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, 1997 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 Pacific 9-3/4% Debentures due April 20, 2004 Pacific Securities Registered Pursuant to Section 12(g) 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] As of March 1, 1998, 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). All shares of Common and Preferred Stock are entitled to one vote per share and generally vote as a single class. The aggregate market value of the Preferred Stock at that date was approximately $82.6 million. _____________ Documents Incorporated by Reference: Proxy Statement for the 1998 Annual Meeting of Shareholders (portions of which are incorporated by reference into Part III hereof). AMERICAN FINANCIAL CORPORATION INDEX TO ANNUAL REPORT ON FORM 10-K Part I Page Item 1 - Business: Introduction 1 Property and Casualty Insurance Operations 2 Annuity and Life Operations 16 Other Companies 20 Investment Portfolio 20 Regulation 22 Item 2 - Properties 24 Item 3 - Legal Proceedings 24 Item 4 - Submission of Matters to a Vote of Security Holders 26 Part II Item 5 - Market for Registrant's Common Equity and Related Stockholder Matters 27 Item 6 - Selected Financial Data 27 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations 28 Item 7A - Quantitative and Qualitative Disclosures About Market Risk (a) Item 8 - Financial Statements and Supplementary Data 37 Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure (b) Part III Item 10 - Directors and Executive Officers of the Registrant 37 Item 11 - Executive Compensation 37 Item 12 - Security Ownership of Certain Beneficial Owners and Management 37 Item 13 - Certain Relationships and Related Transactions 37 Part IV Item 14 - Exhibits, Financial Statement Schedules and Reports on Form 8-K S-1 (a) Not required - market capitalization on January 28, 1997 was less than $2.5 billion. (b) The response to this Item is "none". Forward-Looking Statements The Private Securities Litigation Reform Act of 1995 encourages corporations to provide investors with information about the company's anticipated performance and provides protection from liability if future results are not the same as management's expectations. This document contains certain forward-looking statements that are based on assumptions which management believes are reasonable, but by their nature, inherently uncertain. Future results could differ materially from those projected. Factors that could cause such differences include, but are not limited to: changes in economic conditions, regulatory actions, level of catastrophe losses, and competitive pressures. AFC undertakes no obligation to update any forward- looking statements. PART I ITEM 1 Business Introduction American Financial Corporation ("AFC") was incorporated as an Ohio corporation in 1955. Its address is One East Fourth Street, Cincinnati, Ohio 45202; its phone number is (513) 579-2121. At December 31, 1997, American Financial Group, Inc. ("AFG") owned all of the outstanding Common Stock of AFC (see "Mergers" below). AFC is a holding company which, through its subsidiaries, is engaged primarily in specialty and multi-line property and casualty insurance businesses and in the sale of tax-deferred annuities and certain life and health insurance products. AFC's property and casualty operations originated in 1872 and were the 20th largest property and casualty group in the United States based on 1996 statutory net premiums written of $2.8 billion. Mergers/Capital Contribution On April 3, 1995, AFC merged with a subsidiary of AFG, a new company formed to own 100% of the common stock of both AFC and American Premier Underwriters, Inc. ("American Premier" or "APU"). In the transaction, Carl H. Lindner and members of his family, who owned 100% of the Common Stock of AFC, exchanged their AFC Common Stock for approximately 55% of AFG voting common stock. Former shareholders of American Premier, including AFC and its subsidiaries, received shares of AFG stock on a one-for-one basis. AFC receives dividends paid on AFG common stock; however, its shares generally will not be eligible to be voted as long as AFC is owned by AFG. No gain or loss was recorded on the exchange of shares. AFC continues to be a separate SEC reporting company with publicly traded debentures and preferred stock. At the close of business on December 31, 1996, AFG contributed to AFC 81% of the common stock of American Premier. Since AFC and American Premier were under the common control of AFG, the acquisition of American Premier has been recorded by AFC at AFG's historical cost in a manner similar to a pooling of interests. Accordingly, the historical consolidated financial statements of AFC for periods subsequent to the April 1995 Mergers have been restated to include the accounts of American Premier. General Generally, companies have been included in AFC's consolidated financial statements when AFC's ownership of voting securities has exceeded 50%; for investments below that level but above 20%, AFC has accounted for the investments as investees. (See Note F to AFC's financial statements.) The following table shows AFC's percentage ownership of voting securities of its significant affiliates over the past several years: Voting Ownership at December 31, 1997 1996 1995 1994 1993 American Premier Underwriters 81% 81% (a) 42% 41% Great American Insurance Group 100% 100% 100% 100% 100% American Annuity Group 81% 81% 81% 80% 80% American Financial Enterprises 80% 83% 83% 83% 83% Chiquita Brands International 39% 43% 44% 46% 46% Citicasters - (b) 38% 37% 20% (a) Exchanged for shares of American Financial Group in April 1995. (b) Sold in September 1996. 1 The following summarizes the more significant changes in ownership percentages shown in the above table. American Premier Underwriters In April 1995, APU became a subsidiary of AFG as a result of the Mergers. At the close of business on December 31, 1996, AFG contributed to AFC 81% of the Common stock of American Premier. Chiquita Brands International During the second half of 1997, Chiquita issued an aggregate of 4.6 million shares of its common stock in connection with the purchase of new businesses. Citicasters In 1994, AFEI purchased approximately 10% of Citicasters common stock. In the second half of 1994, Citicasters repurchased and retired approximately 21% of its common stock. In September 1996, the investments in Citicasters were sold to an unaffiliated company. Property and Casualty Insurance Operations AFC manages and operates its property and casualty business in three major business segments: Nonstandard Automobile Insurance, Specialty Lines and Commercial and Personal Lines. Each segment is comprised of multiple business units which operate autonomously but with strong central financial controls and full accountability. Decentralized control allows each unit the autonomy necessary to respond to local and specialty market conditions while capitalizing on the efficiencies of centralized investment, actuarial, financial and legal support functions. AFC's property and casualty insurance operations employ approximately 8,100 persons. AFC operates in a highly competitive industry that is affected by many factors which can cause significant fluctuations in its results of operations. The property and casualty insurance industry has historically been subject to pricing cycles characterized by periods of intense competition and lower premium rates (a "downcycle") followed by periods of reduced competition, reduced underwriting capacity due to lower policyholders' surplus and higher premium rates (an "upcycle"). The property and casualty insurance industry is currently in an extended downcycle, which has lasted nearly a decade. AFC's premiums have been adversely affected by this downcycle, particularly in the extremely competitive pricing environment in certain standard commercial lines of business. The primary objective of AFC's property and casualty insurance operations is to achieve underwriting profitability. Underwriting profitability is measured by the combined ratio which is a sum of the ratios of underwriting losses, loss adjustment expenses ("LAE"), underwriting expenses and policyholder dividends to premiums. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, other income or federal income taxes. Management's focus on underwriting performance has resulted in a statutory combined ratio averaging 101.3% for the period 1993 to 1997, as compared to 105.8% for the property and casualty industry over the same period (Source: "Best's Review/Preview - Property/Casualty" - January 1998 Edition). AFC believes that its product line diversification and underwriting discipline have contributed to the Company's ability to consistently outperform the industry's underwriting results. Management's philosophy is to refrain from writing business that is not expected to produce an underwriting profit even if it is necessary to limit premium growth to do so. 2 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 surplus and net earnings than result from application of GAAP. Major differences include charging policy acquisition costs to expense as incurred rather than spreading the costs over the periods covered by the policies; recording bonds and redeemable preferred stocks primarily at amortized cost; netting of reinsurance recoverables and prepaid reinsurance premiums against the corresponding liability; requiring additional loss reserves; and charging to surplus certain assets, such as furniture and fixtures and agents' balances over 90 days old. Unless indicated otherwise, the financial information presented for the property and casualty insurance operations herein is presented based on GAAP and includes the insurance operations of AFC and American Premier for all periods. The following table shows (in millions) certain information of AFC's property and casualty insurance operations. 1997 1996 1995 Statutory Basis Premiums Earned $2,802 $2,821 $3,006 Admitted Assets 6,983 6,603 6,753 Unearned Premiums 1,133 1,104 1,160 Loss and LAE Reserves 3,475 3,397 3,394 Capital and Surplus 1,916 1,659 1,595 GAAP Basis Premiums Earned $2,824 $2,845 $3,031 Total Assets 9,212 8,623 9,002 Unearned Premiums 1,329 1,248 1,294 Loss and LAE Reserves 4,225 4,124 4,097 Shareholder's Equity 3,019 2,695 2,893 The following table shows the size (in millions), segment and A.M. Best rating 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 lines and nonstandard auto businesses which represented the bulk of 1997 net written premiums. 1997 Net Written Premiums NSA Commercial Company (A.M. Best Rating) Group Specialty and Personal Great American (A) $ - $ 724 $507 Republic Indemnity (A) - 224 - Mid-Continent (A) - 104 - American Empire Surplus Lines (A+) - 23 - Atlanta Casualty (A) 399 - - Windsor (A) 339 - - Infinity (A) 331 - - Leader National (A-) 59 - - Transport (A) 93 - - Other 27 28 - $1,248 $1,103 $507 3 The following table shows the performance of AFC's property and casualty insurance operations (dollars in millions): 1997 1996 1995 Net written premiums $2,858 $2,788 $3,092 Net earned premiums $2,824 $2,845 $3,031 Loss and LAE 2,076 2,132 2,265 Underwriting expenses 783 780 792 Policyholder dividends 7 14 8 Underwriting loss ($ 42) ($ 81) ($ 34) GAAP ratios: Loss and LAE ratio 73.5% 75.0% 74.8% Underwriting expense ratio 27.7 27.4 26.1 Policyholder dividend ratio .2 .5 .3 Combined ratio (a) 101.4% 102.9% 101.2% Statutory ratios: Loss and LAE ratio 73.4% 74.8% 74.8% Underwriting expense ratio 27.3 27.2 25.9 Policyholder dividend ratio .7 .4 1.7 Combined ratio (a) 101.4% 102.4% 102.4% Industry statutory combined ratio (b) 101.6% 105.8% 106.5% (a) The 1996 combined ratios include an increase of 2.8 percentage points attributable to the strengthening of insurance reserves relating to asbestos and other environmental matters ("A&E"). (b) Ratios are derived from "BestWeek" (March 16, 1998 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. Major catastrophes in recent years included Hurricane Fran in 1996 and the Texas hailstorms in 1995. Total net losses to AFC's insurance operations from catastrophes were $20 million in 1997; $85 million in 1996; and $70 million in 1995. These amounts are included in the tables herein. 4 Nonstandard Automobile Insurance General The Nonstandard Automobile Insurance segment ("NSA Group") underwrites primarily private passenger automobile liability and physical damage insurance policies for "nonstandard" risks. Nonstandard insureds are those individuals who are unable to obtain insurance through standard market carriers due to factors such as age, record of prior accidents, driving violations, particular occupation or type of vehicle. Premium rates for nonstandard risks are generally higher than for standard risks. Total private passenger automobile insurance net premiums written by insurance carriers in the United States in 1997 have been estimated by A.M. Best to be approximately $115 billion. Because it can be viewed as a residual market, the size of the nonstandard private passenger automobile insurance market changes with the insurance environment and grows when standard coverage becomes more restrictive. When this occurs, the criteria which differentiate standard from nonstandard insurance risks change. The size of the voluntary nonstandard market is also affected by rate levels adopted by state administered involuntary plans. According to A.M. Best, the voluntary nonstandard market has accounted for about one-sixth of total private passenger automobile insurance premiums written in recent years. While the NSA Group's implementation of significant rate increases during 1995 and early 1996 led to a reduction of premiums written in 1996, it also led to improved underwriting profitability in 1996 and 1997. Premium growth resumed in 1997 as a result of more moderate rate activity and California's stronger enforcement of its mandatory insurance law. The NSA Group writes business in 42 states and holds licenses to write policies in 49 states and the District of Columbia. The U.S. geographic distribution of the NSA Group's statutory direct written premiums in 1997 compared to 1993, was as follows: 1997 1993 1997 1993 California 15.2% 6.9% Mississippi 2.3% 3.1% Florida 11.1 13.2 Arizona 2.1 5.8 Georgia 10.2 12.0 Kentucky 2.1 2.0 Pennsylvania 8.3 * Ohio * 4.0 Texas 5.9 5.6 Alabama * 3.7 Connecticut 5.2 3.6 Washington * 3.3 New York 4.3 * Oregon * 3.1 Indiana 3.3 3.7 Utah * 2.7 Tennessee 2.7 4.5 Arkansas * 2.5 Missouri 2.6 3.7 Virginia * 2.4 Oklahoma 2.6 3.0 Other 22.1 11.2 100.0% 100.0% _____________ (*) less than 2% In addition, the NSA Group has written approximately 4% of its net premiums annually in the United Kingdom. Management believes that the NSA Group's underwriting success has been due, in part, to the refinement of various risk profiles, thereby dividing the consumer market into more defined segments which can be underwritten or priced properly. The NSA Group also generally writes policies of short duration which allow more frequent rating evaluations of individual risks, providing management greater flexibility in the ongoing assessment of the business. In addition, the NSA Group has implemented cost control measures both in the underwriting and claims handling areas. 5 The following table shows the performance of AFC's NSA Group insurance operations (dollars in millions): 1997 1996 1995 Net written premiums $1,248 $1,135 $1,277 Net earned premiums $1,205 $1,183 $1,246 Loss and LAE 898 904 1,036 Underwriting expenses 274 278 273 Underwriting profit (loss) $ 33 $ 1 ($ 63) GAAP ratios: Loss and LAE ratio 74.5% 76.4% 83.2% Underwriting expense ratio 22.7 23.5 22.0 Combined ratio 97.2% 99.9% 105.2% Statutory ratios: Loss and LAE ratio 74.1% 75.8% 83.1% Underwriting expense ratio 21.9 22.5 21.6 Combined ratio 96.0% 98.3% 104.7% Industry statutory combined ratio (a) 98.0% 101.0% 101.3% (a) Represents the private passenger automobile industry statutory combined ratio derived from "Best's Review/Preview - Property/Casualty" (January 1998 Edition). Although AFC believes that there is no reliable regularly published combined ratio data for the nonstandard automobile insurance industry, AFC believes that such a combined ratio would be lower than the private passenger automobile industry average shown above. Marketing Each of the principal units in the NSA Group is responsible for its own marketing, sales, underwriting and claims processing. Sales efforts are directed primarily toward independent agents. These units each write policies through several thousand independent agents. The NSA Group had approximately one million policies in force at December 31, 1997, just under 90% of which had policy limits of $50,000 or less per occurrence. Most NSA Group policies are written for policy periods of six months or less. Competition A large number of national, regional and local insurers write nonstandard private passenger automobile insurance coverage. Insurers in this market generally compete on the basis of price (including differentiation on liability limits, variety of coverages offered and deductibles), geographic availability and ease of enrollment and, to a lesser extent, reputation for claims handling, financial stability and customer service. NSA Group management believes that sophisticated data analysis for refinement of risk profiles has helped the NSA Group to compete successfully. The NSA Group attempts to provide selected pricing for a wider spectrum of risks and with a greater variety of payment options, deductibles and limits of liability than are offered by many of its competitors. 6 Specialty Lines General The Specialty Lines segment 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 Lines and the businesses which they operate: Workers' Compensation Writes coverage for prescribed benefits payable to employees (principally in California) who are injured on the job. Executive Liability Markets liability coverage for attorneys and corporate directors and officers. Inand 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 transportation cargo. Japanese division Provides coverage primarily for workers' compensation, commercial auto, umbrella, and general liability of Japanese businesses operating in the U.S. Agricultural-related Provides multi-peril crop insurance (allied lines) covering weather and disease perils as well as coverage for full-time operating farms/ranches and agribusiness operations on a nationwide basis. Non-profit Liability Provides property, general/professional liability, automobile, trustee liability, umbrella and crime coverage for a wide range of non-profit organizations. General Aviation Provides coverage for corporate and private aircraft and airports. 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. Umbrella and Excess Provides large capacity coverage in excess of primary layers. Specialization is the key element to the underwriting success of these business units. Each unit has independent management with significant operating autonomy to oversee the important operational functions of its business such as underwriting, pricing, marketing, policy processing and claims service. These specialty lines are opportunistic and their premium volume will vary based on current market conditions. AFC continually evaluates expansion in existing markets and opportunities in new specialty markets. The U.S. geographic distribution of the Specialty Lines statutory direct written premiums in 1997 compared to 1993, was as follows: 1997 1993 1997 1993 California 29.5% 46.7% Oklahoma 3.5% 4.2% Texas 8.4 5.0 New Jersey 2.2 2.5 Massachusetts 4.7 3.2 Pennsylvania 2.0 * New York 4.6 5.2 Ohio 2.0 * Florida 4.5 2.6 Michigan * 2.0 Illinois 3.7 2.9 Other 34.9 25.7 100.0% 100.0% _____________ (*) less than 2% 7 The following table sets forth a distribution of statutory net written premiums for AFC's Specialty Lines by NAIC annual statement line for 1997 compared to 1993: 1997 1993 Workers' compensation 23.5% 47.2% Other liability 20.3 16.9 Inland marine 9.2 6.5 Commercial multi-peril 8.4 4.7 Auto physical damage 7.5 2.0 General aviation 7.2 0.1 Allied lines 5.8 4.5 Fidelity and surety 4.1 2.8 Auto liability 3.9 5.7 Ocean marine 3.6 4.2 Other 6.5 5.4 100.0% 100.0% The following table shows the performance of AFC's Specialty Lines insurance operations (dollars in millions): 1997 1996 1995 Net written premiums $1,103 $993 $1,097 Net earned premiums $1,056 $976 $1,085 Loss and LAE 706 527 730 Underwriting expenses 344 295 302 Policyholder dividends (5) - (3) Underwriting profit $ 11 $154 $ 56 GAAP ratios: Loss and LAE ratio 66.8% 53.9% 67.2% Underwriting expense ratio 32.6 30.2 27.9 Policyholder dividend ratio (.4) - (.3) Combined ratio (a) 99.0% 84.1% 94.8% Statutory ratios: Loss and LAE ratio 66.7% 54.1% 67.5% Underwriting expense ratio 31.9 30.3 28.1 Policyholder dividend ratio 1.0 .5 4.2 Combined ratio (a) 99.6% 84.9% 99.8% Industry statutory combined ratio (b) 103.7% 108.9% 109.9% (a) The 1996 combined ratios reflect a reduction of 4.1 percentage points attributable to a reallocation of loss reserves in connection with the strengthening of A&E reserves. (b) Represents the commercial industry statutory combined ratio derived from "BestWeek" (March 16, 1998 Edition). Marketing The Specialty Lines operations direct their sales efforts primarily toward independent property and casualty insurance agents and brokers. These businesses write insurance through several thousand agents and brokers and have nearly 290,000 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. 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 lines compete successfully. 8 Commercial and Personal Lines General Major commercial lines of business are workers' compensation, commercial multi-peril, umbrella (including primary and excess layers) and commercial auto. The workers' compensation business has experienced solid growth and profitability due to adequate rate structures and favorable trends in medical care costs and the success of its Drug-Free Workplace and SafetyWorks programs. AFC's Drug-Free Workplace and SafetyWorks programs for workers' compensation customers assist insureds in setting up drug testing programs (as permitted by law), drug and alcohol education programs and work safety programs. In 1997, there were more than 1,400 insureds in 23 states with such programs producing approximately $83 million in annual net written premiums. Commercial business is written in 26 states where management believes adequate rates can be obtained and where assigned risk costs are not excessive. AFC's approach focuses on specific customer groups, such as fine restaurants, light manufacturers, hotels/motels, workers' compensation safety groups and insureds with large umbrella coverages. The approach also emphasizes site visits at prospective customers to ensure underwriter familiarity with risk factors relating to each insured and to avoid those risks which have unacceptable exposures. Personal lines business consists primarily of preferred/standard private passenger automobile and homeowners' insurance and is currently being marketed in 25 states. AFC's approach is to develop tailored rates for its personal automobile customers based on a variety of factors, including the driving record of the insureds. The approach to homeowners business is to limit exposure in locations which are likely to be unprofitable and those which have significant catastrophic potential (such as windstorms, earthquakes and hurricanes). During 1997, AFC had a reinsurance agreement under which 80% of its homeowners' business was reinsured. The U.S. geographic distribution of the Commercial and Personal Line s statutory direct written premiums in 1997 compared to 1993, was as follows: 1997 1993 1997 1993 Connecticut 13.1% 14.5% Florida 2.7% 4.3% New Jersey 13.0 8.4 Texas 2.5 3.3 New York 11.8 9.8 Illinois 2.3 2.8 North Carolina 10.5 9.4 Kentucky 2.3 * Pennsylvania 5.6 6.0 Utah 2.1 * Maryland 3.9 3.9 Tennessee 2.0 * Ohio 3.7 4.3 California * 3.9 Massachusetts 3.4 * Washington * 2.4 Michigan 3.4 3.5 Oregon * 2.4 Other 17.7 21.1 100.0% 100.0% _____________ (*) less than 2% 9 The following table sets forth a distribution of statutory net written premiums for AFC's Commercial and Personal Lines by NAIC annual statement line for 1997 compared to 1993: 1997 1993 Auto liability 34.6% 32.0% Workers' compensation 27.5 12.3 Commercial multi-peril 19.4 19.6 Other liability 8.1 6.2 Auto physical damage 4.5 12.3 Homeowners 2.5 12.1 Other 3.4 5.5 100.0% 100.0% The following table shows the performance of AFC's Commercial and Personal Lines insurance operations (dollars in millions): 1997 1996 1995 Net written premiums $ 507 $ 660 $ 717 Net earned premiums $ 563 $ 685 $ 698 Loss and LAE 421 538 468 Underwriting expenses 165 206 214 Policyholder dividends 11 14 11 Underwriting profit (loss) ($ 34) ($ 73) $ 5 GAAP ratios: Loss and LAE ratio 74.8% 78.5% 66.9% Underwriting expense ratio 29.2 30.0 30.6 Policyholder dividend ratio 2.0 2.1 1.6 Combined ratio (a) 106.0% 110.6% 99.1% Statutory ratios: Loss and LAE ratio 74.6% 78.8% 67.2% Underwriting expense ratio 30.2 30.4 29.9 Policyholder dividend ratio 1.6 1.0 .6 Combined ratio (a) 106.4% 110.2% 97.7% Industry statutory combined ratio (b) 101.6% 105.8% 106.5% (a) The 1996 combined ratios include 3.9 percentage points (GAAP) and 3.8 percentage points (statutory) due to losses from Hurricane Fran. (b) Ratios are derived from "BestWeek" (March 16, 1998 Edition). Marketing The Commercial and Personal Lines business units direct their sales efforts primarily toward independent agents and brokers. These businesses write insurance through more than 5,000 agents and have approximately 350,000 policies in force. Competition These businesses compete with other insurers, primarily on the basis of price (including differentiation on policy limits, coverages offered and deductibles), agent commissions and profit sharing terms. Customer service, loss prevention and reputation for claims handling are also important factors. Competitors include individual insurers and insurance groups of varying sizes, some of which are mutual insurance companies possessing competitive advantages in that all their profits inure to their policyholders. Management believes that sophisticated data analysis for refinement of risk profiles, disciplined underwriting practices and aggressive loss prevention procedures have enabled these businesses to compete on the basis of price without negatively affecting underwriting profitability. 10 Reinsurance Consistent with standard practice of most insurance companies, AFC reinsures a portion of its business with other reinsurance companies and assumes a relatively small amount of business from other insurers. Ceding reinsurance permits diversification of risks and limits the maximum loss arising from large or unusually hazardous risks or catastrophic events. 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 does not relieve AFC of its liability to its insureds. Reinsurance is provided on one of two bases, facultative or treaty. Facultative reinsurance is generally provided on a risk by risk basis. Individual risks are ceded and assumed based on an offer and acceptance of risk by each party to the transaction. Treaty reinsurance provides for risks meeting prescribed criteria to be automatically ceded and assumed according to contract provisions. In order to limit the maximum loss arising out of any one occurrence, AFC's insurance companies reinsure a portion of their exposure under treaty and facultative reinsurance programs. The following table presents (by type of coverage) the amount of each loss above the specified retention maximum generally covered by treaty reinsurance programs (in millions): Retention Reinsurance Coverage Maximum Coverage(a) California Workers' Compensation $1.5 $150.0 Other Workers' Compensation 1.0 49.0 Commercial Umbrella 1.0 49.0 Other Casualty 5.0 15.0 Property - General 5.0 25.0(b) Property - Catastrophe 20.0 130.0 (a) Reinsurance covers substantial portions of losses in excess of retention. (b) In 1997, AFC ceded 80% of its homeowners insurance coverage through a reinsurance agreement; beginning in 1998, it will cede 90%. AFC purchases facultative reinsurance providing coverage on a risk by risk basis, both pro rata and excess of loss, depending on the risk and available reinsurance markets. Due in part to the limited exposure on individual policies, the NSA Group is not materially involved in reinsuring risks with third party insurance companies. Included in the balance sheet caption "recoverables from reinsurers and prepaid reinsurance premiums" were $82 million on paid losses and LAE and $736 million on unpaid losses and LAE at December 31, 1997. The collectibility of a reinsurance balance is based upon the financial condition of a reinsurer as well as individual claim considerations. Market conditions over the past few years have forced many reinsurers into financial difficulties or liquidation proceedings. At December 31, 1997, AFC's insurance subsidiaries had allowances of approximately $78 million for doubtful collection of reinsurance recoverables, substantially all related to unpaid losses. 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's major reinsurers include American Re-Insurance Company, Employers Reinsurance Corporation, NAC Reinsurance Corporation, Mitsui Marine and Fire Insurance Company, Continental Casualty Company, Transatlantic Reinsurance Company, General Reinsurance Corporation and Vesta Fire Insurance Company. These companies have assumed nearly half of AFC's ceded reinsurance. 11 Premiums written for reinsurance ceded and assumed are presented in the following table (in millions): 1997 1996 1995 Reinsurance ceded $614 $518 $482 Reinsurance assumed - including involuntary pools and associations 89 58 98 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. Future costs of claims are projected based on historical trends adjusted for changes in underwriting standards, policy provisions, product mix and other factors. Estimating the liability for unpaid losses and LAE is inherently judgmental and is influenced by factors which are subject to significant variation. Through the use of analytical reserve development techniques, management monitors items such as the effect of inflation on medical, hospitalization, material, repair and replacement costs, general economic trends and the legal environment. Although management believes that the reserves currently established reflect a reasonable provision for the ultimate cost of all losses and claims, actual development may vary materially. AFC recognizes underwriting profit only when realization is reasonably determinable and assured. In certain specialty lines, where experience is limited or where there is potential for volatile results, AFC holds reasonable "incurred but not reported" reserves and does not recognize underwriting profit until the experience matures. Generally, reserves for reinsurance and involuntary pools and associations are reflected in AFC's results at the amounts reported by those entities. Unless otherwise indicated, the following discussion of insurance reserves includes the reserves of American Premier's subsidiaries for only those periods following the Mergers. See Note Q 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. 12 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 the Mergers. The top line of the table shows the estimated liability (in millions) for unpaid losses and LAE recorded at the balance sheet date for the indicated years. The second line shows the re-estimated liability as of December 31, 1997. The remainder of the table presents development as percentages of the estimated liability. The development results from additional information and experience in subsequent years. The middle line shows a cumulative deficiency (redundancy) which represents the aggregate percentage increase (decrease) in the liability initially estimated. The lower portion of the table indicates the cumulative amounts paid as of successive periods as a percentage of the original loss reserve liability. 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Liability for unpaid losses and loss adjustment expenses: As originally estimated $2,024 $2,209 $2,246 $2,137 $2,129 $2,123 $2,113 $2,187 $3,393 $3,404 $3,489 As re-estimated at December 31, 1997 2,482 2,531 2,520 2,337 2,247 2,178 2,089 2,185 3,342 3,435 N/A Liability re-estimated (*): One year later 102.5% 99.8% 100.4% 98.6% 99.3% 99.9% 98.2% 95.8% 98.7% 100.9% Two years later 103.6% 100.0% 99.3% 97.7% 98.7% 98.3% 94.0% 99.3% 98.5% Three years later 103.1% 99.7% 98.4% 97.4% 98.0% 95.2% 97.4% 99.9% Four years later 102.5% 98.7% 98.2% 99.2% 97.3% 100.3% 98.9% Five years later 102.6% 99.1% 101.1% 100.0% 103.0% 102.6% Six years later 103.5% 103.0% 102.7% 106.3% 105.6% Seven years later 109.4% 104.7% 109.2% 109.4% Eight years later 111.7% 111.4% 112.2% Nine years later 119.2% 114.5% Ten years later 122.6% Cumulative deficiency (redundancy) 22.6% 14.5% 12.2% 9.4% 5.6% 2.6% (1.1%) (0.1%) (1.5%) 0.9% N/A Cumulative paid as of: One year later 29.2% 29.4% 32.3% 26.1% 26.4% 26.7% 25.2% 26.8% 33.1% 33.8% Two years later 49.0% 48.6% 48.2% 43.2% 43.0% 43.7% 40.6% 42.5% 51.6% Three years later 63.5% 59.8% 59.2% 55.3% 55.4% 54.2% 50.9% 54.4% Four years later 72.2% 67.9% 67.6% 64.8% 63.3% 60.8% 59.1% Five years later 78.5% 74.0% 74.3% 71.1% 67.8% 67.0% Six years later 83.6% 79.5% 78.8% 74.5% 72.7% Seven years later 87.7% 83.2% 81.2% 78.6% Eight years later 91.1% 85.2% 84.8% Nine years later 92.7% 88.5% Ten years later 96.2% (*) Reflects significant A&E charges and reallocations in 1994 and 1996 for prior years losses. The following is a reconciliation of the net liability to the gross liability for unpaid losses and LAE. 1993 1994 1995 1996 1997 As originally estimated: Net liability shown above $2,113 $2,187 $3,393 $3,404 $3,489 Add reinsurance recoverables 611 730 704 720 736 Gross liability $2,724 $2,917 $4,097 $4,124 $4,225 As re-estimated at December 31, 1997: Net liability shown above $2,089 $2,185 $3,342 $3,435 Add reinsurance recoverables 791 782 790 748 Gross liability $2,880 $2,967 $4,132 $4,183 N/A Gross cumulative deficiency (redundancy) 5.7% 1.8% 0.9% 1.5% N/A 13 The following table presents certain data from the table above, adjusted to include reserves of American Premier's subsidiaries for periods subsequent to their entry into the insurance business in 1989 and prior to the Mergers in 1995. 1989 1990 1991 1992 1993 1994 Liability for unpaid losses and loss adjustment expenses: As originally estimated $2,616 $2,739 $2,793 $2,886 $3,029 $3,267 As re-estimated at December 31, 1997 2,831 2,873 2,848 2,824 2,871 3,138 Cumulative deficiency (redundancy) 8.2% 4.9% 2.0% (2.1%) (5.2%) (3.9%) Reconciliation of net liability to gross liability: As originally estimated: Net liability shown above $3,029 $3,267 Add reinsurance recoverables 617 742 Gross liability $3,646 $4,009 As re-estimated at December 31, 1997: Net liability shown above $2,871 $3,138 Add reinsurance recoverables 800 766 Gross liability $3,671 $3,904 Gross cumulative deficiency (redundancy) 0.6% (2.6%) 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 $80 million charge for A&E claims related to losses recorded in 1996, but incurred before 1987, 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 environmental coverage was not intended. Other factors affecting development included higher than projected inflation on medical, hospitalization, material, repair and replacement costs. Additionally, changes in the legal environment have influenced the development patterns over the past ten years. 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. Two changes influencing development patterns in the 1980s were the trend towards an adverse litigious climate and the change from contributory to comparative negligence. 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, 1997, are as follows (in millions): Liability reported on a SAP basis $3,475 Additional discounting of GAAP reserves in excess of the statutory limitation for SAP reserves (22) Reserves of foreign operations 37 Estimated salvage and subrogation recoveries based on a cash basis for SAP and on an accrual basis for GAAP (1) Reinsurance recoverables 736 Liability reported on a GAAP basis $4,225 14 Asbestos and Environmental Reserves ("A&E") In defining environmental exposures, 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 greater than those presented by other types of claims. Factors contributing to those uncertainties include a lack of sufficiently detailed historical data, long reporting delays, uncertainty as to the number and identity of insureds with potential exposure, unresolved legal issues regarding policy coverage, and the extent and timing of any such contractual liability. Courts have reached different and sometimes inconsistent conclusions as to when a loss is deemed to have occurred, what policies provide coverage, what claims are covered, whether there is an insured obligation to defend, how policy limits are determined and other policy provisions. Management believes these issues are not likely to be resolved in the near future. Significant industrywide information concerning A&E reserves first became broadly available in mid-1996 following the publication of new data relating to that subject in the 1995 Annual Statements of insurance companies. During 1995 and 1996, a number of insurers recorded large reserve increases for A&E exposures. By the end of 1995, the industry's survival ratio (reserves divided by annual paid losses) had increased from a multiple of six times in the early 1990's to more than nine times. The following table compares AFC's three-year survival ratio for A&E claims with that of the industry. December 31, Survival Ratio: 1997 1996 1995 1994 AFC 10.0 10.5 6.5 7.0 Industry(a) 7.6 8.2 9.4 7.9 (a) Source: 1996-1994 "BestWeek - Property and Casualty Supplement" (September 15, 1997 Edition); 1997 is an estimate. Industry actions and statistics in 1995 caused AFC to re- evaluate its position in relation to its peers as part of the continuing process of obtaining additional information and revising accounting estimates. This process led management to conclude that the A&E reserves should be increased sufficiently to bring AFC's three-year survival ratio in line with those of the top 50 companies. In the third quarter of 1996, AFC strengthened its A&E reserve to approximately 10.5 times average annual paid losses based upon these revised industry standards for reserving such claims. AFC recorded a non-cash, pretax charge of $80 million and reallocated $40 million in reserves from its Specialty Operations. Based on known facts, current law, and current industry practices, management believes that its reserves for such claims are appropriate. The following table (in millions) is a progression of A&E reserves. 1997 1996 1995 Reserves at beginning of year $343.4 $225.7 $224.9 Incurred losses and LAE 43.2 149.0 35.2 Paid losses and LAE (38.7) (31.3) (34.4) Reserves at end of year, net of reinsurance recoverable 347.9 343.4 225.7 Reinsurance recoverable 173.2 162.7 164.2 Gross reserves at end of year $521.1 $506.1 $389.9 Since the mid-1980's, AFC has also written certain environmental coverages (asbestos abatement and underground storage tank liability) in which the premium charged is intended to provide coverage for the specific environmental exposures inherent in these policies. The business has been profitable since its inception. To date, approximately $182 million of premiums has been written, $23 million in losses and LAE have been paid and reserves for unpaid losses and LAE aggregated $29 million at December 31, 1997 (not included in the above table). 15 Annuity and Life Operations General AFC's annuity operations are conducted through American Annuity Group ("AAG"), a holding company whose primary subsidiary is Great American Life Insurance Company ("GALIC") which it acquired from Great American in 1992. GALIC sells (i) flexible premium and single premium annuities in the qualified (not-for-profit) market and (ii) single premium annuities in the non-qualified market. AAG and its subsidiaries employ approximately 1,700 persons. Acquisitions in recent years have supplemented AAG's internal growth as the company's assets increased from $4.5 billion at year end 1992 to over $7.7 billion at year end 1997. In addition, these acquisitions have expanded AAG's focus from primarily traditional fixed annuity products to three areas: (i) retirement products (fixed and variable annuities); (ii) pre-need funding products (life insurance and fixed annuities) and (iii) other life, accident and health insurance. Premiums over the last three years were as follows (in millions): Premiums* Insurance Product 1997 1996 1995 Retirement $489 $540 $457 Pre-need Funding 111 97 - Other Life, Accident and Health 42 43 2 $642 $680 $459 ________________ (*) The table does not include premiums of subsidiaries until their first full year following acquisition. Retirement Products Annuities AAG's retirement products consist primarily of annuities, which 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 on the policy and pays out a benefit upon death, surrender or annuitization. Annuity contracts are generally classified as either fixed rate or variable. With a fixed rate annuity, the interest crediting rate is initially set by the issuer and thereafter may be changed from time to time by the issuer subject to any guaranteed minimum interest crediting rates in the policy. With a variable annuity, the value of the policy is tied to an underlying securities portfolio or underlying mutual funds. Employees of qualified not-for-profit organizations are eligible to save for retirement through contributions made on a before-tax basis. Contributions are made at the discretion of the participants through payroll deductions or through tax-free "rollovers" of funds. Federal income taxes are not payable on contributions or earnings until amounts are withdrawn. 16 GALIC entered the tax-deferred annuity business in 1976 and currently sells fixed rate annuities - both traditional and equity- indexed. The following table (in millions) presents financial information concerning GALIC. 1997 1996 1995 Statutory Basis Total Assets $5,917 $5,752 $5,414 Annuity Reserves 5,446 5,298 4,974 Capital and Surplus 317 285 273 Asset Valuation Reserve (a) 65 91 90 Interest Maintenance Reserve (a) 24 25 32 Annuity Receipts: Flexible Premium: First Year $ 32 $ 35 $ 42 Renewal 160 182 196 192 217 238 Single Premium 241 319 219 Total Annuity Receipts $ 433 $ 536 $ 457 ________________ (a) Allocation of surplus. GAAP Basis Total Assets $6,223 $5,934 $5,608 Annuity Benefits Accumulated 5,330 5,205 4,917 Stockholder's Equity 770 658 623 GALIC's principal products are Flexible Premium Deferred Annuities ("FPDAs") and Single Premium Deferred Annuities ("SPDAs"). FPDAs are characterized by premium payments that are flexible in both amount and timing as determined by the policyholder. SPDAs are issued in exchange for a one-time lump- sum premium payment. At December 31, 1997, all of GALIC's annuity reserves consisted of fixed rate annuities which offered a minimum interest rate guarantee of 3% or 4%. The majority of GALIC's annuity policies are traditional fixed rate annuities which permit GALIC to change the crediting rate at any time (subject to the minimum guaranteed interest rate). In determining the frequency and extent of changes in the crediting rate, GALIC takes into account the economic environment and the relative competitive position of its products. Over the last few years, traditional fixed rate annuities have met substantial competition from mutual funds and other equity- based investments. In response, GALIC developed an equity-indexed annuity which 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. AAG hedges the equity-based risk component of this product through the purchase of call options on the appropriate index. These options are designed to offset substantially all of the increases in the fair values of the equity-indexed annuities. Sales of equity-indexed annuities accounted for 9% of GALIC's premiums in 1997. GALIC seeks to maintain a desired spread between the yield on its investment portfolio and the rate it credits to its policies. GALIC accomplishes this by: (i) offering crediting rates which it has the option to change; (ii) designing annuity products that encourage persistency and (iii) maintaining an appropriate matching of assets and liabilities. GALIC designs its products with certain surrender penalties to discourage policyholders from surrendering or withdrawing funds during the first five to ten years after issuance of a policy. Partly due to these features, GALIC's annuity surrenders have averaged approximately 7% of statutory reserves over the past five years. 17 Marketing and Distribution Sales of fixed rate annuities are affected by many factors, including: (i) competitive annuity products and rates; (ii) the general level of interest rates; (iii) the favorable tax treatment of annuities; (iv) commissions paid to agents; (v) services offered; (vi) ratings from independent insurance rating agencies; (vii) other alternative investments and (viii) general economic conditions. At December 31, 1997, GALIC had more than 265,000 annuity policies in force. GALIC markets its FPDAs principally to employees of educational institutions in the kindergarten through high school segment. Written premiums from this market segment represented the majority of GALIC's total tax-qualified premiums in 1997. GALIC distributes its annuity products through approximately 80 managing general agents ("MGAs") who, in turn, direct over 1,000 actively producing independent agents. GALIC has developed its business on the basis of its relationships with MGAs and independent agents primarily through a consistent marketing approach and responsive service. GALIC is licensed to sell its products in all states (except New York) and in the District of Columbia. The following table reflects the geographical distribution of GALIC's annuity premiums in 1997 compared to 1993. 1997 1993 1997 1993 California 21.9% 21.8% New Jersey 3.8% 5.5% Texas 8.0 3.3 Michigan 3.4 8.5 Washington 7.6 2.4 Indiana 2.9 * Ohio 6.4 5.5 Connecticut 2.8 5.2 Florida 5.4 9.8 Iowa 2.5 * Massachusetts 5.0 8.0 Illinois 2.2 3.3 North Carolina 4.4 3.3 Rhode Island * 2.2 Minnesota 3.9 * Other 19.8 21.2 100.0% 100.0% _____________ (*) less than 2% AAG began marketing variable annuities in the fourth quarter of 1995 through Annuity Investors Life Insurance Company ("AILIC"). With a variable annuity, the earnings credited to the policy vary based on the investment results of the underlying investment options chosen by the policyholder. Policyholders may also choose to direct all or a portion of their premiums to various fixed rate options. For these annuity products, all premiums directed to the variable options are placed in funds managed by third party investment advisers. AILIC had variable annuity sales of $43 million in 1997. Pre-need Funding Products Through American Memorial Life Insurance Company, AAG offers a variety of life insurance and annuity products to finance pre- arranged funerals. In 1997, American Memorial sold its products through over 1,200 funeral homes nationwide. In addition to a general agency force of approximately 200 agents, American Memorial has approximately 800 actively-producing corporate and individual funeral home operators who sell its products. Rapid consolidation is making large chains an important segment of the funeral home industry. American Memorial is a leader in this segment, working with several of the major corporations. In 1997, about one-half of American Memorial's premiums were generated by the largest owner of funeral homes in the world. The remaining one-half was split between other funeral homes and the general agency force. As the funeral home industry continues to consolidate, increased reliance on large funeral home operators may be required. In 1997, American Memorial collected $111 million in life and annuity premiums. At December 31, 1997, American Memorial had total statutory assets of approximately $468 million; reserves for future policy benefits of approximately $424 million; and capital and surplus of approximately $26 million. 18 In March 1998, AAG acquired Arkansas National Life Insurance Company, which also specializes in pre-arranged funeral insurance products. Arkansas National had statutory assets of approximately $74 million at December 31, 1997 and 1997 premiums of $5 million. Life, Accident and Health Products AAG offers a variety of life, accident and health products through Loyal American Life Insurance Company, General Accident Life Assurance Company of Puerto Rico, Inc. and GALIC's life division, which began offering certain term, universal and whole life insurance products in December 1997. Also in 1997, Loyal relocated its home office from Mobile, Alabama to Cincinnati, Ohio to more closely coordinate its efforts with those of other AAG operations. Loyal offers a variety of supplemental life and health insurance products through payroll deduction plans and credit unions. Loyal's products are marketed with the endorsement or consent of the employer or the credit union management. The products currently being offered include traditional whole life, universal life, term life, hospital indemnity, cancer and short- term disability. In 1997, Loyal collected $40 million in life and accident and health premiums. At December 31, 1997, Loyal had total statutory assets of approximately $258 million; reserves for future policy benefits of approximately $197 million; and capital and surplus of approximately $39 million. In December 1997, AAG acquired General Accident which specializes in home service life and supplemental health products as well as credit and ordinary life products, including those utilized in the funeral industry. General Accident had statutory assets of $110 million at December 31, 1997 and 1997 premiums of $46 million (excluding premiums of certain operations sold prior to its acquisition by AAG). General Accident sells its in-home service life and supplemental health products through a network of company agents. Its ordinary life and cancer products are sold through independent agents. Independent Ratings AAG's principal insurance subsidiaries are currently rated by A.M. Best and Duff & Phelps. Such ratings are generally based on items of concern to policyholders and agents and are not directed toward the protection of investors. A.M. Best Duff & Phelps GALIC A (Excellent) AA- (Very high claims paying ability) American Memorial A- (Excellent) AA- (Very high claims paying ability) Loyal A (Excellent) AA- (Very high claims paying ability) AILIC A (Excellent) Not currently rated General Accident A (Excellent) Not currently rated In 1997, A.M. Best increased its ratings of American Memorial (up two levels) and Loyal (up one level); none of the insurance companies received a downgrade from either agency. AAG believes that the ratings assigned by independent insurance rating agencies are important because potential policyholders often use a company's rating as an initial screening device in considering annuity products. AAG believes that a rating in the "A" category by at least one rating agency is necessary for GALIC to successfully market tax-deferred annuities to public education employees and other not-for-profit groups. Although AAG believes that its insurance companies' ratings are very stable, those companies' operations could be materially adversely affected by a downgrade in ratings. 19 Competition AAG's insurance companies operate in highly competitive markets. They compete with other insurers and financial institutions based on many factors, including: (i) ratings; (ii) financial strength; (iii) reputation; (iv) service to policyholders; (v) product design (including interest rates credited and premium rates charged); (vi) commissions; and (vii) service to agents. Since policies are marketed and distributed primarily through independent agents (except at General Accident), the insurance companies must also compete for agents. AAG believes that consistently targeting the same market and emphasizing service to agents and policyholders provides a competitive advantage. No single insurer dominates the annuity marketplace. Competitors include (i) individual insurers and insurance groups, (ii) mutual funds and (iii) other financial institutions of varying sizes. In a broader sense, AAG's insurance companies compete for retirement savings with a variety of financial institutions offering a full range of financial services. Financial institutions have demonstrated a growing interest in marketing investment and savings products other than traditional deposit accounts. In addition, recent judicial and regulatory decisions have expanded powers of financial institutions in this regard. It is too early to predict what impact, if any, these developments will have on the insurance companies. Other Companies Through subsidiaries, AFC is engaged in a variety of other businesses, including The Golf Center at Kings Island (golf and tennis facility) in the Greater Cincinnati area; commercial real estate operations in Cincinnati (office buildings and The Cincinnatian Hotel), Louisiana (Le Pavillon Hotel), Massachusetts (Chatham Bars Inn), Texas (Driskill Hotel) and apartments in Florida, Kentucky, Louisiana, Minnesota, Pennsylvania, Texas and Wisconsin. These operations employ approximately 700 full-time employees. In December 1997, AFC sold the assets of its software solutions and consulting services subsidiary, Millennium Dynamics, Inc., to a subsidiary of Peritus Software Services, Inc. for $30 million in cash and 2,175,000 shares of Peritus common stock. Investment Portfolio General A breakdown of AFC's December 31, 1997, investment portfolio by business segment follows (excluding investment in equity securities of investee corporations) (in millions). Total Carrying Value Market P&C Annuity Other Total Value Cash and short-term investments $ 145 $ 51 $ 35 $ 231 $ 231 Bonds and redeemable preferred stocks 4,362 6,262 29 10,653 10,735 Other stocks, options and warrants 321 78 47 446 446 Loans receivable 101 407 5 513 513 (a) Real estate and other investments 132 58 25 215 215 (a) $5,061 $6,856 $141 $12,058 $12,140 (a) Carrying value used since market values are not readily available. 20 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. 1997 1996 1995 1994 1993 Cash and Short-term Investments 1.9% 3.5% 4.0% 2.2% 2.3% Bonds and Redeemable Preferred Stocks: U.S. Government and Agencies 5.0 4.1 3.7 4.0 2.8 State and Municipal 1.3 1.0 .7 .8 .8 Public Utilities 6.8 8.2 9.8 9.1 9.3 Mortgage-Backed Securities 21.4 22.3 20.9 21.8 24.7 Corporate and Other 50.7 49.5 47.2 48.6 42.0 Redeemable Preferred Stocks 0.6 0.5 1.0 1.4 1.3 85.8 85.6 83.3 85.7 80.9 Net Unrealized Gains (Losses) on Bonds and Redeemable Preferred Stocks held Available for Sale 2.5 1.1 2.7 (1.0) 1.8 88.3 86.7 86.0 84.7 82.7 Other Stocks, Options and Warrants 3.7 2.9 2.3 2.7 4.6 Loans Receivable 4.3 4.9 5.7 8.4 8.5 Real Estate and Other Investments 1.8 2.0 2.0 2.0 1.9 100.0% 100.0% 100.0% 100.0% 100.0% Yield on Fixed Income Securities: Excluding realized gains and losses 7.8% 7.9% 7.9% 8.1% 8.0% Including realized gains and losses 7.9% 7.7% 8.8% 8.1% 8.7% Yield on Stocks: Excluding realized gains and losses 5.6% 5.8% 3.9% 5.1% 4.4% Including realized gains and losses 30.2% 15.1% 8.4% 35.4% 16.9% Yield on Investments (*): Excluding realized gains and losses 7.8% 7.8% 7.9% 8.1% 7.9% Including realized gains and losses 8.2% 7.8% 8.8% 8.8% 9.0% (*) Excludes "Real Estate and Other Investments". Fixed Maturity Investments Unlike many insurance groups which have portfolios that are invested heavily in tax-exempt bonds, 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, 1997 (dollars in millions): NAIC Amortized Market Value Rating Comparable S&P Rating Cost Amount % 1 AAA, AA, A $ 6,970 $ 7,223 68% 2 BBB 2,624 2,714 25 Total investment grade 9,594 9,937 93 3 BB 400 417 4 4 B 330 347 3 5 CCC, CC, C 22 34 * 6 D - - - Total non-investment grade 752 798 7 Total $10,346 $10,735 100% _______________ (*) 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. 21 AFC's primary investment objective for bonds and redeemable preferred stocks is to earn interest and dividend income rather than to realize capital gains. AFC invests in bonds and redeemable preferred stocks that have primarily short-term and intermediate- term maturities. This practice allows flexibility in reacting to fluctuations of interest rates. Equity Investments AFC's equity investment practice permits concentration of attention on a relatively limited number of companies. Some of the equity investments, because of their size, may not be as readily marketable as the typical small investment position. Alternatively, a large equity position may be attractive to persons seeking to control or influence the policies of a company and AFC's concentration in a relatively small number of companies may permit it to identify investments with above average potential to increase in value. Chiquita At December 31, 1997, AFC owned 24 million shares of Chiquita common stock representing 39% of its outstanding shares. The carrying value and market value of AFC's investment in Chiquita were approximately $201 million and $391 million, respectively, at December 31, 1997. Chiquita is a leading international marketer, producer and distributor of bananas and other quality fresh and processed food products. In addition to bananas, these products include other tropical fruit and fresh produce; fruit and vegetable juices and beverages; processed fruits and vegetables; salads; and edible oil-based consumer products. Citicasters In September 1996, AFC sold its investment in Citicasters to Jacor Communications for approximately $220 million in cash plus warrants to purchase Jacor common stock. Citicasters owned radio and television stations in major markets throughout the country. 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 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 1998 from its insurance subsidiaries without seeking regulatory clearance is approximately $221 million. Changes in state insurance laws and regulations have the potential to materially affect the revenues and expenses of the insurance operations. The Company is unable to predict whether or when laws or regulations may be adopted or enacted in such states or what the impact of such developments would be on the future operations and revenues of its insurance businesses in such states. Prior to 1995, minimum premium rates for California workers' compensation insurance were determined by the California Commissioner based in part upon recommendations of the Workers' Compensation Insurance Rating Bureau of 22 California. In July 1993, California enacted legislation (the "Reform Legislation") effecting an immediate overall 7% reduction in workers' compensation insurance premium rates and replaced the workers' compensation insurance minimum rate law, effective January 1, 1995, with a procedure permitting insurers to use any rate within 30 days after its filing with the California Commissioner unless the rate is disapproved by the California Commissioner. Between December 1, 1993 and January 1, 1995, when the "open rating" policy went into effect, the California Commissioner ordered additional rate decreases totaling more than 25%. Most states have created insurance guarantee associations to provide for the payment of claims of insurance companies that become insolvent. Annual assessments for 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 approximately one percent of AFC's net written premiums in 1997. The NAIC is an organization which is comprised of the chief insurance regulator for each of the 50 states and the District of Columbia. In 1990, the NAIC began an accreditation program to ensure that states have adequate procedures in place for effective insurance regulation, especially with respect to financial solvency. The accreditation program requires that a state meet specific minimum standards in over 15 regulatory areas to be considered for accreditation. The accreditation program is an ongoing process and once accredited, a state must enact any new or modified standards approved by the NAIC within two years following adoption. As of December 31, 1997, the District of Columbia and 48 states were accredited including states which regulate AFC's largest insurance subsidiaries. The NAIC model law for Risk Based Capital applies to both life and property and casualty companies. The risk-based capital formulas determine the amount of capital that an insurance company needs to ensure that it has an acceptably low expectation of becoming financially impaired. The model law provides for increasing levels of regulatory intervention as the ratio of an insurer's total adjusted capital and surplus decreases relative to its risk-based capital, culminating with mandatory control of the operations of the insurer by the domiciliary insurance department at the so-called "mandatory control level". At December 31, 1997, the capital ratios of all AFC insurance companies substantially exceeded the risk- based capital requirements. 23 ITEM 2 Properties Subsidiaries of AFC own several buildings in downtown Cincinnati. AFC and its affiliates occupy about three-fifths of the aggregate 650,000 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 GAI's and AAG's home offices in Cincinnati. Two AAG subsidiaries own office buildings in Rapid City, South Dakota and Mobile, Alabama. The office building in Rapid City contains about 52,000 square feet, approximately three- fourths of which is utilized for company purposes. The building in Mobile is being marketed for sale or lease; one-fifth of its 82,000 square feet is company occupied. AFC subsidiaries own transferable rights to develop approximately one million 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. ITEM 3 Legal Proceedings AFC and its subsidiaries are involved in various litigation, most of which arose in the ordinary course of business. Except for the following, management believes that none of the litigation meets the threshold for disclosure under this Item. In May 1994, lawsuits were filed against American Premier by USX Corporation ("USX") and its former subsidiary, Bessemer and Lake Erie Railroad Company ("B&LE"), seeking contribution by American Premier, as the successor to the railroad business conducted by Penn Central Transportation Company ("PCTC") prior to 1976, for all or a portion of the approximately $600 million that USX paid in satisfaction of a judgment against B&LE for its participation in an unlawful antitrust conspiracy among certain railroads commencing in the 1950's and continuing through the 1970's. The lawsuits argue that USX's liability for that payment was attributable to PCTC's alleged activities in furtherance of the conspiracy. On October 13, 1994, the U.S. District Court for the Eastern district of Pennsylvania enjoined USX and B&LE from continuing their lawsuits against American Premier, ruling that their claims are barred by the 1978 Consummation Order issued by that Court in PCTC's bankruptcy reorganization proceedings. USX and B&LE appealed the District Court's ruling to the U.S. Court of Appeals for the Third Circuit. On December 13, 1995, the Court of Appeals reversed the U.S. District Court decision. In its opinion, the Court of Appeals only addressed American Premier's procedural argument that the claims of USX could not proceed because they are barred by the Consummation Order. The Third Circuit expressly recognized in its opinion that it was not deciding any of American Premier's defenses on the merits. In January 1996, American Premier filed a petition for rehearing en banc, which requests all of the judges of the Third Circuit to review the three-judge panel's decision. That petition was denied in February 1996. In May 1996, the U.S. Supreme Court declined to hear American Premier's petition with respect to the bankruptcy bar issue, thereby permitting USX's lawsuits to proceed. American Premier and its outside counsel believe that American Premier has substantial defenses to these lawsuits, besides the bankruptcy bar issue, and should not suffer a material loss as a result of this litigation. 24 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 PCTC and at certain other sites where hazardous waste allegedly generated by PCTC's railroad 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 previously established loss accruals for potential pre- reorganization environmental liabilities at such sites are adequate to cover the probable amount of such liabilities, based on American Premier's estimates of remediation costs and related expenses at such sites 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 intends to seek reimbursement from certain insurers for portions of whatever remediation costs it incurs. In terms of potential liability to American Premier, the company believes that the most significant such site is the railyard at Paoli, Pennsylvania ("Paoli Yard") which PCTC transferred to Consolidated Rail Corporation ("Conrail") in 1976. A Record of Decision issued by the U.S. Environmental Protection Agency in 1992 presented a final selected remedial action for clean-up of polychlorinated biphenyls ("PCB's") at Paoli Yard having an estimated cost of approximately $28 million. American Premier has accrued its portion of such estimated clean-up costs in its financial statements (in addition to other expenses) but has not accrued the entire amount because it believes it is probable that other parties, including Conrail, will be responsible for substantial percentages of the clean-up costs by virtue of their operation of electrified railroad cars at Paoli Yard that discharged PCB's at higher levels than discharged by cars operated by PCTC. In management's opinion, the outcome of the foregoing environmental claims and contingencies will not, individually or in the aggregate, have a material adverse effect on the financial condition of American Premier. In making this assessment, management has taken into account previously established loss accruals in its financial statements and probable recoveries from third parties. 25 ITEM 4 Submission of Matters to a Vote of Security Holders At a Special Meeting of AFC's Shareholders on December 2, 1997, two matters were voted upon: (Item 1) a plan of reorganization pursuant to which all Series F and G Preferred Stock was retired in exchange for Series J Preferred Stock and/or cash, and (Item 2) election of eleven directors. With respect to Item 1, votes cast were as follows: 56,129,555 - For; 335,927 - Against; and 1,352,202 - Abstain or Broker Non-Vote. The votes cast for, or withheld with respect to Item 2 are set forth below: Name For Withheld Theodore H. Emmerich 57,745,234 72,450 James E. Evans 57,745,258 72,426 Thomas M. Hunt 57,745,234 72,450 Carl H. Lindner 57,743,934 73,750 Carl H. Lindner III 57,743,756 73,928 Keith E. Lindner 57,743,756 73,928 S. Craig Lindner 57,743,756 73,928 William R. Martin 57,745,234 72,450 Alfred W. Martinelli 57,745,634 72,050 Gregory C. Thomas 57,745,658 72,026 William W. Verity 57,745,658 72,026 26 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 the Consolidated Financial Statements for information regarding dividends. ITEM 6 Selected Financial Data The following table sets forth certain data for the periods indicated (dollars in millions). 1997 1996 1995 1994 1993 Earnings Statement Data: Total Revenues $ 4,053 $ 4,114 $ 3,628 $ 2,104 $ 2,721 Earnings Before Income Taxes and Extraordinary Items 334 340 252 44 262 Earnings Before Extraordinary Items 208 250 195 19 225 Extraordinary Items (7) (28) 2 (17) (5) Net Earnings 201 222 197 2 220 Ratio of Earnings to Fixed Charges (a) 4.20 4.99 3.10 1.69 2.62 Ratio of Earnings to Fixed Charges and Preferred Dividends (a) 3.52 3.96 2.60 1.40 2.26 Balance Sheet Data: Total Assets $15,738 $14,999 $14,851 $10,593 $10,077 Long-term Debt: Holding Companies 287 340 648 849 771 Subsidiaries 194 178 234 258 283 Minority Interest 510 307 327 106 109 Capital Subject to Mandatory Redemption - - - 3 49 Other Capital 1,393 1,277 1,248 396 537 (a) 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 deducting (adding) the undistributed equity in earnings (losses) of investees. Fixed charges include interest (excluding interest on annuity benefits), 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. 27 ITEM 7 Management's Discussion and Analysis of Financial Condition and Results of Operations GENERAL Following is a discussion and analysis of the financial statements and other statistical data that management believes will enhance the understanding of AFC's financial condition and results of operations. This discussion should be read in conjunction with the financial statements beginning on page F-1. As discussed in Note A to the financial statements, at the close of business on December 31, 1996, AFG contributed to AFC 81% of the common stock of American Premier. Since AFC and American Premier are under the common control of AFG, the acquisition of American Premier has been recorded by AFC at AFG's historical cost in a manner similar to a pooling of interests. Accordingly, the historical consolidated financial statements of AFC for periods subsequent to the April 3, 1995 Mergers have been restated to include the accounts of American Premier. LIQUIDITY AND CAPITAL RESOURCES Ratios AFC's debt to total capital ratio at the parent holding company level (excluding amounts due AFG) improved from nearly 60% at the date of the Mergers to approximately 17% at December 31, 1997. Including amounts due AFG, the ratio was 31% at the end of 1997. AFC's ratio of earnings to fixed charges, excluding and including preferred dividends, on a total enterprise basis for the three years ended December 31, 1997, are shown below. 1997 1996 1995 Earnings to fixed charges 4.20 4.99 3.10 Earnings to fixed charges plus preferred dividends 3.52 3.96 2.60 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, 1997, the capital ratios of all AFC insurance companies substantially exceeded the RBC requirements (the lowest capital ratio of any AFC subsidiary was 3.5 times its authorized control level RBC; weighted average of all AFC subsidiaries was 5.2 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, and shareholder dividends. 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 through operations in the short-term and long-term future. If funds generated from operations, including dividends from subsidiaries, are insufficient to meet fixed charges in any period, AFC would be required to generate cash through borrowings, sales of securities or other assets, or similar transactions. 28 Prior to the Mergers, American Premier had substantial cash and short- term investments at the parent company level. Subsequent to the Mergers, AFC and two of its subsidiaries entered into separate credit agreements with American Premier. Funds borrowed from American Premier under these agreements were used for debt retirements, capital contributions to subsidiaries, and other corporate purposes. In December 1996, American Premier paid a dividend to AFG in the form of a $675 million note receivable from AFC under the credit agreement plus $18.7 million of related accrued interest. AFG then contributed $450 million of the note (without accrued interest) to the capital of AFC. Subsequent to the Mergers, American Premier entered into a credit agreement with AFG under which American Premier and AFG made loans of up to $250 million available to each other. The AFC and APU credit agreements with AFG were replaced in December 1997 with a reciprocal Master Credit Agreement among the various AFG holding companies under which funds are made available to each other for general corporate purposes. Amounts due AFG under the above agreements were $377 million and $401 million at December 31, 1997 and 1996, respectively. In 1996, three nationally recognized rating agencies issued or upgraded ratings on AFC, American Premier and AAG public debentures. All of the AFC and AAG senior debentures are now rated investment grade; the APU and AAG subordinated debentures are rated investment grade by two of the agencies. Generally, the upgrades reflect the expectation that AFC's consolidated debt to total capital will remain conservative and that coverage ratios will benefit from higher subsidiary earnings and a lower level of fixed charges at AFG's subsidiaries. A new five-year, $300 million bank credit line was established by AFC in February 1998 replacing two subsidiary holding company lines. The new credit line provides ample liquidity and can be used to obtain funds for operating subsidiaries or, if necessary, for the parent companies. At December 31, 1997, there was $45 million borrowed under the two holding company lines. In the past, funds have been borrowed under bank facilities and used for working capital, capital infusions into subsidiaries, and to retire other issues of short-term or high- rate debt and preferred stock. Also, AFC believes it may be prudent and advisable to utilize portions of the bank debt in the normal course over the next year or two. In 1996 and 1997, wholly-owned trust subsidiaries of AAG sold preferred securities for cash proceeds totaling $225 million. Proceeds were used to retire outstanding debt and AAG preferred stock and for general corporate purposes, including a capital contribution to a subsidiary. Payments of dividends by AFC's insurance subsidiaries are subject to various laws and regulations which limit the amount of dividends that can be paid without regulatory approval. Under Ohio law, the maximum amount of dividends which may be paid without (i) prior approval or (ii) expiration of a 30 day waiting period without disapproval is the greater of statutory net income or 10% of policyholders' surplus as of the preceding December 31, but only to the extent of earned surplus as of the preceding December 31. The maximum amount of dividends payable (without prior approval) to AFC in 1998 from its insurance subsidiaries is approximately $221 million. For statutory accounting purposes, equity securities are generally carried at market value. At December 31, 1997, AFC's insurance companies owned publicly traded equity securities with a market value of $1.5 billion, including equity securities of AFC affiliates (including subsidiaries) of $1.1 billion. Since significant amounts of these are concentrated in a relatively small number of companies, decreases in the market prices could adversely affect the insurance group's capital, potentially impacting the amount of dividends available or necessitating a capital contribution. Conversely, increases in the market prices could have a favorable impact on the group's dividend-paying capability. 29 Beginning with the 1997 federal tax return, American Premier will join AFC's consolidated return. 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. Uncertainties Two lawsuits were filed in 1994 against American Premier by USX Corporation ("USX") and a former USX subsidiary. The lawsuits seek contribution from American Premier for all or a portion of a $600 million final antitrust judgment entered against a USX subsidiary in 1994. The lawsuits argue that USX's liability for that judgment is attributable to the alleged activities of American Premier's predecessor in an unlawful antitrust conspiracy among certain railroad companies. American Premier and its outside counsel believe that American Premier has substantial defenses and should not suffer a material loss as a result of this litigation. Great American's liability for unpaid losses and loss adjustment expenses includes amounts for various liability coverages related to environmental, hazardous product and other mass tort claims. At December 31, 1997, Great American had recorded $348 million (net of reinsurance recoverables of $173 million) for such claims on policies written many years ago where, in most cases, coverage was never intended. Due to inconsistent court decisions on many coverage issues and the difficulty in determining standards acceptable for cleaning up pollution sites, significant uncertainties exist which are not likely to be resolved in the near future. AFC's subsidiaries are parties in a number of proceedings relating to former operations. See Note O to the financial statements. Most businesses utilizing computing technology are facing a problem with the year 2000. The Year 2000 problem is caused by the widespread use of computer programs that lack the ability to properly interpret two-digit codes representing the year 2000 and beyond. This program flaw can cause computation errors, faulty information processing and reporting and, in some instances, complete shutdown of critical applications. During the early 1990's Great American designed and developed software to automate the Year 2000 conversion process. In 1995 Great American formed Millennium Dynamics, Inc. ("MDI") to publicly market its software and consultative services worldwide. In connection with the sale of MDI in the fourth quarter of 1997, AFC retained licenses to utilize MDI's software internally. Each segment of AFC's operations is comprised of multiple business units most of which utilize stand-alone computer programs. These businesses are in the process of either (i) modifying their programs utilizing the MDI software along with other internal and external resources or (ii) replacing programs with new software that is Year 2000 compliant. AFC's goal is to have program modifications and new software installations substantially completed by the end of 1998. A significant portion of AFC's Year 2000 project will be completed using internal staff. Incremental Year 2000 costs are not expected to have a material effect on AFC's financial statements. Projected Year 2000 costs and completion dates are based on management's best estimate. However, there can be no assurance that these estimates will be achieved. Factors such as the availability of trained personnel could affect the successful completion of the project. Should software modifications and new software installation not be completed on a timely basis, the resulting disruptions could have a material adverse impact on operations. 30 AFC's operations could also be affected by the inability of third parties such as agents and vendors to successfully become Year 2000 compliant. In addition, AFC's property and casualty insurance operations are reviewing policy forms and amendatory endorsements and examining coverage issues for Year 2000 exposures. Management believes that these issues will not have a material impact on AFC's financial statements. While the results of all such uncertainties cannot be predicted, based upon its knowledge of the facts, circumstances and applicable laws, management believes that sufficient reserves have been provided. Investments Approximately 70% of AFC's consolidated assets are invested in marketable securities. A diverse portfolio of primarily publicly traded bonds and notes accounts for 95% of these securities. 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 short-term and intermediate-term maturities with an objective of optimizing total return while allowing flexibility to react to changes in market conditions. At December 31, 1997, the average life of AFC's bonds and redeemable preferred stocks was just over 6 years. Approximately 93% of the bonds and redeemable preferred stocks held by AFC were rated "investment grade" (credit rating of AAA to BBB) by nationally recognized rating agencies at December 31, 1997. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated and non-investment grade. Management believes that the high quality investment portfolio should generate a stable and predictable investment return. Investments in mortgage-backed securities ("MBSs") represented approximately one-fourth of AFC's bonds and redeemable preferred stocks at December 31, 1997. AFC invests primarily in MBSs which have a reduced risk of prepayment. In addition, the majority of MBSs held by AFC were purchased at a discount. Management believes that the structure and discounted nature of the MBSs will mitigate the effect of prepayments on earnings over the anticipated life of the MBSs portfolio. More than 90% of AFC's MBSs are rated "AAA" with substantially all being of investment grade quality. The market in which these securities trade is highly liquid. Aside from interest rate risk, AFC does not believe a material risk (relative to earnings or liquidity) is inherent in holding such investments. Because most income of the property and casualty insurance subsidiaries has been sheltered from income taxes through 1997, non-taxable municipal bonds represent only a small portion (less than 1%) of the portfolio. AFC's equity securities are concentrated in a relatively limited number of major positions. This approach allows management to more closely monitor the companies and industries in which they operate. Prior to the Mergers, the realization of capital gains, primarily through sales of equity securities, was an integral part of AFC's investment program. Individual securities are sold creating gains or losses as market opportunities exist. Pretax capital gains recognized upon disposition of securities, including investees, during the past five years have been: 1997 - $57 million; 1996 - $166 million; 1995 - $84 million; 1994 - $50 million and 1993 - $165 million. At December 31, 1997, the net unrealized gain on AFC's bonds and redeemable preferred stocks was $389 million; the net unrealized gain on equity securities was $293 million. 31 RESULTS OF OPERATIONS - THREE YEARS ENDED DECEMBER 31, 1997 General As previously noted, financial statements for periods subsequent to the April 1995 Mergers include the accounts of American Premier. AFC had accounted for American Premier as an investee from the second quarter of 1993 through the first quarter of 1995. Accordingly, income statement components for 1997 and 1996 are not comparable to prior years. Pretax earnings before extraordinary items were $334 million in 1997, $340 million in 1996 and $252 million in 1995. Results for 1997 include $91 million in pretax gains primarily on the sales of affiliates and other securities, and reflect declines of $41 million in underwriting results in AFC's property and casualty insurance business. Results for 1996 include $203 million in pretax gains primarily on the sales of Citicasters and Buckeye Management Company, reduced by a charge of $80 million resulting from a decision to strengthen insurance reserves relating to asbestos and other environmental matters ("A&E"). In addition to the earnings contribution resulting from the Mergers, results for 1995 include $84 million in pretax gains on the sale of securities. Property and Casualty Insurance - Underwriting AFC manages and operates its property and casualty business as three major sectors. The nonstandard automobile insurance companies (the "NSA Group") insure risks not typically accepted for standard automobile coverage because of the applicant's driving record, type of vehicle, age or other criteria. The specialty lines are a diversified group of over twenty-five business lines that offer a wide variety of specialty insurance products. Some of the more significant areas are California workers' compensation, executive liability, inland and ocean marine, U.S.-based operations of Japanese companies, agricultural- related coverages, non-profit liability, general aviation coverages, fidelity and surety bonds, and umbrella and excess. The commercial and personal lines provide coverages in worker's compensation, commercial multi-peril, umbrella and commercial automobile, standard private passenger automobile and homeowners insurance. To understand the overall profitability of particular lines, the timing of claims payments and the related impact of investment income must be considered. Certain "short-tail" lines of business (primarily property coverages) have quick loss payouts which reduce the time funds are held, thereby limiting investment income earned thereon. On the other hand, "long-tail" lines of business (primarily liability coverages and workers' compensation) have payouts that are either structured over many years or take many years to settle, thereby significantly increasing investment income earned on related premiums received. Underwriting profitability is measured by the combined ratio which is a sum of the ratios of underwriting losses, loss adjustment expenses, underwriting expenses and policyholder dividends to premiums. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income, other income or federal income taxes. For certain lines of business and products where the credibility of the range of loss projections is less certain (primarily the various specialty lines listed above), management believes that it is prudent and appropriate to use conservative assumptions until such time as the data, experience and projections have more credibility, as evidenced by data volume, consistency and maturity of the data. While this practice mitigates the risk of adverse development on this business, it does not eliminate it. 32 While AFC desires and seeks to earn an underwriting profit on all of its business, it is not always possible to do so. As a result, AFC attempts to expand in the most profitable areas and control growth or even reduce its involvement in the least profitable ones. In 1997, underwriting results of AFC's insurance operations outperformed the industry average for the twelfth consecutive year. AFC's insurance operations have been able to exceed the industry's results by focusing on growth opportunities in the more profitable areas of the specialty lines and nonstandard auto businesses. Comparisons made in the following discussion of AFC's insurance operations include American Premier's insurance operations even though they were not consolidated in the financial statements prior to the Mergers. Net written premiums and combined ratios for AFC's property and casualty insurance subsidiaries were as follows (dollars in millions): 1997 1996 1995 Net Written Premiums (GAAP) NSA Group $1,248 $1,135 $1,277 Specialty Operations 1,103 993 1,097 Commercial and Personal Operations 507 660 717 Other Lines - - 1 $2,858 $2,788 $3,092 Combined Ratios (GAAP) NSA Group 97.2% 99.9% 105.2% Specialty Operations 99.0 84.1 94.8 Commercial and Personal Operations 106.0 110.6 99.1 Aggregate (including A&E and other lines) 101.4 102.9 101.2 Operating results for 1996 were adversely impacted by two unusual items: (i) higher than normal catastrophe losses including approximately $30 million in losses due to Hurricane Fran and (ii) increases in A&E reserves (exposures for which AFC may be liable under general liability policies written years ago). A standard insurance measure used in analyzing the adequacy of A&E reserves is the "survival ratio" (reserves divided by three-year average annual paid losses). Due in part to the greater uncertainties inherent in estimating A&E claims, management evaluates its survival ratio in relation to those published for the industry. Based primarily on industry survival ratios published in mid-1996, AFC increased A&E reserves of its discontinued insurance lines by $120 million by recording a third quarter, non-cash pretax charge of $80 million and reallocating $40 million, or approximately 2%, of reserves from its Specialty Operations. Reserves for unpaid losses and loss adjustment expenses of the Specialty Lines were approximately $2.0 billion, $2.1 billion and $2.2 billion at December 31, 1997, 1996 and 1995, respectively. A&E reserves at December 31, 1997, were approximately $348 million, an amount equal to approximately 10 times the preceding three years' average claim payments. NSA Group The NSA Group's 10% increase in net written premiums during 1997 is due primarily to volume increases in California resulting from enactment of legislation which requires drivers to provide proof of insurance in order to obtain a valid permit. During 1995 and early 1996, the NSA Group implemented premium rate increased in various states. In 1996, the higher rate levels along with competitive pressures in the nonstandard automobile insurance industry resulted in an 11% decline in net written premiums. These rate increases contributed to the improvement in combined ratio in 1997 and 1996. 33 Specialty Operations Net written premiums for the specialty operations increased 11% in 1997 due primarily to premiums recorded by a newly acquired aviation division and the return of premiums in 1996 related to the withdrawal from a voluntary pool. The specialty operations had profitable underwriting results for 1997 despite a significant decline in the results of AFC's California workers' compensation business relating to (i) deteriorating underwriting margins on business written in 1996 and 1997 and (ii) reserve reductions in 1996 primarily for business written prior to 1995 in response to fundamental changes in the California workers' compensation market and actuarial evaluations. The specialty lines combined ratio was unusually low in 1996 due primarily to the reallocation of $40 million in reserves to A&E reserves (a combined ratio impact of 4.1 percentage points) and the 1996 reductions in California workers' compensation reserves mentioned above. Net written premiums for the specialty operations declined 9% during 1996 due primarily to a decrease in the California workers' compensation business and withdrawal from an unprofitable pool at the end of 1995, partially offset by increases in other specialty niche lines. The decline in California workers' compensation premiums reflects (i) extremely competitive pricing in the marketplace as a result of the repeal of the California workers' compensation minimum rate law effective January 1, 1995 and (ii) the impact of mandatory premium rate reductions which took effect a year earlier. Excluding the impact of the decreases in the California workers' compensation business and the withdrawal from the voluntary pool, specialty net written premiums increased $16 million (2%) in 1996. The increase is due in part to increases in specialized coverages for fidelity and surety bonds, executive liability, animal mortality and collateral protection exposures. Commercial and Personal Operations Net written premiums for the commercial and personal operations decreased 23% in 1997 due primarily to a reinsurance agreement, effective January 1, 1997, under which 80% of all AFC's homeowners' business was reinsured, and reduced writings of personal automobile coverages in certain states. Excluding the impact of the reinsurance agreement, premiums decreased 10%. Even though underwriting results for 1997 were impacted by several current year commercial casualty losses as well as adverse development in certain prior year claims, improvements in personal lines contributed to a lower combined ratio. Net written premiums for the commercial and personal operations decreased 8% in 1996. The decrease is due primarily to significant reductions in homeowners coverages in certain states as well as competitive pricing conditions in the commercial casualty market, partially offset by increases in writings of workers' compensation coverages. The profitability of the commercial and personal operations declined in 1996 due primarily to deterioration in personal lines operations as well as weather-related losses, including losses from Hurricane Fran. Life, Accident and Health Premiums and Benefits Life, accident and health premiums and benefits increased in 1997 due primarily to an increase in pre-need life insurance sales through the largest owner of funeral homes in the world. The increase in life, accident and health premiums and expenses in 1996 reflects AAG's acquisition of American Memorial and Loyal. Investment Income Changes in investment income reflect fluctuations in market rates and changes in average invested assets. 1997 compared to 1996 Investment income increased $23.4 million (3%) from 1996 due primarily to an increase in the average amount of investments held partially offset by lower interest rates available in the marketplace. 34 1996 compared to 1995 Investment income increased $96 million (13%) from 1995; adjusting for the effects of the Mergers retroactively to January 1, 1995, investment income increased $55 million (7%) from 1995 due primarily to an increase in the average amount of investments held. Investee Corporations Equity in net earnings of investee corporations (companies in which AFC owns a significant portion of the voting stock) represents AFC's proportionate share of the investees' earnings and losses. 1997 compared to 1996 AFC recorded equity in net losses of investee corporations of $5.6 million in 1997 and $17 million in 1996. Chiquita's loss attributable to common shareholders was $17 million for 1997; results were adversely affected by a stronger dollar in relation to major European currencies (mitigated in part by the company's foreign currency hedging program) and by increased banana production costs resulting primarily from widespread flooding in 1996. These factors more than offset the benefit of higher local currency banana pricing in Europe during the second half of the year. For 1996, the loss attributable to common shareholders was $63 million and included pretax writedowns and costs of $70 million resulting from (i) industry-wide flooding in Costa Rica, Guatemala and Honduras, (ii) certain strategic undertakings designed to achieve further long-term reductions in the delivered product cost of Chiquita bananas and (iii) certain claims relating to prior European Union quota restructuring actions. 1996 compared to 1995 AFC's equity in net earnings of investee corporations decreased $32 million in 1996 compared to 1995. Chiquita reported a decrease in earnings attributable to common shareholders of $63 million in 1996 due primarily to the pretax writedowns and costs of $70 million mentioned above. Earnings attributable to common shareholders for 1995 were $946,000 and included a pretax gain of $19 million primarily resulting from divestitures of operations and other actions taken as part of the company's ongoing program to improve shareholder value. These divestitures and other actions included sales of older ships, the sale of Chiquita's Costa Rican edible oils operations, the shut-down of a portion of Chiquita's juice operations and the reconfiguration of banana production assets. Gains on Sales of Investees The gain on sale of investee in 1997 represents a pretax gain to AFC as a result of Chiquita's public issuance of 4.6 million shares of its common stock. The gain on sale of investee in 1996 represents a pretax gain, before $6.5 million of minority interest, on the sale of Citicasters common stock. Gains on Sales of Subsidiaries The gains on sales of subsidiaries in 1997 include (i) a pretax gain of $49.9 million on the sale of MDI and (ii) a charge of $17 million relating to operations expected to be sold or otherwise disposed of in 1998. The gains on sales of subsidiaries in 1996 include a pretax gain of $33.9 million on the sale of Buckeye Management Company and the settlement of litigation related to a subsidiary sold in 1993. Other Income Other income increased $18.0 million (13%) in 1997 compared to 1996 due primarily to income of $46.3 million from the sale of development rights in New York City (including $32.5 million on rights sold to AFG), partially offset by the absence of revenues from a non-insurance subsidiary which was sold in the first quarter of 1997. Annuity Benefits For GAAP financial reporting purposes, annuity receipts are accounted for as interest-bearing deposits ("annuity benefits accumulated") rather than as revenues. Under these contracts, policyholders' funds are credited with interest on a tax-deferred basis until withdrawn by the policyholder. Annuity benefits represent primarily interest related to annuity policyholders' funds held. The rate at which AAG credits interest on most of its annuity policyholders' funds is subject to change based on management's judgment of market conditions. 35 Fixed annuity receipts totaled approximately $490 million in 1997, $570 million in 1996 and $460 million in 1995. Annuity receipts increased each year from 1993 through 1996 due primarily to sales of newly introduced single premium products and, in 1995, the development of new distribution channels. Annuity receipts in 1997 reflect the decrease of business written by a single agency from $99 million in 1996 to $23 million in 1997. AAG is no longer writing business through this agency. Annuity benefits increased $7 million (3%) in 1997 and $17.2 million (7%) in 1996 due primarily to an increase in average annuity benefits accumulated partially offset by decreases in crediting rates on AAG's fixed rate annuities. Interest on Borrowed Money Changes in interest expense result from fluctuations in market rates as well as changes in borrowings. AFC has generally financed its borrowings on a long-term basis which has resulted in higher current costs. 1997 compared to 1996 Interest expense increased $1.0 million (1%) from 1996. The increase reflects increased borrowings from AFG, partially offset by the effect of significant debt reductions during 1996. 1996 compared to 1995 Interest expense for 1996 was $86.1 million and interest expense for 1995, adjusted to reflect the effect of the Mergers retroactively to January 1, 1995, was $116.3 million. The $30 million (26%) decrease reflects significant debt retirements during both 1995 and 1996. Minority Interest Expense Minority interest expense represents the interests of AFG (parent) and non-controlling shareholders of AFC subsidiaries in the earnings of those subsidiaries as well as accrued distributions on trust preferred securities. Minority interest expense for 1996 includes $6.5 million related to the sale of Citicasters shares held by AFEI. Other Operating and General Expenses Operating and general expenses in 1997 include third quarter charges of $5.5 million relating to an arbitration settlement and $4.0 million relating to relocating a subsidiary's operations to Cincinnati. These charges were more than offset by a reduction caused by the absence of expenses from a non-insurance subsidiary which was sold in the first quarter of 1997. Income Taxes See Note M to the Financial Statements for an analysis of items affecting AFC's effective tax rate. New Accounting Standards to be Implemented During 1997, the Financial Accounting Standards Board issued the following Statement of Financial Accounting Standards ("SFAS"); the implementation of these standards will not have a significant effect on AFC's financial position or results of operations. SFAS # Subject of Standard Period to be Implemented 130 Comprehensive Income 1st quarter of 1998 131 Segment Information 4th quarter of 1998 SFAS No. 130 establishes standards for the reporting of a company's change in equity during the period from non-owner sources. For AFC, comprehensive income will principally consist of net income and the change in net unrealized gains on marketable securities. SFAS No. 131 establishes standards for the way companies report information about operating segments, products and services, geographic areas and major customers. Implementation of these standards will not have a significant effect on AFC's financial position, net income or reported segments. 36 ITEM 8 Financial Statements and Supplementary Data Page Report of Independent Auditors F-1 Consolidated Balance Sheet: December 31, 1997 and 1996 F-2 Consolidated Statement of Earnings: Years ended December 31, 1997, 1996 and 1995 F-3 Consolidated Statement of Changes in Shareholders' Equity: Years ended December 31, 1997, 1996 and 1995 F-4 Consolidated Statement of Cash Flows: Years ended December 31, 1997, 1996 and 1995 F-5 Notes to Consolidated Financial Statements F-6 "Selected Quarterly Financial Data" has been included in Note P to the Consolidated Financial Statements. _______________________________________________ PART III The information required by the following Items will be included in AFC's definitive Proxy Statement for the 1998 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission within 120 days after the end of Registrant's fiscal year and is incorporated herein by reference. ITEM 10 Directors and Executive Officers of the Registrant ITEM 11 Executive Compensation ITEM 12 Security Ownership of Certain Beneficial Owners and Management ITEM 13 Certain Relationships and Related Transactions 37 REPORT OF INDEPENDENT AUDITORS Board of Directors American Financial Corporation We have audited the accompanying consolidated balance sheet of American Financial Corporation and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of earnings, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Financial Corporation and subsidiaries at December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG LLP Cincinnati, Ohio March 6, 1998 F-1 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (In Thousands) December 31, 1997 1996 Assets: Cash and short-term investments $ 231,227 $ 404,831 Investments: Bonds and redeemable preferred stocks: Held to maturity - at amortized cost (market - $3,202,300 and $3,528,100) 3,120,106 3,491,126 Available for sale - at market (amortized cost - $7,225,736 and $6,362,597) 7,532,836 6,494,597 Other stocks - principally at market (cost - $153,322 and $142,364) 446,222 327,664 Investment in investee corporations 200,714 199,651 Loans receivable 512,608 568,055 Real estate and other investments 215,472 205,021 Total investments 12,027,958 11,286,114 Recoverables from reinsurers and prepaid reinsurance premiums 998,743 942,450 Agents' balances and premiums receivable 691,005 609,403 Deferred acquisition costs 521,898 452,041 Other receivables 261,454 272,766 Deferred tax asset 41,413 137,284 Assets held in separate accounts 300,491 247,579 Prepaid expenses, deferred charges and other assets 364,385 368,114 Cost in excess of net assets acquired 299,408 278,581 $15,737,982 $14,999,163 Liabilities and Shareholders' Equity: Unpaid losses and loss adjustment expenses $ 4,225,336 $ 4,123,701 Unearned premiums 1,328,910 1,247,806 Annuity benefits accumulated 5,528,111 5,365,612 Life, accident and health reserves 709,899 575,380 Payable to American Financial Group, Inc. 352,766 422,015 Other long-term debt: Holding companies 286,661 339,504 Subsidiaries 194,084 178,415 Liabilities related to separate accounts 300,491 247,579 Accounts payable, accrued expenses and other liabilities 908,622 915,398 Total liabilities 13,834,880 13,415,410 Minority interest 509,619 306,858 Shareholders' Equity: Preferred Stock (liquidation value - $72,154 and $258,638) 72,154 162,760 Common Stock, no par value - 20,000,000 and 53,500,000 shares authorized - 10,593,000 and 45,000,000 shares outstanding 9,625 9,625 Capital surplus 936,154 919,746 Retained earnings 34,350 1,364 Net unrealized gain on marketable securities, net of deferred income taxes 341,200 183,400 Total shareholders' equity 1,393,483 1,276,895 $15,737,982 $14,999,163 See notes to consolidated financial statements. F-2 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS (In Thousands) Year ended December 31, 1997 1996 1995 Income: Property and casualty insurance premiums $2,824,381 $2,844,512 $2,648,703 Life, accident and health premiums 121,506 103,552 15,691 Investment income 868,689 845,330 749,510 Equity in net earnings (losses) of investees (5,564) (16,955) 15,237 Realized gains (losses) on sales of securities 46,006 (3,470) 84,028 Gains on sales of investees 11,428 169,138 335 Gains on sales of subsidiaries 33,602 36,837 - Other income 152,854 134,904 114,602 4,052,902 4,113,848 3,628,106 Costs and Expenses: Property and casualty insurance: Losses and loss adjustment expenses 2,075,616 2,131,421 1,977,395 Commissions and other underwriting expenses 790,324 793,800 707,340 Annuity benefits 278,829 271,821 254,650 Life, accident and health benefits 110,082 92,315 13,202 Interest charges on borrowed money 87,155 86,148 122,568 Minority interest expense 45,477 54,748 28,165 Other operating and general expenses 331,655 344,052 272,888 3,719,138 3,774,305 3,376,208 Earnings before income taxes and extraordinary items 333,764 339,543 251,898 Provision for income taxes 125,227 89,658 56,447 Earnings before extraordinary items 208,537 249,885 195,451 Extraordinary items - gain (loss) on prepayment of debt (7,147) (27,889) 1,832 Net Earnings $ 201,390 $ 221,996 $ 197,283 See notes to consolidated financial statements. F-3 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (In Thousands) Common Stock Net Preferred and Capital Retained Unrealized Stock Surplus Earnings Gain Balance at December 31, 1994 $168,484 $ 904 $223,095 $ 3,500 Adjustment for pooling of interests at April 3, 1995 - 454,969 - 2,400 Net earnings - - 197,283 - Change in unrealized - - - 234,600 Exercise of stock options - 8,721 - - Dividends on: Preferred Stock - - (25,397) - Common Stock - - (29,855) - Capital contribution from parent - 9,333 - - Change in foreign currency translation - 64 - - Balance at December 31, 1995 168,484 473,991 365,126 240,500 Net earnings - - 221,996 - Change in unrealized - - - (57,100) Dividends on: Preferred Stock - - (24,898) - Common Stock - - (560,860) - Purchases and redemptions (22,524) (14,388) - - Sale of preferred shares to employee benefit plan 16,800 - - - Capital contribution from parent - 468,666 - - Change in foreign currency translation - 1,102 - - Balance at December 31, 1996 162,760 929,371 1,364 183,400 Net earnings - - 201,390 - Change in unrealized - - - 157,800 Dividends on: Preferred Stock - - (15,071) - Common Stock - - - - Purchases and redemptions (162,760) - (153,333) - Issuance of Preferred Stock 72,154 - - - Capital contribution from parent - 16,707 - - Change in foreign currency translation - (299) - - Balance at December 31, 1997 $ 72,154 $945,779 $ 34,350 $341,200 See notes to consolidated financial statements. F-4 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands) Year ended December 31, Operating Activities: 1997 1996 1995 Net earnings $ 201,390 $ 221,996 $ 197,283 Adjustments: Extraordinary items 7,147 27,889 (1,832) Depreciation and amortization 76,434 79,425 47,760 Annuity benefits 278,829 271,821 254,650 Equity in net (earnings) losses of investee corporations 5,564 16,955 (15,237) Changes in reserves on assets 7,610 5,656 2,302 Realized gains on investing activities (135,657) (198,676) (84,995) Decrease (increase) in reinsurance and other receivables (189,643) 95,553 25,781 Decrease (increase) in other assets (48,309) 23,665 (10,955) Increase in insurance claims and reserves 206,900 9,171 137,180 Decrease in other liabilities (29,935) (211,697) (255,404) Increase in minority interest 36,440 52,333 18,989 Dividends from investees 4,799 4,799 9,568 Other, net (25,711) (3,989) (1,233) 395,858 394,901 323,857 Investing Activities: Purchases of and additional investments in: Fixed maturity investments (2,555,060) (2,128,015) (2,378,427) Equity securities (37,107) (10,528) (1,034) Investees and subsidiaries (93,841) - (68,591) Real estate, property and equipment (64,915) (38,035) (42,579) Maturities and redemptions of fixed maturity investments 897,786 615,849 308,526 Sales of: Fixed maturity investments 1,407,598 881,114 2,310,837 Equity securities 104,960 53,195 17,379 Investees and subsidiaries 32,500 284,277 - Real estate, property and equipment 23,289 7,981 27,759 Cash and short-term investments of acquired (former) subsidiary 2,714 (4,589) 392,100 Decrease (increase) in other investments (12,892) 594 (7,326) (294,968) (338,157) 558,644 Financing Activities: Fixed annuity receipts 493,708 573,741 457,525 Annuity surrenders, benefits and withdrawals (607,174) (517,881) (412,854) Additional long-term borrowings 184,150 288,775 337,076 Reductions of long-term debt (230,688) (582,288) (1,061,187) Borrowings from AFG 201,000 152,471 102,202 Payments to AFG (224,500) (61,000) (18,174) Issuance of Preferred Stock - 16,800 - Repurchases of Preferred Stock (243,939) (36,912) (2,880) Exercise of stock options - - 8,721 Issuance of trust preferred securities 149,353 72,412 - Capital contribution 18,667 18,666 9,333 Cash dividends paid (15,071) (24,898) (25,397) (274,494) (100,114) (605,635) Net Increase (Decrease) in Cash and Short-term Investments (173,604) (43,370) 276,866 Cash and short-term investments at beginning of period 404,831 448,201 171,335 Cash and short-term investments at end of period $ 231,227 $ 404,831 $ 448,201 See notes to consolidated financial statements. F-5 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS _______________________________________________________________________________ INDEX TO NOTES A. Mergers J. Minority Interest B. Accounting Policies K. Preferred Stock C. Acquisitions and Sales of Subsidiaries L. Common Stock and Investees M. Income Taxes D. Segments of Operations N. Extraordinary Items E. Investments O. Commitments and Contingencies F. Investment in Investee Corporations P. Quarterly Operating Results G. Cost in Excess of Net Assets Acquired Q. Insurance H. Payable to American Financial Group R. Additional Information I. Other Long-Term Debt _______________________________________________________________________________ A. Mergers On April 3, 1995, American Financial Corporation ("AFC") merged with a newly formed subsidiary of American Financial Group, Inc. ("AFG"), a new company formed to own 100% of the common stock of both AFC and American Premier Underwriters, Inc. ("American Premier" or "APU"). In the transaction, Carl H. Lindner and members of his family, who owned 100% of the Common Stock of AFC, exchanged their AFC Common Stock for approximately 55% of American Financial Group voting common stock. Former shareholders of American Premier, including AFC and its subsidiaries, received shares of American Financial Group stock on a one-for-one basis. No gain or loss was recorded on the exchange of shares. AFC continues to be a separate SEC reporting company with publicly traded debentures and preferred stock. Holders of AFC Series F and G Preferred Stock were granted voting rights equal to approximately 21% of the total voting power of AFC shareholders immediately prior to the Mergers. At the close of business on December 31, 1996, AFG contributed to AFC 81% of the common stock of American Premier. Since AFC and American Premier are under the common control of AFG, the acquisition of American Premier has been recorded by AFC at AFG's historical cost in a manner similar to a pooling of interests. Accordingly, the historical consolidated financial statements of AFC for periods subsequent to the April 3, 1995 Mergers have been restated to include the accounts of American Premier. B. Accounting Policies Basis of Presentation The consolidated financial statements include the accounts of AFC and its subsidiaries. Mergers and changes in ownership levels of subsidiaries and affiliates have resulted in certain differences in the financial statements and have affected comparability between years. Certain reclassifications have been made to prior years to conform to the current year's presentation. All significant intercompany balances and transactions have been eliminated. With the exception of the acquisition of American Premier, all acquisitions have been treated as purchases and the results of operations of companies since their formation or acquisition are included in the consolidated financial statements. The preparation of the financial statements in conformity with g enerally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Changes in circumstances could cause actual results to differ materially from those estimates. F-6 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED AFC's voting ownership of subsidiaries and significant affiliates at December 31, was as follows: 1997 1996 1995 American Annuity Group, Inc. ("AAG") 81% 81% 81% American Financial Enterprises, Inc. ("AFEI") 80% 83% 83% American Premier Underwriters, Inc. 81% 81% - Chiquita Brands International, Inc. 39% 43% 44% Citicasters Inc. - (a) 38% (a) Sold in September 1996. Investments Debt securities are classified as "held to maturity" and reported at amortized cost if AFC has the positive intent and ability to hold them to maturity. Debt and equity securities are classified as "available for sale" and reported at fair value with unrealized gains and losses reported as a separate component of shareholders' equity if the securities are not classified as held to maturity or bought and held principally for selling in the near term. Only in certain limited circumstances, such as significant issuer credit deterioration or if required by insurance or other regulators, may a company change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. Premiums and discounts on mortgage-backed securities are amortized over their expected average lives using the interest method. Gains or losses on sales of securities are recognized at the time of disposition with the amount of gain or loss determined on the specific identification basis. When a decline in the value of a specific investment is considered to be other than temporary, a provision for impairment is charged to earnings and the carrying value of that investment is reduced. Short-term investments are carried at cost; loans receivable are stated primarily at the aggregate unpaid balance. Investment in Investee Corporations Investments in securities of 20%- to 50%-owned companies are generally carried at cost, adjusted for AFC's proportionate share of their undistributed earnings or losses. Cost in Excess of Net Assets Acquired The excess of cost of subsidiaries and investees over AFC's equity in the underlying net assets ("goodwill") is being amortized over 40 years. Insurance As discussed under "Reinsurance" below, unpaid losses and loss adjustment expenses and unearned premiums have not been reduced for reinsurance recoverable. Reinsurance In the normal course of business, AFC's insurance subsidiaries cede reinsurance to other companies to diversify risk and limit maximum loss arising from large claims. To the extent that any reinsuring companies are unable to meet obligations under the agreements covering reinsurance ceded, AFC's insurance subsidiaries would remain liable. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsurance policies. AFC's insurance subsidiaries report as assets (a) the estimated reinsurance recoverable on unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid to reinsurers applicable to the unexpired terms of policies in force. AFC's insurance subsidiaries also assume reinsurance from other companies. Income on reinsurance assumed is recognized based on reports received from ceding reinsurers. F-7 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Deferred Acquisition Costs Policy acquisition costs (principally commissions, premium taxes and other underwriting expenses) related to the production of new business are deferred ("DPAC"). For the property and casualty companies, the deferral of acquisition costs is limited based upon their recoverability without any consideration for anticipated investment income. DPAC is charged against income ratably over the terms of the related policies. For the annuity companies, DPAC is amortized, with interest, in relation to the present value of expected gross profits on the policies. Unpaid Losses and Loss Adjustment Expenses The net liabilities stated for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based upon (a) the accumulation of case estimates for losses reported prior to the close of the accounting period on the direct business written; (b) estimates received from ceding reinsurers and insurance pools and associations; (c) estimates of unreported losses based on past experience; (d) estimates based on experience of expenses for investigating and adjusting claims and (e) the current state of the law and coverage litigation. These liabilities are subject to the impact of changes in claim amounts and frequency and other factors. In spite of the variability inherent in such estimates, management believes that the liabilities for unpaid losses and loss adjustment expenses are adequate. Changes in estimates of the liabilities for losses and loss adjustment expenses are reflected in the Statement of Earnings in the period in which determined. Annuity Benefits Accumulated Annuity receipts and benefit payments are recorded as increases or decreases in "annuity benefits accumulated" rather than as revenue and expense. Increases in this liability for interest credited are charged to expense and decreases for surrender charges are credited to other income. Life, Accident and Health Reserves Liabilities for future policy benefits under traditional ordinary life, accident and health policies are computed using a net level premium method. Computations are based on anticipated investment yield (primarily 7%), mortality, morbidity and surrenders and include provisions for unfavorable deviations. Reserves are modified as necessary to reflect actual experience and developing trends. Assets Held In and Liabilities Related to Separate Accounts Investment annuity deposits and related liabilities represent primarily deposits maintained by several banks under a previously offered tax-deferred annuity program. AAG receives an annual fee from each bank for sponsoring the program; if depositors elect to purchase an annuity from AAG, funds are transferred to AAG. Premium Recognition Property and casualty premiums are earned over the terms of the policies on a pro rata basis. Unearned premiums represent that portion of premiums written which is applicable to the unexpired terms of policies in force. On reinsurance assumed from other insurance companies or written through various underwriting organizations, unearned premiums are based on reports received from such companies and organizations. For traditional life, accident and health products, premiums are recognized as revenue when legally collectible from policyholders. For interest- sensitive life and universal life products, premiums are recorded in a policyholder account which is reflected as a liability. Revenue is recognized as amounts are assessed against the policyholder account for mortality coverage and contract expenses. F-8 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Policyholder Dividends Dividends payable to policyholders are included in "Accounts payable, accrued expenses and other liabilities" and represent estimates of amounts payable on participating policies which share in favorable underwriting results. The estimate is accrued during the period in which the related premium is earned. Changes in estimates are included in income in the period determined. Policyholder dividends do not become legal liabilities unless and until declared by the boards of directors of the insurance companies. Income Taxes AFC and American Premier have each filed consolidated federal income tax returns which include all 80%-owned U.S. subsidiaries, except for certain life insurance subsidiaries and their subsidiaries. At the close of business on December 31, 1996, AFG contributed 81% of the common stock of American Premier to AFC. Accordingly, AFC and American Premier will file a consolidated return for 1997. Deferred income taxes are calculated using the liability method. Under this method, deferred income tax assets and liabilities are determined based on differences between financial reporting and tax bases and are measured using enacted tax rates. Deferred tax assets are recognized if it is more likely than not that a benefit will be realized. Benefit Plans AFC provides retirement benefits to qualified employees of participating companies through contributory and noncontributory defined contribution plans. Contributions to benefit plans are charged against earnings in the year for which they are declared. Prior to 1997, both AFC and American Premier had contributory employee savings plans and noncontributory Employee Stock Ownership Retirement Plans ("ESORP"). Effective January 1, 1997, these ESORP plans were combined into a new retirement and savings plan. Under the retirement portion of the plan, company contributions (approximately 6% of covered compensation in 1997) are invested primarily in securities of AFG and affiliates. Under the savings portion of the plan, AFC matches a specific portion of employee contributions. AFC and many of its subsidiaries provide health care and life insurance benefits to eligible retirees. AFC also provides postemployment benefits to former or inactive employees (primarily those on disability) who were not deemed retired under other company plans. The projected future cost of providing these benefits is expensed over the period the employees earn such benefits. Minority Interest For balance sheet purposes, minority interest represents the interests of non-controlling shareholders in AFC subsidiaries, including preferred securities issued by trust subsidiaries of AAG, and AFG's direct ownership interest in American Premier and AFEI. For income statement purposes, minority interest expense represents those shareholders' interest in the earnings of AFC subsidiaries as well as accrued distributions on the trust preferred securities. Statement of Cash Flows For cash flow purposes, "investing activities" are defined as making and collecting loans and acquiring and disposing of debt or equity instruments and property and equipment. "Financing activities" include obtaining resources from owners and providing them with a return on their investments, borrowing money and repaying amounts borrowed. Annuity receipts, benefits and withdrawals are also reflected as financing activities. All other activities are considered "operating". Short-term investments having original maturities of three months or less when purchased are considered to be cash equivalents for purposes of the financial statements. F-9 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Issuances of Stock by Subsidiaries and Investees Changes in AFC's equity in a subsidiary or an investee caused by issuances of the subsidiary's or investee's stock are accounted for as gains or losses where such issuance is not a part of a broader reorganization. Fair Value of Financial Instruments Methods and assumptions used in estimating fair values are described in Note R to the financial statements. These fair values represent point-in- time estimates of value that might not be particularly relevant in predicting AFC's future earnings or cash flows. C. Acquisitions and Sales of Subsidiaries and Investees Millennium Dynamics, Inc. In December 1997, AFC completed the sale of the assets of its software solutions and consulting services subsidiary, Millennium Dynamics, Inc. ("MDI"), to a subsidiary of Peritus Software Services, Inc. for $30 million in cash and 2,175,000 shares of Peritus common stock. AFC recognized a pretax gain of approximately $50 million on the sale. Chiquita During the second half of 1997, Chiquita issued 4.6 million shares of its common stock in acquisitions of operating businesses. AFC recorded a pretax gain in the fourth quarter of 1997 of approximately $11 million representing the excess of AFC's equity in Chiquita following the issuances of its common stock over AFC's previously recorded carrying value. Citicasters In September 1996, AFC sold its investment in Citicasters to Jacor Communications for approximately $220 million in cash plus warrants to purchase Jacor common stock. AFC realized a pretax gain of approximately $169 million, before minority interest of $6.5 million, on the sale. Buckeye In March 1996, American Premier sold Buckeye Management Company to Buckeye's management (including an AFG director who resigned in March 1996) and employees for $60 million in cash, net of transaction costs. AFC recognized a $33.9 million pretax gain on the sale. D. Segments of Operations AFC operates its property and casualty insurance business in three major segments: nonstandard automobile, specialty lines, and commercial and personal lines. AFC's annuity and life business primarily sells tax-deferred annuities to employees of primary and secondary educational institutions and hospitals. These insurance businesses operate throughout the United States. In addition, AFC has owned significant portions of the voting equity securities of certain companies (investee corporations - see Note F). The Financial Accounting Standards Board issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", which is scheduled to become effective during the fourth quarter of 1998. The implementation of SFAS No. 131 is not expected to have a material effect on the segments currently disclosed by AFC. F-10 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The following tables (in thousands) show AFC's assets, revenues and operating profit (loss) by significant business segment. Capital expenditures, depreciation and amortization are not significant. Operating profit (loss) represents total revenues less operating expenses. Goodwill and its amortization have been allocated to the various segments to which they apply. General corporate assets and expenses have not been identified or allocated by segment. 1997 1996 1995 Assets Property and casualty insurance (a) $ 7,517,856 $ 7,116,088 $ 7,443,115 Annuities and life 7,693,463 7,009,127 6,600,377 Other 325,949 674,297 501,417 15,537,268 14,799,512 14,544,909 Investment in investees 200,714 199,651 306,545 $15,737,982 $14,999,163 $14,851,454 Revenues (b) Property and casualty insurance: Premiums earned: Nonstandard automobile $ 1,205,200 $ 1,183,098 $ 954,210 Specialty lines 1,055,935 976,150 995,528 Commercial and personal lines 563,217 684,776 697,512 Other lines 29 488 1,453 2,824,381 2,844,512 2,648,703 Investment and other income 448,849 500,897 465,998 3,273,230 3,345,409 3,114,701 Annuities and life (c) 638,348 585,079 444,082 Other 146,888 200,315 54,086 4,058,466 4,130,803 3,612,869 Equity in net earnings (losses) of investees (5,564) (16,955) 15,237 $ 4,052,902 $ 4,113,848 $ 3,628,106 Operating Profit (Loss) Property and casualty insurance: Underwriting: Nonstandard automobile $ 33,456 $ 1,015 ($ 60,316) Specialty lines 10,888 154,329 50,690 Commercial and personal lines (33,882) (72,513) 5,315 Other lines (d) (52,021) (163,540) (31,721) (41,559) (80,709) (36,032) Investment and other income 311,169 359,002 357,617 269,610 278,293 321,585 Annuities and life 93,794 77,119 79,579 Other (e) (24,076) 1,086 (164,503) 339,328 356,498 236,661 Equity in net earnings (losses) of investees (5,564) (16,955) 15,237 $ 333,764 $ 339,543 $ 251,898 (a) Not allocable to segments. (b) Revenues include sales of products and services as well as other income earned by the respective segments. (c) Represents primarily investment income. (d) Represents primarily losses related to asbestos and other environmental matters ("A&E"). (e) Includes holding company expenses. F-11 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED E. Investments Bonds, redeemable preferred stocks and other stocks at December 31, consisted of the following (in millions): 1997 Held to Maturity Amortized Market Gross Unrealized Cost Value Gains Losses Bonds and redeemable preferred stocks: United States Government and government agencies and authorities $ - $ - $ - $ - States, municipalities and political subdivisions 72.0 73.6 1.8 (.2) Foreign government 8.3 8.9 .6 - Public utilities 459.7 466.7 8.3 (1.3) Mortgage-backed securities 868.9 899.4 30.6 (.1) All other corporate 1,711.2 1,753.7 43.6 (1.1) Redeemable preferred stocks - - - - $3,120.1 $3,202.3 $84.9 ($2.7) 1997 Available for Sale Amortized Market Gross Unrealized Cost Value Gains Losses Bonds and redeemable preferred stocks: United States Government and government agencies and authorities $ 600.8 $ 618.6 $ 18.1 ($ .3) States, municipalities and political subdivisions 86.7 89.3 2.6 - Foreign government 55.9 57.9 2.1 (.1) Public utilities 359.3 374.7 15.7 (.3) Mortgage-backed securities 1,715.7 1,779.4 65.5 (1.8) All other corporate 4,336.9 4,536.9 200.0 - Redeemable preferred stocks 70.4 76.0 5.9 (.3) $7,225.7 $7,532.8 $309.9 ($ 2.8) Other stocks $ 153.3 $ 446.2 $293.7 ($ .8) 1996 Held to Maturity Amortized Market Gross Unrealized Cost Value Gains Losses Bonds and redeemable preferred stocks: United States Government and government agencies and authorities $ - $ - $ - $ - States, municipalities and political subdivisions 80.0 79.9 1.1 (1.2) Foreign government 8.5 9.0 .5 - Public utilities 501.4 501.4 6.4 (6.4) Mortgage-backed securities 935.9 949.0 18.8 (5.7) All other corporate 1,965.3 1,988.8 34.8 (11.3) Redeemable preferred stocks - - - - $3,491.1 $3,528.1 $61.6 ($24.6) 1996 Available for Sale Amortized Market Gross Unrealized Cost Value Gains Losses Bonds and redeemable preferred stocks: United States Government and government agencies and authorities $ 472.2 $ 475.7 $ 7.3 ($ 3.8) States, municipalities and political subdivisions 39.6 39.7 .5 (.4) Foreign government 94.5 94.3 .8 (1.0) Public utilities 443.8 453.6 13.1 (3.3) Mortgage-backed securities 1,626.3 1,637.9 28.1 (16.5) All other corporate 3,624.4 3,733.0 122.2 (13.6) Redeemable preferred stocks 61.8 60.4 1.5 (2.9) $6,362.6 $6,494.6 $173.5 ($41.5) Other stocks $ 142.4 $ 327.7 $191.6 ($ 6.3) The table below sets forth the scheduled maturities of bonds and redeemable preferred stocks based on carrying value as of December 31, 1997. Data based on market value is generally the same. Mortgage-backed securities had an average life of approximately 6.5 years at December 31, 1997. Held to Available Maturity Maturity for Sale One year or less 6% 3% After one year through five years 32 18 After five years through ten years 30 37 After ten years 4 18 72 76 Mortgage-backed securities 28 24 100% 100% Certain risks are inherent in connection with fixed maturity securities, including loss upon default, price volatility in reaction to changes in interest rates, and general market factors and risks associated with reinvestment of proceeds due to prepayments or redemptions in a period of declining interest rates. Included in equity securities at December 31, 1997 and 1996 are $313 million and $220 million, respectively, of securities of Provident Financial Group, Inc. which exceeded 10% of Shareholders' Equity. F-12 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Realized gains (losses) and changes in unrealized appreciation (depreciation) on fixed maturity and equity security investments are summarized as follows (in thousands): Fixed Equity Tax Maturities Securities Effects Total 1997 Realized $ 11,542 $ 34,464 ($ 16,102) $ 29,904 Change in Unrealized 220,320 107,600 (114,772) 213,148 1996 Realized (16,545) 13,075 8,199 4,729 Change in Unrealized (272,583) 70,000 70,904 (131,679) 1995 Realized 77,963 6,065 (13,915) 70,113 Change in Unrealized 810,690 43,700 (288,001) 566,389 Transactions in fixed maturity investments included in the Statement of Cash Flows consisted of the following (in millions): Maturities and Gross Gross Purchases Redemptions Sales Gains Losses 1997 Held to Maturity $ 5.6 $422.3 $ 8.0 $ .5 ($ 1.0) Available for Sale 2,549.5 475.5 1,399.6 37.7 (25.7) Total $2,555.1 $897.8 $1,407.6 $38.2 ($26.7) 1996 Held to Maturity $ 202.2 $331.0 $ 9.3 $ 2.4 ($ 1.2) Available for Sale 1,925.8 284.8 871.8 29.6 (47.3) Total $2,128.0 $615.8 $ 881.1 $32.0 ($48.5) 1995 Held to Maturity $ 774.8 $175.2 $ 12.9 $ 1.9 ($ 2.3) Available for Sale 1,603.6 133.3 2,297.9 88.0 (9.6) Total $2,378.4 $308.5 $2,310.8 $89.9 ($11.9) Securities classified as "held to maturity" having an amortized cost of $8.2 million, $9.5 million and $14.7 million were sold for a loss of $170,000, $159,000 and $1.8 million in 1997, 1996 and 1995, respectively, due to significant deterioration in the issuers' creditworthiness. F-13 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED F. Investment in Investee Corporations All of the companies named in the following table have been subject to the rules and regulations of the SEC. The market value of AFC's investment in Chiquita was $391 million and $306 million at December 31, 1997 and 1996, respectively. AFC's investment (and common stock ownership percentage) and equity in net earnings and losses of investees are stated below (dollars in thousands): Investment (Ownership %) Equity in Net Earnings (Losses) 12/31/97 12/31/96 1997 1996 1995 Chiquita (a) $200,714 (39%) $199,651 (43%) ($5,564) ($18,415) $ 3,628 Citicasters (b) - - - 1,460 4,702 American Premier(c) - - - - 6,907 $200,714 $199,651 ($5,564) ($16,955) $15,237 <FN> (a) Equity in net earnings (losses) excludes AFC's share of amounts included in extraordinary items. (b) Sold in September 1996. (c) Accounted for as an 81% subsidiary beginning in April 1995. </FN> Chiquita is a leading international marketer, producer and distributor of bananas and other quality fresh and processed food products. Summarized financial information for Chiquita at December 31, is shown below (in millions): 1997 1996 1995 Current Assets $ 783 $ 844 Non-current Assets 1,618 1,623 Current Liabilities 483 464 Non-current Liabilities 1,138 1,279 Shareholders' Equity 780 724 Net Sales of Continuing Operations $2,434 $2,435 $2,566 Operating Income 100 84 176 Income (Loss) from Continuing Operations - (28) 28 Discontinued Operations - - (11) Extraordinary Loss from Debt Refinancings - (23) (8) Net Income (Loss) - (51) 9 Net Income (Loss) Attributable to Common Shares (17) (63) 1 G. Cost in Excess of Net Assets Acquired At December 31, 1997 and 1996, accumulated amortization of the excess of cost over net assets of purchased subsidiaries amounted to approximately $133 million and $121 million, respectively. Amortization expense was $11.6 million in 1997, $10.8 million in 1996 and $9.2 million in 1995. F-14 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED H. Payable to American Financial Group Following the Mergers, American Premier agreed to lend up to $675 million to AFC under a line of credit. Borrowings under the credit line bore interest at 11-5/8%. On December 27, 1996, American Premier paid a dividend to AFG which consisted of the $675 million note receivable plus accrued interest. Subsequently, AFG contributed $450 million of the note to AFC. Also subsequent to the Mergers, American Premier entered into a credit agreement with AFG under which American Premier and AFG made loans of up to $250 million available to each other. The balance outstanding under the credit line bore interest at a variable rate of one percent over LIBOR. In December 1997, AFG's credit agreements with AFC and APU were replaced with a ten-year reciprocal Master Credit Agreement among AFG, three AFG subsidiary holding companies including APU, AFC and AFC's direct parent, AFC Holding Company, under which funds are made available to each other at one percent over LIBOR. At December 31, 1997 and 1996, AFC and APU had outstanding borrowings due AFG and AFC Holding under the above agreements of $344.5 million (plus accrued interest of $8.3 million) and $400.4 million (plus accrued interest of $21.6 million), respectively. I. Other Long-Term Debt Long-term debt consisted of the following at December 31, (in thousands): 1997 1996 Holding Companies: AFC 9-3/4% Debentures due April 2004, less discount of $737 and $1,146 (imputed rate - 9.8%) $ 79,792 $164,368 APU 9-3/4% Subordinated Notes due August 1999, including premium of $1,224 and $1,912 (imputed rate - 8.8%) 92,127 93,604 APU 10-5/8% Subordinated Notes due April 2000, including premium of $1,559 and $2,629 (imputed rate - 8.8%) 43,889 54,595 APU 10-7/8% Subordinated Notes due May 2011, including premium of $1,584 and $1,642 (imputed rate - 9.6%) 17,586 18,496 GAHC notes payable under bank line 45,000 - Other 8,267 8,441 $286,661 $339,504 Subsidiaries: AAG notes payable under bank lines $107,000 $ 44,700 AAG 11-1/8% Senior Subordinated Notes due February 2003 24,080 24,080 AAG 9-1/2% Senior Notes - 40,845 Notes payable secured by real estate 49,525 52,543 Other 13,479 16,247 $194,084 $178,415 F-15 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED At December 31, 1997, sinking fund and other scheduled principal payments on debt for the subsequent five years, adjusted to reflect financing transactions through February 1998, were as follows (in thousands): Holding Companies Subsidiaries Total 1998 $ - $ 1,983 $ 1,983 1999 90,903 2,087 92,990 2000 42,330 8,803 51,133 2001 - 38,509 38,509 2002 50,399 61,440 111,839 Debentures purchased in excess of scheduled payments may be applied to satisfy any sinking fund requirement. The scheduled principal payments shown above assume that debentures previously purchased are applied to the earliest scheduled retirements. At December 31, 1997, the weighted average interest rate on amounts borrowed under Great American Holding Corporation's ("GAHC") bank credit line was 6.81%. In February 1998, AFC entered into a new unsecured credit agreement with a group of banks and the GAHC and APU agreements were terminated. Under the terms of the new agreement, AFC can borrow up to $300 million through December 2002. Borrowings bear interest at floating rates based on prime or LIBOR. At December 31, 1997 and 1996, the weighted average interest rate on amounts borrowed under AAG's bank credit lines was 6.80% and 6.68%, respectively. In January 1998, AAG replaced its existing bank lines with a new $200 million unsecured credit agreement. Loans under the credit agreement mature from 2000 to 2003 and bear interest at floating rates based on prime or LIBOR. In February 1998, AAG borrowed $50 million under the line and retired its 11-1/8% Notes (including $24.3 million principal amount held by AAG entities). Significant retirements of long-term debt since January 1, 1996, have been as follows (in millions): Year Principal Cost AFC Debentures 1996 $138.2 $147.9 1997 85.0 96.7 American Premier Notes 1996 160.1 177.2 1997 11.3 12.5 AAG Notes 1996 78.0 84.2 1997 40.8 42.5 1998 (2 mos) 24.1 24.8 Cash interest payments of $98 million, $83 million and $137 million were made on long-term borrowings in 1997, 1996 and 1995, respectively. J. Minority Interest Minority interest in AFC's balance sheet is comprised of the following (in thousands): 1997 1996 Interest of AFG (parent) and non-controlling shareholders in subsidiaries' common stock $284,619 $231,858 Preferred securities issued by subsidiary trusts 225,000 75,000 $509,619 $306,858 F-16 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Trust Issued Preferred Securities Wholly-owned subsidiary trusts of AAG have issued $225 million of preferred securities and, in turn, purchased $225 million of newly-authorized AAG subordinated debt issues which provide interest and principal payments to fund the respective trusts' obligations. The preferred securities are mandatorily redeemable upon maturity or redemption of the subordinated debt. The preferred securities are summarized as follows: Date of Optional Issuance Issue (Maturity Date) Amount Redemption Dates November 1996 9-1/4% TOPrS (2026) $75,000,000 On or after 11/7/2001 March 1997 8-7/8% Pfd (2027) 75,000,000 On or after 3/1/2007 May 1997 7-1/4% ROPES (2041) 75,000,000 Prior to 9/28/2000 and after 9/28/2001 AAG effectively provides unconditional guarantees of its trusts' obligations. Minority Interest Expense Minority interest expense is comprised of (in thousands): 1997 1996 1995 Interest of AFG (parent) and non-controlling shareholders in earnings of subsidiaries $29,978 $53,717 $28,165 Accrued distributions on trust issued preferred securities 15,499 1,031 - $45,477 $54,748 $28,165 K. Preferred Stock Under provisions of both the Nonvoting (4.0 million shares authorized) and Voting (4.0 million shares authorized) Cumulative Preferred Stock, the Board of Directors may divide the authorized stock into series and set specific terms and conditions of each series. At December 31, 1997, the outstanding shares of AFC's Preferred Stock consisted of the following: Series J, no par value; $25.00 liquidating value per share; annual dividends per share $2.00; redeemable at $25.75 per share beginning December 2005 declining to $25.00 at December 2007; 2,886,161 shares (stated value $72.2 million) outstanding at December 31, 1997. At December 31, 1996, AFC's outstanding 11,900,725 shares of Series F Preferred Stock had a stated value of $145.4 million; its 1,964,158 shares of Series G Preferred Stock had a stated value of $17.4 million. In December 1997, AFC retired all shares of its Series F and G Preferred Stock in exchange for approximately $244 million in cash and 2,886,161 million shares of the Series J Preferred Stock. AFC recognized a charge to retained earnings of $153.3 million representing the excess of total consideration paid over the stated value of the preferred stock retired. In December 1996, AFC redeemed 1.6 million shares of its Series F Preferred Stock for $31.9 million and, in October 1996, purchased 250,000 shares of Series F from its ESORP for $5.0 million. In December 1996, AFC issued 1.6 million shares of its Series G Preferred Stock to its ESORP for $16.8 million. During 1995, AFC retired its mandatory redeemable preferred stock for an aggregate of $2.9 million. F-17 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED L. Common Stock At December 31, 1997, American Financial Group owned all of the outstanding shares of AFC's Common Stock. The number of shares of AFC Common Stock outstanding were reduced from 45,000,000 to 10,593,000 in connection with the retirement of Series F and G Preferred Stock in December 1997. M. Income Taxes The following is a reconciliation of income taxes at the statutory rate of 35% and income taxes as shown in the Statement of Earnings (in thousands): 1997 1996 1995 Earnings before income taxes and extraordinary items $333,764 $339,543 $251,898 Extraordinary items before income taxes (11,201) (34,892) 1,551 Adjusted earnings before income taxes $322,563 $304,651 $253,449 Income taxes at statutory rate $112,897 $106,628 $ 88,707 Effect of: Minority interest 10,168 18,507 9,533 Losses utilized (3,164) (43,789) (40,292) Amortization of intangibles 3,362 3,065 3,015 Foreign income taxes 2,954 3,474 359 State income taxes (2,739) 4,140 81 Dividends received deduction (2,002) (7,450) (7,823) Tax exempt interest (384) (597) (897) Other 81 (1,323) 3,483 Total provision 121,173 82,655 56,166 Amounts applicable to extraordinary items 4,054 7,003 281 Provision for income taxes as shown on the Statement of Earnings $125,227 $ 89,658 $ 56,447 Adjusted earnings before income taxes consisted of the following (in thousands): 1997 1996 1995 Subject to tax in: United States $331,855 $318,919 $256,417 Foreign jurisdictions (9,292) (14,268) (2,968) $322,563 $304,651 $253,449 The total income tax provision consists of (in thousands): 1997 1996 1995 Current taxes (credits): Federal $ 27,875 $ 22,450 $ 38,512 Foreign - (1,735) (1,213) State (2,544) 6,369 124 Deferred taxes: Federal 96,301 55,250 18,191 Foreign (459) 321 552 $121,173 $ 82,655 $ 56,166 F-18 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED For income tax purposes, certain members of the AFC consolidated tax group had the following carryforwards available at Decem ber 31, 1997 (in millions): Expiring Amount { 1998 - 2002 $ 35 Operating Loss{ 2003 - 2007 95 { 2008 - 2012 60 Capital Loss 1999 91 Other - Tax Credits 23 Deferred income tax assets and liabilities reflect temporary differences between the carrying amounts of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. The significant components of deferred tax assets and liabilities included in the Balance Sheet at December 31, were as follows (in millions): 1997 1996 Deferred tax assets: Net operating loss carryforwards $ 66.6 $ 83.7 Capital loss carryforwards 32.0 68.2 Insurance claims and reserves 287.5 289.8 Other, net 148.8 142.2 534.9 583.9 Valuation allowance for deferred tax assets (97.9) (131.9) 437.0 452.0 Deferred tax liabilities: Deferred acquisition costs (127.4) (124.9) Investment securities (268.2) (189.8) (395.6) (314.7) Net deferred tax asset $ 41.4 $137.3 The gross deferred tax asset has been reduced by a valuation allowance based on an analysis of the likelihood of realization. Factors considered in assessing the need for a valuation allowance include: (i) recent tax returns, which show neither a history of large amounts of taxable income nor cumulative losses in recent years, (ii) opportunities to generate taxable income from sales of appreciated assets, and (iii) the likelihood of generating larger amounts of taxable income in the future. The likelihood of realizing this asset will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period in which the developments on which they are based become known. The aggregate valuation allowance decreased by $34 million in 1997 due primarily to the expiration of American Premier's loss carryforwards. Cash payments for income taxes, net of refunds, were $43.7 million, $40.2 million and $14.8 million for 1997, 1996 and 1995, respectively. F-19 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED N. Extraordinary Items Extraordinary items represent AFC's proportionate share of gains and losses related to debt retirements by the following companies. Amounts shown are net of minority interest and income tax benefits (in thousands): 1997 1996 1995 Holding Companies: AFC (parent) ($5,395) ($ 9,672) ($1,713) APU (parent) (502) (2,636) 7,102 GAHC - - (611) Subsidiaries: AAG (1,250) (7,159) (201) Other - 57 - Investee: Chiquita - (8,479) (2,745) ($7,147) ($27,889) $1,832 O. Commitments and Contingencies Loss accruals have been recorded for various environmental and occupational injury and disease claims and other contingencies arising out of the railroad operations disposed of by American Premier's predecessor, Penn Central Transportation Company ("PCTC"), prior to its bankruptcy reorganization in 1978. Any ultimate liability arising therefrom in excess of previously established loss accruals would normally be attributable to pre-reorganization events and circumstances and accounted for as a reduction in capital surplus. However, under purchase accounting in connection with the Mergers, any such excess liability will be charged to earnings in AFC's financial statements. American Premier's liability for environmental claims ($39.5 million at December 31, 1997) consists of a number of proceedings and claims seeking to impose responsibility for hazardous waste remediation costs at certain railroad sites formerly owned by PCTC and certain other sites where hazardous waste was allegedly generated by PCTC's railroad operation. It is difficult to estimate remediation costs for a number of reasons, including the number and financial resources of other potentially responsible parties, the range of costs for remediation alternatives, changing technology and the time period over which these matters develop. American Premier's liability is based on information currently available and is subject to change as additional information becomes available. American Premier's liability for occupational injury and disease claims of $58.1 million (included in other liabilities) at December 31, 1997, includes pending and expected claims by former employees of PCTC for injury or disease allegedly caused by exposure to excessive noise, asbestos or other substances in the railroad workplace. Anticipated recoveries of $35.2 million on these liabilities are included in other assets. Recorded amounts are based on the accumulation of estimates of reported and unreported claims and related expenses and estimates of probable recoveries from insurance carriers. AFC has accrued approximately $14.2 million at December 31, 1997, for environmental costs and certain other matters associated with the sales of former operations. In management's opinion, the outcome of the items discussed under "Uncertainties" in Management's Discussion and Analysis and the above claims and contingencies will not, individually or in the aggregate, have a material adverse effect on AFC's financial condition or results of operations. F-20 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED P. Quarterly Operating Results (Unaudited) The operations of certain of AFC's business segments are seasonal in nature. While insurance premiums are recognized on a relatively level basis, claim losses related to adverse weather (snow, hail, hurricanes, tornadoes, etc.) may be seasonal. Historically, Chiquita's operations are significantly stronger in the first and second quarters than in the third and fourth quarters. Quarterly results necessarily rely heavily on estimates. These estimates and certain other factors, such as the nature of investees' operations and discretionary sales of assets, cause the quarterly results not to be necessarily indicative of results for longer periods of time. The following are quarterly results of consolidated operations for the two years ended December 31, 1997 (in millions): 1st 2nd 3rd 4th Total Quarter Quarter Quarter Quarter Year 1997 Revenues $ 945.6 $ 987.5 $1,034.7 $1,085.1 $4,052.9 Earnings before extraordinary items 62.0 60.7 34.9 50.9 208.5 Extraordinary items (.1) - (6.9) (.1) (7.1) Net earnings 61.9 60.7 28.0 50.8 201.4 1996 Revenues $1,030.2 $1,032.8 $1,163.5 $ 887.3 $4,113.8 Earnings (loss) before extraordinary items 78.6 58.5 119.2 (6.4) 249.9 Extraordinary items (7.4) (10.0) (8.3) (2.2) (27.9) Net earnings (loss) 71.2 48.5 110.9 (8.6) 222.0 In the fourth quarter of 1997, AFC increased California workers' compensation reserves by approximately $25 million due to increased claims severity related to business written in 1996 and 1997. The fourth quarter of 1997 also includes income of $46.3 million (included in "other income") from the sale of development rights in New York City partially offset by a $9.0 million charge related to insurance recoverables of American Premier's prior railroad business. In the third quarter of 1996, AFC increased A&E reserves by recording a non-cash pretax charge of $80 million and recorded losses due to Hurricane Fran of approximately $30 million. During the past two years, AFC has continued a strategy of disposing of non-core investments. Sales of significant affiliates have included the following: MDI (December 1997); Citicasters (September 1996); and Buckeye (March 1996). See Note C for a more detailed description of these and other transactions. Sales of subsidiaries in 1997 also includes a fourth quarter pretax charge of $17 million relating to operations expected to be sold or otherwise disposed of in 1998. Realized gains (losses) on sales of securities and affiliates amounted to (in millions): 1st 2nd 3rd 4th Total Quarter Quarter Quarter Quarter Year 1997 $ 2.5 $4.2 $ 29.7 $54.6 $ 91.0 1996 52.6 5.7 172.5 (28.3) 202.5 F-21 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Q. Insurance Securities owned by insurance subsidiaries having a carrying value of approximately $1.4 billion at December 31, 1997, were on deposit as required by regulatory authorities. Insurance Reserves The liability for losses and loss adjustment expenses for certain long-term scheduled payments under workers' compensation, auto liability and other liability insurance has been discounted at rates ranging from 4% to 8%. As a result, the total liability for losses and loss adjustment expenses at December 31, 1997, has been reduced by $60 million. The following table provides an analysis of changes in the liability for losses and loss adjustment expenses, net of reinsurance (and grossed up), over the past three years on a GAAP basis (in millions): 1997 1996 1995 Balance at beginning of period $3,404 $3,393 $2,187 Reserves of American Premier at date of the Mergers - - 1,090 Provision for losses and loss adjustment expenses occurring in the current year 2,045 2,179 2,116 Net increase (decrease) in provision for claims occurring in prior years 31 (48) (139) 2,076 2,131 1,977 Payments for losses and loss adjustment expenses occurring during: Current year (840) (999) (987) Prior years (1,151) (1,121) (874) (1,991) (2,120) (1,861) Balance at end of period $3,489 $3,404 $3,393 Add back reinsurance recoverables 736 720 704 Unpaid losses and loss adjustment expenses included in Balance Sheet, gross of reinsurance $4,225 $4,124 $4,097 Net Investment Income The following table shows (in millions) investment income earned and investment expenses incurred by AFC's insurance companies. 1997 1996 1995 Insurance group investment income: Fixed maturities $830.6 $817.8 $727.3 Equity securities 6.4 8.2 5.3 Other 10.6 13.5 7.9 847.6 839.5 740.5 Insurance group investment expenses (*) (37.3) (38.5) (33.8) $810.3 $801.0 $706.7 (*) Included primarily in "Other operating and general expenses" in the Statement of Earnings. F-22 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Statutory Information AFC's insurance subsidiaries are required to file financial statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). Net earnings and policyholders' surplus on a statutory basis for the insurance subsidiaries were as follows (in millions): Policyholders' Net Earnings Surplus 1997 1996 1995 1997 1996 Property and casualty companies $159 $276 $200 $1,916 $1,659 Life insurance companies 74 67 76 324 287 Reinsurance In the normal course of business, AFC's insurance subsidiaries assume and cede reinsurance with other insurance companies. The following table shows (in millions) (i) amounts deducted from property and casualty premiums in connection with reinsurance ceded, (ii) amounts included in income for reinsurance assumed and (iii) reinsurance recoveries deducted from losses and loss adjustment expenses. 1997 1996 1995 Reinsurance ceded to: Non-affiliates $614 $518 $476 Affiliates - - 33 Reinsurance assumed - including involuntary pools and associations 89 58 93 Reinsurance recoveries 296 306 304 R. Additional Information Total rental expense for various leases of office space, data processing equipment and railroad rolling stock was $36 million, $34 million and $35 million for 1997, 1996 and 1995, respectively. Sublease rental income related to these leases totaled $5.4 million in 1997, $6.1 million in 1996 and $6.2 million in 1995. Future minimum rentals, related principally to office space and railroad rolling stock, required under operating leases having initial or remaining noncancelable lease terms in excess of one year at December 31, 1997, were as follows: 1998 - $37 million; 1999 - $31 million; 2000 - $22 million; 2001 - $18 million; 2002 - $13 million; and $30 million thereafter. At December 31, 1997, minimum sublease rentals to be received through the expiration of the leases aggregated $14 million. Other operating and general expenses included charges for possible losses on agents' balances, reinsurance recoverables and other receivables in the following amounts: 1997 - $7.6 million; 1996 - $0; and 1995 - $0. The aggregate allowance for such losses amounted to approximately $131 million and $123 million at December 31, 1997 and 1996, respectively. F-23 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Fair Value of Financial Instruments The following table presents (in millions) the carrying value and estimated fair value of AFC's financial instruments at December 31. 1997 1996 Carrying Fair Carrying Fair Value Value Value Value Assets: Bonds and redeemable preferred stocks $10,653 $10,735 $ 9,986 $10,023 Other stocks 446 446 328 328 Investment in investee corporations 201 391 200 306 Liabilities: Annuity benefits accumulated $ 5,528 $ 5,319 $ 5,366 $ 5,180 Long-term debt: Holding companies 287 301 340 362 Subsidiaries 194 195 178 183 Trust preferred securities 225 230 75 77 AFC Preferred Stock 72 74 163 264 When available, fair values are based on prices quoted in the most active market for each security. If quoted prices are not available, fair value is estimated based on present values, discounted cash flows, fair value of comparable securities, or similar methods. The fair value of the liability for annuities in the payout phase is assumed to be the present value of the anticipated cash flows, discounted at current interest rates. Fair value of annuities in the accumulation phase is assumed to be the policyholders' cash surrender amount. Financial Instruments with Off-Balance-Sheet Risk On occasion, AFC and its subsidiaries have entered into financial instrument transactions which may present off- balance-sheet risks of both credit and market risk nature. These transactions include commitments to fund loans, loan guarantees and commitments to purchase and sell securities or loans. At December 31, 1997, AFC and its subsidiaries had commitments to fund credit facilities and contribute limited partnership capital totaling $29 million. Restrictions on Transfer of Funds and Assets of Subsidiaries Payments of dividends, loans and advances by AFC's subsidiaries are subject to various state laws, federal regulations and debt covenants which limit the amount of dividends, loans and advances that can be paid. Under applicable restrictions, the maximum amount of dividends available to AFC in 1998 from its insurance subsidiaries without seeking regulatory clearance is approximately $221 million. Total "restrictions" on intercompany transfers from AFC's subsidiaries cannot be quantified due to the discretionary nature of the restrictions. Benefit Plans AFC expensed approximately $21 million in 1997, $17 million in 1996 and $16 million in 1995 for contributions to its retirement and employee savings plans. Transactions With Affiliates In December 1997, AFC recognized a gain of $32.5 million on the sale of development rights to AFG at their appraised value. In 1995, a subsidiary of AFC sold a house to its Chairman for its appraised value of $1.8 million. F-24 PART IV ITEM 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Documents filed as part of this Report: 1. Financial Statements are included in Part II, Item 8. 2. Financial Statement Schedules: A. Selected Quarterly Financial Data is included in Note P to the Consolidated Financial Statements. B. Schedules filed herewith for 1997, 1996 and 1995: Page I - Condensed Financial Information of Registrant S-2 V - Supplemental Information Concerning Property-Casualty Insurance Operations S-4 All other schedules for which provisions are made in the applicable regulation of the Securities and Exchange Commission have been omitted as they are not applicable, not required, or the information required thereby is set forth in the Financial Statements or the notes thereto. 3. Exhibits - see Exhibit Index on page E-1. (b) Reports on Form 8-K: None S-1 AMERICAN FINANCIAL CORPORATION - PARENT ONLY SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT (In Thousands) _____________________________________________________________________ Condensed Balance Sheet December 31, Assets: 1997 1996 Cash and short-term investments $ 10,793 $ 46,493 Investment in securities 908 100,871 Receivables from affiliates 577,661 606,416 Investment in subsidiaries 1,960,328 1,494,447 Investment in investees 22,680 22,647 Other assets 9,550 7,807 $2,581,920 $2,278,681 Liabilities and Capital: Accounts payable, accrued expenses and other liabilities $ 95,513 $ 37,156 Payable to affiliates 1,004,865 791,821 Long-term debt 88,059 172,809 Shareholders' equity 1,393,483 1,276,895 $2,581,920 $2,278,681 Condensed Statement of Earnings Year ended December 31, Income: 1997 1996 1995 Dividends from: Subsidiaries $ 1,247 $861,178 $195,578 Investees 177 177 1,012 1,424 861,355 196,590 Equity in undistributed earnings of subsidiaries and investees 358,816 (470,879) 154,346 Realized gains (losses) on sales of: Securities (2,618) 963 2,389 Investees 421 33,950 (5,034) Subsidiaries 731 - - Investment and other income 55,404 46,980 35,226 414,178 472,369 383,517 Costs and Expenses: Interest charges on intercompany borrowings 28,772 81,623 4,198 Interest charges on other borrowings 15,250 21,796 86,655 Other operating and general expenses 36,392 29,407 40,766 80,414 132,826 131,619 Earnings before income taxes and extraordinary items 333,764 339,543 251,898 Provision for income taxes 125,227 89,658 56,447 Earnings before extraordinary items 208,537 249,885 195,451 Extraordinary items - gain (loss) on prepayment of debt (7,147) (27,889) 1,832 Net Earnings $201,390 $221,996 $197,283 S-2 AMERICAN FINANCIAL CORPORATION - PARENT ONLY SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - CONTINUED (In Thousands) ______________________________________________________________________ Condensed Statement of Cash Flows Year ended December 31, 1997 1996 1995 Operating Activities: Net earnings $201,390 $221,996 $197,283 Adjustments: Extraordinary items 7,147 27,889 (1,832) Equity in earnings of subsidiaries (224,949) (291,270) (235,448) Equity in net (earnings) losses of investees 212 379 (4,254) Depreciation and amortization 1,086 505 492 Realized losses (gains) on sales of subsidiaries and investments 2,262 (34,913) 2,797 Change in receivables from and payables to affiliates 69,603 (10,497) (103,634) Increase (decrease) in payables 57,017 12,790 (50,718) Dividends from subsidiaries and investees 1,424 105,485 166,337 Other 841 7,522 38,421 116,033 39,886 9,444 Investing Activities: Purchases of subsidiaries and other investments (122,969) (43,491) (154,404) Sales of subsidiaries and other investments 143,728 104,967 46,831 Other, net 250 265 (73) 21,009 61,741 (107,646) Financing Activities: Additional long-term borrowings 150 75 98,828 Reductions of long-term debt (94,049) (177,899) (252,880) Borrowings from affiliates 315,000 407,500 785,876 Repayments of borrowings from affiliates (153,500) (263,564) (523,197) Issuance of Preferred Stock - 16,800 - Repurchases of Preferred Stock (243,939) (36,912) (2,880) Exercise of stock options - - 8,721 Capital contributions from parent 18,667 18,666 9,333 Cash dividends paid (15,071) (24,898) (25,397) (172,742) (60,232) 98,404 Net Increase (Decrease) in Cash and Short-term Investments (35,700) 41,395 202 Cash and short-term investments at beginning of period 46,493 5,098 4,896 Cash and short-term investments at end of period $ 10,793 $ 46,493 $ 5,098 S-3 AMERICAN FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE V - SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS THREE YEARS ENDED DECEMBER 31, 1997 (IN MILLIONS) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F (a) RESERVES FOR DEFERRED UNPAID CLAIMS (b) AFFILIATION POLICY AND CLAIMS DISCOUNT (c) WITH ACQUISITION ADJUSTMENT DEDUCTED IN UNEARNED EARNED REGISTRANT COSTS EXPENSES COLUMN C PREMIUMS PREMIUMS CONSOLIDATED PROPERTY-CASUALTY ENTITIES (d) 1997 $260 $4,225 $60 $1,329 $2,824 1996 $257 $4,124 $64 $1,248 $2,845 1995 $2,649 COLUMN G COLUMN H COLUMN I COLUMN J COLUMN K CLAIMS AND CLAIM ADJUSTMENT EXPENSES AMORTIZATION PAID INCURRED RELATED TO OF DEFERRED CLAIMS NET POLICY AND CLAIM INVESTMENT CURRENT PRIOR ACQUISITION ADJUSTMENT PREMIUM INCOME YEARS YEARS COST EXPENSE WRITTEN CONSOLIDATED PROPERTY-CASUALTY ENTITIES (d) 1997 $316 $2,045 $ 31 $620 $1,991 $2,858 1996 $335 $2,179 ($ 48) $628 $2,120 $2,788 1995 $303 $2,116 ($139) $577 $1,861 $2,688 (a) Grossed up for reinsurance recoverables of $736 and $720 at December 31, 1997 and 1996, respectively. (b) Discounted at rates ranging from 4% to 8%. (c) Grossed up for prepaid reinsurance premiums of $189 and $153 at December 31, 1997 and 1996, respectively. (d) Includes American Premier's Insurance Group after April 1, 1995. Signatures Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, American Financial Corporation has duly caused this Report to be signed on its behalf by the undersigned, duly authorized. American Financial Corporation Signed: March 26, 1998 BY:s/Carl H. Lindner Carl H. Lindner Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Signature Capacity Date s/Carl H. Lindner Chairman of the Board March 26, 1998 Carl H. Lindner of Directors s/Carl H. Lindner, III Director March 26, 1998 Carl H. Lindner, III s/Theodore H. Emmerich Director* March 26, 1998 Theodore H. Emmerich s/James E. Evans Director March 26, 1998 James E. Evans s/S. Craig Lindner Director March 26, 1998 S. Craig Lindner s/William R. Martin Director* March 26, 1998 William R. Martin s/Fred J. Runk Senior Vice President and March 26, 1998 Fred J. Runk Treasurer (principal financial and accounting officer) * Member of the Audit Committee INDEX TO EXHIBITS AMERICAN FINANCIAL CORPORATION Number Exhibit Description 3(a) Amended Articles of Incorporation ____ 3(b) Amended Code of Regulations ____ 4 Instruments defining the The rights of holders of rights of security holders. Registrant's Preferred Stock are defined in the Articles of Incor- poration. Registrant has no out- standing debt issues exceeding 10% of the assets of Registrant and consolidated subsidiaries. 10(a) Nonqualified Auxiliary RASP ____ 10(b) 1997 Bonus Plan. ____ 12 Computation of ratios of earnings to fixed charges and fixed charges and preferred dividends. ____ 21 Subsidiaries of the Registrant. ____ 27 Financial data schedule. (**) (*) Incorporated herein by reference. (**) Copy included in Report filed electronically with the Securities and Exchange Commission. E-1