes in
AFC's estimated liability for losses and LAE, net and gross of reinsurance, over
the past three years on a GAAP basis.
The following table presents the development of AFC'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 1995. 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, 2002. The remainder of the
table presents intervening development as percentages of the initially estimated
liability. The development results from additional information and experience in
subsequent years. The middle line shows a cumulative deficiency (redundancy)
which represents the aggregate percentage increase (decrease) in the liability
initially estimated. The lower portion of the table indicates the cumulative
amounts paid as of successive periods as a percentage of the original loss
reserve liability. For purposes of this table, reserves of businesses sold are
considered paid at the date of sale. For example, the percentage of the December
31, 1997 reserve liability paid in 1998 includes approximately 10 percentage
points for reserves ceded in connection with the sale of the Commercial lines
division.
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
Liability for unpaid losses
and loss adjustment expenses:
- ----------------------------
As originally estimated $2,123 $2,113 $2,187 $3,393 $3,404 $3,489 $3,305 $3,224 $3,192 $3,253 $3,400
As re-estimated at
December 31, 2002 2,551 2,464 2,545 3,654 3,667 3,687 3,172 3,194 3,355 3,424 N/A
Liability re-estimated:
- ----------------------
One year later 99.9% 98.1% 95.9% 98.7% 100.9% 104.5% 97.8% 98.1% 105.1% 105.2%
Two years later 98.2% 94.1% 99.3% 98.5% 105.9% 104.6% 96.3% 100.1% 105.1%
Three years later 95.2% 97.4% 99.9% 103.9% 105.2% 102.9% 97.4% 99.0%
Four years later 100.3% 98.9% 109.4% 103.1% 103.6% 105.4% 96.0%
Five years later 102.6% 109.7% 109.0% 102.9% 106.9% 105.7%
Six years later 113.6% 108.8% 108.5% 106.8% 107.7%
Seven years later 112.3% 108.5% 115.3% 107.7%
Eight years later 112.2% 115.5% 116.4%
Nine years later 119.1% 116.6%
Ten years later 120.2%
Cumulative deficiency
(redundancy):
Aggregate 20.2% 16.6% 16.4% 7.7% 7.7% 5.7% ( 4.0%) ( 1.0%) 5.1% 5.2% N/A
==== ==== ==== ==== ==== ==== ==== ==== ==== ==== ===
Excluding the 2002 A.P.
Green settlement charge
and special A&E charges
and reallocations in
1994, 1996, 1998 and 2001 ( 0.9%) ( 3.5%) ( 3.0%) ( 4.8%) ( 2.4%) ( 4.2%) ( 8.0%) ( 5.0%) 1.0% 4.3% N/A
==== ==== ==== ==== ==== ==== ==== ==== ==== ==== ===
Cumulative paid as of:
- ---------------------
One year later 26.7% 25.2% 26.8% 33.1% 33.8% 41.7% 28.3% 34.8% 38.3% 33.6%
Two years later 43.7% 40.6% 42.5% 51.6% 58.0% 56.6% 51.7% 52.7% 52.2%
Three years later 54.2% 50.9% 54.4% 67.2% 66.7% 70.8% 62.4% 60.0%
Four years later 60.8% 59.1% 66.3% 72.0% 77.3% 78.6% 65.6%
Five years later 67.0% 68.0% 69.8% 80.4% 82.8% 81.1%
Six years later 74.0% 70.8% 80.0% 84.7% 84.6%
Seven years later 76.3% 80.6% 84.9% 86.0%
Eight years later 85.9% 85.1% 86.1%
Nine years later 89.5% 86.3%
Ten years later 90.7%
The following is a reconciliation of the net liability to the gross
liability for unpaid losses and LAE.
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
---- ---- ---- ---- ---- ---- ---- ---- ---- ----
As originally estimated:
Net liability shown above $2,113 $2,187 $3,393 $3,404 $3,489 $3,305 $3,224 $3,192 $3,253 $3,400
Add reinsurance recoverables 611 730 704 720 736 1,468 1,571 1,324 1,525 1,804
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Gross liability $2,724 $2,917 $4,097 $4,124 $4,225 $4,773 $4,795 $4,516 $4,778 $5,204
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
As re-estimated at
December 31, 2002:
Net liability shown above $2,464 $2,545 $3,654 $3,667 $3,687 $3,172 $3,194 $3,355 $3,424
Add reinsurance recoverables 956 885 1,126 1,142 1,219 1,841 1,942 1,569 1,681
------ ------ ------ ------ ------ ------ ------ ------ ------
Gross liability $3,420 $3,430 $4,780 $4,809 $4,906 $5,013 $5,136 $4,924 $5,105 N/A
====== ====== ====== ====== ====== ====== ====== ====== ====== ===
Gross cumulative deficiency
(redundancy) 25.5% 17.7% 16.7% 16.6% 16.1% 5.0% 7.1% 9.0% 6.8% N/A
==== ==== ==== ==== ==== ==== ==== ==== ==== ===
13
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, AFC's $100 million special
charge for A&E claims related to losses recorded in 2001, but incurred before
1992, is included in the re-estimated liability and cumulative deficiency
(redundancy) percentage for each of the previous years shown. Conditions and
trends that have affected development of the liability in the past may not
necessarily exist in the future. Accordingly, it may not be appropriate to
extrapolate future redundancies or deficiencies based on this table.
The adverse development in the tables is due primarily to A&E exposures
for which AFC has been held liable under general liability policies written
years ago where such 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. For example, changes in the California workers' compensation law in
1993 and subsequent court decisions, primarily in late 1996, greatly limited the
ability of insurers to challenge medical assessments and treatments. These
limitations, together with changes in work force characteristics and medical
delivery costs, are contributing to an increase in claims severity.
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, 2002
are as follows (in millions):
Liability reported on a SAP basis, net of $238 million
of retroactive reinsurance $3,368
Additional discounting of GAAP reserves in excess
of the statutory limitation for SAP reserves (13)
Reserves of foreign operations 7
Reinsurance recoverables, net of allowance 1,804
Reclassification of allowance for uncollectible
Reinsurance 38
------
Liability reported on a GAAP basis $5,204
======
ASBESTOS AND ENVIRONMENTAL RESERVES ("A&E") In addressing asbestos and
environmental reserves, the insurance industry typically includes claims
relating to polluted waste sites and asbestos as well as other mass tort claims
such as those 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
significantly greater than those presented by other types of claims. For a
discussion of these uncertainties, see Management's Discussion and Analysis
- -"Uncertainties - Asbestos and Environmental-related Reserves", and "Special A&E
Charge" and Note L - "Commitments and Contingencies" to the Financial
Statements.
The survival ratio, which is an industry measure of A&E claim reserves, is
derived by dividing reserves for A&E exposures by annual paid losses. At
December 31, 2002, AFC's three year survival ratio (after adjusting for the sale
of Stonewall and excluding amounts associated with the A.P. Green settlement) is
approximately 22.4 times paid losses for the remaining asbestos reserves and
11.6 times paid losses for total A&E reserves. In October 2002, A.M. Best
reported its estimate that the property and casualty insurance industry's three
year survival ratio for A&E reserves was approximately 7.2 times paid losses at
December 31, 2001.
14
The following table (in millions) is a progression of A&E reserves.
2002 2001 2000
---- ---- ----
Reserves at beginning of year $446.8 $357.7 $576.7
Incurred losses and LAE (a) 48.6 108.0 (1.9)
Paid losses and LAE (28.7) (28.1) (48.7)
Reserves not classified as A&E prior to 2001:
Reserves - 1.4 -
Allowance for uncollectible reinsurance
applicable to ceded A&E reserves - 7.8 -
Reserves transferred with sale of Stonewall - - (168.4)
------ ------ ------
Reserves at end of year, net of
reinsurance recoverable 466.7 446.8 357.7
Reinsurance recoverable, net of allowance 105.1 101.4 105.7
------ ----- ------
Gross reserves at end of year $571.8 $548.2 $463.4
====== ====== ======
(a) Includes $30 million in 2002 related to the settlement of the A.P.
Green asbestos litigation and a special charge of $100 million in 2001.
ANNUITY AND LIFE OPERATIONS
GENERAL
AFC's annuity and life operations are conducted through Great American
Financial Resources, Inc. ("GAFRI"), a holding company which markets retirement
products, primarily fixed and variable annuities, and various forms of life and
supplemental health insurance through the following subsidiaries which were
acquired in the years shown. GAFRI and its subsidiaries employ approximately
1,600 persons.
Great American Life Insurance Company ("GALIC") - 1992(*)
Annuity Investors Life Insurance Company ("AILIC") - 1994
Loyal American Life Insurance Company ("Loyal") - 1995
Great American Life Assurance Company of Puerto Rico ("GAPR") - 1997
United Teacher Associates Insurance Company ("UTA") - 1999
Manhattan National Life Insurance Company ("MNL") - 2002
(*) Acquired from Great American Insurance.
Acquisitions in recent years have supplemented GAFRI's internal growth as
the assets of the holding company and its operating subsidiaries have increased
from $4.5 billion at the end of 1992 to $9.3 billion at the end of 2002.
Premiums over the last three years were as follows (in millions):
Insurance Product(*) 2002 2001 2000
----------------- ---- ---- ----
Annuities $1,001 $ 751 $ 747
Life and supplemental health 313 310 261
------ ------ ------
$1,314 $1,061 $1,008
====== ====== ======
-----------------
(*) Table does not include premiums of subsidiaries or divisions until
their first full year following acquisition or formation.
ANNUITIES
GAFRI's principal retirement products are Flexible Premium Deferred
Annuities ("FPDAs") and Single Premium Deferred Annuities ("SPDAs"). Annuities
are long-term retirement saving instruments that benefit from income accruing on
a tax-deferred basis. The issuer of the annuity collects premiums, credits
interest or earnings on the policy and pays out a benefit upon death, surrender
or annuitization. FPDAs are characterized by premium payments that are flexible
in both amount and timing as determined by the policyholder. SPDAs are issued in
exchange for a one-time lump-sum premium payment.
15
The following table (in millions) presents combined financial information
of GAFRI's principal annuity operations.
2002 2001 2000
---- ---- ----
GAAP Basis
----------
Total Assets $8,014 $7,456 $7,052
Fixed Annuity Reserves 6,111 5,632 5,365
Variable Annuity Reserves 455 530 534
Stockholder's Equity 1,139 1,023 915
Statutory Basis
---------------
Total Assets $7,319 $6,896 $6,620
Fixed Annuity Reserves 6,192 5,729 5,536
Variable Annuity Reserves 455 530 534
Capital and Surplus 419 388 363
Asset Valuation Reserve (a) 63 79 77
Interest Maintenance Reserve (a) 27 11 3
Annuity Receipts:
Flexible Premium:
First Year $ 60 $ 67 $ 71
Renewal 191 176 157
------ ------ ------
251 243 228
Single Premium 750 508 519
------ ------ ------
Total Annuity Receipts $1,001 $ 751 $ 747
====== ====== ======
-----------------
(a) Allocation of surplus.
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; (viii) performance of the equity
markets and (ix) general economic conditions. At December 31, 2002, GAFRI had
over 300,000 annuity policies in force.
Annuity contracts are generally classified as either fixed rate (including
equity-indexed) or variable. The following table presents premiums by
classification:
2002 2001 2000
---- ---- ----
Premiums
--------
Traditional fixed 77% 68% 50%
Variable 18 27 43
Equity-indexed 5 5 7
--- --- ---
100% 100% 100%
=== === ===
With a traditional 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 subject to any guaranteed minimum interest crediting rates or any
guaranteed term in the policy.
GAFRI seeks to maintain a desired spread between the yield on its
investment portfolio and the rate it credits to its fixed rate annuities. GAFRI
accomplishes this by: (i) offering crediting rates which it has the option to
change after any initial guarantee period; (ii) designing annuity products that
encourage persistency and (iii) maintaining an appropriate matching of assets
and liabilities. GAFRI designs its products with certain provisions to encourage
policyholders to maintain their funds with GAFRI for at least five to ten years.
Virtually all of GAFRI's traditional fixed rate annuities offer a minimum
interest rate guarantee of 3% or 4% (as determined by applicable law); the
majority permit GAFRI to change the crediting rate at any time (subject to the
minimum guaranteed interest rates). In determining the frequency and extent of
changes in the crediting rate, GAFRI takes into account the economic environment
and the relative competitive position of its products. Historically, management
has been able to react to changes in market interest rates and maintain a
desired interest
16
rate spread. The recent interest rate environment has resulted in a compression
of the spread, which could continue at least through 2003.
Sales of GAFRI's fixed rate annuities have increased over the past three
years, due to the weak stock market environment, as well as the development of
new products.
In addition to traditional fixed rate annuities, GAFRI offers variable and
equity-indexed annuities. Industry sales of such annuities increased
substantially in the 1990s as investors sought to obtain the returns available
in the equity markets while enjoying the tax-deferred status of annuities. With
a variable annuity, the earnings credited to the policy vary based on the
investment results of the underlying investment options chosen by the
policyholder, generally without any guarantee of principal except in the case of
death of the insured annuitant. Premiums directed to the variable options in
policies issued by GAFRI are invested in funds maintained in separate accounts
managed by various independent investment managers. GAFRI earns a fee on amounts
deposited into variable accounts. Policyholders may also choose to direct all or
a portion of their premiums to various fixed rate options, in which case GAFRI
earns a spread on amounts deposited. With the downturn in the stock market
during the past three years, industry wide sales of variable annuities,
including GAFRI's sales, have decreased substantially.
An equity-indexed fixed annuity provides policyholders with a crediting
rate tied, in part, to the performance of an existing stock market index while
protecting them against the related downside risk through a guarantee of
principal. GAFRI purchases call options designed to offset substantially all of
the increase in the liabilities associated with equity-indexed annuities. In
2002, GAFRI chose to suspend new sales of equity-indexed annuities due primarily
to a lack of volume.
No individual state accounted for more than 10% of GAFRI's annuity
premiums in the past three years except as follows:
2002 2001 2000
---- ---- ----
California 16% 17% 24%
Washington 10 - -
Ohio - 13 -
GAFRI's FPDAs are sold primarily to employees of not-for-profit and
commercial organizations who are eligible to save for retirement through
contributions made on a before-tax or after-tax basis. Contributions are made at
the discretion of the participants through payroll deductions or through
tax-free "rollovers" of funds from other qualified investments. Federal income
taxes are not payable on pretax contributions or earnings until amounts are
withdrawn.
GAFRI distributes its fixed rate products primarily through a network of
130 managing general agents ("MGAs") who, in turn, direct more than 1,300
actively producing independent agents. The top 15 MGAs accounted for nearly
two-thirds of GAFRI's fixed annuity premiums in 2002. No one MGA represented
more than 9% of total fixed annuity premiums in 2002. In addition, GAFRI offers
all of its annuity product lines through financial institutions. Sales of
annuities through financial institutions were approximately 6% of total annuity
premiums in 2002.
In 2002, GAFRI exited the highly competitive single premium, non-qualified
segment of the variable annuity market due primarily to insufficient returns and
a lack of critical mass. GAFRI intends to redesign its variable product and
offer it as an ancillary product solely through its fixed annuity sales
channels. Approximately one-third of GAFRI's variable annuity sales in 2002 were
made through a wholly-owned subsidiary, Great American Advisors, Inc. ("GAA").
GAA is a broker/dealer licensed in all 50 states to sell stocks, bonds, options,
mutual funds and variable insurance contracts through independent
representatives and financial institutions. GAA also acts as the principal
underwriter and distributor for GAFRI's variable annuity products.
17
LIFE AND SUPPLEMENTAL INSURANCE
GAFRI offers a variety of life and supplemental health products through
GALIC's life operations, MNL, Loyal, GAPR and UTA. This group produced $313
million of statutory premiums in 2002.
GALIC offers traditional term, universal and whole life insurance products
through national marketing organizations. In 2002, GAFRI issued over $8.0
billion gross ($1.9 billion net) face amount of insurance through its life
operations; at year-end 2002, this operation had approximately 228,000 policies
and $39 billion gross ($12 billion net) face amount of insurance in force.
UTA, provides supplemental health products and annuities through
independent agents. UTA's principal health products include coverage for
Medicare supplement, cancer and long-term care. In 2000, UTA purchased a block
of approximately 50,000 Medicare supplement and cancer policies.
Loyal offers a variety of supplemental health and life products. The
principal products sold by Loyal include cancer, accidental injury, short-term
disability, hospital indemnity, universal life and traditional whole life. In
2001, Loyal reinsured a substantial portion of its life insurance business,
reduced its operating expenses, and redirected its marketing efforts in that
line of business. In 2002, Loyal's operations were consolidated with UTA's
operations.
At year-end 2002, GAFRI's operating units writing supplemental insurance
products had assets of nearly $800 million and approximately 354,000 policies
with annualized health premiums in force of $185 million and gross life
insurance in force of $1.4 billion.
GAPR sells in-home service life and supplemental health products through a
network of company-employed agents. Ordinary life, cancer, credit and group life
products are sold through independent agents.
INDEPENDENT RATINGS
GAFRI's principal insurance subsidiaries are rated by A.M. Best and
Standard & Poor's. In addition, GALIC is rated A+ (strong) by Fitch and A3 (good
financial security) by Moody's. Such ratings are generally based on concerns of
policyholders and agents and are not directed toward the protection of
investors. Following are the ratings as of March 1, 2003:
Standard
A.M. Best & Poor's
------------- ----------
GALIC A (Excellent) A-(Strong)
AILIC A (Excellent) A-(Strong)
Loyal A (Excellent) Not rated
UTA A-(Excellent) Not rated
GAPR A (Excellent) Not rated
GAFRI 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. GAFRI
believes that (i) a rating of "A" by A.M. Best (its third highest rating) is
necessary to successfully market tax-deferred annuities to public education
employees and other not-for-profit groups and (ii) a rating in the "A" category
by at least one rating agency is necessary to successfully compete in other
annuity markets.
GAFRI's insurance ratings were recently affirmed by Fitch (with a stable
outlook), and affirmed by Moody's (with a negative outlook); its ratings were
downgraded by Standard & Poor's (with a negative outlook). GAFRI's operations
could be materially and adversely affected by additional downgrades. In
connection with recent reviews by independent rating agencies, management
indicated that it intends to maintain the capital of its significant insurance
subsidiaries at levels currently indicated by the rating agencies as appropriate
for the current ratings. Items which could adversely affect capital levels
include (i) a sustained decrease in the stock market in 2003 or beyond; (ii) a
significant period of low interest rates and a resulting significant narrowing
of annuity "spread"; (iii) investment impairments; (iv) a change in statutory
reserving requirements for guaranteed
18
minimum death benefits on variable annuities, (v) adverse mortality, and (vi)
higher than planned dividends paid due to liquidity needs by GAFRI's holding
companies.
COMPETITION
GAFRI'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 and agents; (v) product design (including interest rates
credited and premium rates charged); and (vi) commissions. Since policies are
marketed and distributed primarily through independent agents (except at GAPR),
the insurance companies must also compete for agents.
No single insurer dominates the markets in which GAFRI's insurance
companies compete. Competitors include (i) individual insurers and insurance
groups, (ii) mutual funds and (iii) other financial institutions. In a broader
sense, GAFRI'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 other than traditional deposit accounts.
OTHER COMPANIES
Through subsidiaries, AFC is engaged in a variety of other operations,
including The Golf Center at Kings Island in the Greater Cincinnati area;
commercial real estate operations in Cincinnati (office buildings and The
Cincinnatian Hotel), New Orleans (Le Pavillon Hotel), Cape Cod (Chatham Bars
Inn), Austin (Driskill Hotel), Chesapeake Bay (Skipjack Cove Yachting Resort),
Charleston (Charleston Harbor Resort and Marina) and apartments in Louisville,
Pittsburgh, St. Paul and Tampa Bay. These operations employ approximately 800
full-time employees.
INVESTMENT PORTFOLIO
GENERAL The following tables present the percentage distribution and
yields of AFC's investment portfolio (excluding investment in equity securities
of investee corporations) as reflected in its financial statements.
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Cash and Short-term Investments 6.4% 4.5% 3.8% 3.5% 2.5%
Fixed Maturities:
U.S. Government and Agencies 9.9 8.3 4.7 4.9 4.4
State and Municipal 4.3 3.4 3.6 2.7 1.2
Public Utilities 7.6 6.4 5.5 5.1 6.0
Mortgage-Backed Securities 22.8 21.8 22.7 22.0 20.8
Corporate and Other 39.6 47.3 51.4 55.3 53.2
Redeemable Preferred Stocks .4 .5 .5 .6 .5
----- ----- ----- ----- -----
84.6 87.7 88.4 90.6 86.1
Net Unrealized Gains (Losses) 3.3 1.3 .1 (2.1) 3.5
----- ----- ----- ----- -----
87.9 89.0 88.5 88.5 89.6
Other Stocks, Options and Warrants 2.2 2.6 3.4 3.7 3.7
Policy Loans 1.6 1.7 1.9 1.9 1.9
Real Estate and Other Investments 1.9 2.2 2.4 2.4 2.3
----- ----- ----- ----- -----
100.0% 100.0% 100.0% 100.0% 100.0%
===== ===== ===== ===== =====
Yield on Fixed Income Securities:
Excluding realized gains and losses 7.2% 7.6% 7.7% 7.7% 7.8%
Including realized gains and losses 6.7% 7.5% 7.4% 7.6% 8.0%
Yield on Stocks:
Excluding realized gains and losses 5.4% 4.5% 5.0% 5.9% 5.4%
Including realized gains and losses (4.6%) (.3%) 3.9% 20.7% (5.3%)
Yield on Investments (*):
Excluding realized gains and losses 7.2% 7.6% 7.6% 7.7% 7.8%
Including realized gains and losses 6.5% 7.4% 7.4% 7.9% 7.8%
(*) Excludes "Real Estate and Other Investments".
19
FIXED MATURITY INVESTMENTS
AFC'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 AFC's bonds and redeemable preferred
stocks, by NAIC designation (and comparable Standard & Poor's Corporation
rating) as of December 31, 2002 (dollars in millions).
NAIC Amortized Market Value
------------------
Rating Comparable S&P Rating Cost Amount %
- ------ --------------------- --------- --------- ---
1 AAA, AA, A $ 8,335 $ 8,772 73%
2 BBB 2,304 2,395 20
------- ------- ---
Total investment grade 10,639 11,167 93
------- ------- ---
3 BB 495 435 4
4 B 299 292 2
5 CCC, CC, C 76 74 1
6 D 41 39 *
------- ------- ---
Total noninvestment grade 911 840 7
------- ------- ---
Total $11,550 $12,007 100%
======= ======= ===
-----------------
(*) 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.
AFC's primary investment objective for fixed maturities is to earn
interest and dividend income rather than to realize capital gains. AFC invests
in bonds and redeemable preferred stocks that have primarily intermediate-term
maturities. This practice allows flexibility in reacting to fluctuations of
interest rates.
EQUITY INVESTMENTS
At December 31, 2002, AFC held $299 million in stocks and warrants;
approximately 63% represents an investment in Provident Financial Group, Inc., a
Cincinnati-based commercial banking and financial services company; another 12%
consists of three investments of more than $8 million each. Such 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.
FOREIGN OPERATIONS
AFC sells life and supplemental health products in Puerto Rico and
property and casualty products in Mexico, Canada, Puerto Rico, Europe and Asia.
In addition, GAFRI has an office in India where employees perform computer
programming and certain back office functions. Less than 3% of AFC's revenues
and costs and expenses are derived from sources outside of the United States.
REGULATION
AFC'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
20
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 AFC in 2003 from its
insurance subsidiaries without seeking regulatory clearance is approximately $24
million. During 2002, those companies received approval and paid $92 million in
dividends in excess of the applicable limitation.
Changes in state insurance laws and regulations have the potential to
materially affect the revenues and expenses of the insurance operations. For
example, between July 1993 and January 1995, the California Commissioner ordered
reductions in workers' compensation insurance premium rates totaling more than
30% and subsequently replaced the workers' compensation insurance minimum rate
law with an "open rating" policy. The Company is unable to predict whether or
when other state insurance laws or regulations may be adopted or enacted or what
the impact of such developments would be on the future operations and revenues
of its insurance businesses.
Most states have created insurance guaranty associations to provide for
the payment of claims of insurance companies that become insolvent. Annual
assessments for AFC'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 less than one percent of AFC's net written premiums
in 2002.
The NAIC is an organization which is comprised of the chief insurance
regulator for each of the 50 states and the District of Columbia. 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". At December 31, 2002, the
capital ratios of all AFC insurance companies substantially exceeded the
risk-based capital requirements.
------------------------------------------------
ITEM 2
PROPERTIES
----------
Subsidiaries of AFC own several buildings in downtown Cincinnati. AFC and
its affiliates occupy about three-fourths of the aggregate 660,000 square feet
of commercial and office space.
AFC's insurance subsidiaries lease the majority of their office and
storage facilities in numerous cities throughout the United States, including
Great American's and GAFRI's home offices in Cincinnati. A GAFRI subsidiary owns
a 40,000 square foot office building in Austin, Texas, most of which is used by
the company for its operations.
AFC subsidiaries own transferable rights to develop approximately 800,000
square feet of floor space in the Grand Central Terminal area in New York City.
The development rights were derived from ownership of the land upon which the
terminal is constructed. Since the beginning of 1999, AFC has sold approximately
420,000 square feet of such air rights for total consideration of $22.2 million.
21
ITEM 3
LEGAL PROCEEDINGS
-----------------
Please refer to "Forward-Looking Statements" following the Index in front of
this Form 10-K.
AFC and its subsidiaries are involved in various litigation, most of which
arose in the ordinary course of business, including litigation alleging bad
faith in dealing with policyholders and challenging certain business practices
of insurance subsidiaries. Except for the following, management believes that
none of the litigation meets the threshold for disclosure under this Item.
AFC's insurance company subsidiaries and American Premier are parties to
litigation and receive claims asserting alleged injuries and damages from
asbestos, environmental and other substances and workplace hazards and have
established loss accruals for such potential liabilities. The ultimate loss for
these claims may vary materially from amounts currently recorded as the
conditions surrounding resolution of these claims continue to change.
American Premier is a party or named as a potentially responsible party in
a number of proceedings and claims by regulatory agencies and private parties
under various environmental protection laws, including the Comprehensive
Environmental Response, Compensation and Liability Act ("CERCLA"), seeking to
impose responsibility on American Premier for hazardous waste remediation costs
at certain railroad sites formerly owned by its predecessor, Penn Central
Transportation Company ("PCTC"), and at certain other sites where hazardous
waste allegedly generated by PCTC's railroad operations and APU's former
manufacturing operations is present. It is difficult to estimate American
Premier's liability for remediation costs at these sites for a number of
reasons, including the number and financial resources of other potentially
responsible parties involved at a given site, the varying availability of
evidence by which to allocate responsibility among such parties, the wide range
of costs for possible remediation alternatives, changing technology and the
period of time over which these matters develop. Nevertheless, American Premier
believes that its accruals for potential environmental liabilities are adequate
to cover the probable amount of such liabilities, based on American Premier's
estimates of remediation costs and related expenses and its estimates of the
portions of such costs that will be borne by other parties. Such estimates are
based on information currently available to American Premier and are subject to
future change as additional information becomes available. American Premier
seeks reimbursement from certain insurers for portions of whatever remediation
costs it incurs.
As previously reported, Great American Insurance Company and certain other
insurers have been parties to asbestos-related coverage litigation under
insurance policies issued during the 1970's and 1980's to Bigelow-Liptak
Corporation and related companies, subsequently known as A.P. Green Industries,
Inc. ("A.P. Green"). These claims (some of which are direct actions against
Great American) allege that the refractory materials manufactured, sold or
installed by A.P. Green contained asbestos and resulted in bodily injury from
exposure to asbestos. A.P. Green has sought to recover defense and indemnity
expenses related to those claims from a number of insurers, including Great
American, and in an effort to maximize coverage has asserted that Great
American's policies are not subject to aggregate limits on liability, and that
each insurer is liable for all sums that A.P. Green becomes legally obliged to
pay.
In February 2002, A.P. Green filed petitions for bankruptcy under Chapter
11 of the Bankruptcy Code in the United States Bankruptcy Court for the Western
District of Pennsylvania (In Re Global Industrial Technologies, Inc., et al,
filed February 14, 2002). Prior to the bankruptcy filing, Great American sought
to have these coverage issues decided as part of the contribution and
declaratory judgment action that it brought several years earlier (Great
American Insurance Company, et al v. The Royal Insurance Company, et al, United
States District Court, Southern District of Ohio, filed January 29, 1998) (the
"District Court Action"). The bankruptcy filing, however, stayed the District
Court action.
In March 2002, Great American and other insurers filed a motion in the
Bankruptcy Court to modify the stay so as to permit the District Court action to
22
proceed. During the same month, A.P. Green filed adversary proceedings in the
Bankruptcy Court to decide the coverage issues. In June of 2002, the Bankruptcy
Court entered orders continuing proceedings on both the stay motion and the
adversary proceeding and referred the insurance coverage dispute to non-binding
mediation. The mediation resulted in the negotiated settlement discussed below.
On February 19, 2003, AFG announced that Great American Insurance
Company has entered into an agreement for the settlement of the A.P. Green
litigation. The settlement is for $123.5 million (Great American has the option
to pay in cash or over time with 5.25% interest), all but $30 million of which
will be covered by reserves established prior to September 30, 2002, and
anticipated reinsurance recoverables. The remaining $30 million has been
recorded as of December 31, 2002. The agreement allows up to 10% of the
settlement to be paid in AFG common stock. The settlement, however, is subject
to a number of contingencies, including approval of the Bankruptcy Court
supervising the reorganization of A.P. Green and subsequent confirmation of a
plan of reorganization that includes an injunction prohibiting the assertion
against Great American of any present or future asbestos personal injury claims
under policies issued to A.P. Green and related companies. This process could
take a year or more and no assurance can be made that all of these consents and
approvals will be obtained; no payments are required until completion of the
process. If not obtained, the outcome of this litigation will again be subject
to the complexities and uncertainties associated with a Chapter 11 proceeding
and asbestos coverage litigation.
UTA was named a defendant in a purported class action lawsuit. (Peggy
Berry, et al. v. United Teacher Associates Insurance Company, Travis County
District Court, Case No. GN100461, filed February 11, 2001). The complaint
sought unspecified damages based on the alleged misleading disclosure of UTA's
interest crediting practices on its fixed rate annuities. UTA has entered into
an agreement to resolve this matter. The settlement is subject to approval of
the trial court. The resolution of this matter is not expected to have a
material impact on UTA.
23
PART II
ITEM 5
MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
---------------------------------------------------------------------
Not applicable - Registrant's Common Stock is owned by American Financial Group,
Inc. See Consolidated Financial Statements for information regarding dividends.
24
ITEM 6
SELECTED FINANCIAL DATA
-----------------------
The following table sets forth certain data for the periods indicated
(dollars in millions).
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Earnings Statement Data:
- -----------------------
Total Revenues $3,745 $3,929 $3,820 $3,359 $4,084
Operating Earnings Before Income Taxes 195 70 120 310 269
Earnings (Loss) Before Extraordinary Items
and Accounting Changes 134 13 (23) 153 130
Extraordinary Items - - - (4) (1)
Cumulative Effect of Accounting Changes (a) (40) (10) (9) (4) -
Net Earnings (Loss) 94 3 (32) 145 129
Ratio of Earnings to Fixed Charges (b):
Including Annuity Benefits 1.48 1.14 1.26 1.81 1.69
Excluding Annuity Benefits 3.36 1.56 2.02 4.01 3.44
Ratio of Earnings to Fixed Charges and
Preferred Dividends (b):
Including Annuity Benefits 1.46 1.12 1.23 1.76 1.65
Excluding Annuity Benefits 3.09 1.45 1.87 3.67 3.15
Balance Sheet Data:
- ------------------
Total Assets $19,502 $17,398 $16,407 $16,024 $15,848
Long-term Debt:
Holding Companies 268 228 204 113 315
Subsidiaries 297 271 195 240 177
Minority Interest 494 461 510 490 524
Shareholders' Equity 1,730 1,478 1,454 1,324 1,531
(a) Reflects the implementation in the following years of accounting
changes mandated by recently enacted accounting standards:
2002 - SFAS #142 (Goodwill and Other Intangibles)
2001 - EITF 99-20 (Asset-backed Securities)
2000 - SFAS #133 (Derivatives)
1999 - SOP 98-5 (Start-up Costs)
(b) Fixed charges are computed on a "total enterprise" basis. For purposes of
calculating the ratios, "earnings" have been computed by adding to pretax
earnings the fixed charges and the minority interest in earnings of
subsidiaries having fixed charges and the undistributed equity in losses
of investees. Fixed charges include interest (including or excluding
interest credited to annuity policyholders' accounts as indicated),
amortization of debt premium/discount and expense, preferred dividend and
distribution requirements of subsidiaries and a portion of rental expense
deemed to be representative of the interest factor. Although the ratio of
earnings to fixed charges excluding interest on annuities is not required
or encouraged to be disclosed under Securities and Exchange Commission
rules, some investors and lenders may not consider interest credited to
annuity policyholders' accounts a borrowing cost for an insurance company,
and accordingly, believe this ratio is meaningful.
25
ITEM 7
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
------------------------------------------------
Please refer to "Forward-Looking Statements" following the Index in front of
this Form 10-K.
GENERAL
Following is a discussion and analysis of the financial statements and
other statistical data that management believes will enhance the understanding
of AFC's financial condition and results of operations. This discussion should
be read in conjunction with the financial statements beginning on page F-1.
CRITICAL ACCOUNTING POLICIES
Significant accounting policies are summarized in Note A to the financial
statements. The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that can have a significant effect on amounts reported in the
financial statements. As more information becomes known, these estimates and
assumptions could change and thus impact amounts reported in the future.
Management believes that the establishment of insurance reserves, especially
asbestos and environmental-related reserves, and the determination of "other
than temporary" impairment on investments are the two areas where the degree of
judgment required to determine amounts recorded in the financial statements make
the accounting policies critical. For further discussion of these policies, see
"Liquidity and Capital Resources - Investments" and "Liquidity and Capital
Resources - Uncertainties."
LIQUIDITY AND CAPITAL RESOURCES
RATIOS AFC's debt to total capital ratio at the parent holding company level
(excluding amounts due AFG) was approximately 13% at December 31, 2002 and 2001.
Including amounts due AFG, the ratio was 25% at the end of 2002 and 28% at the
end of 2000. AFC used a portion of the proceeds from the Infinity sale in
February 2003 to repay parent debt. Adjusting to reflect this repayment reduces
the ratio to 6% excluding amounts due AFG and 20% including amounts due AFG at
December 31, 2002.
AFC's ratio of earnings to fixed charges excluding and including preferred
dividends, on a total enterprise basis for the year ended December 31, 2002, was
3.36 and 3.09, respectively. Including annuity benefits as a fixed charge, this
ratio was 1.48 and 1.46 respectively. Although not required to be disclosed, the
ratio excluding interest on annuities is presented because interest credited to
annuity policyholder accounts is not always considered a borrowing cost for an
insurance company.
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, 2002, the capital ratios of all AFC insurance
companies substantially exceeded the RBC requirements (the lowest capital ratio
of any AFC subsidiary was 2.3 times its authorized control level RBC; weighted
average of all AFC subsidiaries was 5.0 times).
SOURCES OF FUNDS 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, shareholder
dividends, and taxes. Funds to meet these obligations come primarily from
dividend and tax payments from their subsidiaries.
Management believes these parent holding companies have sufficient
resources to meet their liquidity requirements. If funds generated from
operations, including dividends and tax payments 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.
26
AFC has a reciprocal Master Credit Agreement with various AFG holding
companies under which these companies make funds available to each other for
general corporate purposes.
In November 2002, AFC replaced its $300 million bank credit line with a
new bank credit agreement. Currently, AFC may borrow up to $280 million under
the new agreement; the line may be expanded to $300 million through the end of
2003. The new line consists of two facilities: a 364-day revolving facility,
extendable annually, for one-third of the total line and a three-year revolving
facility for the remaining two-thirds. Amounts borrowed bear interest at rates
ranging from 1.25% to 2.25% over LIBOR based on AFG's credit rating. This credit
agreement provides ample liquidity and can be used to obtain funds for operating
subsidiaries or, if necessary, for the parent companies. At December 31, 2002,
there was $248 million borrowed under the agreement. At March 14, 2003, there
was $95 million borrowed under the line.
In December 2000, AFC borrowed $155 million under its credit agreement
with AFG to make capital contributions to its property and casualty operations.
For statutory accounting purposes, equity securities of non-affiliates are
generally carried at market value. At December 31, 2002, AFC's insurance
companies owned publicly traded equity securities with a market value of $297
million. In addition, Great American owns GAFRI common stock with a market value
of $603 million and a carrying value of $422 million. 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.
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. The resulting provision (or credit) is currently payable to (or
receivable from) AFC.
INVESTMENTS Approximately two-thirds of AFC's consolidated assets are invested
in marketable securities. AFC's investment portfolio at December 31, 2002,
contained $12 billion in "Fixed maturities" and $299 million in "Other stocks",
all carried at market value with unrealized gains and losses reported as a
separate component of shareholders' equity on an after-tax basis. At December
31, 2002, AFC had pretax net unrealized gains of $457.2 million on fixed
maturities and $125.2 million on other stocks. AFC attempts to optimize
investment income while building the value of its portfolio, placing emphasis
upon long-term performance. AFC'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
intermediate-term maturities with an objective of optimizing total return while
allowing flexibility to react to changes in market conditions. At December 31,
2002, the average life of AFC's fixed maturities was about six years.
Approximately 93% of the fixed maturities held by AFC were rated
"investment grade" (credit rating of AAA to BBB) by nationally recognized rating
agencies at December 31, 2002. Investment grade securities generally bear lower
yields and lower degrees of risk than those that are unrated or noninvestment
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 AFC's fixed maturities at December 31, 2002. MBSs
are subject to significant prepayment risk due to the fact that, in periods of
declining interest rates, mortgages may be repaid more rapidly than scheduled as
borrowers refinance higher rate mortgages to take advantage of lower rates. Due
to the significant decline in the general level of interest rates in 2002, AFC
has experienced an increase in the level of prepayments on its MBSs; these
prepayments have not been reinvested at interest rates comparable to the rates
earned on the prepaid MBSs. Substantially all of AFC's MBSs are investment grade
quality, with over 95% rated "AAA" at December 31, 2002.
27
Summarized information for the unrealized gains and losses recorded in AFC's
balance sheet at December 31, 2002, is shown in the following table (dollars in
millions). Approximately $170 million of "Fixed maturities" and $21 million of
"Other stocks" had no unrealized gains or losses at December 31, 2002.
Securities Securities
With With
Unrealized Unrealized
Gains Losses
---------- ----------
Fixed Maturities
----------------
Market value of securities $10,458 $1,379
Amortized cost of securities $ 9,868 $1,512
Gross unrealized gain (loss) $ 590 ($ 133)
Market value as % of amortized cost 106% 91%
Number of security positions 1,725 328
Number individually exceeding
$2 million gain or loss 23 18
Concentration of gains (losses) by
type or industry (exceeding 5% of
unrealized):
Mortgage-backed securities $ 134.6 ($ 9.1)
Banks and savings institutions 55.2 (1.3)
U.S. government and government agencies 49.5 (1.1)
State and municipal 36.4 (5.6)
Electric services 31.6 (15.2)
Asset-backed securities 14.4 (10.6)
Air transportation (generally collateralized) 5.3 (47.7)
Percentage rated investment grade 97% 65%
Other Stocks
------------
Market value of securities $ 260 $ 18
Cost of securities $ 130 $ 23
Gross unrealized gain (loss) $ 130 ($ 5)
Market value as % of cost 200% 78%
Number individually exceeding
$2 million gain or loss 3 1
AFC's investment in equity securities of Provident Financial Group, a
Cincinnati-based commercial banking and financial services company, represents
$117 million of the $130 million in unrealized gains on other stocks at
December 31, 2002. At March 14, 2003, the unrealized gain on Provident was
approximately $86 million.
The table below sets forth the scheduled maturities of fixed maturity securities
at December 31, 2002, based on their market values. Asset backed securities and
other securities with sinking funds are reported at average maturity. Actual
maturities may differ from contractual maturities because certain securities may
be called or prepaid by the issuers.
Securities Securities
with With
Unrealized Unrealized
Maturity Gains Losses
-------- ---------- ----------
One year or less 6% 5%
After one year through five years 22 27
After five years through ten years 33 39
After ten years 10 17
--- ---
71 88
Mortgage-backed securities 29 12
--- ---
100% 100%
=== ===
28
AFC realized aggregate losses of $11.1 million during 2002 on $72.9 million in
sales of fixed maturity securities (14 issues; 12 issuers) that had individual
unrealized losses greater than $500,000 at December 31, 2001. Market values of
eleven of the securities increased an aggregate of $8 million from year-end 2001
to date of sale. The market value of one of the securities did not change from
year-end 2001 to the date of sale. One of the securities was a Conseco bond that
decreased in value by $5 million from year-end 2001 to the date of sale due to
the continued decline in Conseco's financial condition. The market value of the
remaining security decreased $920,000 from year-end 2001 to the sale date.
Although AFC had the ability to continue holding these investments, its intent
to hold them changed due primarily to deterioration in the issuers'
creditworthiness, decisions to lessen exposure to a particular credit or
industry, or to modify asset allocation within the portfolio.
The table below (dollars in millions) summarizes the length of time securities
have been in an unrealized gain or loss position at December 31, 2002.
Market
Aggregate Aggregate Value as